Global efforts to reduce greenhouse gases typically rely on emissions norms, taxes and subsidies. More recently, carbon trading systems covering a broad spectrum of the economy have apparently been taking effect as well. In theory, these allow for an efficient allocation of resources, but it took years of learning-by-doing to make the European trading system, the world’s first and biggest, function properly. Today, other countries are adopting a similar approach and this is likely to bring significant emissions reductions and create opportunities for carbon saving technologies.

Our observations

• The EU Emissions Trading System (ETS) has been in place since 2005 as a “cap-and-trade” system. In this system, a total amount of carbon credits (or allowances) is distributed across European businesses each year. Some of these are allocated (for free), especially in sectors where emissions savings are difficult to achieve, while others are auctioned. At the end of each year, each company has to prove it can cover all of its actual carbon emissions with the credits it has received, bought at the initial auction or purchased from other businesses (the “trade” part) with excess credits. If approved, international (non-EU) investments in carbon savings may also be used to cover one’s own emissions.
• Every year, the total amount of credits available throughout the EU (i.e. the “cap”) is lowered in order to force businesses to decrease their overall emissions. From 2021, the yearly reduction will be 2.2% and total emission should be down by at least 40%, compared to 2005 levels. Currently, the system covers about 45% of all carbon emissions in the EU (it applies to major polluters only).
• At the outset, too many allowances were available (and too many allocated for free) and allowances were traded far too cheaply to be of any effect. More recently, additional measures (e.g. removing excess allowances from the system) have driven the price to a more effective ~€26 per ton and there continues to be debate over setting a minimum “price floor” to prevent a new collapse in the future (e.g. due to an economic crisis or a Brexit scenario in which British companies are able to dump credits on the European market).
• The ETS is supposed to cover the entire European industry, but not all sectors are treated equally. Power companies have to buy all their allowances from auctions (although exceptions are made for the poorest member states), while airlines, for instance, get most of their allowances (~85%) for free because zero-emission flying is still a long way off. Also, the system only covers the production-end of value chains and this can produce undesirable results. To illustrate, a construction company may choose to save costs by using less insulation material and thus pass on the costs of heating (and hence of emission credits) to the building’s end-user.
• After several experiments in major cities (e.g. Beijing, Shanghai and Shenzhen), China plans to introduce a nationwide carbon trading scheme in 2020. It will start with the power sector and expand to other industries over time. The U.S. cap-and-trade system is as yet limited to the state-level (e.g. California). A recent plan to introduce a similar system in the state of Oregon was quashed by Republicans frustrating the voting procedure.
• Various nations have introduced carbon taxes, mostly in the form of additional fuel taxes in specific sectors (e.g. transportation). The prices per ton vary greatly, although the bulk remains below $30 per ton (Scandinavian countries and Switzerland charge the most) and so does the percentage of total emissions these taxes cover. On average, OECD nations’ carbon taxes cover only 24% of total emissions.
• Many studies have tried to estimate the actual long-term social costs of a ton of CO2 (e.g. the damage done to agriculture and other sectors, human health, direct damage of extreme weather events, etc.). While outcomes vary greatly, a recent meta-analysis concluded that the average social cost amounts to ~$112 per ton of CO2.
• Carbon offset programs (e.g. planting trees to compensate for emissions) have lost popularity over the years. The total volume of offsets has dropped from 135 million metric tons of CO2 equivalent (MtCO2) in 2008 to 63 MtCO2 in 2016. The costs of offsetting vary per method and region (from <$1 in India to $12 per ton in developed economies), but the average price is $3 per ton. Most of these offset options (e.g. reforestation) do not qualify within the European ETS.

Connecting the dots

To stop global temperatures from rising, at some point in the future, net greenhouse gas (ghg) emissions will need to come to a full stop. This can be achieved through targeted (governmental) action that singles out sectors and activities where gains are relatively easy and cheap (e.g. in the power sector). The problem with such solutions, however, is that they do not necessarily address the right sectors and simply go for the ones that are easiest to tax or in which norms can be applied with the greatest ease (e.g. transportation fuels or vehicles). Moreover, economy-wide gains need to be made and sectoral exemptions (e.g. in aviation or long-distance shipping) can easily lead to those sectors postponing any meaningful efforts.

Carbon trading schemes offer a promising alternative in theory, as they would be able to cover a far greater share of economic activities and do so more efficiently. That is, the rationale of cap-and-trade systems is that resources are allocated according to the logic of the market; those sectors which can reduce emissions relatively easily and cheaply will do so and sell credits to others for whom this is more difficult and expensive. Furthermore, they incentivize private capital to invest in R&D for carbon-reducing technologies. As such, in the short-term, carbon trading would be much more effective and efficient than taxes, norms or subsidies. Also, in the longer term, it could even provide a financial incentive for efforts to remove carbon dioxide from the atmosphere. That is, for some activities (e.g. specific industrial processes) no practical zero-emissions alternative may be developed and these emissions would have to be compensated by a form of negative emissions.

Cap-and-trade works on a national level, but even more so on an international level, as the costs of carbon savings still vary greatly throughout the global economy. This is also why, under certain conditions, European business can acquire credits from certified projects in the developing world (where carbon savings still require minimal investments).

Unfortunately, the practice of emissions trading has proved more difficult than the theory and carbon prices have been too low to have any impact. This was due to an excess of carbon credits across the EU (in part due the economic crisis), too cheap means of gaining credits from international projects and so-called “carbon leakage”. The latter refers to businesses offshoring their most carbon-intensive production methods, outside of the EU, in order to escape cap-and-trade systems. Even more so, these companies were able to earn €25 billion from selling excess allowances they had been given for free.
Today, improvements to the system have driven up the price of carbon and it has become a relevant incentive for European companies (although it still falls well short of covering the actual cost of climate change). Looking ahead, various models forecast carbon prices to rise further, from €30 to a maximum of €50 per ton. These higher prices are to result from a further tightening of the total emissions allowances (43% down in 2030 from 2005 levels) and additional mechanisms such as the market stability reserve. The latter will take unused allowances off the market (e.g. in case of economic slowdown) to stimulate relative emissions savings regardless of the overall performance of the European economy.

Higher carbon prices in Europe will, finally, push industries to innovate and clean up their processes. Also, the emergence of similar systems across developed economies could mean that European companies will remain competitive as their international competitors face the same challenges (and costs). Moreover, significantly higher carbon prices would stimulate more businesses to reduce emissions beyond their own “needs” (as defined by a gradual pathway towards 2030, for instance) and make money off credits they can sell to others. For some companies, this could very well become a business model in its own right. In fact, albeit in a different regulatory framework, Tesla has earned more than €1.7 million from selling credits to other car manufacturers who were not able (or willing) to put zero-emission vehicles on European roads.

Implications

• Countries such as China and India may introduce carbon credits to improve the carbon-efficiency of their industries, but rapid economic growth will nevertheless lead to an absolute increase of carbon emissions. Whereas the EU will be able to lower the total amount of credits each year, developing countries will actually have to offer more credits each year (but less each year relative to economic growth). China nevertheless claims that its total emissions will peak in 2030 and drop thereafter.
• Methods to capture CO2 from the atmosphere have received a lot of attention over the last months. Quite a few startups have emerged in this field and all claim to make rapid progress. As it stands, the lowest estimates of the costs of these “direct-air capture” technologies still project a hefty €90 per ton of CO2 and unless further cost reductions are realized, these technologies will not “work” with a carbon price of €30-50. Common forms of carbon offsetting (e.g. reforestation or supplying efficient cooking stoves to developing economies) are much cheaper than European carbon credits, but in most cases, these do not qualify for the ETS. Also, as the long-term potential of these solutions is limited, other forms of carbon storage may be needed nonetheless.
• Capturing (and storing) carbon directly at the source (CCS) is often portrayed as a solution for (new or existing) coal-fired power plants. However, CCS could make these plants three times as expensive and it would most probably be more rational to replace them by renewable energy sources. In sectors in which clean alternatives are not available, such as the cement industry, CCS could become competitive if carbon prices continue to rise (e.g. the lower estimate of CCS in cement production is €42/ton CO2).