Limitations of an ETS

This article was originally published in the Calculus Carbon blog (https://calculuscarbon.com/blog) on July 29th, 2022

ETS as an asset class as well as a regulatory tool, has been leading the charge for carbon markets across the world. ETS markets help regulators align the incentive of market players with the NDC (Nationally Determined Contribution) targets through a fair and transparent market mechanism.

ETS, however isn't the only instrument out there that's available for regulators of these compliant markets. For instance, EU ETS is only one of the suite of tools in the European Commission's arsenal to meet its 'Fit for 55' package published in 2021 aimed at reducing the net GHG emissions by at least 55% by 2030, compared to 1990 levels.

Source: KPMG

When ETS failed at its mission

The recent success of the ETSs owing to the current all time high prices for EU ETS and California ETS, might serve to belie its limitations. As with any other policy tool, an ETS works well only when a certain set of underlying economic conditions are met. As a result, their efficacy is a function of the state of the current economic parameters.

In case of an ETS, the underlying assumption is that the companies or sectors with the lowest cost of decarbonisation shall be rewarded by trading of the emission allowances. Consequently, as the price of these allowances increases, companies or sectors are incentivised to decarbonise, due to a higher loss from having to buy more allowances or a higher profit from selling the excess.

Edge Case I

In case of a recession however, when the economic activity slows down and hence the total emissions, a surplus of allowances in the market leads to a sudden drop in price. This then unintentionally results in companies halting or reversing decarbonisation plans, which may take an unexpectedly long time to reverse.

The same actually materialised leading up to the 2008 global financial crisis, when a slowdown across European markets led to the EU ETS price dropping below €10/t and in fact remained there for over 9 years, even after the economic activity started to recover.

This reoccurred during March 2020 when the EU ETS price dropped from €24.07/t to €15.25/t at the start of COVID pandemic across Europe.

This speaks to the unreliability of depending solely on ETS as a method of regulating decarbonisation across economic cycles.

Edge Case II

In the event where the allowance prices rise too steeply in a short time, it becomes very difficult for companies to phase out their emissions organically is a structured way. As accurately pointed out in a Rabobank research,

Excess volatility brings additional uncertainty, which hampers investment decisions and growth. Companies require a longer lead time to feel comfortable regarding making the significant investments decisions required to transition to a less carbon-intensive economy. From this perspective, a gradual and predictable increase in the EU carbon price might work better for the EU in the long run. In this situation, companies would be more incentivised to make long-term investments in sustainable solutions.

This research spoke to the events in 2021, when the EU ETS price more than tripled from around €30/t at the beginning of 2021, to around €90/t in early 2022, when the Ukraine crisis led to a temporary fall back to €60/t before it soared to the current levels of €100+/t over the last 4 months.

Conclusion

With an ETS, policymakers use the emissions cap and let the market subsequently decide the price for each allowance. However, as apparent in both the edge cases highlighted above, it is hard for policymakers to occasionally step in while not seemingly meddle with the process of market finding its equilibrium.