The EU must press ahead with ambitious reforms of its carbon market if it is to continue to stimulate emission reductions, according to a new study.
Prices have fallen to record lows this year due to a surplus of carbon emission allowances, this reduces the incentive for participants to cut emissions.
The report – produced jointly by the London School of Economics’ (LSE) Grantham Institute and the Climate Change Economics and Policy at Leeds University – is the latest in a series of warnings over the future of the world’s most important carbon market.
“The lack of flexibility in the structure of the EU ETS cap, and its inability to adjust to radically shifted wider economic conditions, in the shape of the financial crisis, threatens to undermine its efficacy in providing incentives for abatement,” it says.
The study identifies three reasons for the drop in price. The original cap being placed too high, the recession cutting economic output (and the emissions to go with it) and an underestimate of how deep companies could cut their greenhouse gases through innovation.
Despite this challenge it finds the Emissions Trading Scheme (ETS) has reduced the emissions of the big emitters taking part by 40-80 Mega tonnes of CO2 a year, or around 2-4% of the cap on their total greenhouse gas output.
A higher price would encourage companies to cut emissions so that they don’t have to buy excess allowances and to provide an incentive to have spares to auction.
LSE research found that when an industry was facing a shortage of allowances, they found ways to change their behaviour and invested in new innovations to meet their cap.
The cement industry changed its chemical processes and began using biomass for some of its kiln fuel to meet its obligations.
A higher carbon price would drive further innovations that could see other industrial sectors emulate some cement firms and cut their emissions below the capped level.
The report also suggests that the large number of surplus credits, held by steel and cement manufacturers in particular, could derail efforts.
Spare emission allowances equivalent to 672 MtCO2 will pass from the previous round of the ETS to its next phase. These spares reduce the need for new emission reduction efforts by their holders in the next phase.
The EU plan to withhold 900m credits would only compensate for this in the short term.
The low price has meant that there has been less investment in low carbon energy generation and efficiency savings than expected.
A summary of previous work found that the ETS was not having a large impact on investment decisions.
The volatile carbon price was cited as the main reason for this hesitation.
Despite this, the report points out that some carbon intensive investments may have been deterred as a result of the ETS.
The EU reforms are expected to be put to the vote in April.