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Time to Unleash the Carbon Market?

What’s a ton of carbon (dioxide equivalent) worth? Not much if you ask the world’s carbon markets. The graph below summarizes prices and quantities covered by existing carbon emissions trading programs (green) and carbon taxes (blue).  Nearly all carbon market prices are below $13/ton.


          Source: State and trends of carbon pricing 2015

These low carbon prices have been making headlines, particularly in the context of the two largest carbon trading programs: Europe’s Emissions Trading Scheme (ETS) and California’s GHG emissions trading program. In California last month, the carbon allowance auction price hit the floor of $12.73, with only 11 percent of the 77.75 million allowances up for sale finding a willing buyer. European allowance prices have averaged around €6  in the first half of 2016, far below the €30 or more needed to encourage a shift away from coal-fired electricity generation.

The European lawmaker in charge of overhauling the EU ETS post-2020 has compared his carbon market without a price to “ a car without an engine”.  I would spin this automotive analogy a little differently.  As far as I can tell, these carbon markets have a working engine. We’re just not allowing them enough room to drive.

Here in California, the GHG emissions trading program (covering 85 percent of the state’s GHG emissions) has been cast in a supporting role. The updated scoping plan projects that over 70 percent of emissions abatement required under the 2020 target will be driven by “complementary measures” (e.g. mandated investments in low carbon technologies) rather than the permit price.  Once you factor in offsets and the potential for emissions leakage and reshuffling, there’s not much work left for the carbon market to do.

In Europe the story is a little different. Because the ETS is less comprehensive (covering  approximately 45 percent of emissions), many complementary measures are designed to tap abatement potential that lies outside the reach of the carbon market.  But there are also important prescriptive measures mandating  emissions reductions that fall within the scope of EU ETS. To put this into some perspective, the value of interventions (i.e. subsidies, feed in tariffs, etc. ) designed to accelerate investments in  renewable energy has significantly exceeded the market value of emissions allowances in recent years (thanks Carolyn Fischer  for highlighting this fact).

Prescriptive policies come at a cost

This preference for using prescriptive policies –rather than market mechanisms- to coordinate abatement helps explain why carbon prices are so low.   Some simple graphs summarize the basics behind this cause and effect.

In the cartoon graph below, each colored block represents a different abatement activity (e.g. coal-to-gas fuel switching, renewable energy investments,  energy  efficiency improvements, etc.). Think Sesame Street meets the McKinsey curve. The width of the block measures achievable emissions reductions. The height of the blocks measures the cost per ton of emissions reduced.


In this cartoon cap-and-trade story, suppose baseline emissions are 200 and policy makers are seeking a 25% reduction. If we rely entirely on a permit market to get us there, we’d allocate 150 permits and let the market figure out where the 50 units of abatement will come from. An efficient market would drive investment in  the lowest cost options:  A  + B + 1/2 C. The total abatement cost incurred to meet the target would be  (20 x $10) + (20 x $20) + (10X$50) = $1100. The market clearing price (and the marginal abatement cost/ton) would be $50.

Now imagine that, in addition to the permit market, complimentary measures are introduced to mandate deployment of options D  and E.  These mandates take us 80% of the way towards meeting the emissions target.  The role of the carbon market has been seriously diminished –  we need only  10 more units of abatement to hit the target.


Under this scenario, the carbon market will incentivize investment in 10 units of A. The permit price drops to $10.  The total cost of meeting the emissions  target rises to  10 x $10 + 20 x $100 + 20 x $150 = $5100. And we wring our hands about low carbon prices and broken carbon markets.

Of course, this cartoon picture omits lots of real-world complexities (see this important EI paper for a more detailed analysis of California’s abatement supply and allowance demand). But it illustrates two real-world considerations. First, when complementary measures mandate relatively expensive abatement options, the carbon price we observe in the market will not reflect the marginal cost of reducing emissions. Second, a reliance on complementary measures to reduce emissions can significantly drive up the costs of hitting a given emissions target.

In California and in Europe, there is growing evidence that low allowance prices in the carbon market belie much higher abatement costs associated with complimentary policies.  For example, this paper estimates that the California Solar Initiative delivered emissions reductions at a cost of $130 – $196 per metric ton of CO2.  California’s  LCFS credit price (which reflects the marginal incentive to reduce a ton of MCO2e)  is currently averaging around $120 per metric ton CO2. In Europe, researchers estimate that the implicit costs of renewable energy targets per metric ton of CO2 are on the order of hundreds of euros for solar (and wind in some locations).

Time to unleash the carbon markets?

Looking out past 2020, more ambitious targets are being set and the process of charting a course to meet these targets is now underway.  This could be a turning point for carbon markets. How heavily are we going to lean on prescriptive policies versus carbon markets to meet these future emissions abatement goals?  If the increased stringency of future emissions targets is met with increasingly aggressive mandates and measures, we may be signing up for another round of low carbon prices.

I’m not suggesting we should leave *all*  of the driving to the carbon markets. There are good reasons for complementing carbon markets with some truly complementary policies and mandates (some of which are fleshed out here). But there are also costs associated with keeping the carbon market mechanism on a tight leash while chasing emissions reductions with prescriptive mandates and programs (see, for example, Jim’s recent post here).  Right now, carbon markets are hamstrung by a growing medley /cacophony of policies that drive allowance prices down. If we want to see carbon markets really work, we need to give them more work to do.



27 thoughts on “Time to Unleash the Carbon Market? Leave a comment

  1. Perhaps the low trading prices provide the opportunity to decarbonize faster than initially scheduled. This is useful as bad climate news seems to be piling up swiftly and highlighting the need to decarbonize quickly. What are some suggestions for… How might we design mechanisms to tighten the allowance levels when prices are “low”?

  2. I agree that designers of carbon markets have been too caution in terms of their demands and that greater stringency is needed. One thought on your chart: It would be interesting to see gasoline/diesel taxes, too. These are functionally equivalent to a carbon fee on these fuels of course. If all the gasoline taxes in the United Kingdom were called, “carbon taxes,” they would amount to about $420 per ton of CO2. The U.K. gas tax is about 76 p/liter. This implies a price increment of 2.86p/gallon or $3.80/gallon at post Brexit vote exchange rates.

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