European Climate Policy: Up in Smoke?

The design of the European Trading System was deeply flawed.

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Das E.ON Steinkohlekraftwerk Scholven steht am Mittwoch, 16. Dezember 2009, unter Dampf. Mit einer Nettogesamtleistung von rund 2200 Megawatt ist das Kraftwerk eines der groessten Steinkohlekraftwerke Europas und das groesste der E.ON Kraftwerke. Kohlekraftwerke werden wegen ihrem hohen CO2 Ausstoss zunehmend kritisch gesehen. In Kopenhagen versucht der Klimagipfel den CO2 Ausstoss und den amit verbundenen Klimawandel zu begrenzen. (AP Photo/Martin Meissner)--- Steam and smoke is seen over the coal burning power plant in Gelsenkirchen, Germany, on Wednesday, Dec. 16, 2009. Coal power plants are among the biggest producer of CO2, that is supposed to be responsible for climate change. The climate summit in Copenhagen, Denmark, is trying to reduce greenhouse gas emissions.

Robert Hahn is director of economics and professor at the Smith School, University of Oxford. Peter Passell is a senior fellow at the Milken Institute and editor of The Milken Institute Review. They co-founded, a web portal on economic regulation.

Once again, European policymakers are divided on a major issue. And this time, we feel their pain because our own views are divided, too. The issue is climate policy, specifically the EU's rejection this week of a proposal from Climate Commissioner Connie Hedegard to revise Europe's "cap-and-trade" system for limiting greenhouse gas emissions.

Worried that the price of emission allowances had fallen so low that industry would have little incentive to pare emissions further, Hedegard pushed a mid-course correction, called "backloading," under which market prices for emissions allowances would be raised by delaying a planned auction of new allowances. But the European Parliament narrowly rejected the plan in response to pleas from heavy industrial emitters – notably, those in Poland.

[See a collection of political cartoons on energy policy.]

We're of two minds here. Changing rules in mid-stream would have been a bad precedent, undermining the efficiency of the market by leading both buyers and sellers of emissions allowances to second-guess the constancy of government policies. On the other, the failure to sustain a reasonably high price for allowances means that innovation in emissions-containment techniques will be retarded, and that the market price will remain far below estimates of the external costs of adding greenhouse gases to the atmosphere.

With hindsight, it's pretty clear that the design of the European Trading System was deeply flawed.  It would have been far better to reduce price uncertainty by setting a price floor (and, arguably, a price ceiling) on emissions prices, with government buying emissions or issuing extra ones to keep prices within range.

The worst of all possible worlds is the one the Europeans made for themselves – an environment in which outcomes in the emissions allowance market is subject to ongoing lobbying, and Europe's commitment to doing its part in managing climate change is increasing suspect. Well, at least the EU (unlike the United States) is trying.

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