Cap-and-Trade Market Failure

The NY Times recently editorialized on the collapse in the price of carbon on the European Climate Exchange (the ECX system of emissions trading) after the Copenhagen Conference. Although the price of carbon emissions has collapsed to $18.20 per ton, the Times is optimistic: "Fortunately, there is good reason to believe the price of European emission permits will rise over time. Their price tends to fall when the price of oil or the economy slows---dynamics that reduce energy usage and naturally cut emissions of carbon. As the world fell even deeper into recession last year, the price of permits tumbled from a peak of around $45 per ton in July 2008."

The graphic above shows the three relvant time series and a forecast for each. The upper panel shows total volume on the ECX and the second panel shows the price of futures contracts for carbon emissions in December 2010 (data from the ECX). My business-as-usual (BAU) forecast is for a continued price decline and a rebound next year. The bottom panel shows World Oil Prices (data from the US EIA). In the model as in the Times analysis, futures prices of carbon emissions and world oil prices are intimately related. And, my BAU forecast is for increasing oil prices (this shouldn't be a surprise).

The other part of the Times analysis, however, is equally important. Everything depends on what happens in the world economy.

If Europe manages to disconnect from the world economy (no carbon leakage) and fix CO2 emissions, the forecast above would suggest the ECX would be on the path to developing an effective cap-and-trade system.

However, if Europe continues to be linked to the world system (more likely?), there will be continued instability in emissions with no evident cap. If that happens, the cap-and-trade system would probably collapse.

In 2008, the GAO did an analysis of the ECX and concluded it wasn't working as anticipated and made a number of other interesting points I'll discuss in a future posting. Through all this hand-wringing, however, it's important to remember that the best proven way to limit carbon emissions is to control the growth of the world system (best in that controversial cap-and-trade markets are not need, proven in that we've just seen slowing growth of the world system reduce emissions and least likely given the political reality of growth mania).