Carbon Trading: What Europe Can Actually Teach Us

Of all the questions about climate policy, one of the biggest is whether a cap-and-trade system for greenhouse gases will even work. Will it actually and tangibly reduce emissions? The only real-world example we have is the EU's Emissions Trading System, set up in 2005. Conservatives take it as a given that the ETS has failed—see Martin Livermore's Wall Street Journal column last week. But on closer inspection, the ETS seems to be working pretty well after a few early miscues, and there's plenty that American policymakers can learn from Europe's experience.

It's helpful to divide the ETS into phases. In Phase I (2005-2007), the cap only covered about 45 percent of EU emissions, including electric utilities, mining, and the steel and chemical industries. Crucially, according to a 2007 Lehman Brothers analysis, the European Commission had no good data on EU emissions, so they initially relied on industry estimates. As a result, member states gave out way more permits than there was actual pollution—meaning, in effect, the cap was set way too high at first. The price of carbon crashed to nearly zero, and emissions increased in some countries.

In another early stumble, the EU gave away nearly all of the pollution permits for free, rather than auctioning them off. Policymakers hoped that if electric utilities didn't have to pay for their carbon allowances, they would pass the savings on to ratepayers and consumers. But utilities didn't do that. Instead, they jacked up electricity prices and simply kept the value of the permits for themselves, earning windfall profits.

Happily, the United States should be able to avoid many of these blunders. For one, the Energy Information Administration has much more comprehensive data on U.S. carbon-dioxide emissions than Europe did in 2005. And, while the House climate bill only auctions off 15 percent of its allowances, it does give a hefty number to heavily regulated electricity distributors, which are required by law to pass on savings to ratepayers. Some watchdog groups like Public Citizen are worried that these distributors will wriggle free of oversight, and that's a real concern, but in theory, there's a mechanism to avoid windfall utility profits.

Moving on, in Phase II, the EU tightened its caps and started auctioning off a greater chunk of the pollution permits. According to Lehman, once the initial kinks were hammered out, the system "succeeded, and fairly quickly, in imposing a price on carbon." Emissions have now fallen for four straight years. According to the European Environment Agency (EEA), the EU-15 has slashed emissions 5 percent below 1990 levels, and is on pace for a 11.3 percent cut by 2012—easily exceeding the 8 percent goal required by the Kyoto Protocol. Here's a graph:

For the final batch of cuts, the EEA estimates that 7 percent will come from actual reductions, 1.4 percent from stuff like planting trees, and 3.3 percent through clean-energy projects in the developing world. Even if you consider the latter two actions somewhat dubious (I agree), that's still a significant real reduction driven by the cap. And, to be sure, some of the recent drop has been due to the global recession, but not all of it. In 2008, the EU economy shrunk 0.8 percent, but emissions fell much faster—3 percent. The European Commission credits the ETS with much of that drop.

There's also anecdotal evidence that Europe's carbon cap is having an effect. The U.K.-based consulting firm GHK recently studied more than a dozen companies in Europe and found that the cap-and-trade system was driving real changes in business behavior:

The reviewers found that these companies' major moves so far have been aimed at improving energy efficiency. "Energy efficiency is the first thing they look at," said James Medhurst, director at GHK Consulting. Power plants have become more efficient, companies have invested in new fleets of cars, airlines in new planes and transport companies in new trucks. ... [I]n internal operations, these companies have taken widespread measures to substitute high-energy-intensity goods and services with services that burn less energy. ...

As for jobs, the study shows that climate change policies among the companies reviewed have an impact on skills rather than on actual employment levels. "It's essentially a greening of existing jobs," said Medhurst. The researchers found a widespread need for new skills and a general need for upskilling, which companies are attempting to meet by gearing up the introduction of new training programs....

Switzerland-based Holcim (90,000 employees), one of the world's largest producers of cement, told researchers that the E.U. ETS and other market instruments such as the Clean Development Mechanism are key players in driving the company to reduce CO2 emissions. Holcim said it has achieved a 16.3 percent reduction in net CO2 emissions per ton of cement in 2007 from 1990 by optimizing products and processes, and investing in research and development such as bringing out new types of cement and using alternative fuels.

Now, it's true, a few special circumstances have helped Europe meet its targets more easily. Germany is well below 1990 emission levels thanks, in part, to the collapse of Eastern German heavy industry. And Britain's cuts came, in part, because Margaret Thatcher broke the coal-miners' union in the late '80s, which eventually led the country to shift to cleaner natural gas. That said, Europe has long had higher energy taxes and stricter efficiency standards than the United States, so you could argue that we have a lot more fat to trim, and that making initial cuts will actually, in many respects, be easier for us than it was for Europe.

My biggest caveat is that, when you look at Europe's "outsourced" emissions, the picture looks much grimmer. According to the Stockholm Environment Institute, Britain's carbon emissions have actually grown by 20 percent when you factor in imports from China. No domestic cap-and-trade system can fully work unless it's placed in a global context. But on the bright side, an international treaty would also make cutting emissions far cheaper. A recent analysis by PointCarbon found that EU permit prices—and hence the cost of reducing carbon emissions—would drop dramatically if the EU and the United States could link up cap-and-trade systems.

Bottom line: The EU cap-and-trade system suffered a slew of early mishaps, but the United States has been watching and learning, and we should be able to avoid most of those fumbles. What's more, now that the problems have been ironed out, Europe's cap genuinely appears to be working, spurring companies to become more energy-efficient and making meaningful cuts in emissions. That said, the China factor is still huge: Europe obviously can't stop global warming all by itself, and there's no substitute for an international treaty.

--Bradford Plumer