As the European Union begins the second phase of its emissions trading scheme (ETS), what are the lessons that the United States can apply to its own carbon trading program? During today's OnPoint, Massachusetts Institute of Technology's Denny Ellerman, discusses his new report, "The European Union's Emissions Trading System in Perspective." Ellerman assesses the success of the ETS thus far and explains which areas the United States should focus on for improvement. Ellerman discusses some of the key issues with the first phase of the ETS and explains how the United States can minimize the price volatility of carbon credits that Europe experienced early on.
Monica Trauzzi: Welcome to OnPoint. I'm Monica Trauzzi. Joining me today is Denny Ellerman of the Massachusetts Institute of Technology and co-author of the new report, "The European Union's Emissions Trading System in Perspective." Denny, thanks for coming on the show.
Denny Ellerman: Thank you. It's a pleasure, Monica, to be here.
Monica Trauzzi: Perfect timing for this report as the Senate prepares to take up the Lieberman-Warner bill in June. And the report is focusing on lessons learned from the European emissions trading scheme. Let's break it down very generally first. Do you think it was a success, what we've seen so far, or a failure? How would you characterize it?
Denny Ellerman: I think a definite success. I think one needs to take into account what its objective was, which is really to put the mechanism is in place to create the infrastructure of a trading system during, this was called a trial period and a learning-by-doing pilot phase for what they viewed as the real test, which was the second trading period that just started and that coincides with the Kyoto Protocol. And in that sense, I think those institutions are in place, there is a price on carbon. I think it's very hard to argue it's not a success.
Monica Trauzzi: And so, moving forward, into this second phase, do you see emissions reductions happening?
Denny Ellerman: Yes. And there were emissions reductions in the first phase as well. I mean there was a considerable price for carbon for the first year and a half of the program before surplus came to be revealed. And there were changes in dispatch of coal plants, others, I mean we're doing research on that, but there was some abatement. Now, it was not a large amount of abatement. It wasn't transforming in any sense, but the ambition of the trial period was very modest in terms of reductions. I don't think anyone doubts that with the caps that have been set for the second period, that there's not going to be a reduction. I'd say emissions would have been higher but for the caps.
Monica Trauzzi: What are the key areas where the U.S. has the most work to do in terms of creating an effective emissions policy, now that we're looking at what Europe has done over the last three years?
Denny Ellerman: I think it's working the politics of adopting a system. We know how to do it. I mean they actually learned from us in terms of, yes their two system was very influential in terms of setting an example that it could be done. And I think technically the issues here are not that complicated or not that different than what we've done for SO2 and for NOX. The real question is dealing with what I would call the real politics of this is a regional interests involved, their differing industry impacts. I mean it's real politics and working out the compromises that are necessary to pass legislation that is important.
Monica Trauzzi: In your report you point to several areas where the U.S. needs to improve upon what Europe has done, and one major issue with the ETS was the overall location of allowances. And so what can the U.S. do to preemptively ensure that we don't fall into a similar trap?
Denny Ellerman: A lot of the over-allocation problem was a data problem to start with. So, we stress in our report that one has to look at the conditions under which the trial period was created, which was in a big rush and there was very little time. It was incredible that they actually were able to put it into effect. But one of the consequences of that was that there was very little time to get the data right, particularly in terms of what installations were included, to do the modeling as to what the impacts would be. And the short of it is that in the initial period they ended up allocating more allowances than with emissions. Now, some of that was due to abatement, but I don't think there's any question that the allocations were greater than what the emissions would have been. And that became evident when the first data release took place. So I think one is get the data right. Now, I think our data is generally better. We've kept pretty good data. CO2 emissions from power plants have been measured now for 10 years, other areas. Registers have been put in place. I mean there's a lot of the data, but that's one of the lessons, is get the data, have the data in hand so that you know what the emissions are that are being capped and that it can be used for allocations, to the extent that you have free allocation.
Monica Trauzzi: And so we also ended up seeing these major price fluctuations in Europe. So, how do you minimize this price volatility? Because that's going to have an impact on incentives for people to not ...
Denny Ellerman: Right.
Monica Trauzzi: ... pollute and also advancements in technology, so there is a trickle-down effect. So, how do you ensure that that kind of volatility doesn't happen here?
Denny Ellerman: There is an initial what I would call a calibration problem. I mean the big price collapse that occurred when the first data was released was ... everyone knew what the cap was at that point. They didn't know what the emissions were going to be. And when they came in much lower than what people expected, that led to the collapse of price. I think in terms of how to provide the incentives the European system is very odd in that the price ultimately went to zero. And that was the result of a design feature of the system, which was a political decision at the beginning to make this a self-contained period, that there would be no carryover, no banking or borrowing between the first and the second period. And so that virtually guaranteed that either the price was going to be, at the end of the period, very high, at the penalty level, or zero, depending on what was the relationship between the total allowances for the three years and the cap. It turned out to be a surplus. But I think one of the important lessons for the U.S. in the European system is that, first of all, there's no reason not to have banking and borrowing. And the European system is unusual in that they allow borrowing, unrestricted borrowing from the next year's allocation. And it was used. There was no abuse of it. I mean this is the first experiment in actually using borrowing. And I think the research and everything we're looking at with now the data is in on the year, that you see firms that appear to have borrowed against their forward allocations, but then they made it up later. In some cases they probably saved themselves a lot of money because they borrowed when the price was high and then purchased later when the price turned out to be quite a bit lower. Whether that was a speculation on their part or they were just lucky we'll never know.
Monica Trauzzi: What happened with windfall profits in Europe?
Denny Ellerman: That's a very convoluted issue. We discuss that in great detail in the report. There are two points I think we would make. First of all is that you are creating value whenever you create a constraint and in a cap-and-trade system it's very evident that value is conveyed by the allowances. So, whomever you give those allowances to receive that value. And, of course, if you auction them the value goes to the government, so that's a very important issue and that's there. I mean somehow it's not clear whether that was fully understood. The second point we make is in considering those impacts it's very important to consider the state of, let's say, liberalization of electricity markets, which are always a big part of the power sector. It's a big part. And you have a system in Europe wherein part of the electricity market is liberalized and part of it isn't. And a lot, in where the electricity system isn't and you have sort of traditional cost plus regulation, of course, that value, it's not a cost because it's free allocation. It gets passed on to customers. But if the market has been liberalized, of course, the beauty of the systems, if you wish, it is there is an opportunity cost. I mean if you use one of these allowances given to you, you can't sell it, so you've foregone, it's a penny saved a penny earned sort of situation. So you ended up having both of those situations. I mean there were many cases where value was created, many cases where what was called windfall profits, in fact, was taken back. And then you think of Spain was the place where the regulators took all of those windfall profits back, did not pass them on to consumers. But that depended upon the state of regulation. So I think for us to think electricity regulation counts and realize you are creating value. I think people realize that.
Monica Trauzzi: In terms of legislation here in the U.S., Lieberman-Warner specifically, how much work needs to be done before we're at a point where we have a piece of legislation that's going to avoid similar problems that we saw in Europe?
Denny Ellerman: Let's take one. I mean prices will be volatile, whether we'd see as larger prices…there's no reason to have a zero price collapse or let's say going to zero. The price is higher and it falls, and then, I mean the SO2 price, after all, fell by 50 percent in the first year that it came in because emissions were not as high as people thought. So if you're going to have a cap-and-trade system, you're going to have volatile prices. Now, we have volatile prices. It's all a question of the degree of volatility and they're no more volatile than, one of points made in our report is they're are as volatile as electricity prices and natural gas and others. Not as volatile as crude oil prices or coal prices, but it's not an order of magnitude greater volatility than other commodities that these companies normally deal with.
Monica Trauzzi: Critics of the ETS say it failed. It was unsuccessful. Why in the world with the U.S. even want to go down the same route? The U.S. should consider something different. Is there any value to a criticism like that?
Denny Ellerman: I think these are people that disagree with the basic decision to have a system. There is an interesting feature in Europe that I think, compared to U.S. cap-and-trade systems, which is that sort of once the political decision was taken on it, particularly from industry, there was a lot of continued opposition. Where I would characterize the SO2 to program is much of the industry position, after it had been adopted, they were not necessarily for it before, but once it's adopted they supported the system. I mean they complied with it. Everyone in Europe complied with it as well, but they didn't fight it in the view as this is better than the alternative, which is our command-and-control regulation. I think in Europe a lot of industry likes the traditional form of regulation, so part of this is this is a different form of regulation and it's not as easy to work with in some ways. And depending on your point of view, that can have good or bad points.
Monica Trauzzi: Okay. We're going to end it right there on that note. Thanks for coming on the show.
Denny Ellerman: Thank you Monica.
Monica Trauzzi: This is OnPoint. I'm Monica Trauzzi. Thanks for watching.
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