Here’s How Europe’s Sputtering Economy Crashed the Carbon Market

There’s lots of angst in Euroland over the plunging price of European Union CO2 Allowances. Trading activity has crashed along with prices. And the Eurocrats are casting about ways to “fix” the “problem.” And Eurocrats being Eurocrats, their mooted fixes are interventionist monstrosities that make a mockery of the idea of a “market” for CO2.

The reason for the price decline is blindingly obvious. The European economy is sputtering, and lower industrial activity translates into lower output of CO2, and hence lower demand for emissions allowances.

In other words, the Europeans wanted to reduce CO2 emissions, and they got their wish. Just not the way they intended: a bad economy accomplished their mission for them. If they’re so intent on reducing CO2, you’d think they’d be happy.

But no, of course, they’re not. They were hoping that economic activity would be robust, and that the resulting demand for allowances would keep the price high, thereby making powering this activity by fossil fuels more expensive. This, in turn, would lead to greater reliance on no-carbon renewables like wind and solar. In this version of Euro Disneyland, where wishes come true, windmills and solar panels would be powering a thriving economy: they would have their low carbon cake, and their economic growth ice cream too.

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But no such luck. The sluggish economies, and the resulting low price of CO2, have delivered a body blow to the economics of renewables.

And that’s where much of the angst is coming from. If it was all about reduced CO2 output, it shouldn’t really matter how you get there. But of course investors in wind, solar, etc., want to support those investments, and the cratering of the CO2 price is very bad news for them.

So the angst is about protecting investments in renewables.

How are they going to go about this? There have been proposals to delay the issuance of some new allowances for a couple of years to support the price, but these were shot down in the European parliament. That delay — “backloading” — was considered by many to be prelude to canceling them altogether.

Such interventions make a mockery of the idea of a carbon market. The man-made “supply” of allowances is subject to change at political whim, and becomes contingent on price, and how that price affects political constituencies. This adds a huge element of risk to trading in this market. It also adds a huge element of risk to any investment that depends on the price of CO2.

This can include not just wind and solar, but conventional power plants, and any other investment (e.g., refining or chemical manufacturing) that emits CO2. And once the EU allows the economic interests of industries to drive supply decisions so as to affect price, all these affected parties have an incentive to influence the process. That consumes real resources, and given the unpredictable and shifting nature of political equilibria, adds to the uncertainty over future supply.

In other words, these man-made carbon markets are not time consistent. Unless the EU can commit not to change supply in the future, the “market” will largely involve speculation on future policy, with a huge degree of feedback. Speculations about policy will affect prices, and prices will affect policy, which will affect prices, and on and on. (Example: the price of CO2 allowances fell by 50 percent when the Euro Parliament rejected backloading.)

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Which is wickedly ironic, given Euro attitudes about speculation.

That’s no way to make a market. And come to think about it, any “market” that is a completely political construction is almost a contradiction in terms. It can be at best a simulacrum of a market, at most a form of “market socialism”, but not the idealized market socialism of years past, but a market socialism buffeted by special interest politics and political economy considerations.

Craig Pirrong is a Professor of Finance and Energy Markets Director of the Global Energy Management Institute at the Bauer College of Business, University of Houston. He is also author of The Street Wise Professor.

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