Shapiro and Kamarck: Remember Europe’s Cap-and-Trade Experience

Posted July 8, 2010 at 11:24am

The tragic oil spill in the Gulf of Mexico should make us face the hard choices before us as the result of our dependence on fossil fuel. We know that we have to put a price on carbon. How we do that, however, is a matter of great importance. As a former president of Harvard University, Derek Bok, once famously noted, “If you think education is expensive, try ignorance.” Therefore, as the nation turns to the carbon problem, we should take a moment to look at the model now on the table for pricing carbon — cap-and-trade — and see what can be learned from the experiment with this system so far in Europe.

[IMGCAP(1)]A new analysis issued this week by Harvard professor Richard Cooper surveyed the operations of the European “Emissions Trading Scheme” since its 2005 implementation. The study found that, thus far at least, the ETS has failed to spark the “green” energy transition that its supporters predicted.

Why has the European system failed to live up to its promise? Mostly this has to do with the price of carbon. Prices for emissions permits have moved up and down so much that the markets have been plagued by uncertainty, adding yet more volatility to energy prices for European businesses and consumers. Perhaps the most notable instance of this occurred three years ago, when excessive government handouts of permits and the market’s general uncertainty depressed ETS permit prices to near zero. Soon after, extreme and unexpected weather changes drove up energy use, which caused permit and energy prices to soar. Since then, the recent recession sharply reduced demand for energy across Europe; yet, the European Union’s distribution of permits failed to reflect this change. The result is that companies have been hoarding excess emissions permits, driving down their price and creating a strong disincentive for businesses and investors to pour new capital into energy-efficient products and research.

This history should be especially troubling to those who now want to pass a cap-and-trade system for the United States. The whole point of putting a price on carbon is to encourage investment in energy sources that replace carbon. Investors need stability in the price of carbon, not volatility.

People who are thinking of investing in wind farms or in other expensive projects don’t like volatility. In fact, the only people who do like volatility are traders. In Europe, the emergence of risky derivatives has added another layer of confusion to the ETS and even raises the possibility of a genuine crisis in the commodities markets. Vast sums are at risk in these capricious markets, a fact that simultaneously deters investors and attracts financial speculators, or worse.

The goal of the ETS cap-and-trade regime was to transition the member states of the EU toward a green future. Because that requires steady, higher prices for carbon-intensive energy, in order to create the incentives for all sectors of the European economy to favor cleaner technologies and fuels, the ETS’ inability to place a steady, predictable price on carbon counts as its biggest failure. Only a stable price on carbon can send the signals necessary to drive this transition.

American lawmakers have to seriously weigh Europe’s ill-fated foray into cap-and-trade before jumping into the deep end themselves. A steady, persistent price signal on carbon needs to be transmitted to businesses and households, so they have a real reason to reduce their use of the fuels that produce climate-changing carbon dioxide emissions. The best approach would be straightforward, transparent and, above all, effective.

The alternative that has attracted the most serious interest is a simple, revenue-neutral, carbon-based fee or tax that recycles its revenues through other tax cuts. This approach would create the stable price for carbon necessary to provide the needed incentives to encourage American businesses to develop and adopt alternative fuels and technologies, without subjecting consumers and companies to energy prices even more volatile than today. Regions that have adopted such a strategy, notably Scandinavia, have seen lower greenhouse gas emissions even as their economies have grown.

Congress should consider the flaws and shortcomings of Europe’s cap-and-trade experiment and adopt a simple and straightforward tax shift.

Dr. Robert J. Shapiro, chairman of the U.S. Climate Task Force and head of the economic advisory firm Sonecon LLC, served as undersecretary of commerce in the Clinton administration. Dr. Elaine C. Kamarck, former senior policy adviser to Vice President Al Gore, serves as CTF co-chairman and lectures at the Kennedy School of Government at Harvard University.