• Alessandro Vitelli

What’s the point of a carbon floor price?

Every so often in Europe, the discussion over carbon floor prices raises its head above the parapet and sets off a flurry of learned papers and debates among policy experts and academics.

Let’s think about this in terms of the principle of carbon pricing. The idea is that a price on emissions identifies the cheapest way to abate. In the EU ETS this search cuts across nearly 30 countries. One the cheapest reductions have been exploited and the overall limit on emissions is reduced, the market moves to find the next cheapest reductions. And so on.

An overarching principle, elaborated by the EU whenever this debate cranks up, is that the EU ETS is a system that targets volume rather than a specific price. That is, the goal is to reduce emissions to a target number, or percentage reduction, rather than ensuring that the price of carbon allowances fluctuates within a managed band.

What proponents of a price floor are overlooking is the current price is, historically speaking, at relatively high levels and historically reductions are happening at a higher pace than ever before (notwithstanding the global financial crisis in 2009.

Look at the impact of current EUA price and how it’s helping the switch from coal to gas. The obvious implication of this switch is that fewer emissions are generated so yes, the price does fall in the short term, until supply is reduced to balance the market. And the EU ETS does employ a gradually falling cap, as well as a supply adjustment system.

But is the drop in emissions due to the carbon price alone, or is it the outcome of the interaction between energy prices? Ask any analyst and they’ll tell you that an excess of natural gas production and consequently low prices is a central element of the current situation. If gas is cheaper than coal, utilities will burn gas wherever they can, thereby reducing emissions.

(And a floor price might not be able to sustain fuel switching if energy prices moved while EUAs couldn't.)

And yes, at present Covid-19 is also having an impact. Experts predict that this year’s lockdowns will cause emissions to fall by anywhere from 100m to 400m tonnes (5-20%) in 2020. That’s on top of a 9% drop in 2019.

But these are relatively short-term phenomena and their impact will be absorbed over time, particularly through the actions of the declining cap and the market stability reserve (MSR).

So why the talk of a carbon floor price? The EU ETS, and the gyrations of the international energy markets are already producing the desired result of reducing CO2 emissions in Europe.

The EU has taken a big step towards more dynamic management of the supply of allowances with the introduction of the MSR. In any other market, supply is managed in order to prevent prices collapsing: OPEC cuts production, shale producers idle their rigs, central banks buy currency or raise interest rates, you name it. Nobody ever talks about a “floor price for oil”, do they?

The point is that all these actions – by OPEC, central banks and the MSR – are first and foremost about managing supply. Yes, the corollary is that there is an impact on prices (and yes, that is the main motivation), but none of these interventions actually *regulates the price*, only the supply; the price can react howsoever it wants.

One thing I will and do frequently admit is that the MSR is a rather cumbersome and slow mechanism. I’ve written before about how long the delay is between the fact of the oversupply and the first action to address it. Even OPEC countries can call a meeting and decide to cut output faster than the MSR.

But the MSR unfortunately needs to be cumbersome, in order to tick all the political boxes about transparency, predictability and fairness. The EU ETS is a political construct and obeys different rules than a raw market. After all, nobody ever accused the oil market of being transparent, fair or predictable.

Back in 2010 I wrote a paper making the case for a European central carbon bank, an agency that would be equipped with a mandate to maintain EUA supply (not price!) in a specific band that would correspond closely to demand, be it forecast or actual.

Instead, we got the MSR, a totally mathematically-driven formula (that was built by humans, yes) that does away with the need for repeated human intervention. And perhaps that’s the fairest way of all. It removes the need for political decisions every year (though the withdrawal rate is something that needs to be discussed soon), and it just trundles transparently along.

Setting a floor price for carbon would be a completely human intervention, and a political one. What price would Poland want? What level would satisfy Germany or France? There’s so much room for discussion there, as we saw when prices neared €30 and there were different interpretations of the cost containment trigger level.

The EU has largely agreed a target of achieving net zero by 2050. That is the target. There will be enough difficulty in deciding how to achieve the “net”, let alone the “zero” that there is no time for the debate to be muddied with talk of a floor price.