You’d be forgiven for assuming that given the low temperatures and the demand for energy they create, that the carbon price might have been firming recently, not elegantly swan diving as it has been so far this year.

The reason for the price decline is the gloomy economic forecast. The Commission has just announced it expects the economies in the Euro zone to contract by 1.9% this year – a much more pessimistic prediction than those being made pre-Christmas. A change of this scale all but eliminates demand for emissions permits, since the number created and handed out to participants took into account often very optimistic growth predictions.

This serves to highlight one of the risks of cap and trade schemes – implement them too timidly, with no contingency for changes in the underlying assumptions and you can create a scheme which delivers nothing but hot air i.e. spare emissions permits generated with zero effort. We saw this in Phase I of the scheme where the price crashed to zero due to over allocation. In this phase the price will likely remain low but positive since spare permits can be banked and used in the next phase, beginning in 2013. The rules for this future phase were settled, up to a point, just before Christmas and as outlined would allow unlimited banking from this phase into the next. This will carry over the hot air, making targets in the next phase easier to hit and reducing the price in that phase too.

This is potentially very damaging – reducing investment incentives and undermining confidence in the market – but fortunately the ink is not yet dry on the future rules. Because the agreement reached last year is explicitly contingent on what happens in the international negotiations this year and next, there will be more discussions and decisions needed before the final details are agreed. These discussions will need to take into account the new economic context. If Europe’s economy is contracting by 1.9% a year then a target which requires emissions reductions of less than this will be completely redundant. And if the recession is sustained throughout this trading period, restrictions on banking will need to be introduced to prevent price deflation.

The fact that trading schemes are so vulnerable to more powerful economic forces and that, far from being a leading cause of recession, carbon pricing is a another potential victim of it, is timely in another sense too – the US and other countries are in the process of designing their emissions trading schemes and hopefully they will observe the European experiment and not make the same mistakes.