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The provisional data issued last week by the Commission reveals that the EU’s flagship climate policy – its Emissions Trading Scheme – has in fact just narrowly avoided hitting the rocks.

Due to the economic downturn in Europe carbon emissions fell between 2007 and 2008 by roughly 5%. A significant reduction but fortunately not big enough to throw the whole scheme into disarray by taking emissions below the level of allocated permits. If economic growth remains in negative figures, however, because allocations are the same each year, the situation in 2009 could be much worse.

Looking at the figures in aggregate also fails to tell the whole story. For example, two of the biggest countries in the scheme – Germany and the UK – only succeeded in creating a net demand for permits by handing out significantly reduced allocations to the power sector – heavy industry were by and large given generous allocations based on anticipated growth projections. The change in Europe’s underlying economic performance now makes these already overly generous allocations look like substantial windfalls. This effectively creates a cross subsidy out of the pockets of European electricity consumers into the hands of big industry – a fact that should be much more widely debated.

The other casualty revealed by the data is the market for overseas project credits. It would be a brave investor indeed who would continue to put money into projects in developing countries when demand for permits from EU ETS participants last year appears to be as low as 100 M tonnes and there are already around 1,800 M tonnes of credits in the delivery pipeline.

In light of this near miss, there are many issues that must now be considered before the revised Directive is finally completed and ahead of the Copenhagen meeting of the UNFCCC, to make the ETS work better:

– the level of ambition in the next phase of trading needs to be increased to take account of the unanticipated carry-over of banked industrial permits – to remove ‘hot air’;
– provisions need to be included that allow for policy interventions to reduce caps in the event of significant changes in the factors underpinning initial allocations; and,
– incentives should be introduced to encourage voluntary cancellation of spare permits from the industrial sectors, since this is likely to be Europe’s most cost effective way to comply with its Kyoto targets and those that succeed them.

In an ideal world, if Europe were able to act swiftly to adjust policy in light of the recession, it would also be able to take a more ambitious opening position to the negotiations in Copenhagen – which in turn could unlock more ambition within rapidly developing countries.

But, international politics aside, these issues must still be debated in the coming months, or last weeks’ near miss could, in future, turn into an even steeper price collapse and an unhelpfully low carbon price for many years to come. And the US, who are watching our progress with interest, should take note of this lucky escape and ensure they do things differently from the start.