Extreme caution needs to be taken while mulling of linking different carbon markets

Ever since the green shoots of carbon markets sprung up in countries outside the European Union (EU), economists all over the world are sharpening their modelling and forecasting tools to once again create a new chaos – that of linking the markets together. It seems no lessons have been learnt by the earlier EU emission trading collapse and the United Nations carbon market degeneration. Worse still, there are clear parallels between the causes of EU financial crisis and the linking of carbon markets. Yet no one wants to make an effort to see beyond the veil.

Countries such as South Korea, Australia, China and Brazil and provinces such as California (USA) and Quebec (Canada) have kick-started their carbon markets in 2012 and are expected to go full throttle in the coming years. While Japan does not have a national domestic scheme yet, three of its provinces are already under the ambit. In all, the management of the factories under these regions such as power, steel and cement are now reluctantly warming up to forecast the future market price and heading to the drawing board.

Australia started with a carbon tax of USD 23/ tonne CO₂ in September 2012, whereas four cement producers in China's Guangdong province have bought the first CO₂ permits from the local government at USD 9.50/tonne in the same month.

China in fact has started seven pilot ETS schemes covering factories in five cities of Beijing, Chongqing, Shanghai, Shenzhen Tianjin and the two provinces of Guangdong and Hubei last month. The country plans to bring in a nationwide scheme by 2015. A fortnight ago, news reports inform Thailand and Vietnam announced plans to launch domestic emissions trading schemes. New Zealand has already a well established domestic market.

Meanwhile, economists and consultants world over are grinding their axe to model how all these carbon markets could be sewed up together to drive what they claim - to the lowest marginal abatement costs. But then they fail to learn that linking has several hazards which can crash the entire trust in the market.

Not too long ago in 1992, select EU countries signed up the Maastricht Treaty to move towards formation of a single currency ‘Euro’. The treaty required member countries to have an upper limit of annual government deficit at 3% of their gross domestic product (GDP).  Countries teamed up hoping that unifying currencies would lift the overall wealth of the populace.

Later peripheral countries such as Ireland, Portugal and Greece too joined in to enjoy the party.  Countries went on a spending binge as if there as no financial gravity. Budget deficits rules of 3% limits were broken by almost all member states, including France and Germany in 2003. And the European Commission, the regulator, too gave a big thumbs-up confirming things were fine till as late as 2010. Everyone knows what happened thereafter.

The lesson – individual countries with their own political interests and which are being fed free lunch from the European Union cannot tighten their belts and foresee impending risks.  One country’s economy, say of Finland, can be severely imperiled because of inadequate prudence and integrity of budgeting of a distant country, say of Greece. This has now brought degeneration and low morale into the entire populace of 17-member Eurozone nations, never mind that of the world. The few sincerely complying EU member states are now stuck between a rock and a hard place.

Similar phenomenon occurred in the carbon markets. In the first phase of EU-ETS between 2005-2007, poorer EU member states awarded generous permits to their respective factories. Once the overall surplus was realised in April 2006, the market nosedived. Policy makers assured that all corrections would be made in the subsequent phase II (2008-2012), but lo-behold it again collapsed from 30 Euros in July 2008 to 7 Euros in September 2012 (see Graph 1). Meanwhile the UN carbon credits called Certified Emission Reductions  (CERs) slumped from 15 Euros to just 1.7 Euros during this period. Dusting off the problems in first two phases, it was assured that imperfections and distortions would not be repeated. But alas, by now even the phase III (2013-2020) has been declared surplus and hence effectively dead.

Graph 1: EU carbon permit price trend

Source: Kettner C., Koppl A and Schliecher S. (June 2012), “Carbon Authority as Price Stabilising Institution in the EU ETS”, Austrian Institute of Economic Research, www.wifo.ac.at/wwa/pubid/44536

A major blame for the collapse of EU carbon market is the surplus inflow of UN carbon credits from projects having dubious integrity such as waste industrial gases (HFCs) and super-critical coal based power plants. UN regulatory agencies are unable to see the woods for the trees and continue issue dubious credits. Economists, who drew optimistic carbon emissions baseline till 2020 considering steady-state economic growth, are also to be equally held responsible.

While the general citizens were at the receiving end of the financial crisis, the factories which had planned huge low carbon investments have been at the receiving end in EU and UN carbon markets. To such an extent there has been aversion for economic policies that people and factories just want to break free from the shackles of daily misery.

Given these historical lessons, utmost care and caution is need of the hour while contemplating linking of different carbon markets. For instance, if Australia and California have unified their carbon markets, a small regulatory change in California brought in by a local court decree can have a devastating effect on the Australian factories.

In India, the Renewable Energy Certificate (REC) market is already losing faith among project developers and investors because multiple state-owned distribution companies, crippled by their own limitations and political interests, are reluctant to buy the certificates.

Policy certainty, stability and simplicity are what drives and maintains low carbon momentum. Shallow or twisted economic models and theories would end up in chaos and even outright distress. It’s time economists and policy makers designing environmental market mechanisms are not taken on face value.