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3 notable news around cap-and-trade systems made its round in the community this week.

Beijing became the 3rd Chinese city to launch a carbon trading scheme, with first trades at 8.20 USD per metric ton of carbon per permit.

At around the same time California sold all cap-and-trade carbon allowances in its 5th auction, raising now a total of 1.4 billion USD, while trading at 11.48 USD per metric ton per allowance.

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And also happening in November 2013, the White House released a technical support document explaining why it raised its estimate of the social cost of carbon to 35 USD per metric ton in May 2013. (Reminder: The social cost of carbon is used to calculate the benefits of reducing greenhouse gas emissions. Back in May 2013, the United States government significantly altered a key economic measure used to assess the damage caused by carbon emissions and the benefit of carbon reduction, increasing the “social cost of carbon” (the SCC) by over 60% from 22 USD to 36 USD per metric ton of carbon. This figure is meant to approximate externalities, such as property damage from extreme weather or changes to agricultural productivity and human health, associated with carbon emissions and global warming).

Throw in te European Union emission trading scheme which tanked to a record low of 3.8 USD per metric ton at the beginning of the year(from a peak level of 41 USD in April 2006), you might wonder if the market forces are working in the right direction. Even the highly regarded California trading scheme shows a steady decline in carbon prices so far…..all while we are heading for new record level emissions of 36 billion metric tons in 2013. (Source: Reuters)

Compare the revised social cost of carbon (=35 USD) with the existing traded prices for carbon in all trading schemes, you easily see a discrepancy. The idea of all carbon trading schemes is(was) simple: policy makers issue a pre-determined quantity of carbon emissions allowances and require a covered surrender of allowances for each metric ton of carbon companies emit throughout the year. The increasing scarcity of allowances, combined with their tradability, creates a market price. In return, heavy emitters have to choose between structural abatement options versus buying allowances from the market. So much to the theory.

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How comes the carbon price is till ‘too low’ on a trajectory to decarbonize the economy by mid-century and also compared to the estimated social cost of carbon mentioned above?

An ongoing depressed economy (starting with the recession in 2009) and reduction as well as outsourcing of industrial production in EU and North America towards emerging economies is certainly a part of the explanation. Some experts believe lack of transparency about long-term scarcity of allowances and assumptions about long-term abatement costs are also part of the problem. Some analysts estimated that the current supply of allowances will not begin to force carbon emission reductions until after 2020. (Source: CDCclimat Research)

At least in the European Union the question of (one-time?) intervention is now on the table. There is a fear that it would be a precedent to ongoing intervention. And intervention could go in both directions. In the worst case scenario it could be decided to loosen the cap on emissions during future economic highs. Current options discussed are:

.) set a more ambitious post-2020 target:  and hope that carbon price goes up. This would mean the EU would depart from Kyoto guidelines in a
unilateral way and take leadership to go above and beyond Kyoto.

.) withdrawal of allowances to (artificially) raise carbon prices: would not question the overall trading scheme, but justification must be clear and transparent. It could be set up as a ‘one-time’ occurrence, or as automatic regular adjustment when surplus allowances are not used over certain amount of time. Nevertheless, it would set a precedent for intervention into market forces.

.) many experts are asking for a federal reserve equivalent for energy as well as carbon authority. You don’t like the revised interest rate? Sorry. It would require to hand over our energy and carbon policy to a statutory price-managing authority. But it works for money today (to a certain extent).

.) Reserve price for carbon: Could support the carbon price until demand is recovered. But who should set the reserve price and based on what? And how does it change over time?

Since the EU cape-and-trade system is seen as a pioneer, the world will be watching how these issues can be resolved. But it seems like action is required soon. Even in California people started already questioning if cap-and-trade could stifles innovation leading to a ‘lowest-common-denominator compliance mindset’ ?

Disclaimer: I’m certainly not an expert in cap-and-trade systems, but I studied economics and I’m trying to watch and follow. I’m sure some readers will have much more insight and will correct some of the perspectives here. Looking forward to your comments……

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