Carbon market crashes with a whisper, not a bang

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“Roll up for the great pollution fire sale, the ultimate chance to wreck the climate on the cheap. You sir, over there, from the power company — look at this lovely tonne of freshly made, sulphur-rich carbon dioxide. Last summer it cost an eyewatering 31 euros [US$39] to throw up your smokestack, but in our give-away global recession sale, that’s been slashed to a crazy 8.20 euros. Dump plans for the wind turbine! Compare our offer with costly solar energy! At this low, low price you can’t afford not to burn coal!”

Set up to price pollution out of existence, carbon trading is pricing it back in. Europe’s carbon markets are in collapse.

Yet the hiss of escaping gas is almost inaudible. There’s no big news headline, nothing sensational for TV viewers to watch; no lines outside banks or missing Texan showmen. You can’t see or hear a market for a pollutant tumble. But at stake is what was supposed to be a central lever in the world’s effort to turn back climate change. Intended to price fossil fuels out of the market, the system is instead turning them into the rational economic choice.

That there exists something called carbon trading is about all that most people know. A few know, too, that Europe has created carbon exchanges and traders who buy and sell. Few but the professionals, however, know that this market is now failing in its purpose: to edge up the cost of emitting carbon dioxide.

The theory sounded fine in the boom years, back when former World Bank senior vice president Nicholas Stern described climate change as “the biggest market failure in history” — a market failure to which carbon trading was meant to be a market solution. Instead, it’s bolstering the business case for fossil fuels.

Understanding why is easy. A year ago European governments allocated a limited number of carbon emission permits to their big polluters. Businesses that reduce pollution are allowed to sell spare permits to ones that need more. As demand outstrips this capped supply, and the price of permits rises, an incentive grows to invest in green energy. Why buy costly permits to keep a coal plant running when you can put the cash into clean power instead?

All this only works as the carbon price lifts. As with 1924 French wine estate Chateau Lafite or artist Damian Hirst’s diamond skulls, scarcity and speculation create the value. If permits are cheap, and everyone has lots, the green incentive crashes into reverse. As recession slashes output, companies pile up permits they don’t need and sell them on. The price falls and anyone who wants to pollute can afford to do so. The result is a system that does nothing at all for climate change but a lot for the bottom lines of mega-polluters such as the steelmaker Corus. It becomes industrial assistance in camouflage.

“I don’t know why industrials would miss this opportunity,” one trader said last week. “They are using it to compensate for the tightening of credit and the slowdown, to pay for redundancies.”

A lot of the blame lies with governments that signed up to carbon trading as a neat idea, but then indulged polluters with luxurious quantities of permits. The excuse was that growth would soon see them bumping against the ceiling.

Instead, exchanges are in meltdown. A tonne of carbon has dropped to about 8 euros, down from last year’s summer peak of 31 euros and far below the 30 euros to 45 euros range at which renewables can compete with fossil fuels.

The lesson of the carbon slump, like the credit crunch, is that markets can be a conduit, but not a substitute, for political will. They only work when properly primed and regulated. Europe hoped that the mere creation of a carbon market would drive everyone away from fossil fuels. It forgot that demand had to outstrip supply and that if growth stops, demand drops too.

There is not much time to rescue the system. Carbon trading remains at the heart of the international response to climate change. US President Barack Obama backs what Americans call cap and trade. Australia wants to try the same thing. It should be at the heart of a deal at the Copenhagen summit this winter.

The market must be unashamedly rigged to force supply below demand. The obvious way would be to cut the number of permits in circulation, but in a recession no government will be brave enough to do that. And private initiatives such as Sandbag, which encourages individuals to buy and lock away permits, so far can exert little pressure on price in a market awash with them.

However, Europe can choke off tomorrow’s supply without hitting business today. First the EU must stop importing permits from countries such as Russia — a bonus for a paper transaction. No one really believes that 15 million tonnes of carbon dioxide on imported permits will not still be emitted by a steelworks somewhere east of Novosibirsk.

Second, it must publish plans to crack down on the surplus of permits when the recession is over. Warnings of famine ahead, when the scheme enters its third stage in 2012, would raise prices now, if firms believe it.

Like medieval pardoners handing out unlimited indulgences, governments have created a glut. Reformation must follow. Wanted: a modern Martin Luther to nail a shaming truth to the industry’s door: Europe’s whiz-bang carbon market is turning subprime.