VIEWPOINT Michael Grubb

Despite a volatile beginning, carbon markets promise to be a key player in the fight against climate change , says Professor Michael Grubb. However, he warns that governments must not “snatch defeat from the jaws of victory” by failing to take the necessary steps to ensure their longevity.

To create a market that collapses once is unfortunate. Twice is careless; thrice would be outright foolish

Barack Obama wants one; Gordon Brown wants one; the planet desperately needs it, but still an effective carbon market remains stubbornly elusive.

Prices in the EU’s version, the Emissions Trading System (ETS), exceeded 20 euros per tonne of carbon dioxide (tCO2) throughout 2008.

Yet, earlier this year, they fell below 10 euros/tCO2. Prices for international carbon credits that fund emission reduction projects in developing countries have been dragged down further.

However, they are still way above a newly formed carbon market in the US, which languishes at about 2.6 euros/tCO2.

Unlike most markets, these were created by governments to deliver specific policy goals.

They established a market in allowances to emit CO2 to drive emission reductions efficiently, promote low carbon investment, and fund projects internationally on least-cost market principles.

Too cheap to notice wasn’t the idea, because a year or more of rock-bottom prices will gut many emergent carbon reduction businesses. Confidence will be destroyed, low carbon investment deterred and scepticism reinforced.

‘Victim of own success’

It’s only fair to acknowledge that the price variability is partly a problem of success. The carbon savings from credit mechanisms that fund developing country projects have exceeded expectations.

Europe has also been more successful than expected in cutting its own emissions, partly in response to the EU ETS and other policies.

We need to turn carbon into gold

This has cut demand, which is driven by the gap between domestic emissions and targets set out in the Kyoto Protocol.

The Bush Administration said these targets were far too hard to be met, yet they are turning out to be collectively too easy.

The tragedy is that governments now seem determined to snatch defeat from the jaws of victory, with a mantra of non-intervention.

“Not our problem, guv,” they say.

“To make the system stable and predictable, it is important we don’t change the rules.”

Sadly, it’s looking all too predictable.

The UK’s pilot emissions trading system peaked around 20 euros/tCO2 before declining to oblivion.

The first phase of the EU ETS, which started in 2005, also had prices above 20 euros before collapsing slowly to zero.

To create a market that collapses once is unfortunate. Twice is careless; thrice would be outright foolish.

Banking on allowances

Partly, governments are relying on the fact that this time round, companies can “bank” any unused EU allowances for use in the next round, which begins in 2012 – after the current Kyoto commitments expire.

The defining feature of the carbon market – that governments set the quantity – is the key to its salvation

The EU has already put its cards on the table with cutbacks to 2020. In theory, “buy to bank” should bolster short-term prices. but not by much.

The EU’s unilateral commitments might – just – shore up future prices within the EU, but to do that they largely insulate the EU ETS from the global market, and the EU’s targets don’t toughen up without a global deal.

Re-engaging the US around wide-ranging cutbacks after 2012 offers the best long-term solution, and the UN Copenhagen conference at the end of this year is aiming towards this.

But a final, robust and bankable deal will take longer. And twice bitten, thrice shy: markets won’t bet much this year on a successor deal driving prices high after 2012.

The defining feature of the carbon market – that governments set the quantity – is the key to its salvation.

EU calls for global carbon market

We currently have a unique structure in which supply is fixed and impervious to price.

Not surprisingly, the result of highly uncertain demand is then huge volatility.

Yet this feature also holds the key to stabilisation.

Some of the emission allowances in the EU ETS are to be auctioned, and there is nothing that prevents those auctions having a minimum reserve price.

If companies pay the price, fine; if they don’t, those additional allowances won’t enter the market. It acts as a price floor, in ways clearly and simply set out in advance.

The volume of allowances still to be auctioned in the current phase (to 2012) offers a buffer sufficient to forestall risk of further collapse this year.

Knowing that the only way from the reserve price is up, the markets would settle somewhere above it.

For governments holding these auctions, selling fewer allowances at a moderate price is better than selling a lot of allowances for next to nothing.

Auction reserve prices would need to be co-ordinated, but only a few countries had the sense to retain some allowances for auction, and these are dominated by the UK and Germany.

These two pioneers of global climate change action now find the keys in their hands. Let’s hope they have the wisdom to use them.

Professor Michael Grubb is chief economist for the Carbon Trust and a member of the UK Committee on Climate Change

The Green Room is a series of opinion articles on environmental topics running weekly on the BBC News website