carbon cap-and-trade

For my inaugural post (also the first of a new decade!), I thought I might take a look at something our crafty European friends dreamed up in 2005 while we were busy fighting the war on terror-- the European Union Greenhouse Gas Emission Trading System (EU ETS). You can read all about it here or there, but basically the ETS covers around half of the CO2 emissions in the EU and requires large emitters to return emission allowances to the government equal to the amount of CO2 they emit in a given year, the ultimate aim being to reduce carbon emissions over time. What is this an example of? A cap-and-trade system!

In the simplest terms, cap-and-trade might work like this:

Step 1: the government tells big emitters they can't emit more than X amount of carbon, which may be different for each emitter.

Step 2: big emitters say, "okay" (grudgingly) and then try to emit no more than X.

Step 3: emitter A ends up emitting more than X, but emitter B ends up emitting less than X.

Step 4: emitter A gives money to emitter B to make up for being bad.

The actual mechanisms can vary greatly, but really we're just talking about rewarding emission reductions and punishing emission increases (the old carrot-or-stick approach). One interesting mechanism is a carbon spot market, where carbon credits are sold as commodities just like stocks. The two major spot markets in the the EU are BlueNext and the European Climate Exchange (ECX). Interestingly, both markets seem to have flat-lined over roughly the last year.

Let's look at some data. First, the complete historical record of ECX market data going back to early 2006:

Notice the market price per tonne (EUR) in orange dipped violently starting in mid-2008 and has stabilized around 15 Euro over the past few months. Also take a look at the crazy fluctuations in market volume on an almost daily basis -- indicating a very young and instable market which may scare away big investors.