Despite its aim, the European Trading Scheme (ETS) for carbon is widely regarded as an inefficient market. The initial design of the scheme has caused trading reactions that do not follow the pricing patterns of other, more efficient commodities.
Within ETS, it isn’t carbon’s price volatility that makes its market seem uncharacteristic of other commodities markets; commodity markets are often characterized by volatility. Instead, it is the fact that carbon’s price drivers are not so easily pinpointed and, therefore, its volatility seems arbitrary.
Currently, the most obvious symptom of inefficiency is that carbon allowances trade cheaply in Europe – so cheaply that companies buy allowances rather than cut pollution. Theoretically, carbon prices should be closely linked with the marginal cost of switching to lower-carbon fuels. Thus the failure of allowance prices to trend towards the marginal cost line suggests a lack of normal supply and demand dynamics – this inefficiency may only be explained when one takes into account the numerous artificial drivers pressing on carbon prices.
The overarching driver of carbon market inefficiency is political risk. Carbon players confront a particularly unpredictable market because there is only one regulator and one supplier – the government, which can act arbitrarily and politically. This risk is fueled and exasperated by several other factors: the exporting of polluting industries to no-cap countries, the impracticality of present alternative-fuel technology, the psyche of market players, and the dearth of long-term speculation.
Europe has much to teach the American government with respect to implementing a cap-and-trade market in the US. But perhaps the most valuable lesson of ETS is the government’s inability to manufacture an efficient market for carbon. As a result, carbon as a financial product is capricious at best, and this may undermine the original environmental goal – to move industry to low-carbon production through an efficient market solution.
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