ASK a European what the continent is good at, and sooner or later he or she will say protecting the environment. Our economies may be struggling. We may be failing to integrate Muslims. But, by golly, we are green and cuddly, like a Martian teddy bear.
Yet at a time when policies on climate change are coming under scrutiny, the European Union's flagship programme, the emission-trading scheme, is in serious trouble. It was set up last year amid high hopes: it is the first international arrangement that uses markets to reduce soot and smoke. But unless reformed, it will go down as a good idea, badly executed.
The system works as follows. National governments decide how much carbon the five dirtiest heavy industries in their countries may spew forth (the industries are things like power generation, pulp and paper, and metal bashing). They then allocate “permits to pollute” to each company in that line of business. If a firm wants to go over its limit, it must buy “pollution permits” from cleaner firms or credits from developing countries that have set up special projects to lower emissions.
The case for such a European policy is strong. When it comes to the environment, individual countries suffer “the tragedy of the commons”: they capture the benefits of polluting while the costs are dumped on the common land, air and water. Ideally, pollution controls would be universal, but since (as the Kyoto treaty showed) that is impossible, the EU is the next best thing: big enough to make an impact, coherent enough to constrain members' behaviour. Arguably, if climate-change measures cannot work in the EU, they cannot work at all.
Moreover, as EU policies go, this one is fairly well designed, in principle anyway. It manages to set a carbon price and encourages trading in environmental assets (the pollution permits). That should be the most efficient way to control emissions. It is a welcome contrast to the command-and-control systems, such as the common agricultural policy, that the EU has preferred in the past. And although economists may argue forever about the relative merits of carbon trading versus a carbon tax, Europe's decision to go for the former at least has the merit of decisiveness. Britain's environment minister calls the scheme “the most innovative and efficient method yet invented for reducing carbon emissions”. Arnold Schwarzenegger, the governor of California, wants to set up a similar arrangement between his and other states. Indeed, Gordon Brown, the British chancellor of the exchequer, says the European and Californian schemes one day should be linked as part of a worldwide carbon-trading network.
Yet even while lauded as a model for others, the scheme is failing at home. It will lead to cuts in emissions only if the permits are strict enough, so the question of who allocates them is vital. For political reasons, the EU left the power of allocation to national governments. As a result, what should have been an exercise in setting rules for a new market became a matter of horsetrading about pollution limits, with powerful companies lobbying for the largest possible allowances.
Last year, governments gave away (ie, did not sell) pollution permits that amounted to more than the pollution companies were actually spewing forth. That risks making the scheme pointless. The European Commission is now reviewing proposals for allocations in 2008-12. If approved, these would allow companies to increase emissions by a further 15%.
Lax allocations do more than just fail to cut greenhouse gases (bad enough, you might think, given that this is the main point of the scheme). They also damage the market. When it became clear, in April, that most allocations were larger than actual emissions, the price of carbon halved almost overnight. Some volatility is probably inevitable in a new market, but when combined with irresponsible behaviour by governments it hardly encourages people to enter the emissions-trading business.
It gets worse. The plunging price sends a market signal to developing countries that have installed pollution controls partly so that they could sell the resulting “pollution credits” for a nice profit. That no longer looks like a good idea.
A blackening reputation
Similarly, some countries (Germany, France and Poland) have scattered permits around like confetti while a few (Britain, Ireland and Spain) have been sparing because they want to cut emissions. Companies in the second group are buying permits issued in the first, so the market is transferring resources from places that are using the scheme to curb pollution to those that are not. Brilliant.
The European Commission could reject the proposed national allocations outright and insist that offending governments slash the allowances substantially. They could also push governments to sell the permits, rather than give them away (taxpayers would like that too). But in the long run, argues Michael Grubb of Cambridge University, countries need independent agencies to issue the permits, just as there are independent central banks to issue money.
And if governments refuse? They might remember that they have already promised to meet emission-reduction targets under the Kyoto protocol. If they miss them they will sooner or later face a choice: either buy up offsetting pollution credits from countries that have cut their emissions (thus sending the carbon price soaring again and spending lots of taxpayers' money). Or flout the Kyoto obligations they solemnly undertook and admit to voters that they were not really serious about curbing greenhouse gases.
In a recent British report on climate change, Sir Nicholas Stern said the European emission-trading scheme could become “the nucleus of future global carbon markets”. It could. But only if politicians allow it to work properly.
