The role of carbon markets in preventing dangerous climate change - Environmental Audit Committee Contents

Memorandum submitted by the Cambridge Centre for Climate Change Mitigation Research (4CMR) Annela Anger, Dr Terry Barker, Dr Athanasios Dagoumas, Dr Lynn Dicks, Dr Yongfu Huang, Dr Serban Scrieciu and Stephen Stretton


    — Carbon trading is a critical policy instrument in addressing climate change, but it is not sufficient to stabilise the climate at 2°C, even if it operates globally. Direct regulatory measures and technology-push policies will also be required, as well as establishment of carbon price signals that are loud, lasting and clear. We recommend setting a minimum carbon price to ensure the carbon markets function effectively.— Stringent climate change mitigation could provide economic benefits, in terms of increased GDP growth, relative to a business-as-usual baseline where fossil fuels dominate across the 21st century. Contrary to the conventional view in the literature, our research argues that the benefits of mitigation increase with the stringency of the stabilisation target.— Carbon trading and other climate change mitigation policies are currently being undermined by the economic recession. The solution to this is to announce more stringent emission reduction targets, sending a strong signal of a long-term stable carbon price, and to use revenues from auctioning emission allowances to subsidise low-carbon technologies. The resulting increase in investments in a low-carbon economy may contribute towards the dual goal of solving both the economic and climate crises.

    — The fate of auctioning revenues is critical to the success of emissions trading in mitigating climate change. One recent study shows that if auctioning revenues from introducing aviation in the EU ETS are added to general government budgets, they may cause a slight increase in overall European greenhouse gas emissions at lower allowance prices, the opposite of the policy's objective.

    — Auctioning revenues should be directed towards new abatement technologies and used to support households and businesses that suffer unfairly from higher energy prices, without subsidising their fuel costs.


  4CMR is an interdisciplinary research centre within the Department of Land Economy at the University of Cambridge.

Our objective is to foresee strategies, policies and processes that are effective in mitigating human-induced climate change. We combine computer modelling with expert knowledge from economics, energy systems, engineering, applied mathematics and environmental science to understand how the transition to a low-carbon economy can happen quickly, efficiently and equitably.


  1.  For a reasonable chance (50:50 or better) of meeting the 2°C target for global average temperature rise, the world should be aiming for complete decarbonisation by 2050 or earlier (Barker, 2008). This statement is based on the model predictions presented in the IPCC's Fourth Assessment Report on climate change mitigation (IPCC, 2007).

2.  The safe level for the 2°C target, allowing for uncertainty in the sensitivity of the climate to greenhouse gas concentrations, is 380 ppm CO2-eq, lower than the current level of about 430 ppm CO2-eq (Barker, 2008). This implies that to be sure of stabilising the climate at 2°C above pre-industrial average temperature, we need actual reductions in atmospheric greenhouse gas concentrations.

  3.  Carbon trading is one of the critical policy instruments for accelerated decarbonisation. But it is not sufficient on its own. Other measures, such as direct regulation, carbon taxes for non-trading sectors and direct investment into low-carbon technologies are also needed.

  4.  We have shown that the G8 target of a 50% reduction in CO2 emissions by 2050 cannot be met by carbon price alone, even when there is a global carbon price that rises to $100/tCO2. To make such a reduction, on a world scale, governments must use a substantial percentage of the revenues raised from taxing carbon, or selling emission permits, to stimulate investment in low-carbon technologies and energy efficiency improvements, and promote environmental friendly behaviour (for example in the transport and buildings sectors). Even with all those investments, the 50% reduction target is unlikely to be met without guaranteeing the carbon price, so that it has an accelerated rise to $100/tCO2 by 2030 (Barker, Scrieciu and Foxon, 2008).

  5.  Our E3MG model[27] shows that in a low-carbon society, where the 50% reduction in CO2 emissions by 2050 has been met, GDP is slightly above the baseline case with no reduction in emissions. In other words, there are economic benefits of this stringent mitigation. This is a consequence of more rapid development induced by extra investments in low-carbon technologies and practices and increased technological change (Barker, Scrieciu and Foxon, 2008).

  6.  Unfortunately, the current allowance price in the EU ETS is well below the required level, around €10/tCO2 on the date of writing (see paragraph 14 below). And there is, as yet, no global emissions trading scheme.


  7.  To be an effective part of a portfolio of policies that achieve the 2°C target, emissions trading will have to become global.

8.  Action is needed to make the future carbon price high and reliable. The earlier and stronger these actions, the higher are the investments and the greater the benefits from decarbonising the economy.

  9.  The 20% reduction on 1990 levels by 2020[28] incorporated into the EU ETS Phase III is too low and creates a weak signal. Carbon prices and auctioning revenues will be too low, at this level, to stimulate the technological changes and emission reductions necessary to meet a 2°C target. We have previously recommended setting the reduction target at 40% or higher by 2020.[29]

  10.  Penalties for non-compliance in the EU ETS should be adjustable not only to changes in inflation but also to the carbon price. Otherwise, they effectively signal a ceiling on the carbon price, at €100/tCO2, the current penalty.

  11.  We strongly oppose the recent suggestion from the European Parliament (Article 29) that there should be a ceiling on the carbon price in the EU ETS. We would prefer to see governments guaranteeing a minimum price for carbon. A carbon price floor would provide much greater long-term certainty and encourage investment in low-carbon technologies. It is especially helpful during recession, when both energy demand and investment are likely to be lower.

  12.  We welcome the longer trading period in Phase III of the EU ETS (eight years instead of five), as this increases predictability and certainty.

  13.  We also welcome the diminishing cap, the high levels of auctioning, the increased intertemporal flexibility (banking of allowances) and the harmonised allocation methodology in the proposals for Phase III.

Impacts of the economic recession

  14.  Allowance prices in the EU ETS have been falling over the last six months, undermining prospects for profits and growth in the carbon markets. This loss of confidence is a result of the drop in demand for allowances due to falling demand for carbon-based electricity and other products from industries covered by the EU ETS as a result of the on-going global economic crisis.

15.  If the short-term reduction in demand for emission permits leads to a further collapse of allowance prices to near zero, we risk losing the experience and institutional knowledge in the carbon market gained since the EU Emissions Trading Scheme and the Kyoto Protocol began. The loss of knowledge and learning will be through bankruptcies and failure of individual carbon reduction projects.

  16.  One way to restore profitable allowance prices in the Scheme is to tighten the emission reduction targets for 2020. Even an announcement that such tightening is being considered may be enough to support the prices, through encouraging entities to bank their allowances for the future.

  17.  Revenues raised from carbon taxes and auctioning revenues from emission permit sales could also be used to reduce taxes that bear on employment and investment. This is a particular benefit for economies with chronic unemployment or underinvestment.

Use of auctioning revenues

  18.  All permits in the EU ETS should be auctioned. This provides fair treatment and avoids possible windfall profits in all sectors. Current proposals for EU ETS Phase III include 100% auctioning for the power sector only. Other industries will start with only 20% auctioning, rising to 100% by 2020 (or 2027). The aviation industry is likely to have to purchase only 15% of its allowances by auction throughout Phase III, although this is subject to change. Also, auctioning levels can be lowered if an industry is seen to be at risk of carbon leakage.

19.  The fate of auctioning revenues from the emissions trading scheme is critical to the overall success of the scheme at reducing greenhouse gas emissions. Our evidence for this view is presented in paragraphs 22 to 32 below.

  20.  Auctioning revenues should be returned as subsidies for re-structuring to low-greenhouse-gas products, processes and practices, and for financing adaptation to climate change. We agree that the amount of revenues returned and the list of who gets them should be revised every three years, as proposed.

  21.  We would advise that auctioning revenues are partly used to help low-income households (and small businesses) who will be unfairly disadvantaged by increased fuel prices. However, the revenues should be directed towards lowering income tax, or improving the quality of housing, not towards subsidising fuel bills. The latter reduces incentives to develop low-carbon technologies.

A case study on including aviation in the EU-ETS

  22.  4CMR has carried out research on the economic and environmental impacts of introducing aviation into the EU ETS, in association with Cranfield University and the University of Maine (USA). The project "Air Transport in the European Emissions Trading Scheme" was completed and reported on in February 2009. Results have not yet been published in the peer-reviewed literature, but were presented at an Omega workshop on 11 December 2008.[30]

  23.  The study used was the energy-environment-economy model E3ME to predict the likely impacts of introducing aviation into the EU ETS. This model describes the European economy as 42 industry sectors, one of which is air transport. It uses real historical data from 1970-2004 to estimate the interactions between different sectors of the economy. Taking these interactions into account, it estimates the impacts of short and medium-term greenhouse gas mitigation policies and predicts future economic changes to 2020. More information about the model can be found at:

  24.  E3ME treats emissions trading as a tax on fossil fuel use. It adds a cost to fuel, based on the carbon content of that fuel. The model has been run with and without aviation being included in the EU ETS, so the economic and environmental effects of including aviation can be analysed.

  25.  The study assumes that aviation is included in the EU ETS with 85% of allowances allocated free and 15% auctioned. It assumes that up to 15% of allowances for each airline can be bought from the Kyoto Clean Development Mechanism (CDM). It also assumes that there are no emissions reduction targets for non-ETS sectors. Finally, it assumes that the allowances for aviation are capped at 97% of 2004-06 levels in the first year, 95% in the second year, and then diminish at around 2% per year until 2020, as proposed for Phase III (2013-20) of the EU ETS for other sectors.[31] For this study, E3ME was run with three allowance price scenarios—allowance prices of €5, €20 and €40 per tonne of CO2.

  26.  The results showed that with emissions trading, actual CO2 emissions from air transport will be reduced compared to the reference scenario with no aviation emissions trading. However, the reductions will be small. Carbon emissions will be less than 1% lower with an allowance price of €5/tonne. At €20/tonne, CO2 emissions will be reduced by 3.4% in 2020, and by around 7.4% at €40/tonne.

  27.  Similar reductions in emissions from aviation can be achieved by running the model with moderately high oil price scenarios and no emissions trading.

  28.  The model predicts a very small drop in demand for air travel—less than 1% reduction in 2020 even at the high allowance price. The air transport sector is able to continue to grow, because it becomes a net purchaser of allowances, buying allowances largely from the power sector.

  29.  However, contrary to expectation, the model does not show a reduction in CO2 emissions from the entire economy (including the power sector), despite an increased demand for emission allowances created by the aviation industry.

  30.  In fact, CO2 emissions from the wider European economy are predicted to increase slightly when aviation is included in the EU ETS, at lower allowance prices—by 0.2% at €20 per tonne and 0.1% at €5 per tonne. This effect is a result of auctioning revenues being returned into the general economy and increasing other economic activities in non-trading sectors. The study assumes there are no greenhouse gas reduction measures in sectors outside the EU ETS. At the highest allowance price, emissions from the wider economy are reduced, although only by 0.2%.

  31.  In other words, when the entire economy is taken into account, introducing aviation into the EU ETS may not be very effective at cutting carbon emissions, because of the counter effect of allowing auctioning revenues to enhance other economic activity. If auctioning revenues were earmarked for spending on carbon reduction technologies, or used to support air transport companies through the tax system, this effect may not happen.

  32.  More research is needed to analyse how sensitive overall CO2 emissions might be to different treatments of auctioning revenues in this context.


  33.  In its current form the cap and trade system applied only to EU is necessary but not sufficient to dramatically reduce emissions and avoid catastrophic climate change. A global scheme involving at least the main greenhouse gas emitters is called for.

34.  To meet the 2° target, we would suggest that a carbon price rising to at least $100/ tCO2 by 2020 is needed, for OECD countries. This is in line with the necessary carbon price suggested by the IPCC. This could emerge from emissions trading schemes for the energy-intensive sectors with a strong greenhouse gas reduction target of at least 30% below 1990 levels by 2020.

  35.  Such a scheme would lead to a gradual increase in the cost of electricity (we estimate an increase of about 70% in the USA, over 10 years, for example). But revenues from auctioning emissions allowances would accrue to countries regulating their emissions, not to the oil producers. They can be used to compensate those who lose employment and to provide incentives for low-carbon alternative sources of energy.

  36.  If the energy sector responds rapidly, the CO2 allowance costs will fall rapidly and the electricity price rise will be lower.

  37.  Emissions trading schemes are less suitable for other sectors, especially transport, buildings and agriculture. These sectors contain a large number of small entities, so the administrative costs of carbon trading are problematic. Here, a portfolio of measures is necessary, including regulation and subsidies targeted at market failures, to address institutional, technical and behavioural barriers to change.

  38.  Markets are not as good as they should be at driving innovation, because innovators are not able to capture all the benefits that accrue from innovation, even with the patent system. This is why a complete overhaul of our energy technology system requires public investment, subsidy and regulation in addition to the carbon price. Auctioning revenues from carbon markets can also be used to reduce or offset the financial risk of implementing new technologies.

Comments on the shadow carbon price

  39.  The shadow carbon price set by Defra (£25.50/tCO2 for 2007, rising to £59.60/tCO2 in 2050)[32] is too low. It was not estimated as the level that would achieve the 2° target, but using a cost benefit analysis, with an outdated estimate of the costs of climate change that substantially discounts the value of health and lives of future generations and ignores the significant risks of catastrophe.

40.  This shadow carbon price is recommended for use in cost benefit analyses for major energy projects such as for new coal-fired power stations like the one planned at Kingsnorth on Kent. As such, it seems likely to slow our progress towards achieving emission reduction targets.

Linking the EU ETS with other cap and trade schemes

  41.  Linking the EU ETS with other national or subnational schemes will widen the scope and increase the efficiency of the scheme. In theory, joining schemes from regions with different abatement costs will adjust the carbon price and stimulate a more efficient global effort to reduce emissions, by targeting mitigation in areas where it can happen the most cheaply. However, this only holds if the schemes are based on similar rules regarding allocation, auctioning and the stringency of emissions caps.

42.  Linking emissions trading schemes without an obligation to have similar rules can provide an incentive for regions to set less stringent emission reduction targets as a way of increasing their supply of allowances. The current allowance price[33] in the US Regional Greenhouse Gas Initiative (RGGI) is $3.38/tCO2, compared to €10.25/tCO2 in the EU ETS. The lower price in the US may be a function of low demand, due to less stringent reduction targets (10% reduction in emissions by 2018), rather than cheaper abatement options.

The CDM (Clean Development Mechanism) and other offset schemes

  43.  Econometric research carried out at 4CMR studied the effect of CDM projects on national CO2 emissions for 34 CMD host countries. The research found that CDM projects lead to reduced per capita CO2 emissions in the host countries, especially in the manufacturing and energy sectors (Huang and Barker, 2009).

44.  Even so, we argue that allowing high levels of CDM and JI credits (flexible mechanisms under the Kyoto Protocol) to be used under Phase II of the EU ETS contradicts the Linking Directive, which stressed that usage of CDM/JI credits should be supplemental to domestic efforts in greenhouse gas reduction. In Phase II, Member States were each able to decide their own limit for the use of flexible mechanism offsets, up to a maximum of 20%. As a result it is possible to use these credits to offset up to 13.4% of allocated emissions overall, about 1.4 billion credits. These credits represent carbon emission reductions outside Europe. They are not included in the cap imposed under the EU ETS. The effect of using them is that, rather than dropping by 6.5% on 2005 levels, emissions from EU ETS industries within Europe could actually rise by just over 6%.

  45.  The access to credits from flexible mechanisms in Phase III of the EU ETS is unclear, because it depends on whether or not an international agreement is reached. This adds to uncertainty. It would be better to clearly specify how many credits from flexible mechanisms can be used by Member States/trading entities.

  46.  We welcome the proposal that once an international agreement has been reached, only credits generated in countries ratifying the agreement should be accepted in respect of emissions in Europe.

  47.  Issuing allowances in respect of domestic offsetting projects in non-ETS sectors (Article 24a) is not advisable. This will reduce the responsibility of non-ETS sectors for their emissions and could reduce the effectiveness of the EU ETS. There are currently no institutions or rules in place to assure the quality of this kind of offset project. Establishing rules and institutions would have high administrative costs.

REFERENCESBarker, T (2008). Achieving the 2°C target through carbon trading. Tyndall Centre Briefing Note no 25. Available at

Barker, T, Scrieciu, S S and Foxon, T (2008). Achieving the G8 target: modelling induced and accelerated technological change using the macro-econometric model E3MG. Climate policy 8: S30-S45.

Huang, Y and Barker, T (2009). The Clean Development Mechanism and sustainable development: a panel data analysis. Tyndall Centre working paper 130. Available at

IPCC (2007). Summary for policymakers. In: Climate Change 2007: Mitigation of climate change. Contribution of working group III to the Fourth Assessment Report of the IPCC. Eds: B Metz, O R Davidson, P R Bosch, R Dave and L A Mayer. Cambridge University Press, Cambridge.

3 March 2009

27   E3MG is a 20 region structural, dynamic, annual econometric simulation model based on data covering the period 1972-2006 and projected forward to 2100. It has been developed by 4CMR and Cambridge Econometrics. More information can be found at Back

28   Rising to 30% given a post-Kyoto agreement. Back

29 Back

30 Back

31   We understand it has now been agreed that for aviation, the cap will remain at 95% of 2004-06 levels until 2020, but this percentage may be reviewed. Back

32 Back

33   These prices were correct at the time of writing. Taken from and, accessed 3 March 2009. Back

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