As early as 1992, the Adam Smith Institute propagated the use of marketable permits for tackling high CO2 emissions (see Rethinking the Environment). This cap and trade system means that while the government has limited the overall value of emissions, firms (polluters) can trade their pollution permits. The incentive to reduce emissions is created by the cost of buying extra permits and selling your surplus if you are more efficient.
So only 13 years later, the EU entered Phase I (2005-2007) of its Emissions Trading System that sought to do just that. Over the same time period CO2 emissions in the EU rose 1.9 %. Why does the market approach appear to have failed?
Firstly, Phase I only covered a two year period; it takes time for firms to invest in more efficient methods of production and consequently reap the benefits of lower CO2 output.
Secondly, the scheme only applied to installations in the energy and industry sectors which accounted for less than half of the EU‚s emissions of CO2. In other words, the emissions trading system was not able to have its full effect.
Thirdly, the ETS was subject to lobbying and mismanagement by the EU and its member states. They allowed far too many permits to be issued, and of those only 5% were auctioned, the rest being freely allocated. This is evident in the price of allowances- from April 2006 to September 2007, it fell from •30 per tonne of CO2 to •0.10. The result: the incentive to reduce emissions vanishes.
Now in 2008 as Phase II begins, the EU has decided that it, and not the member states will allocate the emissions caps- the caps themselves will be lowered and more permits auctioned. Also, coverage of the scheme will increase to contain aluminium and ammonium producers, and, by 2010, the aviation industry. But don't hold your breath. The EU will be just as vulnerable to lobbyists as its members making overallocation just as likely. And increasing the proportion of permits auctioned from 5% to 7% is less of a step in the right direction, and more of a snail's pace.
Instead, lowering the caps to a more effective level and auctioning them all will better reflect the ideas that were suggested 16 years ago, and in the long run will help to vindicate a market based approach to the environment.