Good intentions, wrong price tag. Photographer: Chris Ratcliffe/Bloomberg
Good intentions, wrong price tag. Photographer: Chris Ratcliffe/Bloomberg

President Barack Obama recently said in an interview on climate and energy that if there’s one thing he would like to see, it would be for the U.S. to be able to put a price on carbon emissions. He is right -- an effective market-driven approach to carbon pricing is crucial to tackling climate change and reducing emissions. The U.K. was the first to adopt carbon trading in 2002, and it continues to trade under the European Union’s Emissions Trading System.

The EU cap-and-trade system is the world's largest. By putting a price on every metric ton of carbon emitted and allowing companies to trade allowances, the system enables carbon-reduction targets to be met at the least cost.

Carbon Markets 2.0

But the market currently has a surplus of about 2 billion emission allowances, equivalent to a year’s supply. As a result, carbon prices are at an unhealthy low. So what has gone wrong, and what can we do about it?

Some believe that a weak carbon price benefits business and the economy, but it does not. It undermines the low-carbon investment we need now to meet long-term targets. Ambitious emissions-reduction targets are here to stay, so delaying low-carbon investments just pushes the cost of achieving them later down the line and risks increasing it. It also means losing out on the potential growth and jobs that come with such investments.

So today, the U.K. government will publish a blueprint for ambitious and urgent reform of the Emissions Trading System that will tackle the surplus, protect against risk of competitive disadvantage and cut red tape.

First of all, we must cancel a substantial amount of the surplus allowances to help restore the balance between supply and demand, thus supporting a stronger carbon price. The persistent surplus sends a false signal that companies do not need to abate carbon now, and this increases their incentive to build carbon-intensive infrastructure today that will only have to be abandoned tomorrow. The Market Stability Reserve, proposed by the European Commission, can potentially be a helpful mechanism, but it is not the comprehensive reform we urgently need.

Second, the trading system must make sure that the allocation of free allowances continues to help industries stay competitive during the global transition to a lower-carbon economy. As the amount of free allowances within the cap continues to fall after 2020, allocation must target the sectors that are genuinely at risk of losing their competitive edge.

Third, the system needs to strike a better balance between fairness, cost-effectiveness and simplicity. For example, compliance costs and administrative burdens could be reduced by ensuring that small sources of emissions are treated proportionately.

The development of similar carbon-pricing mechanisms around the world would allow emissions to be reduced at the lowest cost across the globe. Many countries are already developing carbon-pricing and emissions-trading policies, including China.

The EU can pave the way for linking cap-and-trade proposals to create a global carbon price. This would enable emissions reductions to take place wherever they are cheapest worldwide; increase the liquidity of carbon markets and stabilize the price for investors; expand low-carbon business opportunities; and drive greater global climate cooperation. It could be the game changer for low-carbon investment.

But to deliver this prize, the Emission Trading System must first lift its own ambition. The reforms I am pushing for today are vital, not only for the U.K. but also for the world's concerted fight to contain climate change.

(Ed Davey is the U.K.'s secretary of state for energy and climate change.)

To contact the writer of this article: Ed Davey at correspondence@decc.gsi.gov.uk.

To contact the editor responsible for this article: Mary Duenwald at mduenwald@bloomberg.net.