13/11/2012 12:22 GMT | Updated 12/01/2013 05:12 GMT

ETS: Putting a Price on an Invaluable Commodity


To understand why the EU is putting a price on polluting emissions through the Emission Trading System (ETS), you first have to understand what economists call negative externalities, that is when you reap benefits individually, but pay the price collectively.

So, while companies watch their energy use in order to cut back on electricity bills, they tend to care less about polluting emissions. Pollution does real damage to the environment and people's health but as it does not affect a company's bottom line, there is no real incentive to act.

One way to force a more socially-responsible attitude is to criminalise the unwanted behaviour. For this approach to be a success there must be sufficiently off-putting punishment in the form of high fines and prison sentences, as well as a reasonable chance of getting caught.

Another way is to create incentives. This is what the EU's Emission Trading Scheme sets out to do with pollution. It puts a limit on the amount of greenhouse gases that can be emitted each year. Limits are set on companies and if they emit less they can sell their outstanding allowances. However, if they exceed the limit they must purchase extra allowances. This cap and trade system gives firms a monetary incentive to cut down on emissions. The total limit is gradually lowered over the years to encourage participants to become greener.

The European Parliament has always broadly supported the scheme, but is looking into how it could be improved. ETS will only work if the right incentive is created by setting the right price. If the carbon price - the price of additional allowances - is set too low, there won't be enough of an incentive to force companies to make the effort to become greener. But if the price is too high, it could hurt European companies' competitiveness.

In March 2012 MEPs adopted a non-binding resolution that called for improvements to ETS, such as the possibility to set aside pollution permits to ensure a good carbon price and for aviation emissions to be fully included in the scheme despite the opposition of countries outside the EU.

On 12 November the Parliament's environment committee will hold an extraordinary meeting to discuss with experts and representatives of the Commission and the Council's presidency how it can be fine-tuned, including the timing of auctions of greenhouse gas allowances.

Getting the price of polluting emissions right is vital if we want to avoid their cost.

Thank you to Kaysha for making the photo available under the Creative Commons license