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The Pitfalls of Manufacturing a Market

New America Foundation, July 16, 2009

By Emily Gallagher

Despite its aim, the European Trading Scheme (ETS) for carbon is widely regarded as an inefficient market. The initial design of the scheme has caused trading reactions that do not follow the pricing patterns of other, more efficient commodities.

Within ETS, it isn't carbon's price volatility that makes its market seem uncharacteristic of other commodities markets; commodity markets are often characterized by volatility. Instead, it is the fact that carbon's price drivers are not so easily pinpointed and, therefore, its volatility seems arbitrary.

Currently, the most obvious symptom of inefficiency is that carbon allowances trade cheaply in Europe—so cheaply that companies buy allowances rather than cut pollution. Theoretically, carbon prices should be closely linked with the marginal cost of switching to lower-carbon fuels. Thus the failure of allowance prices to trend towards the marginal cost line suggests a lack of normal supply and demand dynamics—this inefficiency may only be explained when one takes into account the numerous artificial drivers pressing on carbon prices.

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