Jake's take

Summary

• EU Emissions Trading System works
• Cap-and-trade systems are powerful policy options to reduce pollution
• Unfortunately, systemic EU overregulation, especially in financial services, risks overshadowing this success
• Sustainable finance regulations cannot effectively protect the environment because they do not allocate the cost of environmental protection
• ESG investing and sustainable investing can’t cause any more positive environmental impact than other investment themes
• Most investors’ aims are mostly financial
• If governments correctly set a cost on pollution and offer rewards for de-pollution in the real economy (modify incentives), as EU ETS does, financial markets follow and become sustainable or climate-friendly by themselves
• Time to focus on “no nonsense” environmental regulation all while reducing general overregulation

Something’s working

The EU’s Emissions Trading System (EU ETS) and its carbon price may have managed to bring the EU closer to respecting the Paris agreement.

According to an article in the weekly The Economist (April 25^th 2024), CO2 emissions fell by 15.5% in the EU in 2023, in part thanks to the carbon price (the war in Ukraine and cheaper green technologies exported by China playing a part as well). The article contends that new emissions reduction targets may well be reachable, thanks to the effective carbon pricing system.

It’s worth summarizing what EU ETS really is:

The EU Emissions Trading System is a “cap-and-trade” system with the aim of reducing CO2 emissions within the EU, initially adopted in 2005 following the Kyoto protocol. Covered installations need to buy emissions allowances for their emissions, while total emission allowances issued in the EU are capped.

The system has been progressively improved and tightened over four phases (2005 – 2007, 2008 – 2012, 2013 – 2020 and 2021 – 2030).

Based on the initial 2003 EU ETS Directive (amended 16 times), it covers electricity and heat generation, energy-intensive industry, and aviation.

Concretely, the main features of the system are:

• installations covered must apply for a GHG emissions permit
• installations need to monitor and report emissions
• a EU-wide cap of emissions is set for year N, in November N-1
• emission allowances amounting to that cap are issued and allocated by two means: auctioning by member states (57%) or free allocation (up to 43% of the cap)
• free allocation to specific sectors is based on performance benchmarks
• by 30 April in year N+1, installations need to hand in emission allowances for their emissions in year N
• In the fourth phase (2021 – 2030), the total emission cap was planned to decrease by 2.2% per year, which has been tightened to 4.3% per year in 2023.
• A “carbon border adjustment mechanism” is being introduced to avoid international carbon leakage.
• Free allocations are planned to be progressively reduced and phased out.

The price per tonne of emissions has gravitated since 2022 around 80 EUR, which constitutes a clear market signal and successfully creates incentives for industries to adjust.

Why it works

Why is it, that economic systems combine capital and labour to produce a wide and evolving array of sophisticated goods and services, but tend not to produce the service of conserving or improving natural capital?

Why would economies meet so many needs, but disregard the need of a stable climate?

That’s because, at least until recently, nobody consistently paid for CO2 emissions abatement or improvements. Without demand, there can be no market.

Contrary to things like tech gadgets or food, it’s not obvious who should pay for the climate or for conservation of natural capital.

With sober realism: competitive markets leave limited room for businesses to graciously pay for “optional” costs. And the private sphere is not very different. There’s a free-rider problem.

It is impossible for a free market to move towards environmental sustainability by itself. In the absence of any environmental regulation, an environmentally sustainable producer would progressively become poorer than a polluting one. If both producers were listed on a stock exchange, the sustainable producer’s valuation would be lower than the polluting one’s, because investors’ attention gravitates around expectations and future scenarios regarding financial performance of firms.

Economic theory calls environmental problems “externalities” and describes why markets may fail to produce satisfying outcomes in the presence of material externalities (Cecil Pigou, William Nordhaus). It also suggests that these externalities should be “internalized” by governments, to correct incentives. That’s what EU ETS does.

Climate policy conundrum

Due to the inherently global nature of climate change, any isolated national or regional measures can only have limited success. A stand-alone policy to impose a cost on carbon would risk driving business and emissions to states not imposing that cost.

International cooperation happens within the 1993 UNFCCC (United Nations Framework Convention on Climate Change), that led to the Kyoto protocol in 1997 and to its successor, the Paris Agreement in 2015.

But instead of vague agreements, what is needed is a lean and smart policy. Alas, such a policy may be impossible to agree on by a multitude of competing states.

Kyoto introduced important mechanisms based on tradable emissions permits which were the basis for the EU’s initial EU ETS. But the Kyoto protocol eventually failed, in part due to non-ratification by the US Senate.

The Paris agreement signed in 2015 only rests on voluntary pledges (“Nationally Determined Contributions”), and lacks something that could be called a policy.

It’s the EU that managed the inter-governmental feat to produce something that works.

It’s important to recognize that the triangular setup between the European Commission as the “executive arm” defending the common European perspective, the Council of the EU representing the perspective of Member states, and the EU Parliament as a European legislative arm, can lead to robust decision-making for the common interest.

ESG smoke and mirrors

A simple lesson could be drawn from this success: the main way to set economies on a path towards environmental goals, is for governments to set a price on pollution and rewards for improvement.

This seems very sober and simple, considering the ethereal hopes that have recently sprung from the ESG movement and sustainable investing.

ESG refers to environmental (E), social (S) and corporate governance aspects (G) of a company’s activities and related voluntary commitments. ESG investing refers to the pursuit of competitive returns while “aiming to correctly identify, evaluate and price social, environmental and economic risks and opportunities when investing”.

ESG investment involves a confusingly large number of private and multilateral actors, including ESG ratings agencies, labelling agencies, foundations, business associations, non-profits, international organisations (especially the UN), multilateral development banks, stock exchanges and private businesses providing verification and certification.

While some instruments, like green bonds, are straightforward, ESG ratings remain highly opaque, and strategies like impact investing, ESG integration and ESG optimisation are poorly defined.

A key vulnerability is a lack of clarity whether an instrument’s aim is purely financial (i.e. to outperform by investing into sustainable businesses), or also ethical and impact related. In the latter case, how do we objectively evaluate the relative performance of asset managers on impact-related grounds?

At any rate, it is difficult to escape the conclusion that if environmental market failures were properly addressed already in the real economy by effective policies, they would automatically feed into the financial sector.

Unfortunately, as a response to the free-wheeling ESG investment industry, the EU has been pushing an gigantic sustainable finance agenda, including a unified classification system for sustainable economic activities (EU Taxonomy, 2020/852), asset managers transparency duties in relation to sustainability (SFDR, 2019/2088), corporate sustainability reporting (CSRD, 2022/2464), incorporation of sustainability into financial advice (MIFID2 update, 2021/1253), EU green bond standard (EU GBS, 2023/2631) and low carbon benchmarks (2019/2089).

These regulations are becoming counterproductive and lead to frustration with all sustainability-focused regulations, just at a time when EU ETS regulation is being effective.

Realism requires us to suppose that most investors’ aims are mostly financial (focus on returns and risk).

Crucially: do sustainable finance regulations clarify who should pay for the service of conserving and improving natural capital, climate, and environment? They do not.

As a result, they risk becoming a distraction. They should be streamlined.

Smart and lean

EU ETS and similar measures should take the centre stage. The work programmes of regulators should be focused on smart and effective regulations like EU ETS, to put a cost on pollution and rewards on “de”-pollution.

The concept of tradable emissions permits can still be improved and applied to other domains such as biodiversity and oceans. Monitoring technologies become ever cheaper.

Effective collective action requires smart and lean regulations. We must support the tricky but required supranational governance to make such schemes work.

If the retreat of glaciers ever stops, it will probably happen thanks to functioning markets and carbon prices.

References:

The Economist, April 25th 2024, “Carbon emissions are dropping—fast—in Europe”

The Economist, July 23rd 2022, “ESG: Three letters that won’t save the planet”