Jake's take

Summary

• 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 in a sense follow and become more sustainable or climate-friendly as a result
• Cap-and-trade systems are sensible policy options to reduce pollution, and EU ETS works
• Within the discussions on sustainable finance regulations, we shouldn’t forget about incentive systems, to ensure the cost of environmental protection is actually allocated.
• Transparency regarding sustainable characteristics of investments, or regarding sustainable economic activies, alone, may not be sufficient to efficiently allocate the cost of building sustainable economic systems and favour lasting real outcomes

EU ETS

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), EU CO2 emissions (those covered by EU ETS) 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).

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.

(cf to Annex below with the outline of how EU ETS works)

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 to stumble regarding the vital service of conserving or improving natural capital?

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

One important factor is that contrary to goods like tech gadgets or food, it’s not obvious who should pay for the climate or for conservation of natural capital.

Competitive markets sometimes leave limited room for businesses to pay for “optional” costs. And the private sphere is not that different. There’s a free-rider problem.

It is difficult 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.

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, has made possible a type of robust decision-making for the common interest that other regions lack.

ESG

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”.

A vulnerability in the concept of ESG investing is a lack of clarity whether a financial instrument’s aim is purely financial (i.e. to outperform by investing into sustainable businesses), or also ethical and impact-related.

Another vulnerability is blurriness as to what criteria should justify calling a product ESG-compliant or sustainable. That becomes particularly important when an instrument’s stated aims are specifically more than financial, with additional ethical and impact-related objectives.

In part as a response to the growing ESG investment industry, the EU pushed an ambitious 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).

One of the main goals of these regulations was transparency: providing objective information on how sustainable an economic activity is, and on the criteria used to define investment approaches that claim to be sustainable.

However, regarding the environment, the recent sustainable finance regulations do not provide new answers to the question of who should pay for the service of conserving and improving natural capital, climate, and environment.

Smart and lean

EU ETS and similar measures should now benefit from a renewed focus: smart and effective regulations that 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 more powerful and cheaper, thanks to AI. Multilateral approaches based on that concept can become powerful vectors for transformation.

We must support the tricky but required supranational governance to make such schemes work.

Functioning and dynamic capital markets, and carbon prices, should thus be important priorities for regulators.

Transparency regarding sustainability characteristics of economic activities and financial instruments should, where possible, be linked to incentive mechanisms to help effectively allocate the additional cost of sustainability.

Annex: EU ETS and how its works

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.

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”