Private Means for Public Ends

Pricing, Planning and the Law of the European Carbon Market

The European Union (EU) is steadfast in its commitment to achieving net climate neutrality by 2050—an ambitious and commendable goal. Its chosen policy approach has been the two-decade-old Emission Trading Scheme (ETS). The ETS has promised cost-efficient reductions by capping emissions and establishing a market for emission allowances. The idea is simple enough: Trading allowances leads to emission reductions in areas where it’s most cost-effective and concentrates emissions in areas where reductions are more expensive. This is how the market mechanisms have been employed for the public end of emission reductions.

However, the ETS has not delivered the expected results. By general acclaim, it has been largely ineffective in reducing emissions. And yet, with the recent overhaul of its carbon market, the EU has doubled down on the ETS as its flagship policy to pursue the objectives of the European Green Deal (EGD). Effective and equitable climate action demands more than just carbon pricing; it necessitates robust planning. Essential changes, such as transitioning to renewable energy production, electrification of production, and transforming transportation and consumption, all require levels of innovation and central coordination that decentralized market mechanisms and price signals alone cannot achieve. [1] It is fortunate that planning, especially since the pandemic, is finally back in fashion. In February 2023, the Commission pitched its Green Deal Industrial Plan for the Net-Zero Age. However, it faces challenges, hampered by old mantras of cost-efficiency, commitments to a ‘level playing field’, and concerns about global competitiveness. The shift from pricing to planning needs to go further. Not prices should signal action, but desired futures must determine what is needed now.

Legal arrangements and infrastructures are crucial to achieving these objectives. For one, translating climate targets into legal commitments is crucial for effectively anchoring policies and binding relevant actors. The 2021 European Climate Law has made significant strides in this regard. However, law also plays other, often overlooked, roles with potentially adverse consequences: It contributes to path dependencies that are difficult to escape, and it tends to favour, perhaps inherently so, private interests over public ones. The law has amplified market demands over the original goals of emission reductions, further strengthening the staying power of market mechanisms. These legal dynamics must be reckoned with in European climate policies’ shift from pricing carbon to planning the transition.

The European Carbon Market—A Brief History

Currently, there are around 30 emission trading schemes globally. The idea for the EU ETS, celebrated as the first and still the most significant of its kind, emerged in the early 1990s alongside global efforts to reduce emissions under the United Nations Framework Convention on Climate Change (UNFCCC). During the negotiations on countries’ emission reduction targets leading to the 1997 Kyoto Protocol to the UNFCC, the concept of a global emissions market made a late entry when the United States (US) declared it to be a precondition for its support of the Protocol. In the US, market-based mechanisms in environmental policy had already supplanted many traditional command-and-control policies. In tune with the changing zeitgeist of the 1980s, market-based mechanisms were increasingly employed to incentivize economic actors through price signals, rather than imposing regulations.

Initially, neither EU Member States nor the Commission embraced the idea, fearing that issuing allowances for emissions would be perceived as a ‘right to pollute’ or ‘trading in indulgences’. [2] However, the Kyoto Protocol established an international emissions market, created the Clean Development Mechanism (CDM), and allowed developed countries to meet their emission targets by purchasing certificates signifying reductions in developing countries. Cost-efficiency was the key promise of this mechanism: emissions would be reduced where it is cheapest, funded by those whose emissions would be more costly to cut. The scheme faced numerous criticisms, including its inability to prevent ‘greenwashing’, its susceptibility to fraud, and the perpetuation of power imbalances between the Global North and South.

As early as 1992, the EU Commission leaned towards pursuing emission reductions through carbon pricing, then later through a tax scheme. However, the project failed due to a lack of unanimity among the Member States. The eventually adopted tax measure was diluted to the point of ineffectiveness, clearly inadequate to meet the emission targets set under Kyoto. Today, this outdated tax instrument is under review again, aiming to align it with the ambitions of the EGD, though its prospects remaining unclear.

The ETS emerged two decades ago as an alternative to the failed tax scheme. Unlike the fiscal policy of taxation, the ETS, as an environmental policy instrument, required only a qualified majority, not unanimity, in the Council. Interestingly, while Industry lobbyists and individual companies like British Petroleum and Shell had resisted a tax measure, they now advocated in favour of emission trading. The reasons for this shift will soon become evident.

Means Turn into Ends

The 2003 Emission Trading Directive (ETD) wholeheartedly endorses the principle of cost-efficiency. In its own terms, it ‘establishes a system for greenhouse gas emission allowance trading … to promote reductions of greenhouse gas emissions in a cost-effective and economically efficient manner.’ [3]

The political feasibility of emission trading required that emission allowances initially be allocated for free, primarily based on historical emissions benchmarks. Those who were committed to emission reductions gambled that, once in place, the scheme could transition to reducing the emission cap and allocating allowances through auctions, thereby driving up the price of emissions and incentivizing decarbonization. Perhaps this transition is finally taking place: after years of very low allowance prices, the current price per tonne hovers around €90, two decades later. Those less dedicated to emission reductions, or those with the most to lose, also embraced emission trading, as they believed it would make little difference. Even today, the EU has only committed to phasing out free allowances by 2034.

When the EU ETS began operating, it initially placed a price only on additional emissions, not historical ones, for which operators received free allowances. Intensive lobbying, overreporting, and insufficient oversight from public regulators led to high historical benchmarks and an oversupply of allowances, exacerbated when production declined in the wake of the 2008 financial crisis. Additionally, the EU ETS connected with the global mechanism for emission trading under the Kyoto Protocol, permitting the importation of cheap carbon credits—offsets—intended to represent emission-saving projects in developing countries.

Consequently, polluters did not pay, they profited. At the expense of consumers and public budgets, companies enjoyed a windfall profit of somewhere between €30 to €50 billion between 2008 and 2019, derived from selling free allowances, importing cheaper credits, and passing on a significant portion of the opportunity costs of free allowances. [4] Instead of incentivizing emission reductions, the EU ETS inadvertently redistributed wealth regressively.
Lobbying and ill-conceived design choices are primarily to blame for this outcome. While the EU has implemented various adjustments since then, such as changing the basis for allocating allowances, discontinuing the importation of offset credits, and introducing a Market Stability Reserve, the underperformance to date is also attributed to the initial reliance on the market, which has overshadowed the original objective of reducing emissions.

Legal Code

The emissions market, like most markets, is a legal construct and relies on law to fulfil essential functions. The law establishes the validity of transactions, ensures payments, safeguards consumers, defines product standards, and more. In the context of emission trading, the law’s role as a market-maker is most evident: emission allowances or credits are non-tangible, existing solely through legal frameworks. A market created in this manner could be structured differently or, in principle, be dismantled. However, once established, markets generate demands that the law accommodates and amplifies, making it challenging to reshape the market or transition to non-market mechanisms. These demands are reflected in the legal coding of assets, as outlined by Katharina Pistor in The Code of Capital: the law extends the validity of legal titles across time, contributes to their acceptance, and to their convertibility into other assets or, ultimately, into money. [5] Here are three developments in the legal framework of the European carbon market that illustrate this dynamic.

First, shortly after the EU ETS became operational, it became clear that emissions were lower than anticipated. The question immediately arose whether allowances could be banked, i.e. carried over from one period to the next. According to the European Court of First Instance (now known as the General Court), this was not possible because the EU ETS directive was silent on the issue. [6] The price of allowances immediately plummeted to zero. According to the Commission, such uncertainties during the transition from one period to the next caused interruptions in the market and advocated for removing limitations on the use and temporal validity of allowances. This would, according to the Commission, ‘avoid possible perceived regulatory risk at the end of trading periods [and] would give a fully coherent signal to the market.’ [7] Revised legislation clarified that allowances are now valid indefinitely, benefiting the market and corporate profits but not advancing the original goal of reducing emissions.

Second, there is an ongoing debate regarding whether emission allowances can be considered property and enjoy legal protection as such. The EU ETS itself does not definitively clarify the legal nature of emission allowances, leaving it to the laws of Member States, which vary significantly in this regard. While holders of emission allowances have yet to secure protection under the right to property at the European level, this may change in the future. General Advocate Kokott remarked that the right to property, as protected under Article 17 of the European Charter on Fundamental Rights, extends only to ‘rights with an asset value creating an established legal position under the legal system, enabling the holder to exercise those rights autonomously and for his benefit’. [8] This protection, she argued, did not apply in cases involving the expectation of receiving free allowances, especially because the directive foresaw the possibility of reductions in free allowances. In the future, as the allocation of allowances increasingly shifts more towards auctioning rather than free distribution, the weakening of property rights becomes more pronounced. [9] This scenario could potentially open the door to characterizing policy adjustments as direct or indirect expropriation, imposing constraints on policy flexibility and limiting the ability to respond effectively to lessons learned.

Third, pressures to secure the durability of allowances grow alongside the financialization of emission trading and the emergence of secondary markets. A vast majority of transactions in the European carbon market (99%) occur in the secondary market of derivatives (futures, forwards, options, swaps, etc.), [10] not directly involving allowances or credits. Regardless of the benefits (supporting the primary market’s promise of cost-efficient allocation) or drawbacks (contributing to price volatility and unpredictability), the secondary market demands even greater legal certainty and stability concerning the underlying assets—allowances—on which these secondary financial products are based. Once again, this financialization is not inherent or inevitable but is a choice embedded in law, to which the legal code is highly receptive. The ETS’s legal framework allows not only companies obligated to surrender allowances for their emissions but also various actors, including investment firms, credit institutions, and other intermediaries, to participate in bidding for and trading allowances. [11]

Law has not been a neutral instrument in the European carbon market; instead, it has favoured of market functionality over emission reductions. It has exhibited an inherent bias that is evident in the fact that it safeguards against regulatory takings but does not recognize regulatory offerings. Simultaneously, it is clear that allowances may not only be thought of as private property but also under other legal categories as well, such as public administrative rights. [12] The EU’s pivot from pricing to planning—sputtering and half-hearted as it may be for now—must also extend to legal thinking and re-coding, shifting from private to public law categories and exploiting the tensions between them.