In 2005, the European Union's (EU) Emissions Trading Scheme (ETS) began a test phase, in which emissions credits were over-allocated, resulting in a price collapse in late 2006. In Phase II of the ETS, which began in 2008 (and runs through 2012), the European Commission (EC) more carefully screened National Allocation Plans to control for over-allocation of credits and to ensure compliance with member state emission reduction targets under the Kyoto Protocol and the EU's own Burden-sharing Agreement.
The global economic downturn created concern that the ETS would fail once again to reduce emissions because emissions allocations would not be scarce. Indeed, just before Easter, the EC issued data indicating that the carbon market was over-supplied with emissions credits mainly due to an 11 percent reduction in energy use from 2008 to 2009. Needless to say, environmentalists were not pleased.
However, something unexpected happened. According to today's Financial Times (here) carbon credit prices did not drop. In fact, they have risen slightly since Easter to 13.50 Euros. The reasons: first, unlike in 2006, the market had already accounted for the economic downturn in carbon permit prices, so the EU's data did not take market participants by surprise; second, and perhaps more importantly, unlike carbon permits in Phase I, Phase II carbon permits issued this year will not be expiring soon, but remain useful until 2012 (and possibly beyond). Thus, short-term economic fluctuations have less of an impact on carbon permit value.
Apparently, the EU learned some important lessons during Phase I of the ETS, and has implemented those lessons to good effect in Phase II. The institutional tweaks have made the ETS a more resilient and effective market-based program for reducing carbon dioxide emissions.