It’s hardly news at this point, but oil prices hit yet another new high yesterday. Adjusted for inflation, oil is now as expensive as it’s ever been—even more expensive than it was during the energy crunch of the late 1970s and early 1980s.
Of course, part of the reason for the rise in prices is the fall in the value of the dollar against other international currencies. When the dollar’s worth less, it takes more US currency to buy a barrel of oil on the international markets. Still, energy prices are rising even in Europe, where the currency hasn’t taken such a beating.
So, given rising prices, I’d expect energy demand to fall, at least a bit, leading to lower emissions. And under a carbon trading scheme, when emissions fall, then the price of carbon permits should fall too—right??
Unfortunately, it may not work that way—at least, not in the European emissions trading market.
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I checked out carbon prices on the European emissions trading market yesterday, and lo and behold, the price of carbon had reached a two-month high, despite surging oil prices.
That was completely contrary to my intuitions. Again, I’d assumed that higher prices would temper demand, which would reduce consumption—which, in turn, would reduce emissions. And as emissions fell, the price of carbon would fall too. That’s what I thought, anyway.
But the European carbon market simply doesn’t work that way—largely because the emissions system doesn’t cover transportation emissions.
Instead, Europe’s carbon trading scheme only covers major industrial energy users and electricity generators. Those sectors are subject to a gradually declining cap. But transportation—which is the biggest consumer of petroleum—is not. It’s out of the system entirely. So even if petroleum consumption falls, emissions from within the capped sectors won’t necessarily fall in sync. And that leads to some wacky results.
The press is has explained the simultaneous rise in oil prices and emissions prices as follows:
- Oil and natural gas prices are closely linked. A few applications can use either oil or gas, and this interplay links oil and gas prices together, at least over the short term.
- So the recent runup in oil prices caused a simultaneous increase in natual gas prices.
- The surge in natural gas prices shifted the European electricity mix away from low-carbon natural gas generation, and towards higher-carbon coal.
- Thus, the rise in petroleum prices indirectly increased coal consumption in the capped sectors.
- And that, in turn, increased the aggregate emissions in the sectors operating under the emissions cap.
- As emissions rose, coal generators had to buy more emissions allowances—which drove up the price of allowances.
Voila: a simultaneous increase in oil prices and allowance prices.
Of course, this sort of perverse cycle would be a lot less likely if Europe had covered transportation under its emissions cap. In that case, oil price increases would yield modest (but real) cutbacks in gasoline and diesel consumption, reducing emissions under the cap.. Those emissions reductions would at least partially offset the increases in the electricity sector—resulting in more stable, less volatile emissions prices. An increase in oil prices could still increase coal consumption, but the effects on emissions prices would be far more moderate.
To me, that’s a good rationale for including transportation in an economy-wide cap and trade system—not only does it help guarantee economy-wide reductions, it can help smooth out volatility in the emissions market. (And that, perhaps, is a major reason why so many electric utilities in the western US are pressing to have transportation included in an economy-wide cap.)