Artificial Market Risks in the European Carbon Market and Their Implications

ARTIFICIAL MARKET RISKS IN THE EUROPEAN CARBON MARKET AND THEIR IMPLICATIONS

Jens Krause, University of Oxford, +44 (0) 753 407 4907, [email protected]

Overview This article develops a theoretical framework to study systemic risk in artificially created markets. It reports results of an empirical study of the European carbon market. Studying the European Union Emissions Trasing Scheme (EU ETS) as a natural experiment, the article considers both policy objectives considered in the transition towards a low- carbon economy: efficient technology choice and incentivising the technological development. It builds on empirical findings to contribute to the debate on which policy instruments are appropriate to achieve those objectives. It is shown that market participants' perceptions of the EU ETS’s purpose differ and that the legal framework created by the EU ETS is necessary, but not sufficient to create a carbon price. Building market institutions, which for artificial markets include a shared purpose, a legal basis for property rights, and expected scarcity of goods, as well as maintaining them, pose sources of systemic risk. The article concludes that the EU ETS needs reform, but no revolution.

The paper is structured as follows: first, the rationale and policy framework of the EU ETS are introduced. Second, a framework is developed to study systemic risks in artificial markets. This framework is largely based on new institutional economics/neo-institutional theory. Third, the results of an empirical study of the EU ETS are reported. Particular attention is given to the purpose of the EU ETS and property rights aspects. Fourth, the empirical results are related to previous literature and the public policy debate regarding a reform of the EU ETS.

Methods

26 in-depth interviews with senior carbon market participants and policy-makers. Discussion of results in light of existing literature and public policy debate.

Results

The fieldwork has shown that market participant’s perception of the EU ETS’s purpose differ. The legal framework created by the EU ETS is necessary, but not sufficient to create a carbon price. Market participants, especially compliance firms and financial intermediaries, expressed doubt that the formally codified emission permit reduction targets will materialise. A self-fulfilling prophecy occurs when national or EU-wide additional policies are used to increase incentives for behavioural change. As additional policies influence the subjective composite carbon price, they are seen as a sign that the EU ETS cannot deliver a sufficiently scarce supply of emission permits. As a logical consequence, the actual price of an emission allowance becomes less important in strategic decisions. Building credible market institutions, which for artificial markets include a shared purpose, a legal basis for property rights, and expected scarcity of goods, as well as maintaining them poses additional sources of systemic risk. Currently, the contested purpose of the carbon market, as well as the inability of policy-makers to create expectations of scarcity hold systemic risk potential. Conclusions

Artificial markets are created for political reasons and are distinctly different from other commodity markets. Their main challenges arise from the construction of market institutions, which are developed and maintained by actions of market participants as well as policymakers. The EU ETS needs reform, but no revolution. It should be used as a tool to price the environmental costs of pollution and thus primarily as an information signal leading to efficient technology choices. To drive the technological transition towards a low-carbon economy, additional country and sector specific action is necessary, which can be market or policy driven. Although theoretically both environmental and technological externalities are addressable with a carbon price, the study suggests that the ‘double externality’ cannot be solved with just one instrument.

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