Europe's emissions trading scheme has failed to create incentives for utilities to use cleaner energy fuels, meaning that governments will have to switch to simpler tools, such as subsidies and regulation, to enforce emissions reduction targets.
One of the most effective steps to reduce emissions would be to switch from coal-fired power generation to gas, which produces about half the emissions of coal.
The European Union's emissions trading system (ETS) puts a price on allowances to emit greenhouse gasses into the atmosphere. But since the scheme's launch in 2005, the system has failed to create sufficient incentives for industry and power generators to switch to cleaner energy sources, Reuters data show.
At current market prices for power, gas and coal, a tonne of CO2 emissions would have to cost almost €40 to make gas more attractive than coal-fired power generation, Reuters data show. The actual price for CO2 emissions is less than €7 a tonne.
"What is becoming clear is that the result of the inherent inefficiencies in gas pricing are limiting the market-share gains of that commodity and are pushing users in high gas price regions [Europe and Asia] to continue using coal," Barclays Capital said in a research note on Thursday (14 June).
"This is locking the world into a much higher emissions path [and] we estimate that global CO2 emissions from primary energy consumption were up by 2.9% year on year.
Not costly enough
The most obvious failure of the ETS has been that emissions allowances are not expensive enough to make it more attractive to invest in cleaner fossil fuel sources.
Yet an equally big, if more hidden, failure of the ETS has been that there are too many market variables at play to make emissions consistently expensive enough to facilitate the long-term investment decisions needed for fundamental changes in the way electricity is generated.
One such variable that the ETS has no control over is the foreign exchange market. European utilities sell their electricity in local currencies, such as the euro or sterling, but have to buy coal in the dollar-denominated coal market.
This means that swings in the dollar affect their purchasing power in the coal market.
At current market prices for power, coal and the euro/dollar, German wholesale electricity generated from coal for delivery in 2013 is generated and sold at a profit of about €11 per megawatt hour (MWh).
Should the euro drop to its historic low of about $0.83, the loss in purchasing power in the coal market would mean that German utilities would sell power at a loss of over €5 per MWh. At the euro's historic high of just under $1.60, the profit per MWh would be almost €20, Reuters research shows.
At its historic average of around $1.18, the profit would be almost €9 per MWh, about €15 more attractive than current gas power generation, which is a loss-maker.
The implications of these swings for the so-called fuel switching price of carbon (the price that a tonne of carbon would need to be to make gas-fired power generation more attractive than coal) are huge, ranging from €9 a tonne at the euro's historic low versus the dollar to €50 for its historic high.
In effect, a carbon price of €15 to €20 a tonne, recently voiced by the European Commission as a desired price level, would be sufficient only in a long-running scenario of an extremely low euro.
A fuel switch price of €30 or more, often quoted by analysts as necessary to push power generation away from coal and towards gas, would be possible only in a long-running scenario of an extremely strong euro against the dollar.
By contrast, current euro/dollar rates of about $1.25 give no incentive at all to switch to cleaner fossil fuels.
A Reuters poll suggests that the euro and sterling are both set to move sideways against the dollar, implying a continuation of a market that would favour coal over gas-fired power generation in Europe.
Critics of the ETS are increasingly calling for alternatives to push for cleaner energy sources. Michael J. Sandel, a Harvard University law professor, says that an ETS gives polluters in rich countries an opportunity to shy away from real emissions reduction measures, such as high pollution taxation.
"Carbon offsets, while reflecting a laudable impulse to put a price on the damage we do to our environment, contain the risk that those who use them will consider themselves absolved of further responsibility ... such schemes could have the effect [of] giving misbehaviour a moral license," he said in his recent book, What Money Can't Buy.