On January 1, 2005, the EU Emissions Trading Scheme (ETS) went into effect to the fanfare of EU leaders and environmentalists alike. Designed as Europe’s flagship policy instrument in the fight against climate change, the ETS was widely touted as a market-friendly regulatory scheme to reduce overall greenhouse gas emissions in the most cost-effective way. A brief study of its history, however, reveals that the ETS has not only failed dramatically in its stated objective of reducing overall emissions, but has in fact ended up providing billions of euros in indirect subsidies to some of Europe’s most carbon-intensive industries. In its first three years, EU emissions actually increased by 1.9 percent, while the scheme “fruitlessly [gave] away public assets currently worth €14 billion to industries taking no corresponding environmental action.”

To be fair, emissions trading was never really Europe’s first choice. Initial attempts at introducing an EU-wide carbon tax – which many economists consider to be more effective than a cap-and-trade mechanism – floundered in the 1990s in the face of strong business opposition. More recently, in 2010, Nicolas Sarkozy was forced to backpedal on an election promise to introduce a carbon tax, with the New York Times citing government ministers and members of his ruling UMP party as saying that “the tax would put French companies at a disadvantage to their European neighbors.” The ETS thus came about “as a combination of the growing enthusiasm for market mechanisms … and the strong lobbying by polluters for a permits scheme rather than a tax.” Shell, for instance, announced its support for the ETS fairly early on, stating it “prefers market-based mechanisms … over a carbon tax.”

Yet business was not united in its pragmatic support for the ETS. The chemical industry, for example, represented by the European Chemical Industry Council, vehemently protested the ETS, running media ads against it, funding studies on its harmful economic impact and personally pressing Chancellor Merkel to oppose its implementation. Similarly, the steel and cement sectors vigorously lobbied against the scheme, eventually forcing the Commission to provide billions of euros in free emission allowances to get these industries on board. By the end of Phase II of the scheme, the steel and cement sectors are estimated to have gained €2.3 billion and €1.8 billion, respectively, in free allowances. The ten most over-allocated companies in 2008 managed to somehow quadruple their allocations surpluses by 2009 and stand to gain some €3.4 billion in emission permits over the five years of Phase II. Projected into the future, these firms have accrued so many surplus allowances that they could afford to grow their emissions 50 percent by 2020. All of this threatens to ‘trap‘ Europe in a high-carbon energy infrastructure for decades to come.

As the Financial Times observed:

The first brush with reality came at the market’s inception. In an effort to overcome business opposition, the European Commission, the EU’s executive arm, set a generous cap and allowed national governments to lavish favoured industries with free permits. In some sectors, such as electricity, companies subsequently reaped millions of euros in windfall profits by passing on the market price of the permits to customers even when they themselves paid nothing for them.

The over-allocation of permits led to volatility and a precipitous fall in the carbon price, largely undermining the price signal the scheme was supposed to send to investors. In January 2008, the European Commission proposed to redress some of these ‘teething problems’ by partially moving from free permit allocation to permit auctioning. But industry blocked the initiative once more, arguing that limiting the amount of free allowances in the system would drive costs up so far that entire sectors would be forced to move their operations – and with them millions of jobs – overseas. Most importantly, industry representatives argued that stricter regulation would have the counter-productive effect of actually increasing emissions as industry would be forced to relocate to lesser regulated parts of the globe – a process referred to as ‘carbon leakage’. And so, as EurActiv reported, “fears that tighter controls on CO2 emissions in Europe [would] drive factories to relocate abroad led the EU to grant sweeping exemptions for industries deemed to be at risk.”

Throughout this regulatory battle, the approach of industry rested on a fairly simple strategy: to convince risk-averse and ill-informed policymakers that the impact of further regulation would have severe economic consequences. The trade association of the cement industry (CEMBUREAU), for instance, hired the Boston Consulting Group to publish a report on the impacts of the Commission’s new plans. Its dramatic conclusion was that “at current CO2 prices of 25 euros per tonne, approximately 80 percent of clinker production will be off-shored if no free allowances are allocated. This would heavily affect employment and the gross value added (GVA) generated by the industry.” As CEMBUREAU’s Chief Executive commented afterwards, “the results of this study highlight the point we have been making all along: that the European cement industry is vulnerable to carbon leakage. Recognition of this fact is urgently needed as any delay is already impeding investment decisions in the EU.” In another example, the Corporate Europe Observatory obtained a letter from the managing director of Lafarge Cement UK to Industry Commissioner Verheugen, “threatening to stop investments if the decisions on which sectors were deemed at risk of carbon leakage were not taken before the end of 2009.”

Similarly, steel giant Arcelor Mittal, possessing over €1.3 billion in surplus allowances, warned the Commission that 90,000 jobs were “directly at risk” in Germany alone. Yet as subsequent research has indicated, industry threats of job losses and carbon leakage turn out to be greatly exaggerated. Steel and cement production in particular rely on large upfront capital investments in immobile assets, while most trade is regional (not global) in nature, rendering an ‘exit threat’ by these industries fairly unrealistic. Still, these relatively immobile sectors managed to take advantage of their expertise and exploit the lack of knowledge among policymakers to stir a ‘credible’ fear of divestment. It is thus no surprise that, “during the development of the ETS, industry was involved extensively, not least because the EU lacked knowledge about the mechanism.”

A report by the Fridjof Nansen Institute concludes that “industry had an effect on decision-makers,” citing a warning by Commissioner Verheugen “that the needs of energy-intensive industries must be taken into account to avoid carbon leakage.” In the end, “the lobbying activities from industry seem to have paid off, as the final directive was less strict than the Commission’s proposal and some of the changes made during the decision-making process benefited energy-intensive industries.” British MEP Chris Davies also confirms that “corporate lobbying has been tremendously effective,” adding that “politicians are very nervous about doing anything that could close an industry or cost jobs.” Here, it is useful to recall an observation by the famous political scientist Charles Lindblom that “businessmen often predict dire consequences when a new regulation is imposed on them, yet thereafter quickly find ways to perform under it.” In the end, “far from being a competitive disadvantage,” climate action group Sandbag rightly concludes that “the EU ETS appears to have helped subsidize these industries as the recession entered full swing.”