ETS Must Address its Architectural Cracks

Robert Raney, Assistant Professor of Accounting and Control at IESE Business School, explains how and why Europe’s world-leading carbon market is being exploited.

A frontrunner in pricing pollution, Europe is home to the world’s largest and most liquid carbon market. The EU’s Emission Trading System (ETS) was created in 2005, forming a cornerstone of the region’s efforts to reduce greenhouse gas (GHG) emissions by 80-95% by 2050. But there is one major shortfall in the framework that policy-makers perhaps didn’t anticipate: that the companies involved may use it for financial, rather than environmental, gain – with the ETS left paying the bill.

It’s an issue not only for the ETS itself, because lessons from this trailblazing model – now nearly 20 years old – are being used to inspire the institutional design of carbon markets worldwide. Around 46 countries have begun pricing emissions through carbon taxes or trading schemes, and over 20 more are considering them, according to the International Monetary Fund. And Europe’s recent introduction of the Carbon Border Adjustment Mechanism – which taxes imported goods that have not already paid for their pollution – has increased pressure on other nations to join the carbon market revolution.

Yet, while cap-and-trade systems like the ETS are vital in our mission to ensure a safe future below the 1.5°C mark, they’re also open to exploitation. Let’s explore why.

The problem with allowances

Within a typical priced carbon scheme, governments set an overall cap on GHG emissions, which is lowered over time. Allowances – or the right to emit one ton of CO₂ or its equivalent – are then allocated to businesses. In the EU ETS, a set number of allowances are distributed for free to companies involved across power plants, industrial factories and the aviation sector, and the rest are sold through auction.

This framework then gives way to a secondary market, whereby participating companies can also buy and sell allowances from each other. If a business manages to reduce emissions more than expected, it can sell those extra allowances, and if it overshoots its emissions limits, it will have to buy additional ones. In addition, C-suite leaders can decide whether it’s cheaper to invest in reducing emissions or to buy additional offsets (effectively paying another company to reduce its emissions instead). It’s this trading process that sets the price for carbon.

So far, so good. But the waters become muddied when we look at the motivations behind everyday carbon transactions. According to IESE research, ETS companies may sell their emission allowances primarily to boost their liquidity or improve their financial performance – rather than to comply with environmental standards.

IESE research shows that the selling of allowances is significantly more common when the transactions are likely to address a liquidity issue or provide a reporting advantage (i.e., boosting earnings to avoid accounting losses). The magnitude of the documented patterns is not negligible. For firms with liquidity constraints, the probability of selling allowances increases by a factor of close to 0.3x. For firms with losses, the probability of selling allowances increases by a factor of close to 0.5x and the sales proceeds on average amount to €1 million per firm, which translates into an increase in return on assets, of 0.6 percentage points.

The difference is important because opportunistic trading in this vein can distort the price of carbon and negatively impact the normal functioning of the ETS (or any similar model). Trading starts to align around liquidity needs and the financial performance of individual businesses rather than the higher goal of pollution management. It also means companies may be less willing to invest in sustainable policies because they’ve lost sight of the bigger picture. Companies do not appear to bear material costs for using the system in this way. In fact it’s arguable that they receive a concentrated benefit at the expense of the normal functioning of the ETS.

A confusing picture

The questionable practice of selling carbon allowances to avoid financial losses is more prominent towards the end of the fiscal year. And it’s also made worse by the wider lack of accounting guidance on how such assets are reported.

As a new type of currency, most regulations are unclear on whether carbon allowances are a financial asset, inventory or something more intangible. This lack of clarity leaves businesses open to gaming the market by forming an off-balance sheet pool of allowances. In other words, they’re building a cache of undocumented assets that can be sold off strategically as and when it helps their financial performance.

The answer to this dilemma comes down to enforcing more transparent reporting standards. Other academics in the field of pollution reduction suggest that companies should account for allowances at fair value – not historical cost – in their financial statements for each reporting period.

This allows greater visibility over how allowances are impacting the financial position of a given business. At the same time, it removes their ability to time allowance sales in order to ‘manage’ their financial performance during a bad quarter.

Building in balance

As one of the pioneering tools of economic-led pollution reduction, the ETS has a responsibility to tighten up its regulation – reducing the risk of regulated companies benefiting financially at its expense.

There are several ways the ETS could be strengthened to do this:

Reduce supply of free allowances: The EU has struggled to allocate the correct number of allowances, allowing some companies to end up with more rights than they need. It’s a system-wide excess that we must address, using more careful supply methods – with limits on the amount of allowances a business can receive for free.
More timely disclosure of transactions: Trading data from Europe’s ETS transaction log is currently made public three years after the close of the compliance period. That means a trade made today would be disclosed in May 2028. Such a big lag makes it harder to monitor companies’ trading habits. Greater accountability via more timely reporting would reduce the incentive for businesses to boost their performance via impulsive allowance sales.
Tighten overlaps in compliance periods: The ETS compliance period runs from January to December, giving companies until April of the following year to surrender allowances – leading to an overlap with the subsequent compliance period. This four-month period allows a company to borrow some of the new allowances they receive – intended for the following year – to cover current emissions. Restricting this capacity would stem such behaviour and ensure that companies are not spending next year’s allowances to cover the current year’s emissions.

In the years since its formation, the EU’s ETS has made huge strides in cutting down emissions in the energy, manufacturing and transport sectors. But if this key policy tool – the first and largest of its kind – is to serve as a template for other global carbon markets, it must address its architectural cracks. More robust measures are needed to ensure the focus stays on carbon assets as an incentive to adopt cleaner technologies and business practices.

As The Economist recently reported, carbon prices are taking over the world, covering a quarter of global emissions and counting. For the ETS to remain the flagship scheme, fighting climate change at the lowest cost possible, a series of supply, reporting and compliance changes are called for. These, in turn, will ensure that the companies involved at the heart of the policy are driven by the kind of priorities that make the entire system work.

This article was co-authored by Gaizka Ormazabal, Professor of Accounting and Control at IESE Business School.

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