Initial attempts to create a market for carbon trading in Europe have failed to provide effective incentives for green energy. A&O's Matt Townsend and Jennifer Wallace assess the challenges ahead

There is no shortage of targets when it comes to Europe's climate change policy. In addition to commitments under the Kyoto Protocol, the European Union (EU) aims to achieve a 20% reduction (from 1990 levels) of greenhouse gas (GHG) emissions by 2020 (rising to 30% if other countries commit to similar levels in ongoing negotiations). By the same date, the EU wants to see 20% of all its energy come from renewable sources. In the UK, the Climate Change Act 2008 requires a 34% cut in GHG emissions by 2020, and a cut of 80% by 2050. The concern is whether the mechanisms used by European governments will work to deliver these targets.

One such mechanism has been the development of a price for carbon. This has largely been achieved, in Europe, through the EU Emissions Trading Scheme (EU ETS), a cap and trade scheme linked to the global carbon market created by the Kyoto Protocol's flexible mechanisms. The level of the cap and the market in allowances to emit carbon dioxide create a price for carbon emissions.

In theory, the development of a carbon price should increase the relative costs of carbon-intensive operations and thus make low-carbon technologies more attractive to investors and developers. At a certain carbon price, generating a unit of electricity from fossil fuels becomes more expensive than a unit generated from renewables or nuclear and the economic case for renewables and nuclear becomes more compelling.

An investor's assessment of the relative returns from different kinds of energy generation technology is, of course, a long-term one. The price of carbon must reach a certain level to create an incentive for investment in renewables and nuclear, but investors also crave certainty about what that price will be in the long-term. Many observers, from major players in the energy industry to environmental NGOs, have argued that fluctuation in (and the level of) carbon prices are seriously undermining investment decisions and hampering the development of low-carbon technologies. A look back at historical carbon prices in the EU ETS (the largest part of the global carbon market in volume and value) suggests they may have a point.

In Phase I of the EU ETS (2005-2007), there was a significant excess of EU carbon allowances over actual emissions. When data confirming this over-supply was released to the market in May 2006, the price of Phase I EU emission allowances (EUAs) fell precipitously from over E30 per allowance to around €10. Phase I EUAs could not, as a rule, be banked for use in subsequent phases and this contributed to their further steady decline in price until, in December 2007, they could be bought for a few euro cents.

Stricter allocations in Phase II (2008-12) initially kept the price of EUAs higher. However, the carbon market has not proved immune to the economic downturn and, with a major fall in industrial production, carbon emissions and the demand for allowances have also fallen. Operators sought to ease short-term cash flow problems by selling their allowances, further increasing supply. The price of Phase II allowances fell from around the €29 mark in June 2008 to around €7 in January 2009, though it has since recovered to €14.

Improvements to the structure and operation of carbon markets may help to stabilise and raise carbon prices. Changes have been made to the EU ETS for Phase III (2013-2020) with this in mind. The length of that phase (eight years rather than five) is intended to allow a longer-term price signal to emerge. Governments hope that over-allocation will be eliminated by auctioning a large proportion of allowances, rather than allocating them for free. Where free allocations are made, they will be determined by the European Commission on the basis of EU-wide benchmarks, rather than by individual member states who may be influenced by considerations of national interest. The rules for Phase III also incorporate a mechanism for smoothing out spikes in the carbon price by bringing forward auctions.

Despite these changes, significant uncertainty remains for investors. EU law makers have resisted calls for a floor price to be imposed on EUAs. The current lack of a global consensus on how to tackle climate change also makes it harder to assess the future carbon price. Current emission reduction commitments under the Kyoto Protocol will expire at the end of 2012 and, while negotiations for a successor international agreement are ongoing, the prospects for a detailed, comprehensive agreement at Copenhagen in December look increasingly slim.

To encourage investment in renewables and nuclear generation, governments will have to continue to use a range of carrots and sticks. However, developing a framework that delivers a stable carbon price at levels sufficient to change investment behaviour is a critical part of the picture. If Europe is to achieve its climate change targets and broaden its energy mix, governments should look again at whether the EU ETS is capable of delivering on its promises.

Matt Townsend is a partner and Jennifer Wallace an associate in Allen & Overy's global climate change practice.