ETS Design Failures

The EU ETS spent its first decade as a case study in how not to design a carbon market. Prices crashed to near zero twice (2007 and 2012), not because the climate problem disappeared but because the cap was set too loosely, free allowances were distributed too generously, and the system had no mechanism to adjust when reality diverged from projections.

Phase 1 collapse (2005-2007). The EU allocated more allowances than actual emissions, creating a surplus. Allowances could not be banked into the next phase. Price crashed from 30 euros to 0.03 euros. Lesson: set the cap based on verified emissions data, not industry-reported projections that inflated baselines to secure more free allowances.

Phase 2 oversupply (2008-2012). The 2008 financial crisis cratered industrial production and emissions, but the cap did not adjust downward. Surplus grew to over 2 billion allowances. Price languished at 5-8 euros for years. Lesson: fixed caps cannot respond to economic shocks. An adjustment mechanism is needed.

The fix arrived in 2019. The Market Stability Reserve, covered in the ETS mechanics lesson, finally gave the system an automatic supply adjustment; prices rose from 8 euros (2018) to 80+ euros (2023).

Why did it take 14 years to fix?

Because every fix creates losers. Tightening the cap raises costs for energy-intensive industries. Reducing free allocation hurts incumbents. Each reform required years of political negotiation among 27 member states with different industrial structures and energy mixes. The technical fix was straightforward; the political economy of implementing it was not.

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