Why are carbon markets failing?

European Union Emission Trading System (EU ETS) is the most important and largest carbon market.  Its principle was from the 1997 Kyoto Protocol.  After 18 years, has the concept worked and played a significant role in combating carbon emission?

How the EU ETS works?  The regulator of the system sets a cap on the total emission EU sectors are allowed to emit and permits are distributed to polluters.  These permits are allowed to be traded between market participants.  Market participants here do not only refer to polluters (consumers) but also include suppliers, intermediaries, end users and regulator.  The EU ETS is an interactions between these participants and connects buyers of carbon credit with buyers.

The idea of carbon market is to reduce the demand by increasing the price of carbon emission and creates incentive in low-carbon technologies, why has it failed?

1.  Too much of carbon permits

Basic economic concept:  too much supply without sufficient demand, price falls.  During the first period of the trading system, too many permits were allocated by the regulator because countries had inaccurate emission data.  Whether this is resulted from countries protecting their industrial sector is not know, but asymmetric information in the market had created.  This form of market failure results from economic agents in the market do not have perfect information of the market and drives the price too high or too low.  The overcapacity is roughly around 2 billion tonnes which is around a year's emissions.  As a result, price fell by 75% from €20/tonne to €5/tonne in 2 years.  (carbon price is roughly €8.5 at the moment).  The intention to raise private cost of polluters to meet the social cost to eliminate the negative externalities is therefore not significant.

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economist

2.  Intention of participant

"If global warming is inevitable, why don't we invest in businesses that will profit as the planet gets hotter".  The problem of failing to correct the market failure as mentioned is that firms simply switch to (or maintain) high carbon emission production.  As Bloomberg reported , big energy companies are putting their efforts in increased extraction of fossil fuels rather than renewable energy as will yield more profit. (theguardian)

The inefficiency of the market is also examined by Crossland, J (2013).  Crossland mentioned in the paper that the main participant can earn profit simply using the historical price information.  If a market is not efficient it will open door for investor in the market to earn abnormal profit.  The trading system has violated the principle of efficient market because price is predictable.  A market is efficient if price don't exhibit predictability.  Carbon price followed a certain patterns within a year because it is heavily influenced by weather factors.

The focus of reducing carbon emission seem to be shifted away.

3. A single price

Certain sectors (power sector with 64% of permits) and countries have more influenced in the market.  This will create some kind of monopoly power within these agents in the market.  Because carbon price is homogenized, agents with significant market power may result in misuse of market power such as price formation.  One solution is to include the factors of carbon intensity or output based goals into the settings of carbon price.  Those sector with higher market share tend to produce largest amount of carbon emission.  The potential price differential for these sectors will force them to reduce more emission (rather than buying cheap permits from the market) and will also stop them from abusing market power.(Carbonpulse)