Just as the federal government prepares to announce details of its carbon pricing regime in the next week or two, the European emissions trading scheme is lurching through another crisis. Or should that be crises?

The European carbon price has plunged dramatically in the past month, with an 11% slump on Friday to €12, extending a 30% slump in previous sessions. It is now at its lowest levels in more than two years.

It’s been caused by a confusion of seemingly separate but ultimately interrelated factors: The Greek debt crisis and the threat of another European-wide recession; the failure to agree on more ambitious emissions reductions targets; a massive overhang of free permits; a major spat between Europe, China and the US over the inclusion of non-EU airlines in the European ETS; and the proposed introduction of new energy efficiency targets.

Views differ on the import of the various factors, but there is no doubt that without corrective action they could combine to create a massive overhang of pollution permits by 2020 and a carbon price that ultimately falls to zero. The European Commission has canvassed this very scenario in a recent assessment.

It is one of the conundrums of emissions trading schemes that — as nearly any economist will tell you — while they are effective at finding the least cost of abatement, when low-cost abatement is combined with modest targets, or over-generous compensation, the carbon price can slump dramatically, unhinging the business plans of those relying on it going up. The EU experience in the past six years has been akin to a dog chasing its tail.

In Europe, there are fears of another recession. This means that abatement targets will be likely met through a reduction in production rather than any serious abatement measures or technology switches, adding to the considerable overhang of permits caused by overly generous handouts to industries such as the steel and cement sectors.

According to the European Commission, the GFC and other energy-saving incentives have already reduced the business-as-usual projections out to 2020 by about 14%. It fears that new energy efficiency obligations, which require energy utilities to achieve annual savings equivalent to 1.5% of their sales, and other measures, could ultimately push emissions some 35% below 1990 levels by 2020.

Of course, this would be a good outcome as far as the environment is concerned — but it’s way more than the current 20% emission reduction target and, combined with the 20% renewable energy target, could create an overhang of another 2.5 billion permits, HSBC noted in a report.

The EC has outlined two scenarios: one where the carbon price remains stuck at around €14 a tonne by 2020 (compared to forecasts of at least €30, and possibly more than €50); and another where it is effectively zero. The European industrial giants trying to compete with Asian counterparts in seizing a share of the so-called “green economy” say they will be hamstrung if this is the case. They want a carbon price of €30 or more by 2020.

As HSBC economist Nick Robins noted, this has created the bizarre situation where some have argued against further efforts to save energy, arguing that it overlaps with sectors covered by the ETS. “These energy efficiency improvements, the argument goes, will reduce power demand, thereby cutting emissions from the power sector, resulting in excess ETS allowances, and pushing down carbon prices,” he wrote.

The obvious solution to this, notes Robins, is to create a higher abatement target, which is what those industrial groups, as well as the UK, France and Germany, have been pushing for. It is why the UK has proposed a supplementary carbon tax.

But a steeper emissions reduction target requires agreement, and Poland earlier this week effectively vetoed a push agreed by other European countries to lift the emissions reduction target to 30% by 2020. And as Poland will soon inherit the presidency of the EU for the next year, there is little hope this will be achieved any time soon. The other option — recalibrating the ETS to set aside allowances — also requires political agreement.

Deutsche Bank analysts Isabelle Curien and Mark Lewis says the apparent lack of agreement between the various EU bodies on the primacy of the ETS as the cornerstone of its long-term climate change policy is damaging market confidence. “There is little or no incentive for buyers to step in, and … there is therefore now a clear risk of prices falling further still over the coming days and weeks,” they wrote in a report on Friday. “Fear will dominate (trading) in the near term.”

The experience in the European ETS, past and present, underline why it was that the Australian Greens wanted to impose a relatively high fixed price on emissions — because without one it does not necessarily spark the transformation to new technologies that is hoped for.

How to manage the transformation from a fixed carbon price to a market-based system is one of the key measures to be resolved by the Greens and the Gillard government in their negotiations. Ultimately this, and the long-term governance structures, will be more important than the starting price, or even the amount of compensation handed out to coal-fired utilities and coal mines in the short term.

It also explains the sudden skittishness of Australian energy retailers about the proposed inclusion of an energy efficiency scheme in Australia as part of the package of measures. All three major retailers — Origin, TRUenergy and AGL — are heavily invested in at least the idea that gas will replace coal. They may fear that a robust energy efficiency target, without a higher emissions target, would not provide the price incentive via a carbon price to make that coal-to-gas transition.

Deutsche Bank’s Lewis says the slump in the price of EUAs comes despite the emergence of other factors that would normally push carbon prices higher. This includes the decision by Germany to scrap its nuclear power stations, the recent anti-nuclear vote in Italy, and the introduction of a stricter Phase 3 for the EU ETS from 2013.

But, he says, the price slump points to a spiralling crisis of confidence in the “will and the wherewithal” of the EU authorities to achieve their stated policy aims — economic as well as environmental.

“In other words, we think that the sharp fall in EUA prices is down to fear: fear that the Eurozone and broader EU economy might now be on the verge of another severe slowdown, and fear that under such a scenario the commission would not be able to take the necessary measures to re-establish price tension in the EU-ETS.”

*This first appeared at Climate Spectator.