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Symposium 2015

Solution for The EU’s Emission Trading System: More Than Hot Air?

The Challenge

The EU's emissions trading system (EU-ETS) is the largest existing emissions trading scheme. This scheme is the main economic climate policy instrument of the EU, and it also serves as a blueprint for ...

The EU's emissions trading system (EU-ETS) is the largest existing emissions trading scheme. This scheme is the main economic climate policy instrument of the EU, and it also serves as a blueprint for other emissions trading schemes world-wide.

In 2014, the EU agreed on new and ambitious emissions reduction targets for 2030. While the EU-ETS is considered a key instrument in reaching these new targets, its effectiveness has been impeded by low carbon prices that fall short of providing the necessary incentives for urgently needed technological changes. So far, attempts to change this incentive structure have failed. The Reform proposed by the European Commission, the so-called Market Stability Reserve, will probably not go far enough for various reasons.

An EU ETS Reform Package

Background to the proposed package:

The EU ETS is currently questioned in its ability to deliver its objectives as the allowance price is persistently low at around 5€/tCO2. The cap was met and emissions actually declined in recent years, ensuring the environmental effectiveness of the scheme. However, the low price may affect the long-term cost-effectiveness of the instrument by reducing the incentive for investment and deployment of low carbon technologies. Consequently, no significant increase in the EU ETS allowance price is expected before 2020, and probably not beyond, without reform. Empirical analysis shows that only a small proportion of price fluctuations can be explained by factors such as the economic crisis, renewable deployment or international offsets.

Therefore, it is likely that political factors and regulatory uncertainty have played a key role in the price decline. As a consequence, any reform of the EU ETS has to deliver a mechanism that reduces such uncertainty and stabilizes expectations of market participants. The Market Stability Reserve (MSR) that will most probably be implemented is unlikely to address the problem of the low price, and the uncertainty of future price development remains substantial. Its ability to deliver long-term cost-effectiveness is, thus, questionable.

Proposed solutions:

Instead of a narrow reform of the EU ETS, a fully-fledged reform addressing several aspects of carbon pricing is required. The dominant problem is the low credibility of the long-term scarcity, which is reflected in the weak price signal. Given the impossibility of establishing long-term policy credibility, the best approach is to directly manage expectations of market participants. Instead of a narrow reform, the following reform package puts the ETS in a broader perspective. At the same time, it would avoid a relapse into national climate and energy policies across Europe, which could result in much higher costs and inefficiencies.

Setting a price collar, i.e., a lower and an upper boundary on the price, both of which increase over time. A price collar can immediately deliver a stable and sufficiently high allowance price. In addition, the price collar is a useful way to manage expectations of future prices in line with the long-term cap of the EU ETS. A credible price collar would, therefore, directly incentivize investments in innovations that are required for cost-effective long-term decarbonization. Moreover, a price collar would allow national preferences to be addressed at the EU level, for example, the setting of more ambitious domestic mitigation goals without undermining the environmental effectiveness of other national policies (e.g., renewable supporting scheme or efficiency standards) given that the EU ETS is operating at the price floor. However, there are challenges with respect to the implementation of a price collar and its political feasibility.

  1. Pricing carbon emissions in more sectors (for example, transport and heat). The EU ETS currently covers about 45% of all GHG emissions, but in order to achieve long-term reductions, other sectors will also need to significantly reduce their GHG emissions. Setting a uniform price for GHG emissions which standardizes marginal costs across sectors is more cost-effective than setting emission standards. However, emission standards can be justified when other market failures are present and they can be a temporary substitute for carbon pricing. A pragmatic interim step might be a dual price system, with an ETS and a carbon tax in the other sectors. The long-term perspective, however, should aim towards the full sectoral coverage of the EU ETS. Including more sectors in the EU ETS might also increase the chance of a 2030 agreement, because full sectoral coverage would incorporate the least-cost options. However, short-term feasibility and distributional aspects must be properly taken into account.
  2. Policy instruments for the innovation and diffusion of low carbon technologies, other than carbon pricing, are required if there are additional market failures. There are indications that innovation spillovers are high. R&D policies could therefore support innovation and should be part of the portfolio if market failures occur. Support during the adoption and diffusion stage can be provided by deployment policies, creating a market pull for some technologies. There is, however, no consensus among economists for the adoption of deployment policies, e.g., for renewables.
  3. Addressing the possible problem of carbon leakage by expanding the group of countries that participate in the EU ETS or by linking it to policies in other regions: The main political economy concern with the EU ETS is about carbon leakage, resulting from the setting of ambitious targets by the EU in isolation from the rest of the world. Such leakage questions the environmental effectiveness of the instrument and could undermine political feasibility if the burden for industry is perceived to be too high. As carbon leakage predominantly concerns energy-intensive and sectors exposed to international competition, it could be substantially reduced by a scheme that focuses on a few key sectors. Free allocation of some emission permits as well as tailor-made trade policies could be considered for these sectors. The best way to tackle the problem of carbon leakage and the most efficient way to reduce emissions globally is, of course, to increase the number of countries applying carbon policies and agreeing on a common minimum price.
  4. Smart revenue recycling policies have the potential to reduce net policy costs and improve the acceptance and the effectiveness of carbon pricing, providing a double dividend. Revenues from carbon pricing, for example, through auctioning, could be used to lower labor and capital taxes, thus reducing net policy costs and potentially compensating for increased energy costs incurred by households. Another option is to forego auction revenue and lower the policy costs of industries threatened by competitiveness concerns.

 

The political feasibility of implementing this full-fledged reform package is probably limited. But without a comprehensive reform of the EU ETS that goes beyond the MSR reform, the joint EU climate policy is endangered. There is not only the danger that the EU ETS might not survive as a functioning instrument of European climate policy, but also that the whole EU climate policy will fail through a return to fragmented climate and energy policies across the region. These would have the potential to substantially increase the costs of climate policy. By contrast, the proposed reform, and in particular the price collar, would allow the Member States to implement their national energy and climate policies according to their preferred technology mix, and the level and timing of their emission reduction plan. The diverse national policies would no longer reduce the price below the minimum set for the EU ETS, and would, therefore, allow for a minimum of coordination between the Member States. Although a reform package with a price collar as the primary element might be perceived to be politically infeasible, it might be the best way to tackle different problems at the same time.

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