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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.

Back to Basics: Reinstating the Focus on Emissions Reduction

The reason for the EU to introduce the cap-and-trade-based ETS was primarily to impose an overall cap on greenhouse gas emissions and to reduce this cap over time. Compared to regulatory measures like, for instance, fuel economy standards in the car industry or fuel taxes or feed-in-tariffs/subsidies for renewable energy, a market-based cap-and-trade system efficiently addresses the issue of limited information about the supply and demand parameters of a multitude of economic actors. According to Coase´s theorem, the creation of tradeable property rights (like EU Allowances) ensures that a given CO2 reduction is reached at minimum overall costs independently of how individual economic entities are endowed with emission rights. The focal point should, hence, be emissions reduction or, in other words, the cap setting.

    1. The cap-and-trade ETS is an efficient instrument to reduce greenhouse gases cost effectively. It is not necessarily a good instrument to promote additional goals like Energy Efficiency improvements or increasing the share of Renewable Energy Technologies as the ETS supports the most cost effective technologies first. Both goals, however, have their legitimacy beyond climate protection because they specifically address the issues of “security of supply/control” and “affordability of energy,” leading the way into a low or no carbon economy. Energy Transformation entails shifting a country´s energy system to a different point within the coordinate system defined by the “Energy Triangle.” The notion of “control of energy” has been increasingly emphasized as citizens, municipalities and regions strive to build their own local and decentralized energy systems. In line with these different goals, the EU has set three targets: a 40% reduction of CO2 emissions compared to the level of 1990, a 27% share of renewable energy consumption and 27% energy savings by 2030. This has several consequences:

      a) The emissions impact of these additional goals needs to be estimated and factored into the cap-and-trade mechanism.

      b) Once the cap is set, the price for emissions rights should be determined by the market process, rather than being adjusted arbitrarily to a level that is regarded as “appropriate.” Any such intervention is likely to hinder the market mechanism from operating effectively on the climate issue as it comingles the goal of emission reduction with other goals, e.g., the promotion of certain clean technologies. Price bands should also be taken into account only very carefully.

      c) National policies within the ETS region that support divergent goals need to be reconciled and erratic moves that create misalignment should be avoided. National strategies and policy measures that predominantly aim at tackling the climate issue within the context of a supranational ETS are redundant.

       

    2. The ETS is a quantity-based system, i.e., given an absolute reduction target it determines a reduction path. This path relates to the region and the sectors within the regions covered by the ETS. This has several consequences:

      a) Emission reductions in the EU–ETS can be offset by an increase in emissions in regions/ sectors that are not covered (“leakage”). This issue creates a “free-rider” problem. One solution is to extend the ETS to other sectors and regions. On sectors: 1.c) needs to be considered in order to avoid redundancy. Some remarks to the regions:

          • Several regions outside the EU have adopted or are about to adopt an ETS (California, Alberta and Quebec in Canada, South Korea and hopefully China). Linking these regional approaches is crucial in order to move on to a global emission reduction framework (Hone 2015; Bullensee-Thesen 2010: 10).
          • A cooperation between “large emitters” such as the USA, the EU, the BRICs, Japan and others might be another way to foster regionally extension (Bullensee-Thesen 2010: 10).
          • Offset mechanisms are helpful to disseminate carbon trading across the globe. The existing tools need to be reviewed in the light of the “additionality” test in order to make sure the emission reduction is “real.”

         

            b) A reduction path is subject to specific assumptions about a future development (economic growth, roll out of renewable capacity or energy efficiency measures, etc.). Hence, the cap should be adjusted as a reaction to new developments as promptly as possible and trading periods should be kept within a foreseeable range of years. With regard to the current eight year trading period which lasts until 2020, it is discussed how to cope with the surplus of emission rights and raise their current price. In addition to the back-loading of 900 million allowances into the years 2019 and 2020, the EU is discussing the introduction of a market stability reserve in 2019 in order to manage the quantity issue. These proposals increase the complexity of the current ETS. An alternative proposal by RWI (2015) focuses on adjusting the cap on a more rigorous basis through the deletion of the back-loaded emission rights.

                c) The trading periods should be independent of each other in order to avoid a spillover of emissions rights from one period into another. Banning banking and having emission rights from previous periods expire is too disruptive to individual actors. However, the overall amount of these allowances should be taken into account in order to determine the reduced cap for the next period. If the term for the trading period is set at a moderate level this should sufficiently smooth operational ups and downs (e.g., a warm winter or particularly cold winter).

                 

                    3. According to Coase´s theorem the final allocation of property rights is independent from their initial allocation if their distribution is determined by a market mechanism. As Ronald Coase has shown in his 1939 Nobel Prize awarded work on “The Problem of Social Cost,” trading enables to separate between the initial distribution of property rights and their final allocation. The Coase theorem laid the foundation for a school of thought called “Economic Analysis of Law.” Consequently, the question as to whether emission rights are granted for free or auctioned is a matter of who is regarded as the “owner” of clean air—the polluters themselves or the wider public. If the public is viewed as being entitled, the issuance of emission rights should be nongratuitous. Free allocation of allowances for energy intense sectors covered by the EU–ETS—however arbitrary—is a means to support them to compete fairly with polluters outside the system. Other possible measures discussed are border tariff adjustments on imported carbon intensive goods, reimbursement of abatement cost on exported quantities or the obligation for countries outside the system to buy emission rights for their exports. Side effects need to be evaluated carefully (see Bullensee-Thesen 2010: 8).

                    The above proposal focusses on emission reductions as an instrument to tackle climate change. It builds on the market mechanism as the most effective and cost efficient mechanism to address climate change. This model can be used on national and regional levels in a way that governments retain control of their environmental policy. Ultimately the goal should be to have a global system. As politicians are often sceptic about such a market mechanism and also want to remain in control of their national climate policy, the promotion of an ETS across the world needs education on how this market-based tool compares to other policy measures to address climate change. Science, NGOs and not least IETA play a crucial role here. In this context the Paris 2015 Climate Summit should emphasize Emissions Trading as the central global instrument to tackle climate change, strengthen the foundations of the trading mechanism and foster the proliferation of this instrument.

                      Literature


                      Bullensee-Thesen (2010). Weiterführende Überlegungen zur Klimaschutzpolitik. Oldenburg.

                      Coase, R.H. (1960). The Problem of Social Cost. Journal of Law and Economics 3 (Oct.,1960): 1–44.

                      Hone, D. (2015). Putting the genie back: Why carbon pricing matters. Kindle eBook.

                      Rheinisch-Westfälisches Institut für Wirtschaftsforschung (RWI) (2015)., Position #65: The right way to reform the EU emissions trading system.

                      Alternatives to the Market Stability Reserve. Essen, May 28, 2015.

                      Sinn, H.-W. (2012). Das grüne Paradoxon. Berlin.

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