National subsidies and other forms of support for renewable energy and energy efficiency have seriously undermined the functioning of the EU’s Emissions Trading Scheme (EU ETS), writes Arnold Mulder of the University of Groningen. His PhD research, supervised by professors Catrinus Jepma, Steven Brakman and Erik Dietzenbacher, shows that current efforts to reform the system and increase CO2 allowance prices will not work if this adverse policy interaction is not addressed.
The EU ETS (Emission Trading Scheme), one of the largest and most far reaching climate instruments in the world, covering 11,000 installations responsible for roughly half of the EU’s CO2 emissions, has so far failed to achieve a key purpose: incentivise companies to invest in CO2 abatement technology. There are two main reasons for this: market prices for allowances are too volatile and national policies in EU member states undermine the strength of the scheme by reducing the CO2 price.
Price volatility
At the inception of the system in 2005, many experts believed that CO2 prices would increase to levels of 20 to 30 euros, and rise further toward (much) higher levels. In reality, price levels have been highly volatile, with a peak above 30 euros and recently falling to below 5 euros per tonne of CO2 equivalent.
The Market Stability Reserve is unlikely to fundamentally change the investment outlook for firms under the EU ETS
The problem of volatile and unpredictable allowance prices is that they undermine the efficiency of the scheme, by creating investment uncertainty. The greater the investment uncertainty, the more inefficient the ETS is, and the greater the costs of reaching the emissions targets.
This is an issue that has been insufficiently recognised in the debate around the EU ETS. Volatile and unpredictable prices tend to be inherent in cap-and-trade schemes. This was already evident in the US emissions cap-and-trade scheme of the 1980s and 1990s which served as a source of inspiration for the EU ETS. The recent history of the EU ETS provides further proof and future price developments are unlikely to follow a more stable path.
The main reason for this is that allowance caps and allocation regimes are based on political choices which tend to be inflexible because they are based on political compromises that cannot be easily overturned without serious backlash. As a result, the supply-demand balance determining allowance prices on the market is basically determined by technology trends and the erratic stochastics of the business cycle. Because allowance prices turn out to be rather sensitive to small shifts in the supply-demand balance, economic cycles have an exceptionally strong impact on allowance prices, which therefore are inherently volatile.
The uncertainty associated with volatile prices hinders investments in low carbon technologies, especially those that are highly capital intensive and have long construction lead-times.
Policymakers have proposed several options to influence the allowance price, although the issue of allowance price volatility is often not directly addressed. For example, several attempts have been made to reduce the supply of emission allowances. These proposals would put upward pressure on average allowance prices, but would not address the problem of allowance price uncertainty and volatility.
Efforts by consumers, the government, and the private sector to combat climate change do not add up, but to a large extent cancel each other out
As we show in our research, such measures could actually increase investment uncertainty faced by investors, exacerbating the inefficiency of the ETS. To see why, consider that many investors face limited investment uncertainty if the CO2 price is expected to be volatile yet low on average (e.g. 5 euros on average). Many investors would conclude that conventional technologies remain more profitable and continue investing accordingly. However, if the average price is expected to be volatile and higher on average, around the break-even point of many abatement technologies, investors face a more difficult decision. Should they invest in a conventional technology, a low carbon alternative, postpone the decision, or maybe not invest at all? Choosing the least-cost alternative becomes much more difficult. A more stable and predictable price development is a better guide for investors in these instances, for example by introducing a price corridor (floor and ceiling).
A measure that was recently introduced, the Market Stability Reserve (MSR), is unlikely to fundamentally change the investment outlook for firms under the EU ETS. The MSR would postpone the auctioning of some emission allowances to a later date. However, given that 1) the MSR will not become effective before 2021, 2) firms still have a large stock of banked allowances available to them, and 3) the MSR would in any case not reduce the cumulative number of emission allowances, its impact on average allowance prices in the medium to long term is likely to be insignificant.
Adverse interaction
A second problem with the ETS is that national policymakers across the EU actively undermine (often indirectly and unintended) the effectiveness of the scheme with their policies. Our research shows that if they continue to do so, allowance prices may be no higher in 2030 than they are today.
This has to do with what is called ‘adverse policy interaction’, i.e. policy instruments that interfere with the EU ETS and each other. Economic history shows many examples of conflicting combinations of policy instruments, but the EU ETS and national climate policies may well offer one of the most dramatic examples.
Many observers have pointed out that policy instruments such as subsidies for renewables and other regulatory instruments are likely to interfere with the signals in the EU ETS system by reducing the demand for allowances. This has now been corroborated empirically by our research, which has focused on the German energy sector but can be extended to the rest of the EU as well.
Our results confirm that climate-related instruments (in both ETS and non-ETS sectors) have considerably undermined allowance prices, and in fact prevented them from rising to significant levels. Our modelling work suggests that without this interference the average allowance price could double.
Another alternative that would provide investment certainty and would avoid interference would be to move toward a CO2/energy tax
The reason why ‘parallel instruments’ have an adverse impact on the EU ETS price level is rather straightforward. For example, if you receive a subsidy to install solar panels on your roof, your demand for electricity from a EU ETS covered power supplier will decline. As a result, the electricity producer needs fewer emission allowances, which results in lower allowance prices. This in turn means other firms in the EU ETS have fewer incentives to invest in CO2 abatement projects.
This interaction is adverse for two reasons. First, there is no or little net climate gain: any gain that was achieved by installing solar panels is offset by higher emission levels from other installations under the EU ETS. Secondly, efforts by consumers, the government, and the private sector to combat climate change do not add up, but to a large extent cancel each other out. If the mix of policy instruments would be better aligned such that the interference is avoided, the CO2 emission reduction target could be reached sooner, or a more ambitious reduction target could be reached.
Policy impact
Our conclusion is that the EU at least partly paralyses its own climate policy ambitions through the wrong combination of policy instruments. In other words, there is a serious problem of adverse policy interaction. One measure that could be taken to improve the system is to ‘fiscalise’ the EU ETS by introducing – as the UK already did – minimum allowance prices that are subsequently systematically raised. Such a price floor provides investment certainty for firms, while limiting adverse interactions between the EU ETS and other instruments.
Volatile and unpredictable prices tend to be inherent in cap-and-trade schemes
Another alternative that would provide investment certainty and would avoid interference would be to move toward a CO2 /energy tax. Ideally such a tax would apply worldwide or at least EU-wide. Member States that want the energy transition to retain momentum, could take initial steps to that end. That would not be easy politically, but it would at least have a better chance to achieve effective mitigation.
Editor’s Note
Readers who want to obtain a free digital copy of Arnold Mulder’s PhD study can send an email to arnold.mulder@rug.nl
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Peter Lang says
Carbon pricing or any other command and control policies that will raise the cost of energy globally are politically unsustainable. They are highly unlikely to succeed. This explains why there is little likelihood that carbon pricing can succeed:
“Why carbon pricing will not succeed” http://anglejournal.com/article/2015-11-why-carbon-pricing-will-not-succeed/
Increasing the cost of energy is the wrong approach. Instead we should be advocating for policies that reduce the cost of energy, not increasing it. This can be done with appropriate policies, but not by continuing to advocate for the policies that have been failing for the past 30 years.
Grace Adams says
Maybe EU would be better off phasing in an emissions tax, say at 5 euros/metric ton of CO2 equivalent first year and increase by 5 euros/metric ton each year until social cost of carbon is reached, then monitor and increase tax any year tax fails to cover social cost of carbon. I suspect social cost of carbon is calculated each year anyhow.
Mike Parr says
“ETS….has so far failed to achieve a key purpose: incentivise companies to invest in CO2 abatement technology” – thing is – was that the “key” aim – or rather was it to put a price on carbon & let “markets” decide on appropriate tech?
“Our modelling work suggests that without this interference the average allowance price could double” – Ok Euro10 not Euro 5 – with EC saying it needs to be Euro25 – 30 to have an impact.
“Secondly, efforts by consumers, the government, and the private sector to combat climate change do not add up, but to a large extent cancel each other out” – which is why the EU hit its 20% 2020 target in 2015? & will probably do 27 – 29% by 2020? Oh hang on – that would be RES & energy efficiency – all those policies that up set the exquisitely formed ETS?
Quoting Stern addressing the EP in 2011: “humanity faces an existential crisis with climate change”. I have a feeling that much of the article, far from addressing this – is focused on deck chair re-arranging. In July in Bx at an ETS meeting the Bx Dong rep’ said “ETS has made zero difference to EU carbon emissions” (the EC rep demurred from responding). ETS is dead – time to bury it.
Tax, carbon taxes are the way forward – not just my view – but that of Dieter Helm (& even the CEPS mob) . Furthermore, that would open the door to border carbon taxes – & before anybody gets funky about them (“That would not be easy politically” oh yeah?), – first read the WTO report on the subject (2009) – which green lights them (the French love them).
Arnold Mulder says
+5 euros against today’s price, but +20 euros against the average forecasted price per 2030 (i.e. from 20 to 40 euros). Note that these are averages. Thesis provides 80% uncertainty intervals around averages.
So far, ETS has indeed made little difference wrt EU emissions (i.e. investment behavior). That’s why we highlight the need for price support (via a floor and ceiling, or alternatively a tax), which would help firms in choosing the appropriate and least-cost tech.
Mike Parr says
Thanks for responding Mr Mulders – apologies for being argumentative: “ETS has indeed made little difference wrt EU emissions (i.e. investment behavior)” – you could look at EU RES (& energy efficiency) policies as the backstop to ETS. RES policies drove investment, ETS failed to do so & keeps on failing. As Einstein observed: the definition of insanity is to keep on doing the same thing & expect a different result. ETS pretends to be a “market solution” but is so heavily politicised it has zero chance of delivering – ever. Price support, a la the Brits? why not just…..replace ETS with taxes/border carbon taxes. These would in no uncertain terms sort out some of the EU’s trading partners. Ain’t going to happen because too many boys n girls in DG Clima have their careers nailed to the ETS mast & this is what it is all about – careers – not results.
Grace Adams says
I favor everyone being able to make a living. So yes, let them have their careers. If they can’t make it in DG Clima and need a government sinecure to make a living–OK give them each a job working for the government in a community service employment program doing something constructive.
Nichol Brummer (@Twundit) says
Yes.. would be nice if more people could get a job that allows them to make a contribution to progress. These people don’t seem to be doing much. However, although I’m no insider, I’m afraid the blockage isn’t at DG Clima, but rather from countries blocking anything that would put a floor under the ETS price. If Poland doesn’t like it, it doesn’t matter even if the whole EU parliament is unanimous. It won’t happen.
And that’s why the only way forward is for a small club of countries to join the UK by adding a floor under the ETS. And then put all possible pressure on the remaining countries to join.
Or give up on an ETS. And if we acknowledge that the ETS is a dead horse, we should logically return to the triple goals of CO2, efficiency, and renewables.
Plutonius says
So renewables support scheme “undermine”the ETS?
So the important thing is the ETS, not to cut CO2?
Except for ETS, hundreds of things have been tried, often less than perfect. But collectively they have worked.
We are indeed cutting the CO2 emissions. Not (as you probably want) through more nuclear power or CCS or by or by flexible mechanisms (letting someone else do the job). We cut the emissions by support schemes for renewables, and by politically driven energy efficiency requirements.
Wind power and photovoltaics have spread from Europe to China and India and several other countries.
This explains a lot of why global emissions stopped growing 2014 and 2015. It may save the world, who knows.
If we (as you want) had put all our bets on ETS, we would only have picked the lowest hanging fruits until there were none left.
If the ETS can be mended, fine. If it can’t, we now have a lot of options to cut CO2 more, because a lot of democratically elected leaders did not listen to people like you.
What you demand is that politics should be subservient to estethically pleasing mathematical models of a perfect market.
We live in an imperfect world, where half measures, inconsistencies and even downright stupid legislation play a role. We try, we sometimes fail, we try again, until we win. It may not be so pretty, but it is real.
Grace Adams says
We need to go beyond net zero greenhouse gas emissions to get greenhouse gas concentration in atmosphere down to 350 ppm. I don’t care that much how we do it, but we need to make the world safe for agriculture in order to remain civilized.
Karel Beckman says
The commenters (Plutonius and Mike Parr) seem to misinterpret the article. The research of the authors shows that national support schemes for renewables and the ETS cancel each other out, to put it simply. So Plutonius, you don’t seem to get the point that your support schemes are not working. Yes, they lead to more renewables, but not to lower CO2 emissions. You are blaming the messengers. And Mike, the authors actually recommend a CO2 tax.
Hugh Sharman says
I am disappointed that the authors do not mention the word “swindle” in an otherwise worthy article. The ETS has been (continues to be?) a vehicle for multi-billion Euro swindles which, as far as I am still aware, the hapless Europol has been unable to prosecute.
http://www.wsj.com/articles/SB10001424052748703439504576116020196050548
….all in the name of “saving the world from frying” of course!
Which, I believe, is why European journalists seem so terribly reluctant to pursue, “nail and expose” the perpetrators, nor the equally hapless EU Commission worthies, responsible for this useless scheme who were involved at the time.
It is a monstrously costly scheme designed to enrich bankers and traders, among whom there are so many fraudsters.
Karel knows what I mean!
Nichol Brummer (@Twundit) says
I’m liking this ‘frank exchange’ 🙂
The ETS is a typical EU scandal caused by inability to decide on something for our common good .. because any country can veto any feature that might make the measure actually work, if they feel it will be hard on their industry. But wasn’t that the whole point of the ETS, to create serious pressure towards decarbonisation? So we end up trying, then supporting with great cost, a measure that is never allowed to work.
Just like having a Schengen with a common border, but without a common agreement and commitment to organise and patrol the common outside border. We’re leaving that delicate task to the countries with an ‘outside’ border, and then cynically blame them if they get swamped with war refugees.
No surprise in such a ‘union’ without unity, without common responsibility, without solidarity .. that the dutch people just voted against an association accord with Ukraine.
Grace Adams says
You sound very unhappy. I wonder if a carbon tax, starting at recent ETS price and rising from there might be easier for participants. Many taxpayers prefer knowing what the tax rate is in advance rather than having to participate in an auction to get a tax rate quote.
Grace Adams says
About your earlier comment–granting need for work to give life meaning but then switching to want a floor under ETS sort of like having EU which is having the ETS scheme start with a minimum bid. Or have a carbon tax instead of ETS auctions. The goal is to make emissions more expensive to emitter by increasing the price of carbon and thus make renewable energy more cost-competitive compared to burning carbon based fuel.
Yes, disincentive for carbon emissions and incentive for renewable energy to replace carbon based fuel should help slow down climate change due to global warming.
Grace Adams says
Emissions Trading Scheme is an auction of permits for emissions. Many firms would rather government set a tax rate so firm could just pay the tax rather than have to hassle with bidding in an auction and having to guess at both how many permits they need to buy and what price they will have to bid.
Tilleul says
The ETS is the way the natural gas lobby wants us to subsidize their CCGT. That’s why you always have this discussion about 20 to 30 euros because that’s the price difference between coal power plant and gas. Note that in Europe making such a switch would make us unable to reach 2030 target as we would subsidize the replacement of ageing coal power plant who would be closed in the 10 next years no matter the cost of carbon by brand new gas power plant and also the co2 difference between coal and gas are mainly due to the ETS only caring about the combustion emission while natural gas as large emissions at the well and transportation step (outside Europe so not in the ETS)
Karel : the EU has overachieved its Kyoto reduction target ! EU achieved both reduction of emissions and growth of renewable energy.
The claim that the author made by stating that the renewable policy is “paralysing its own climate ambition” is just wrong. Maybe national countries are paralysing the ETS but what the point as both real life and theory show it’s not a good instrument for reducing emissions (see https://energypost.eu/new-framework-climate-policy-carbon-pricing-enough/ ).
And what about corporate policies ? If a renewable target sets by Cyprus would destroy the ETS as the author found, the voluntary targets set by large companies like Google of Unilever will have the same impact that national policy. And what about other policies which are using RE&EE to achieve their goal and not natural gas : rural development, energy independence, energy démocratisation, water protection, building quality and so on ? From what I have understood these are also classified as renewable support which prevent the ETS from working. If the ETS can’t work if we are making environmental and social policies or if companies are pursuing other goals that lead to reduction of emissions then it means the costly ETS will never work because we won’t stop having environmental and social policies just because the natural gas lobby want to hide a subsidy to its sector.
Grace Adams says
I suspect most businesses would rather pay an emissions tax than have to deal with an emissions trading scheme, both less uncertainty and less paperwork.
Grace Adams says
Also methane, whether fossil fuel or from animal husbandry and even human poor digestion, is lighter than air and goes all around world until it drifts off into outer space at top of atmosphere.
Hugh Sharman says
No! Grace! It does “not drift off into outer space” !Wíki explains it quite well at the heading “Removal Processes” athttps://en.wikipedia.org/wiki/Atmospheric_methane
Chris says
Surely what is needed is both an emission scheme which focuses on the lowest abatement cost per tonne of emission (which EUETS arguably does but most of EED and national govt interventions don’t) plus some real action elsewhere in the world. Without both we would be better off having a carbon border tax.
Grace Adams says
But I want taxes on carbon based fuel to have prohibitive tariff effect to drive up the cost of carbon based fuel emissions to give us cleaner air. Wind and solar can be harnessed to give much lower total emissions over full life of system than we can get burning carbon based fuels. I hope main effect of emissions tax would be to persuade utilities to buy wind turbines, and solar power systems, and energy storage, and maybe some enhanced geothermal systems.