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.
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.
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.
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.
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