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Economic iNsTRuments to Achieve Climate Targets in Europe

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EU study suggests a ‘right policy mix’ for the future ETS

Can the EU Emission Trading Scheme (ETS) be considered as a success? Using comprehensive data from regulated companies and plants across Europe, a team of EU scientists tried to find out. The ENTRACTE project results pinpoint stumbling blocks, identify room for improvement and provide recommendations to policy makers.

Climate Change and Environment

With COP21 now behind us, the time has come to reflect on the best ways to reach carbon neutrality by 2050, as the 195 parties taking part in the conference committed to. In Europe, key to this reflection are the future evolutions of the EU ETS in light of lessons learned since it was first launched in 2005. ‘We needed to assert that the EU ETS has achieved its core objective: reduce emissions of the covered installations,’ says Dr Olivier Schenker, who coordinated the EU-backed ENTRACTE (Economic iNsTRuments to Achieve Climate Targets in Europe) project for the Centre for European Economic Research (ZEW) in Germany. ‘The economic crisis reduced demand and thus emissions. So it is not that straightforward to identify the level of emission reductions caused by the EU ETS.’ ENTRACTE aimed to fill this knowledge gap, showing for instance that, in France, regulated plants reduced their emissions by an average 15.7 % compared to non-ETS plants between 2005 and 2012. While this could be interpreted as proof of the ETS success, the project team prefers to remain cautious. It highlights the potential major impact of carbon leakage, and chose to focus on aspects of the ETS where there is substantial room for improvement. A too lenient system The ETS was not without drawbacks. One of the issues studied under ENTRACTE was the surplus of emission allowances: Having built up since 2009 due to the economic crisis and its impact on industrial activity, this surplus is still paralysing the EU ETS to this day, with a total surplus of over 2 billion allowances. ‘The main reason why the EU ETS has so far not exploited its full potential and has not fulfilled its intended role of flagship of the EU climate policy, is a cap that has turned out to be too lenient — and insufficient political will to correct this fundamental flaw,’ says Dr Schenker. While the carbon price system has been proven to work, he underlines that only scarcity on the allowance market can ensure its effectiveness, which requires a strong political commitment. Similarly, a carbon tax can only be as effective as its level allows it to be: ‘The carbon pricing tools currently implemented in the EU fall short of exploiting their full potential. While there is some room for improving their design, the main reason for this underperformance is a lack of political will.’ The Market Stability Reserve (MSR), which intends to make the annual supply of allowances flexible by providing the EU with the means to adjust the supply to be auctioned, is welcomed by Dr Schenker, although he does not believe this is enough to solve the problem. ‘The recently adopted MSR is a step in the right direction, but appears too modest to deliver a sufficiently strong carbon price signal soon enough,’ he says. A key learning from ENTRACTE in this regard is the evidence that compliance in Member States varies greatly due to differences in underlying principles of enforcement strategies, institutional settings and funding. Such a lack of compliance in one or a few Member States may indeed harm the functioning of the ETS in its entirety. ‘A consistent implementation of monitoring and enforcement across all participating states is crucial to the integrity and the success of the EU ETS’, Dr Schenker says. He adds that, while monitoring and enforcement is crucial, it also its cost.. ‘“Monitoring, reporting and verification” (MRV) has costs for the regulated firms and installations which may affect overall effectiveness of the EU ETS. Our analysis of these transactions showed a substantial impact on average costs, in particular for “Small and medium enterprises” (SMEs). This indicates a passive, compliance-oriented behaviour of these emitters, merely accepting the cost of allowances as another operating expense rather than seeking improvements in their carbon efficiency.’ The team couldn’t find any supporting evidence that economy-wide productivity has been either increased or decreased by ETS regulation, or any concrete information on the innovation it has triggered within the market. The right policy mix ENTRACTE not only points at existing problems, it also proposes concrete solutions. To help increase carbon prices and reduce volatility, the researchers developed a model of the ETS including an adjustment allocation mechanism for allowances — similar to the MSR. Then, in order to reduce transaction costs for SMEs, they suggested allowing some smaller firms to opt out of the scheme, by focusing regulation on the carbon content of fossil fuels, rather than measuring end-of-pipe emissions at the installation level. Learning-by-doing and learning-by-using externalities also need to be addressed. The team suggests a market premium (or a renewable portfolio standard) on top of the wholesale electricity price which would compensate RES-E producers for their contribution to reducing cost. They go on to say that a learning-by-searching externality has to be considered, since the generation of knowledge through R&D is partly a public good. Several market failures that hamper the uptake of energy-efficient technologies were also identified. However, ‘these market failures are very specific and have particular effects on different consumers. Thus, successful policies need to be very well calibrated in order to reduce distortions. The risk of doing more harm than good is certainly high,’ Dr Schenker warns. Still, the project results show that ‘in addition to a price on carbon, there is a positive rationale for using a policy mix that addresses specific market failures beyond the climate externality.’ Dr Schenker insists that appropriately targeted complementary policies would not be distorting, but rather potentially cost-reducing. ‘A particularly interesting finding is that the need for these complementary policies diminishes over time as the effects of spill-overs, learning-by-doing, scale economies, and breaking of informational or other barriers, are realised,’ he says. ‘More particularly, measures related to innovation and technology adoption can reduce costs by as much as one third when compared to a “pure” price approach.’ Since the project was completed in September 2015, the team has published a Joint-Policy Brief in cooperation with its sister project CECILIA2050. Schenker is confident that the project’s findings have increased ETS understanding among policy makers in Brussels and EU Member States. ‘I hope our work will make them fully aware of the complexity and unintended side effects that policy making in this complex web of regulation and institutions can have,’ he concludes.

Keywords

ETS, Emission Trading Scheme, carbon price system, Market Stability Reserve

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