The risks of dangerous climate change require a global reduction of greenhouse gas emissions. Many economists, policy-makers, and environmentalists favor carbon pricing as a financial mechanism to cut emissions. This would allow for the environmental costs of production to appear in the financial books of emitting companies. Carbon pricing can be done in two ways: through an emissions trading system or through a carbon tax. In 2005, the European Union (EU) went for the first option and implemented the EU Emissions Trading System (EU ETS), creating the world’s first large carbon market. More than a decade later, the EU ETS is still the most prominent market-based application of economic principles to the problem of climate change, but many do not like what it has become.^[1] The EU ETS holds great potential to cut GHG emissions but is currently failing to trigger major low-carbon investments, which are urgently needed to achieve decarbonization by mid-century. Actually, regulatory uncertainty could result in low carbon prices, which in turn cause market participants to postpone investments in low carbon technologies.

Why is the Carbon Price Low?

As the central pillar of EU climate policy, the EU ETS is supposed to lead the way to the long-term target of 80-95% emission reduction by 2050.^[2] But in the recent years, the EU ETS has been under constant scrutiny due to the unstable and arguably low certificate  price level of around 6€ per ton of CO₂.^[3] For comparison, a comprehensive meta-study on the social costs of carbon suggests a weighted average of about 50€/t of CO2.^[4] This price discrepancy calls into question the long-term effectiveness of the EU’s central climate policy instrument. The EU ETS is essentially failing to price emissions at a rate that spurs the low-carbon technology innovation needed to meet the 2050 target.^{[3, 5-7]}

The low carbon price was long explained by a short-term decline in the demand for certificates, due to the economic recession, overlapping policy instruments and the influx of international credits.^{[8, 9]} But current research indicates that these factors explain only a small fraction of the price drop within the EU ETS.^[10] Against the long-term 2050 target scholars have suggested that the government-created EU carbon market suffers from a policy credibility problem.^{[7, 10-12]} As market participants face substantial regulatory uncertainty about the future design and ambition of the EU ETS, they do not sufficiently take into consideration the long-term emission reduction path of the system. If they did, extensive banking activities of CO₂certificates could be expected, causing a subsequent carbon price increase.^[13] Since market participants’ certificate trading behavior is expected to reflect only short-term considerations – ignoring the long-term outlook – the EU ETS suffers from an intertemporal market failure.^{[7, 11]}

Is a Lack of EU ETS Policy Credibility the Root of Low Carbon Prices?

Researching policy credibility empirically can be a very difficult task. But, recent research has taken on the challenge, defining EU ETS credibility as the degree in which market participants perceive the system as crucial for meeting the EU’s 2050 target.^{[14, 15]} Testing this definition empirically through in-depth interviews with major market participants from various EU countries[1] and sectors[2] provides evidence of how real-world market participants perceive the credibility of the EU ETS. It also clarifies the factors that market participants pay attention to for their credibility assessment.

The majority of market participants interviewed express skepticism about EU policy makers’ long-term political commitment to the EU ETS, which leads them to take a wait-and-see approach. In accordance, they report a limited impact of the system on low-carbon technology innovation. Overall, many respondents indicated severe doubt over the credibility of the EU ETS in meeting the 2050 target. These preliminary findings provide good reason to be skeptical of the current EU ETS sending a credible signal of long-term decarbonization to its market participants.

So, what’s next?

To reduce carbon emissions, more research as well as policy reform is needed. Research should try to further conceptualize the EU ETS’ credibility and investigate if the low carbon price and lack of substantial low-carbon investments are indeed the results of long-term regulatory uncertainty. For policy makers, these preliminary findings show the need for reform efforts as proposed by various experts: introducing a CO₂ certificate minimum price, implementing a rule-based adjustment mechanism for the allocation of certificates or delegating the governance of the EU ETS to an independent authority, outside of the political sphere.^[16] All these policy reform options aim at providing long-term regulatory credibility for market participants in the EU carbon market. They could help in bringing the carbon price closer to its long-term socially-optimal path. In this way, the current market failure could be overcome, and the EU’s large carbon market could be awakened to fulfill its innovative potential in meeting the 2050 target at the lowest societal cost.

This article was submitted on October 31, 2017 as part of our essay competition on Rethinking Economic Policy.

References

^[1] A Denny Ellerman, Claudio Marcantonini, and Aleksandar Zaklan, “The European Union Emissions Trading System: Ten Years and Counting,” Review of Environmental Economics and Policy 10, no. 1 (2016): 89-107.

^[2] European Commission, “Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the Committee of the Regions a Roadmap for Moving to a Competitive Low Carbon Economy in 2050,” 2011, accessed October 30, 2017, http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:52011DC0112.

^[3] Ottmar Edenhofer,, Christian Flachsland, Christoph Wolff, Lisa Katharina Schmid, Anna Leipprand, Nicolas Koch, Ulrike Kornek, and Michael Pahle, “Decarbonization and Eu Ets Reform: Introducing a Price Floor to Drive Low-Carbon Investments,”  (2017).

^[4] Tomas Havranek, Zuzana Irsova, Karel Janda, and David Zilberman, “Selective Reporting and the Social Cost of Carbon,” Energy Economics 51 (2015): 394–406.

^[5] Raphael Calel and Antoine Dechezlepretre, “Environmental Policy and Directed Technological Change: Evidence from the European Carbon Market,” Review of economics and statistics 98, no. 1 (2016): 173-191.

^[6] Karoline Rogge, “Reviewing the Evidence on the Innovation Impact of the Eu Emission Trading System,” 2016, accessed October 30, 2017, http://sro.sussex.ac.uk/60881/1/2016_09_SWPS-Rogge.pdf.

^[7] Sabine Fuss, Christian Flachsland, Nicolas Koch, Ulrike Kornek, Brigitte Knopf, and Ottmar Edenhofer, “An Assessment Framework for Intertemporal Economic Performance of Cap-and-Trade Systems: Lessons from the Eu-Ets,” accepted for Review of Environmental Economics and Policy  (2017).

^[8] Nicolas Berghmans, Benoît Chèze, Emilie Alberola, and Julien Chevallier, “The Co2 Emissions of the European Power Sector: Economic Drivers and the Climate-Energy Policies Contribution,” 2014, accessed October 30, 2017, http://www.i4ce.org/wp-core/wp-content/uploads/2015/09/14-10-CDC-Climat-R-WP-14-17-Power-sector-in-the-EU-ETS.pdf.

^[9] Germà Bel, and Stephan Joseph, “Emission Abatement: Untangling the Impacts of the Eu Ets and the Economic Crisis,” Energy Economics 49 (2015): 531-539.

^[10] Nicolas Koch, Sabine Fuss, Godefroy Grosjean, and Ottmar Edenhofer, “Causes of the Eu Ets Price Drop: Recession, Cdm, Renewable Policies or a Bit of Everything?—New Evidence,” Energy Policy 73 (2014): 676-685.

^[11] Nicolas Koch, Godefroy Grosjean, Sabine Fuss, and Ottmar Edenhofer, “Politics Matters: Regulatory Events as Catalysts for Price Formation under Cap-and-Trade,” Journal of Environmental Economics and Management 78 (2016): 121-139.

^[12] Dieter Helm, Cameron Hepburn, and Richard Mash, “Credible Carbon Policy,” Oxford Review of Economic Policy 19, no. 3 (2003): 438-450.

^[13] A Denny Ellerman, Vanessa Valero, and Aleksandar Zaklan, “An Analysis of Allowance Banking in the Eu Ets,” 2015, accessed October 30, 2017, http://cadmus.eui.eu/bitstream/handle/1814/35517/RSCAS_2015_29.pdf?sequence=1&isAllowed=y.

^[14]  Rafael Postpischil, “The Credibility of the European Union Emissions Trading System: How Do Market Participants Assess the Credibility of the System?,” (Forthcoming).

^[15] Godefroy Grosjean, William Acworth, Christian Flachsland, and Robert Marschinski, “After Monetary Policy, Climate Policy: Is Delegation the Key to Eu Ets Reform?,” 2014, accessed 10.04.2017, https://www.mcc-berlin.net/fileadmin/data/pdf/Publikationen/Grosjean_et_al_2014_Is_Delegation_the_Key_to_EU_ETS_Reform_May2014.pdf.

^[16] Godefroy Grosjean, “After Monetary Policy, Climate Policy: Is Delegation the Key to Eu Ets Reform?,”Climate Policy 16, no. 1 (2016): 1-25.

[1] Latvia, Germany, Czech Republic, Poland, Great Britain and Greece

[2] Energy utilities, ceramics, steel and cement