Overall, the EU Emissions Trading System (EU ETS) is an effective instrument for reducing greenhouse gas (GHG) emissions. In an article published today in the ifo DICE Report, researchers Herman Vollebergh and Corjan Brink from the Netherlands Environmental Assessment Agency (PBL) conclude that the EU ETS guarantees a credible and binding reduction in emissions in the sectors to which the regulation applies. The article describes a number of lessons learned in the EU, which other economic regions across the globe could also take into account when trying to effectively reduce greenhouse gas emissions.
The effectiveness of the EU ETS lies in its binding cap. The cap applies to the total number of greenhouse gas emission allowances in all the EU Member States to which the regulation applies and guarantees a gradual reduction to zero emissions by 2057. Through this gradual annual reduction in the total number of allowances, the EU ETS has already contributed to a decrease by 20% in emissions, since its first phase started in 2005. The EU ETS is the largest cap-and-trade system of its kind in the world.
Trade flexibility essential, but to be applied with care
Another distinguishing feature of the EU ETS is the fact that it facilitates the trade in allowances, within a certain timeframe, between individual companies (i.e. between those with a surplus in allowances and those needing more than the amount allocated to them). Since the second phase of the EU ETS (2008–2012), intertemporal trade has also been possible, with allowances remaining valid indefinitely. This provides companies with more flexibility, as it allows them to even trade future expected emissions. This give individual companies the ability to optimise compliance over their entire planning horizon. However, Vollebergh and Brink observe that this flexibility should be applied with care. Intertemporal trade could lead to low prices if allowances are abundantly available. In such circumstances, for the system to remain a credible carbon pricing instrument, additional measures are unavoidable; for example, quantity rules such as the current Market Stability Reserve or a price collar.
Extending the EU ETS to include other sectors not self-evident
In its current form, the EU ETS carbon price base covers most emissions within the electricity sector and in energy-intensive industry. Discussions are ongoing about whether to broaden the range of sectors under the EU ETS. For instance, the European Green Deal of the European Commission argues to include the maritime sector into the EU ETS. Some economists go much further and are in favour of extending the EU ETS to also include the transport sector. In their article, the authors conclude that it is far from obvious why the EU ETS should cover the entire carbon emissions base. Including small-scale installations and other individual emitters that are difficult to monitor may simply be too costly — particularly in situations where other instruments are already available, such as explicit or implicit carbon taxes and standards.
Grounds for border adjustment mechanisms, if other regions will not apply carbon pricing
The authors observe a gradual shift in emissions towards regions outside Europe. This can also be seen in the rising carbon footprint of European consumption. Ideally, this issue should be addressed through more international coordination of carbon pricing. In the absence of such a well-functioning coordination, policy measures such as a price correction for CO2-intensive products at the border should be applied to avoid a CO2 'race to the bottom'. By applying such measures only to countries who have not implemented carbon pricing, such price corrections could also be used in strengthening a global coalition to reduce greenhouse gas emissions, worldwide.