“Market-based” approaches to regulating emissions: cap-and-trade and carbon tax
(updated 28 November 2020)
In this blogpost we look at the so-called “market-based” approaches to regulating GHG emissions: cap-and-trade (=emission trading systems, or ETS) and carbon taxes.
Market-based regulation of emissions
The idea behind the so-called “market-based” mechanisms — emissions trading and carbon taxes — is that a de-centralized, market-guided system is assumed to have the potential to identify the most efficient ways how to cut emissions.
These are distinguished from “traditional” emissions regulation (also termed “source-by-source regulation” or “command-and-control”), which sets limits for each emitting installation. An example for a “traditional” form of regulation is Regulation (EU) 2019/631 setting CO2 emission performance standards for new passenger cars and for new light commercial vehicles. It defines am emission target for new cars of 95 g CO2/km, from 2020 onwards. If this limit is exceeded, the manufacturer must pay a fine.
Market participants are believed to be incentivized to cut emissions if they can earn money by doing so. Emitters either have to pay a certain amount per emitted ton of CO2 (=carbon tax), or have to acquire an emission certificate (=emissions trading). If the cost of emissions are thereby raised to a sufficiently high level, emitters will be incentivized to cut emissions in the most efficient way. Ideally, the costs of emissions represents their full social costs (i.e., health costs, environmental costs): in the language of economists, this would “internalize” the “externalities” (“externalities” are costs that a producer does not have to pay for, like environmental damages. “Internalizing” these costs means that an emitter has to pay for the full cost of emissions, e.g. by paying a carbon tax).
Emission trading schemes (or “cap-and-trade”, as it is called in the US) differs from carbon taxes because they essentially allow emitters to pay others to cut emissions for them: if another operator can cut emissions more cheaply, she will sell her superfluous certificates to other emitters who might not be able to cut their emissions in a similarly efficient way. The total amount of certificates is capped (ideally with a falling total number of certificates), so that the overall emissions will fall in any case, regardless of who uses the certificates. Cap-and-trade had originally been developed to reduce sulfur dioxide (SO2) emissions in the US in the 1990s. SO2 is created when fossil fuels are burned, and is responsible for the “acid rain” that caused significant damage of e.g. forests until the 1980s. It has been argued that SO2-emissions-trading has been successful in bringing down emissions in the US; however, it should not be ignored that European countries, still employing traditional source-by-source regulation, achieved much deeper SO2 emission cuts in the same time period.
Emissions trading was introduced into the Kyoto Protocol at the request of the US. It should be understood in conjunction with the rise of neoliberal thought in the 1980s and 1990s, which held that market-based solutions are usually superior to “traditional” forms of government regulation.
EU emissions trading system (ETS)
Today, the second-largest emissions trading system is run by the EU; a number of other countries also implemented such system (Norway, Switzerland, New Zealand), are currently in the process of establishing one (China) or are considering it. Emission trading systems also exist on a regional level, for example in California and in a number of Canadian provinces. The Kyoto Protocol suggested that these systems might eventually be linked into a global emissions market (so that e.g. European emitters can trade with Canadian emitters). We will now take a closer look at the EU ETS, which implements a number of policies laid down in the Kyoto Protocol. You may remember that the Kyoto Protocol provided for the so-called “flexibility mechanisms.” These include emissions trading systems (or “cap-and-trade”), the “Clean Development Mechanism” (CDM) and “Joint Implementation” (JI). We will look closer at these policies and how they have been implemented in the EU in this segment. We first provide a short overview of the ETS:
- Emitters need to acquire one emission certificate (called European Emission Allowances, or “EUA”) for each ton of CO2 they emit. Emitters who do not comply with this requirement are fined.
- Certificates are typically auctioned, but also partly allocated for free. Initially, all certificates were freely allocated, and auctions were phased in step-by-step for each industry sector.
- Emitters can trade certificates, either at public exchanges, or privately.
- Certificates are registered electronically by an European registry. In order to buy or sell certificates you need to open an electronic account.
- The total number of certificates issued will be reduced each year (by 1.74%, and from 2021 onwards by 2.2%), which means that the CO2 emissions covered by the EU ETS will drop at the same rate, or faster.
- Not all CO2 emissions in the EU are covered by the ETS, as numerous industry sectors are still excluded (currently 45% of emissions are covered). The remaining sectors are scheduled to be phased in in the future. The remaining emissions are covered under the Effort-sharing Regulation.
- The ETS exists alongside other European and national emission policies. They may complement each other, but can also undermine each others effectiveness.
- Emitters can also gain credits from international projects (CDM or JI), and use them to “pay for” emissions (we will discuss this further below).
The EU ETS will enter its fourth phase next year:
- Phase I (2005–2007) was the introductory phase. The regulatory basis was the ETS Directive, which allowed each Member State set up its own national registry for emission certificates, and also to decide on the number of certificates and on their allocation to the emitters autonomously. Phase I was characterized by an over-allocation of certificates (which means that there were more certificates than needed), by competitive distortions (as the different states allocated certificates differently) and by administrative and legal problems (the Commission rejected a number of national plans as conflicting with the ETS Directive, against which the states appealed to the Court of Justice of the European Union). However, this was, essentially, just a try-out phase.
- Phase II (2008–2012) corresponded to the first Kyoto commitment phase. It saw the integration of the “Clean Development Mechanism” and “Joint Implementation” (CDM and JI) into the ETS (see discussion below). Moreover, a single European registry was created, not least because some of the national registries suffered from cyber-attacks, where certificates were stolen. Over-allocation and administrative problems continued.
- Phase III (2013–2020) saw an overhaul of the system, reacting to the shortcomings just mentioned. This includes the partial phase-in of auctions, and the introduction of an overall EU cap on certificates. In particular, the use of credits from the CDM and the JI was limited. Towards the end of Phase III, the Market Stability Reserve (MSR) was introduced (discussed further below).
- Phase IV (2021–2028) will bring a factual minimum carbon price (i.e., the price of certificates will no longer be allowed to fall below a certain threshold). Moreover, the cap will be reduced by 2.2% each year.
We will now look at some specific issues relating to the EU ETS.
The price of an EUA
The underlying idea of the ETS is that a carbon price is established, which creates an incentive to cut emissions. This requires, however, that the price remains high enough to incentivize emission cuts, and that market participants have trust in the fact that the system is effective and will remain in place in the future: otherwise they would not commit to long-term investments necessary to cut emissions. However, the certificate price has collapsed in both Phase I, II and III because too many certificates had been allocated. Because of the economic crisis that started in 2008, economic activity (which is related to GHG emissions) was much lower than projected, which means that there were too many EUAs.
Since the establishment of the EU ETS, the price of EUAs has usually been very low. During much of the current Period III (2013–2020), one EUA (which is the right to emit 1 ton of CO2) sold for about 5–6 Euros. This is not much; to compare, the US government estimates that 1 ton of CO2 emissions would cause damages of 37$ (=35 Euro), and Nicholas Stern (author of the Stern Report that we discussed) works with a carbon price of 35$. However, studies suggest that the carbon price should in fact be much higher, as the social cost of CO2 emissions might be as high as 220$ (=208 Euro). Consequently, it can be argued that the carbon price established by the EU ETS was far too low to be an effective incentive for private operators to cut emissions.
Over the past years, the EU has taken a number of steps to increase the certificate price. For example, it postponed the auctioning of parts of the certificates in the current period (called “back-loading”). From 2019 onwards, the so-called “market stability reserve” (MSR) is in operation. The MSR essentially works like a central bank: if there are too many EUAs on the market, it withdraws them. This ensures, in practice, a minimum carbon price. In the chart below you can see the effects of “back-loading” from 2018 onwards. With the introduction of the MSR in 2019, the EUA price stabilized somewhere between 20–30 Euro.
Problem 1: partial coverage of emissions
The EU ETS does not yet cover all emissions (currently ca 45%), and will do so only in the distant future.
The main reason forwarded was the fear of losing price competitiveness in comparison to products from countries with lower regulatory standards. As emission certificates increase production costs, European products would become more expensive as compared to products from countries without emission regulations, and production would shift to these countries (this is called “carbon leaking”). Consequently, the activities facing the least competitive pressure were covered first (most notably this included electricity production, as electricity is not imported into or exported from the Union). In the subsequent phases, an increasing number of activities have been or will be included. The possibility to exclude certain sectors from the ETS has led to significant lobbying by the various industries, which aim to be excluded from the ETS as long as possible.
Problem 2: free allocation
In the first and the second phase of the ETS, 95% and 90% of the certificates were allocated for free. The free allocation was based on historical emission data: essentially, those industries and operators that emitted the most also received most of the certificates (thereby essentially being rewarded for past climate inaction). The emitters who received the certificates for free could then sell the certificates they did not use (e.g. because they had cut emissions, or because too many certificates had been emitted). This led to huge profits for these emitters. Over time, free allocation will be phased out, and replaced by auctioning — the timetable depends on the sector (e.g., the electricity sector no longer receives free certificates since 2013, and must buy all the necessary certificates). The last free allocation will be phased out in 2027. The benefits from the auctions go to the states’s budget, and thus no longer benefit the emitting industry sectors.
→ This shows that the EU ETS (like any other regulatory measure) has potentially significant distributive implications (i.e., who gains from the process, and who loses out). For example, the free allocation of certificates to emitters essentially constitutes a transfer of resources from the public (who gives away a public good for free) to certain private operators. However, it could be argued that such “pay-off” is a short-term cost that is necessary in order to achieve the long-term objective. Do you agree or disagree?
Problem 3: Clean Development Mechanism + Joint Implementation
As already discussed, the Kyoto Protocol provided for the “Clean Development Mechanism” (CDM) and the “Joint Implementation” (JI) mechanism. Investors could finance emission cuts in other developed countries (JI) or in developing countries (CDM) and would receive “emission reduction units”, which can be exchanged into certificates that can be used within the EU ETS:
- JI concerns projects in other developed countries that had binding emission reduction targets under Kyoto (usually ex-Soviet countries). E.g. if an emission reduction project is implemented in Russia, the gained credits may be “transferred” into the EU, but they have to be subtracted from the Russian total number of allowances.
- CDM concerns projects in developing countries which were not subject to binding emission targets under Kyoto.
The idea of CDM and JI is — expanding on the market-based conception of emissions trading — that the most efficient (i.e., cheapest) emissions cuts could potentially be achieved in countries other than the EU countries. In practice, however, both CDM and JI are fraught with difficulties:
- The majority of JI projects took place in countries like Russia and Ukraine, where — especially during the economic transition of the early 1990s—emissions dropped far below the emission limits established by Kyoto. Consequently, emission credits “transferred” from e.g. Russia to the EU ETS will not actually lead to an overall reduction of emissions. Moreover, studies show that the environmental benefits of a staggering 80% of JI projects was questionable. In particular, most JI projects would have been implemented regardless of whether they received additional benefits from the transfer of credits (i.e., the environmental benefits would have accrued even in absence of the JI project, which means that the emission allowance that is gained from JI does not really represent reduced emissions). Today, credits from JI projects in countries that do not participate in the second Kyoto commitment period (from 2013 onwards) can no longer be exchanged for EUAs.
- Under CDM, emission credits can be gained from implementing emissions-reducing projects in developing countries. These can then be employed within the EU ETS. A key problem of CDM is supervision: it must be ensured that the projects actually cut additional emissions (i.e., the project contributes to emission cuts — this is called “additionality”). However, many CDM projects would have been implemented in any case (regardless of the CDM project): in such situation, emission credits are acquired even though no additional emissions have actually been cut. Moreover, CDM has created what are called “perverse incentives”: emitters can first increase their emissions, only to receive credits for cutting them thereafter (see the picture below for an example). Finally, CDM projects may have adverse effects in the developing country where they are executed. For example, large-scale projects in developing countries (such as hydropower plants) may negatively affect indigenous populations.
In reaction to these problems, the EU has limited the use of JI and CDM credits since 2012 (Phase III). Credits created through certain projects can no longer be employed in the EU ETS: this includes nuclear plants, projects involving the destruction of industrial gases, and large hydropower projects. The total number of credits from JI and CDM that can be used has been limited. New CDM projects can only be set up in Least Developed Countries. According to the EU Commission, the EU “does not currently envisage continuing use of international credits after 2020.” However, a successor project is envisaged by the Paris Agreement.
Summary
How can the success of the EU ETS evaluated? As its objective is to cut emissions, we can start by looking at the development of CO2 emissions under EU ETS. Emissions regulated under the EU ETS have been stagnating or falling since 2008 (see graphic below).
Moreover, GDP growth and emissions have decoupled since the 2008 economic crisis (see graphic below): until a few years ago, higher GDP was always related to higher emissions. Since the crisis, however, the two indicators no longer move in conjunction: while GDP growth has picked up again since the crisis, emissions have stagnated or fallen. This could be seen as an indication that the European economy is “decarbonizing” (i.e., relying less on fossil fuels).
The Commission argues that the drop in emissions is an effect of the EU ETS. However, many commentators doubt this. This is because the effect of the EU ETS on the overall emissions level cannot be isolated from the effect of of other European and national measures (most notably the support for renewable energy and energy efficiency measures). In fact, many argue that these other measures are in fact responsible for the observable drop in emissions. This claim is supported by the fact that the certificate price — which is the main mechanism how the EU ETS is supposed to incentivise market actors to cut emissions — was, until recently, far to low and to volatile to provide any meaningful, long-term incentive for private actors to cut emissions. However, since the introduction of the Market Stability Reserve a relatively predictable and non-marginal EUA price has been established.
Carbon tax + minimum carbon price
The other “market-based” form of emission regulation is the carbon tax. If emissions are made sufficiently expensive, the theory goes, emitters will increasingly look for ways to cut emissions. While they cannot pay others to cut emissions for them (as in emissions trading), they may still figure out efficient ways to cut emissions themselves. The revenue from the carbon tax may go to the general budget (then it essentially constitutes a redistribution from the emitters to the general public), or may be purpose-bound for investment in climate change-related projects. A carbon tax can complement the EU ETS (you can see at the map above that some European countries subject to the EU ETS also levy a carbon tax).
Many countries first introduced energy taxes as a means to curb energy use after the energy crisis of 1973. Levies on fuel or on cars have equally been around for a long time. Specific taxes on CO2 emissions have been levied since the early 1990s (e.g. in Norway). Over the past years, some European countries have implemented or consider implementation of a minimum emissions price, which requires domestic emitters to pay a minimum price for CO2 emissions even if the current market price for certificates is lower. For example, the UK has introduced the “carbon floor price” of 18 pounds (=21 Euros). The UK “carbon floor price” has been credited for quickly pushing down the use of coal in energy production (see graphic on the left).
The various national carbon taxes differ significantly. Currently, Sweden has by far the highest (see graphic below).
Summary
Today, 58% of GHG emissions are subject to either en ETS system, a carbon tax, or both (see graphic below). However, the carbon price under the various systems differs greatly. Moreover, each system covers different economic sectors, which makes comparisons difficult.
