The European Union Emissions Trading System (ETS) has long been criticized as having a carbon price too low to incentivize meaningful carbon emissions. However, a new study argues that, despite low prices, the ETS actually helped reduce emissions. The study indicates that low prices today can cut emissions by signaling much higher carbon prices in the future. However, strong political commitment to decarbonization is needed for this to be true. This conclusion provides some useful perspectives for the policy design of a carbon tax, in which starting with a low carbon price and then ramping up over time could be better for decarbonization that is generally assumed.
The ETS is the EU’s major policy tool in tackling climate change. It’s a system that allows companies to trade greenhouse gas emission allowances. The program has three trading periods: 2005-2007, 2008-2012, and 2013-2020. Trading prices remained low for the last decade. Only in 2018, after a series of reforms, did prices ramp up up to €24 a ton by the end of the year. Recently, prices dropped to €16.35/ton–the lowest since November 2018–as a result of the fall in demand driven by the coronavirus pandemic.
The study estimates that the program cut cumulative emissions by about 1.2 billion tons from 2008 to 2016, or approximately 3.8 percent relative to the total EU emissions over the same period. It compares the actual emissions levels under the ETS program with emission levels in the hypothetical world in which ETS was not implemented. The paper emphasizes that this reduction in emissions was on top of any reduced economic output during the 2007/2008 financial crisis. Additionally, it argues that as long as regulated companies interpret the carbon pricing policy as a credible long-term tool, they have incentives to account for the increased cost in their long-term investment strategies.
One caveat that the study acknowledges is that carbon leakage–namely, transfer of production outside of the EU to jurisdictions with less stringent carbon policies–is not accounted for. Some of the emission reduction the study attributed to the ETS system might have been caused by companies moving their carbon-intensive productions overseas. A recent blog post explains how a border adjustment mechanism–which is a policy that the EU is actively considering–can help prevent carbon leakage.
As we are in the midst of an unprecedented public health and economic crisis, now is probably not the best time to focus our energies on enacting a carbon tax. But when the public health crisis finally dissipates and we are on track to economic recovery, starting with a modest carbon tax would help reduce emissions and create government revenue to restore fiscal balance. As long as there is a strong political commitment to increasing the carbon tax rate over the long run, we can finally be on the right path towards achieving meaningful carbon emission reduction.
Photo credit: Envisat satellite / CC BY-SA 3.0-IGO (https://creativecommons.org/licenses/by-sa/3.0-igo)