Higher Price, Lower Costs? Minimum Prices in the EU Emissions Trading Scheme

• Author: Sebastian Rausch,Hidemichi Yonezawa,Jan Abrell
• Published date: 01 April 2019
• DOI: http://doi.org/10.1111/sjoe.12279
• Date: 01 April 2019

Scand. J. of Economics 121(2), 446–481, 2019

DOI: 10.1111/sjoe.12279

Higher Price, Lower Costs? Minimum Prices

in the EU Emissions Trading Scheme*

Jan Abre ll

ETH Zurich, 8092 Zurich, Switzerland

jabrell@ethz.ch

Sebastian Rausch

ETH Zurich, 8092 Zurich, Switzerland

srausch@ethz.ch

Hidemichi Yonezawa

Statistics Norway,NO-0033 Oslo, Norway

hidemichi.yonezawa@ssb.no

Abstract

In this paper, we examine the introduction of a price floor in an emissions trading system (ETS)

when some emissions are regulated outside the ETS.We theoretically characterize the conditions

under which a price floor enhances welfare. Using a numerical simulation model of the European

Union (EU), we find that moderate minimum prices in the EU ETS can reduce the costs of

EU climate policy by up to 30 percent. We also find that, because of tax-interaction effects,

the optimal minimum price in the EU ETS should be about four times higher than the average

marginal abatement cost in non-ETS sectors.

Keywords: Emissions trading; EU ETS; general equilibrium; par titioned regulation;price floors

JEL classification:C68; H23; Q52; Q58

I. Introduction

While emissions trading systems (ETSs) have become centerpieces of

market-based environmental regulation in many countries, they have been

shown to suffer from two major issues. First, they typically cover only a

subset of emissions, thereby undermining the static cost-effectiveness of

pollution control as marginal abatement costs (MACs) are not equalized

across all sources (B¨ohringer et al., 2006, 2014). Second, exogenous

shocks (economic recessions, fuel prices, and technology shocks) and

overlapping environmental policies (B¨ohringer and Rosendahl, 2010;

*This research is part of the activities of the Swiss Competence Center for Energy Research,

Competence Center for Research in Energy,Society and Transition (SCCER-CREST), which is

financially supported by the Swiss Commission for Technology and Innovation(CTI).

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The editors of The Scandinavian Journal of Economics 2017.

J.Abrell, S. Rausch, and H. Yonezawa 447

Fischer and Preonas, 2010) can lead to unforeseen impacts on the ETS

permit price. Importantly, this might reduce the investment incentives

for low-cost pollution-extensive “clean” future technologies with negative

effects for dynamic cost-effectiveness. The first (and still by far the

biggest) international system for trading greenhouse gas emission (GHG)

allowances, the European Union (EU) ETS also faces these issues: the

EU’s climate policy is highly partitioned with only about one-half of

the EU’s emissions covered by the EU ETS;1and the price for EU

emissions allowances is conceived to be too low (Nordhaus, 2011; European

Commission, 2014).2

In this paper, we examine whether and by how much the abatement

costs of achieving a given environmental target under partitioned climate

regulation that is heavily based on an international ETS can be reduced by

introducing a minimum price for ETS permits (or, similarly, by tightening

the cap of the ETS). We theoretically characterize the conditions under

which a price floor for ETS permits enhances the static cost-effectiveness

by reducing the differences in MACs across the partitions of environmental

regulation. Assuming that the environmental target always has to be fulfilled,

we show that, in the absence of pre-existing taxes, a higher ETS permit

price (induced by a binding minimum price policy) reduces total abatement

costs if MACs across countries and sectors in the non-ETS partition are on

average higher than the minimum ETS price. However, with pre-existing

taxes, it might be optimal to set the minimum price above the average

MACs in the non-ETS partition. In both cases, the binding price floor

policy in combination with the decision to reallocate abatement from the

non-ETS to the ETS part of the economy means that the regulation in the

non-ETS part must be loosened up.

Our theoretical analysis is complemented by an empirical, quantitative

assessment of the efficiency and distributional impacts of introducing a

minimum price in the EU ETS to achieve the emissions reductions goals of

EU Climate Policy (European Union, 2008). Employing a numerical multi-

country multi-sector general equilibrium model of the European carbon

1The EU ETS coversabout 45 percent of the total EU-wide emissions, mainly from electricity and

energy-intensive installations.By 2020 and compared with 2005 levels, a 21 percent reduction in

emissions has to come from sectors coveredby the EU ETS and an additional 10 percent reduction

from non-ETS sectors covered by the Effort Sharing Decision under the EU’s 2020 Climate

and Energy Package, including transport, buildings, services, small industrial installations, and

agriculture and waste. Sources not covered under the EU ETS are regulated directly bymember

states, often relying on renewable support schemes and technology policies.

2This normative judgment is mainly based on the observations that the estimates of the

social cost of carbon tend to be substantially higher (Tol, 2009; Knopf et al., 2014; United

States Environmental Protection Agency, 2015) and that a too low price signal is detri-

mental for low-carbon investments.

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The editors of The Scandinavian Journal of Economics 2017.

448 Minimum prices in the EU emissions trading scheme

market, we find that ETS price floors on the order of US$50–70 per

ton of CO2can reduce the welfare costs of achieving EU climate policy

targets by 20–30 percent relative to current policy, assuming that the

regulation of emissions in the non-ETS sectors loosens up. The efficiency

gains are mainly driven by two effects: (1) a decrease in the difference

in MACs between firms in the ETS and non-ETS partition; and (2) the

reduction in adverse tax-interaction effects arising from shifting abatement

away from sectors that are subject to high pre-existing fuel taxes and

are not covered by the EU ETS (such as, for example, transportation).

We find that tax-interaction effects are a main driver of the efficiency

gains obtained by introducing a minimum ETS permit price: without any

pre-existing tax distortions, the maximum efficiency gain is about 10

percent, whereas it can be as large as 30 percent if the actual economy

with pre-existing taxes is considered. The optimal minimum price in the

EU ETS should be about four times higher than the average marginal

abatement cost in non-ETS sectors. We further find that (1) and (2) are

driven to a large extent by the high MACs as well as existing fuel

taxes in the transportation sector. Importantly, we find that an effective

minimum price policy can achieve outcomes close to that which would be

obtained with uniform carbon pricing if environmental regulation was not

partitioned.

The efficiency argument for a minimum price in the EU ETS is

strengthened by our finding that the likely distributional impacts among

the EU member states do not adversely affect regional equity. Introducing

a minimum ETS permit price entails welfare gains for the majority of

countries, with the gains of winning countries vastly exceeding the losses

of losing countries. We thus argue that, given the feasibility of inter-country

transfers within the EU, the efficiency gains from introducing a minimum

EU ETS price can be shared among all countries in a way that makes each

country better off.

Our main result that a minimum ETS permit price would bring about

sizeable welfare gains relative to current EU climate policy is robust

with respect to uncertainty in parameterizing production and consumption

technologies. Using systematic (Monte Carlo-type) sensitivity analysis,

we find that optimal minimum price policies guarantee welfare gains of

between 15 and 40 percent.

This paper contributes to the existing body of literature in several

ways. First, our paper is related to the literature on segmented carbon

markets and partitioned regulation in the context of European climate policy.

Using computable general equilibrium analysis, B¨ohringer et al. (2006,

2014) have shown that the limited sectoral coverage of the EU ETS or

strategic partitioning (B¨ohringer and Rosendahl, 2009; Dijkstra et al., 2011)

undermines “where-flexibility”, in turn creating substantial excess costs for

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The editors of The Scandinavian Journal of Economics 2017.