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

AuthorSebastian Rausch, Hidemichi Yonezawa, Jan Abrell
Publication Date01 Apr 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
Sebastian Rausch
ETH Zurich, 8092 Zurich, Switzerland
Hidemichi Yonezawa
Statistics Norway,NO-0033 Oslo, Norway
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).
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.
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
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
The editors of The Scandinavian Journal of Economics 2017.

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