8th February 2012

Making the carbon market wider and deeper

by Georg Zachmann on 8th February 2012

A drastic change in the way we produce and consume energy is necessary to contain the risk of a global environmental catastrophe. For its part, the EU has set targets for reduction of GHG emissions by up to 80-95% of 1990 levels by 2050 to keep global temperature increases below 2°C. One key policy for achieving this target cost-effectively is the European Emission Trading System (EU ETS). However, the only partial coverage of important emitting sectors (namely transport) creates economic inefficiency. While the ETS has succeeded in containing carbon emissions in the power sector, it has not provided sufficient signals for incentivising low-carbon investments. Thus, we suggest making the EU ETS wider and deeper.

Widening the ETS: Inclusion of (all forms of) transport in the EU ETS

As vehicles become more fuel-efficient, a rebound effect might arise. Consumers might use cars more often as fuel savings lead to lower driving costs relative to other modes of transport. Lower fuel bills may also mean more money available to be spent on transport. A price on carbon for fossil fuels is necessary for stimulating efficient emissions-mitigation behaviour on the part of consumers. An arbitrary price on carbon is, however, not efficient. The proposed carbon component in the fuel tax is insufficient for ensuring efficient economy-wide greenhouse gas mitigation. A carbon tax would be different from the volatile marginal abatement costs in ETS-regulated sectors. Transport fuels produced in different sectors would then face different carbon costs. For example, the electricity used in electric vehicles (or for electrolysis to produce hydrogen) is covered by the ETS, while gasoline production is not covered by the ETS. Hence, fossil fuelled transport would abate too much/little if the carbon tax is higher/lower than the ETS price. In addition, taxes are a less good incentive for long-term investment decisions because they can easily be changed by policymakers. Only a broad scheme providing a single carbon price across sectors would ensure cost-optimal abatement. Including transport in the ETS could achieve this. Furthermore, inclusion of transport in the ETS would increase the depth of the carbon market and make the system more resilient. Implementation could take the form of obliging fuel outlets to buy emission allowances for the fuel they sell. This would result in the harmonisation of the carbon price across sectors and create an incentive for the use of the cheapest available abatement options.

Deepening the ETS: Lock-in of a long-term carbon price (Government credibility)

In addition to aligning the carbon cost across the different transport sectors, governments can reduce uncertainty for investors by providing assurance that carbon would be sensibly priced beyond 2020. Currently, the EU emission cap for 2020, the sectoral coverage, the institutional setting beyond 2020 and other key elements of the ETS, are subject to change. As investors cannot predict the direction that likely political changes will have, the ETS lacks credibility in the long-run and thus fails to provide clear long-term investment signals. As it might be politically and institutionally impossible to lock-in a credible long-term commitment to a tight emissions trading system, in the absence of an international agreement, second-best options for creating investment certainty should be considered. A carbon floor price might seem attractive to today’s low-carbon investors. However a general floor price is a rather inflexible tool. In case future carbon reduction potential turns out to be much cheaper than anticipated (eg because of new technologies or lower economic growth) a high floor price could result in carbon reductions becoming needlessly expensive. In addition, a politically set floor is subject to change and hence not credible either, in the long term. A more targeted alternative would be the establishment of bilateral option contracts between public institutions and investors. The public institutions would guarantee a certain carbon price to an investor through such a contract. In case the realised carbon price is below the guaranteed price, the public institution (the option writer) would pay the difference to the investor (the option holder). Hence, in case of a low carbon price, potentially detrimental to the competitiveness of low-carbon investments, the investor gets some compensation. This would reduce the investor’s risk. At the same time, if the public institution issues a large volume of option contracts, it creates an incentive for policymakers not to water down climate policies in the future. Policies that reduce the carbon price will have a direct budget impact through increasing the value of the outstanding options. This would increase the long-term credibility of the ETS.

Georg Zachmann is the author of the policy contribution Cutting carbon, not the economy.

A version of this comment was also published in EU Energy Policy Blog