Resources for the future Report

The EU Emissions Trading System (EU ETS) is the world’s largest carbon market and has become a model for market-based approaches to reduce greenhouse gas emissions in other world regions. Evaluating and improving its effectiveness thus have been a concern not only for European policymakers but also for the success of carbon pricing policies at a global level. Conventional wisdom is that the environmental effectiveness of a cap-and-trade system such as the EU ETS is guaranteed. This expectation is based on its design, which limits total emissions to a specific level (the emissions cap), and is supported by the observation that compliance with cap-and-trade programs is virtually 100 percent, meaning the emissions target is achieved. The recent recovery of prices for emissions allowances (EUAs) to moderate levels indicates that investors may have regained confidence in the bindingness of the cap. Nonetheless, many observers have challenged the role of cap and trade. A major concern remains that the future price path could be too low to incentivize innovation and investment in low-carbon technology that is necessary to comply with the EU’s long-term emissions reduction goals for 2030 and 2050. A second concern is that the emissions cap also serves as an emissions floor; that is, it not only sets a maximum level of emissions but also specifies the actual level of emissions that will result. This appears to hamstring the ability of independent actors or subsidiary jurisdictions such as member states in the EU to pursue emissions reductions beyond the EU’s own goals. These challenges have led to calls for a thorough reform of the EU ETS. In contrast, others object that the ETS price on carbon already imposes an unfair cost on EU industries, which must compete with unregulated industries in other countries. Even at present low prices, industry groups have stressed that the economic impacts of the trading scheme may undermine their ability to compete in international markets. This policy brief begins with a review of the empirical evidence on the accomplishments of the EU ETS and concerns about industry competitiveness. We discuss various drivers of current and future EUA price development. While the EU ETS undeniably has had some success in reducing emissions and alleviating economic costs in the short term, the current policy design still raises concerns about its success in the long run. Allowance prices have been persistently low for most of the three trading periods, and despite recent increases, they could soon revert to this pattern. The uncertainty about the future supply in EUAs introduces the risk that high-carbon infrastructure and industrial assets will become locked in, making it expensive to achieve long-term carbon reduction goals. To address these structural flaws, we argue for a comprehensive carbon price signal supported by a minimum price floor in the EU ETS. Such a measure would stabilize investors’ expectations about the future price path and stimulate the demand for low-carbon technologies. This reform is also essential to mitigate the economic and political costs of carbon pricing, which may otherwise rise steeply in the future and become detrimental to achieving the climate goals under the Paris Agreement. A recent reform in the EU—the Market Stability Reserve—takes a step in the right direction; however, it appears insufficient to address our concerns fully. We look to the North American carbon trading programs, which all have a minimum price floor, as models that can influence the EU’s program design. In this regard, the lessons obtained from the European experience have important implications for the functioning and expansion of carbon markets worldwide.