Carbon Pricing: European Union

Carbon pricing allows policymakers to support decarbonization by charging polluters for each unit of emissions. Today there are over 70 such programs around the world, with penalties typically levied through a tax or market-based system.

Overview

The most common form of market-based policy is a ‘cap-and-trade’ scheme, as implemented in the European Union, the UK and California. In general, the government sets an upper limit, or ‘cap’, on allowed emissions in the sectors covered, which typically decreases every year.

Permits or allowances are allocated to the market either via auctions or directly to compliance entities as free allocation. Participants without freely allocated permits can then choose to either continue emitting and pay for permits, or reduce their emissions and thereby their carbon costs.

Depending on the scheme, participants may also have an option to pay a fixed fee to the government or to submit a carbon offset deemed equivalent to an allowance. Many schemes also allow allowances to be traded directly with other participants, as well as with carbon traders or brokers, or in the form of futures or spot contracts.

Impact

The European Union Emissions Trading System (EU ETS) represents one of the largest carbon markets globally in terms of traded value. The emissions allowance supply is provided and mostly pre-determined by European lawmakers to ensure emissions targets are met, with some adjustments applied dynamically to stabilize the market’s supply-demand balance.

In general, allowances are auctioned. But a significant number are also given out for free. This free allocation of permits was introduced to ensure that companies operating in the EU were not competitively disadvantaged versus overseas counterparts that are not exposed to carbon costs. Free allocation is primarily calculated through a bottom-up approach based on each compliance entity’s activity level, relevant product benchmarks and a carbon leakage exposure factor. A top-down budget is also applied where the total free allocation cannot exceed more than 43% of the cap.

To date, a significant portion of industrial emissions have been covered by free allocation, while free allocations for electricity generation have largely been phased out. For the most part, as the number of free allowances has decreased, so too have emissions for those sectors.

The goal of a carbon price is to drive polluters to reduce their emissions by, for example, decreasing energy or material demand, and/or switching to less carbon-intensive fuels. In this respect, the EU ETS appears to be effective: participating countries cut greenhouse-gas output 43% between 2005 (when the scheme began) and 2023.

The biggest decrease in emissions came from fuel combustion in the power sector. Even though carbon prices over 2013-18 were well below €10 ($12) per metric ton, when combined with other policy support measures, this price was high enough to trigger the shift to lower-carbon sources.

Opportunity

Most jurisdictions with a carbon price have also implemented a range of other policies designed to promote decarbonization, including subsidy programs paid for using revenues from the carbon market. Such measures are often needed to promote innovation – for example, through financial and fiscal incentives targeted at research and development, as well as pilot and demonstration projects. The EU Innovation Fund helps funnel money raised from the EU ETS into supporting innovative low-carbon technologies that are not yet economically competitive. It is estimated to reach €40 ($43.6) billion over 2020-30 if the carbon price averages €75 ($82) per metric ton.

Parallel national and subnational policies may reinforce each other but could also lead to inefficiencies. An unnecessarily complicated market environment could increase not only compliance costs for industry but also subsidy and enforcement costs for government. Other incentives may also reduce emissions, thereby decreasing demand for carbon permits and prices.

Almost all cap-and-trade schemes have mechanisms to help control the market to enable them to react to external shocks. Accurately forecasting emissions trajectories is challenging, and the fixed cap – at least in volume-based systems – cannot automatically respond to changes in the supply-demand balance. Governments may also implement control mechanisms to avoid overly high or volatile prices, especially in more controlled (rather than free-market) economies.

Emissions trading programs should facilitate compliance while avoiding carbon leakage. As such, free allowances can be necessary at first, but the allowance cap and the portion of free allowances should become more stringent with time to give producers a sufficient signal to decarbonize.

Source