Environmental Economics

Economic impacts of the EU ETS: preliminary evidence

img_EEThe rationale for a cap-and-trade system of emissions trading is that it ensures that pollution abatement will take place where it can be done at the lowest costs, while the outcome in terms of an emissions ceiling is guaranteed. In principle, therefore, emissions trading will always lead to net efficiency gains and have a positive impact on overall welfare, unless transaction costs are very high or serious market failures exist. Ex ante assessments of the European greenhouse gas emissions trading scheme (EU ETS) predicted that compliance costs of this scheme would be around 25% less than a reduction scheme that would not allow trade of allowances between Member States. While it is difficult to validate this claim, even in retrospect, it is possible to compare a number of predicted economic and environmental
impacts of the EU ETS against actual observations from the first trading period, 2005-2007.

The ex ante assessments commonly modeled the EU ETS as being equivalent to the least-cost solution to an optimization problem, solved by one, fully informed, European planner. What the assessments therefore did not foresee was the significant impact of asymmetric information by market participants on trade and prices, and hence on the volatility of the price of CO2 allowances. In addition, the assessment assumed a binding cap on emissions, while the cap in the first phase of the EU ETS was, in effect, and on balance, not binding (mainly due to overallocation of allowances). When market participants realised in April 2006 that the market of allowances was in over supply, the market price of allowances suddenly collapsed and did not recover until the end of the trading period (see Figure 1).
Despite this unforeseen collapse, preliminary evidence from the first trading year (2005), does suggest that the scheme was actually influencing operational and strategic decisions of energy intensive industry in the EU. Even though some details (e.g. regarding prices and trading patterns) of ex post outcomes may differ from ex ante estimates, one can say that the system was, by and large, delivering the expected economic results. There are also strong indications that the EU ETS actually contributed to emission reductions and to investment in the development and application of new, low-carbon technology. Nevertheless, the ‘real’ test for the scheme will be in the current trading period 2008-2012, and beyond. Growing experience, a broader scope (in terms of sectors and countries), a permanent ‘scarcity signal’, the introduction of auctioning, more harmonisation of allocation and trading rules, and less restrictions on trading (e.g. no ‘ex-post’ adjustments): all this will probably contribute to a better economic performance, enabling the instrument to reveal its full potential in terms of cost-effective emission reduction.
For more information, see Onno Kuik and Frans Oosterhuis (2008). ‘Economic impacts of the EU ETS: preliminary evidence’ (pages 208-222), In: Faure, M. and M. Peeters (eds.), Climate Change and European Emissions Trading, Cheltenham, UK/ Northampton, MA, USA: Edward Elgar.  

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onno kuik
frans oosterhuis