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Why Europe Still Needs a Carbon Price Floor

Reforms to the European Union's emissions trading system have strengthened the program, but a price floor is still needed to safeguard its success.

Carbon pricing policies are considered the gold standard when it comes to policy measures to address climate change. A carbon price provides incentives to guide investments and behavioral change while leaving the decision about how to respond to those incentives to individual actors in the economy. There exist limits to the effective reach of carbon pricing and strong arguments in favor of sector-specific policies as companions to carbon pricing; however, to the extent carbon pricing can be implemented, the outcome is expected to be frequently more efficient than prescriptive regulation. 

In Europe, carbon pricing has been declared a cornerstone of climate policy, but most analyses have found it to have gained relatively little traction in driving behavior or investments that result in emissions reductions. The dilemma in Europe, as in many trading programs, is that the price has been much lower than expected—lower, in fact, than the level identified as necessary to spark a transformation of the energy economy toward low-carbon alternatives.

Since 2005, the EU has made three runs at reforms that were intended to boost the carbon price in the European Emissions Trading System (EU ETS), but the first two found only temporary success. The most recent one, finalized in early 2018 and described previously on these pages, appears likely to have the most enduring effect.

Under the new reforms, beginning in 2021 the issuance of new emissions allowances falls 2.2 percent per year. Even more important is the amendment to the Market Stability Reserve (MSR), which is a mechanism calibrated to reduce the number of allowances in circulation (the “bank”) when the total number is large, and reintroduce allowances when the bank is small. The reform will cause some allowances in the MSR to be permanently withheld from the market (“invalidated”) when the MSR grows too large. This feature is expected to trigger the invalidation of about 2 gigatons of emissions allowances in 2023—more than the quantity of allowances associated with the electricity sector that are auctioned each year—and additional cancelations are possible after that. We have presented an interactive tool illustrating its effects on allowance supply.

After announcement of the reforms, the price for emission allowances has risen five-fold over an eighteen-month period to $25–$30 per metric ton of carbon dioxide (CO2), which is broadly in line with European climate targets. Indeed, the sharp price increase over the last months has restored market confidence in the willingness of EU policymakers to pursue ambitious climate policy. However, it is uncertain whether the reform has anticipated all the possible influences on the EU ETS. There remains a persistent risk that future economic or political shocks might cause the price to again fall significantly, as it has done repeatedly in the past.

In July 2018, RFF cosponsored a dialogue on the role for a minimum price among various stakeholders, lawyers, and scientists held at the Center for European Policy Studies (CEPS) in Brussels. Together with scientists of the Mercator Research Institute on Global Commons and Climate Change (MCC), the Potsdam Institute for Climate Impact Research (PIK), CEPS, IVL in Sweden, and RFF University Fellow Carolyn Fischer at VU Amsterdam, we recommend in a new report the introduction of a price floor as an important addition to the design of the ETS, helping to safeguard against low or declining prices in the future.

The carbon pricing programs in North America have already addressed the challenge of persistent downward pressure on prices through the introduction of a carbon price floor. We explain in our paper that in these programs a price floor is implemented as a minimum (reserve) price in the allowance auction; allowances will not sell at bids below this price. Other approaches to implementing a price floor are also possible; the UK’s carbon price floor requires power sector facilities to pay a carbon price support that scales with the price of emissions allowances such that the sum of the two achieves a specified minimum level. Both these approaches have champions in Europe, but the idea of a minimum price has thus far faced stiff opposition, based, we argue, on various errors and misconceptions (or myths).

Our new paper confronts five “myths” that argue against the introduction of an EU ETS price floor. The scientists refute arguments that, for example, assert the alleged legal or practical infeasibility of the price floor, or that determination of a level for the price floor would fragment EU climate policy because of differing views about the level of the price floor. Further, we identify several entry points for introducing an EU ETS carbon price floor in the EU policy process in the upcoming years: when the EU climate strategy will be reviewed in late 2018, when the MSR will be reviewed in 2021, or at review of the Paris agreement in 2023.

The recent reforms strengthen the EU ETS substantially and reinforce it as the world’s most important carbon pricing program. However, the program remains subject to influences that could cause prices to fall precipitously again. If this were to occur, it would again require administrative interventions to support the carbon price, such as has occurred by the European Commission previously. In arguing for a price floor in the ETS, we acknowledge that administrative interventions are always possible and sometimes may still be needed. But, rule-based approach to supporting the carbon price provides an automatic adjustment that can be more reliably anticipated by the market even before administrative actions take shape. As a complement to the current MSR, it could make an already strong carbon market even stronger.

About the Author

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Dallas Burtraw

Dallas Burtraw is the Darius Gaskins Senior Fellow at RFF

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