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.