Nordic Economic Policy Review 2023

Markku Ollikainen

The European Union’s climate policy framework covers three sectors: (i) The emissions trading sector comprises the energy and processing industry. As a single market, EU ETS is a cost-efficient instrument ensuring that marginal abatement costs equal the emission allowance price across emitters. (ii) The effort-sharing sector (ESR) covers the remaining fossil emissions – generated in transport, agriculture, waste management, heating of houses, small energy use and F gases. In this sector, the mandatory reduction targets are set separately for each member state, resulting in marginal cost differences between countries and ETS. (iii) Finally, the land-use, land-use change, and forestry (LULUCF) sector regulates the net carbon sink (the removals of carbon), which is roughly a product of forest sink and soil emissions from agriculture and land-use change, that also sets separate targets for each member state, contributing to the achievement of the EU’s overall LULUCF net sink.

The difference in the marginal abatement costs between the ETS and ESR sectors and, consequently, between member states’ marginal costs poses a challenge for those countries with a high reduction requirement in the ESR sectors. Finland and Sweden provide an instructive example of this problem. Both are among the ten richest countries measured by GDP and have been assigned a 50% emissions reduction requirement by 2030. In Finland, the estimated marginal abatement cost of achieving this goal is €120–150 /t CO2e, that is, much higher than the allowance price in the EU ETS (Honkatukia et al., 2021). The recent EU plans for the new EU mechanisms, such as ETS for heating and transport, are based on the EU average. This means that, in practice, member states with high ESR reduction targets may have difficulty achieving them. Therefore, the most advanced member states need to establish overlapping regulations, which some stakeholders often perceive as unnecessary and incomprehensible. Furthermore, business opportunities associated with the green transition are also leading to differences in national energy and industrial policies.

These tensions lie at the heart of Liski and Vehviläinen’s paper. They examine how emissions trading schemes can be applied as a nationally cost-efficient instrument that copes with the overlap between national and EU regulations. They also examine how trading can tackle distributional issues. In addition, they discuss how the development of electricity markets has become increasingly policy-driven and functions as a cost-efficient means of achieving the policy targets instead of promoting emerging technologies via market mechanism.

The starting point for the discussion on transport centres on the fact that Finland has set a 50% reduction target for transport. Initially emerging as an estimate for the cost-efficient contribution of transport to achieving the Finnish ESR target (when the target was a 39% reduction of emissions), it has since become outdated, as the current Finnish ESR reduction target is 50% (the authors do not note this change in their paper). Liski and Vehviläinen suggest a national emissions trading for transport. This is not a new suggestion, as experience from other transport trading schemes around the globe is readily available and shows that such a mechanism works well (Ahlvik et al., 2022). The suggested mechanism entails a licensing system for distributors, setting an upper limit on CO2 emissions. I believe that the suggested scheme represents an excellent solution. It ensures cost-efficiency and certainty in achieving any climate target. It can easily be linked to the EU-wide emissions trading for transport and heating. Further, they show that trading not only provides funds to correct the distributional impacts but also levels these out through economic behaviour. Although the authors do not specifically discuss it, my understanding is that emissions trading also improves producers’ incentives to supply alternative fuels above and beyond mandatory blending requirements as demand for alternative fuels increases. Another interesting aspect not discussed in the paper relates to the difference between light and heavy-duty vehicles. The price elasticity of heavy transport is extremely low and, therefore, trading greatly affects industry’s costs. Recently, there has been much discussion of compensatory mechanisms for logistic firms. This is not analysed in the paper, even though revenue generated would facilitate it.

One drawback to the paper is the lack of numerical analysis. The Finnish Climate Change Panel has examined trading using estimates for short- and long-term price elasticities in the Finnish transport sector (Ahlvik et al., 2022). The target was to produce an additional reduction of emissions of 0.6 Mt above the existing instruments by 2030 to ensure that Finland achieves its reduction target for the ESR sector. This requirement results in a need for a greater than 50% reduction in transport emissions. We account for the uncertainty on price elasticities and report results in terms of medians and 50% and 90% confidence intervals. The median carbon price in the year 2030 would be €205 /CO2t resulting in a €0.34 /l medium increase in that year. Linking the scheme to the EU ETS would mean companies buying both EU and national allowances so that the effective CO2 price is the sum of national and EU prices. Naturally, in this case, state revenue would be lower than under the purely national scheme. Our numerical calculations show that the suggested mechanism works well, lending credence to Liski and Vehviläinen’s suggestion.

In contrast to transport, the suggestion of employing emissions trading in the building and construction sector is novel and perhaps one of the more unusual I have heard concerning emissions trading. The essence of the proposal lies in tailoring emissions trading to building materials’ emissions and, more precisely, emissions embodied in or created when producing these materials. Under this mechanism, the builder would acquire a given number of emissions rights at public auction or on secondary markets, corresponding to the embedded carbon emissions from building materials and, on completion, submit allowances matching emissions from these.

In Finland, building materials cover 25–30%, buildings 5%, energy use of houses 60%, and demolition 1–2% of emissions from construction. Emissions from energy use are already covered by carbon policies, and demolition should be subject to recycling policies. Thus, the suggested emissions trading on building materials would cover 25–30% of emissions from buildings. Steel, concrete (cement), wood, and bricks constitute the primary building materials. Emissions from steel and cement production belong to the EU ETS, and wood is subject to LULUCF regulation. The authors emphasise that under this system, Finland should cancel emission allowances from EU ETS if this policy leads to an additional reduction of emissions, but no suggestions are offered in relation to the LULUCF sector, which is equally subordinate to climate policy.

The suggested mechanism is interesting but by no means easy to implement. The authors rightly point out the data challenges involved and the existing regulation overlap. I would like to add the need to focus on the system boundaries of the suggested trading scheme. Suppose construction companies minimise materials’ emissions costs. This may not prove optimal for the use of energy and for the overall carbon footprint of construction. What if these choices lead to lower rates of insulation, higher use of energy and emissions and greater costs to the consumer, for example? Would this distort the climate efficiency of the overall system? I believe this is a more serious problem than the possible overlapping impact on the EU ETS. Moreover, for the planned regulation and the suggested mechanism, it is crucial to note that there is a considerable step from architecture and planning to practical implementation – where are the crucial decisions actually made, in the planning or in the construction phase? To demonstrate the benefits of the suggested trading scheme at a systemic level, and to examine in detail the information requirements, behavioural impact analyses and numerical assessment of the outcomes would be required. This exercise would be an invaluable way of demonstrating how promising this suggestion is.

In an ideal well-functioning scenario, electricity markets would promote emerging and evolving production technologies. The authors note that individual countries’ targets currently have a major impact on the direction electricity markets take. For example, Sweden and Finland have different targets for nuclear power: the former is closing plants, and the latter is increasing capacity. As a result, the way the electricity markets serve these targets also differs (nationally). The upshot is electricity price variations within a country (Sweden) or between countries (Finland vs Sweden and Norway). In contrast, the EU promotes single electricity markets, which should gradually lead to unified electricity prices. The authors conclude that integrated electricity markets are at a crossroads, where governments gravitate towards manipulating new investment decisions. It would have been interesting to see the authors’ assessment of this current situation and the measures required to maintain and strengthen an integrated electricity market. Contrary to the previous section, should the EU impose common policy principles to prevent national subsidies, increased competition and divergence of electricity production within member states? The answer to this question remains open.

The tension between EU policy and mandatory requirements for member states and national aspirations is clear and will continue to be in the future. The authors propose some interesting and well-defined solutions to overcome this discrepancy and ensure that advanced climate-ambitious countries can continue to promote national obligations and ambitions in a way that is coherent with EU policies and targets. In an exemplary fashion, the paper demonstrates the power of economic analysis in climate policy. It also shows how instrumental economics can be in analyses of just transition by assessing the impacts of climate policy in the transport sector on income distribution.

Seppänen A., Ahlvik L., Weaver S. and Ollikainen M. (2022). Tieliikenteen kansallisen päästökaupan toteuttaminen ja vaikutukset [Implementation of national emissions trading for transport sector]. The Finnish Climate Change Panel, Report 4/2022. Retrieved from https://www.ilmastopaneeli.fi/wp-content/uploads/2022/10/ilmastopaneelin-raportti-4-2022-tieliikenteen-paastokauppa.pdf

Koljonen, T., Honkatukia, J., Maanavilja, L., Ruuskanen, O-P., Similä, L., and Soimakallio, S. (2021) Hiilineutraali Suomi 2035 – ilmasto - ja energiapolitiikan toimet ja vaikutukset (HIISI) Synteesiraportti – Johtopäätökset ja suositukset [Carbon neutral Finland 2035 – measures and impacts of the climate and energy policies. Synthesis report – conclusions and recommendations].  Report of the state council – and Research publication series, 2021:62. Retrieved from https://julkaisut.valtioneuvosto.fi/bitstream/handle/10024/163638/VNTEAS_2021_62.pdf?sequence=1&isAllowed=y