Carbon pricing policies are considered by many to be the gold standard due to their economic efficiency. Carbon pricing regimes are often preceded and accompanied by companion policies, which can include innovation support, regulatory standards, subsidies, and additional carbon pricing policies. Carbon pricing programmes hold the advantage of identifying least-cost means of reducing carbon emissions. Non-price-based companion policies provide other advantages, such as targeting specific technologies, providing infrastructure, addressing social impacts and providing additional incentives for behavioral changes when carbon prices are too low to adequately do so. Companion policies therefore plays an important role in meeting climate goals, but some inefficiencies are expected when carbon pricing and companion policies interact.
Carbon pricing policies involve placing a per-unit price on carbon dioxide emissions. Carbon prices can be imposed in the form of a per-unit emission tax, or by introducing scarcity through an emissions cap. Under cap and trade, entities that are required to comply with the cap either purchase or receive freely allocated emissions allowances, and compliance entities can trade allowances amongst one another. The market for emissions allowances enables an equilibrium carbon price to emerge, representing the marginal cost of emissions reductions that compliance entities face.
The function and effectiveness of cap-and-trade programmes are complicated by companion policies, which often precede and exist alongside carbon pricing. Companion policies like technology standards and subsidies also drive down emissions, but they tend to have greater costs per unit of emissions reductions. Inefficiencies can be expected when cap-and-trade programmes are accompanied by companion policies. Generally, an emission cap not only serves as a maximum level of emissions but also as a minimum level – that is, the emissions cap determines the actual level of emissions that will occur.
Consequently, emissions reductions that are achieved by companion policies reduce the scarcity of allowances in the carbon market and drive down emissions allowance prices. In the short run, it is likely resulting in a net-zero impact on emissions. In the long run, the lower allowance price in the carbon market may trigger administrative reforms and a tightening of the cap, but the prospect of future changes in the emissions cap introduces additional uncertainty that can undermine confidence in the carbon market.
Between 2013 and 2018, the EU ETS was plagued by a consistently low price on allowances, between €3 and €8. This was due to an imbalance of allowance supply and demand, resulting mainly from the economic crisis, the influx of credits under the Clean Development Mechanism, and free allocation based on historical output levels. Moreover, renewable targets and energy efficiency policies further reduced emissions, without necessarily adjusting the supply of allowances commensurately, thereby contributing to a growing surplus. The low price was clearly not providing incentives for emissions reductions and adoption of low carbon technologies.
In response to the low allowance price, some member states introduced or wanted to introduce additional policies in order to comply with national climate objectives. However, additional emission reductions under an emissions cap are problematic for two reasons. First, if the total volume of emissions allowances is fixed, extra emissions reductions in one country can lead to emissions increasing elsewhere in the EU, undermining the effectiveness and integrity of the national policies. This is sometimes referred to as the “waterbed effect.” It is like sitting down on one side of a waterbed and seeing it rise on the other side. Moreover, if additional policies are introduced, the surplus of allowances may increase even further, putting downward pressure on the carbon price and reducing the incentive to adopt new technologies even further (Burtraw et al, 2018).
In 2017, the EU ETS was reformed. From 2019 allowances corresponding to 24 percent (12 percent from 2024) of the allowance surplus are transferred into a market stability reserve (MSR). From 2023 onwards, the MSR is only allowed to hold as many allowances as were auctioned the previous year – the rest are invalidated. Estimates show that about 3 Gt of allowances will be invalidated between the years 2023 and 2030 (Burtraw et al, 2018). This has contributed to driving up allowance price from €5 and €9 per ton CO2 in 2017 to between €25 and €30 in 2020, and between €38 and €96 in 2021 (ICAP climate, 2022). This development has contributed to reducing coal-based power production in the EU. Studies show that this invalidation mechanism reduces the waterbed effect to some extent, but as the cap shrinks towards 2030, the waterbed effect is expected to increase again (Burtraw et al, 2018).
The emissions reductions from companion policies, as mentioned above, often come at a higher cost than the marginal cost of reductions achieved by the trading programme. Companion policies may push down allowance prices, but actually increase overall costs without creating additional emissions reductions. This type of inefficiency is expected in a static framework, according to economic theory, but it may be less of a concern when considered in a dynamic setting. If companion policies push down emissions under a cap this creates an opportunity (and a need) for the regulator to tighten the cap. This was the case when the EU ETS was reformed in 2009 and 2018 (European Commission 2009 and 2018) resulting in a faster linear reduction factor. Although carbon pricing can lead to effective emissions reductions, companion policies have the potential to drive faster introduction of new technologies and behavioral changes than would be achieved by carbon pricing alone. This process might enable greater emissions reductions over time, but the waterbed effect, if not addressed, erases emissions reductions in the short term, presenting a serious challenge to climate policy (Burtraw et al, 2018).
Overlapping policies are common both at EU and member state levels. It’s likely that the EU ETS will continue to co-exist with other policies. For that reason, it’s important that the EU ETS can manage imbalances in supply and demand that may occur due to overlapping policies. In the 2018 revision of the EU ETS, a market stability reserve was introduced. If the surplus of allowances (defined as the total number of allowances in circulation) reaches above a prescribed threshold level, 25 percent of the surplus is transferred to an allowance reserve. The reserve is only allowed to hold a maximum number of allowances, the rest are invalidated (EU Commission, 2018). Another option is to introduce a price floor in the EU ETS. A price floor can also provide resistance in the event of unexpected shocks, thereby providing investment certainty and maintaining market confidence and support. Price floors have been successfully implemented in the emissions trading systems in North America (Flachsland et al, 2019).