On December 11 2020, EU Member States (MSs) jointly endorsed one of the world’s most ambitious climate change mitigation targets to date. To that end, an extension of the EU Emissions Trading System (EU ETS) to sectors such as road transport and buildings is currently being considered by the European Commission. If carefully designed, this would provide a powerful, EU-wide, dynamic incentive to reduce emissions efficiently.
The targets that the EU has set for itself are daunting: attaining them will require cutting emissions on an unprecedented scale and speed in the history of EU climate policy. Since 1990, the EU has reduced its greenhouse gas emissions (GHG) at an average pace of 1% per year. By contrast, to achieve the 2030 target, the annual rate of reduction should reach about 4.3% – more than 4 times the pace achieved over the last 30 years based on Eurostat GHG emissions data. This is an enormous task, especially considering the fact that these reductions will have to be delivered by sectors whose emissions have either grown (e.g. road transport, +0.85% per year) or have been reduced at the EU average pace (e.g. buildings heating, -1.18% per year) over that same period.
This makes finding an instrument capable of providing a credible and binding commitment to achieving the 1.5-2°C-compatible carbon budget all the more important. By placing a binding cap on cumulative emissions through 2050, an extended EU ETS would create a quantity-based backstop, ensuring that the EU as a whole does not overshoot the combined carbon budget of all sectors included in it. In addition, it would represent a pan-European tool that could prove invaluable for managing the coordination challenge that reducing emissions across 27 institutionally and economically diverse countries represents.
In this configuration, an EU ETS with extended coverage – and working alongside targeted sector-specific complementary policies – would either (i) deliver additional emissions reduction needed to meet the EU’s carbon budget and not currently mandated by any of the existing EU or MSs policies, or (ii) deliver emissions reduction instead of these policies, should any of these fail.
The political difficulty of an ETS, however, is that it makes the cost of emissions explicit. For instance, every €10/tCO2 increase in the price of CO2 emissions would raise the retail price of a litre of gasoline by about 2.3 cents and of diesel by 2.7 cents. Hence, other policies (e.g. standards-based), whose burden on households and industrial sectors is implicit, have traditionally commanded higher support. There is, however, no free lunch: the fact that the price tag of these policies is not immediately observable does not make it nil. Indeed, it is clear that the hidden cost of ever more stringent standards-based policies cannot remain concealed going forward.
A recent analysis shows that combining a carbon price with standards-based policies in some sectors can help achieve substantial cost savings, when compared to a scenario where only standards are used. These gains arise from ensuring that all cost-effective emissions reduction opportunities are exploited. Furthermore, it would also reduce uncertainty over the emissions target, thereby reducing the cost of capital for GHG-reducing projects. In addition, in the context of the EU, further gains are to be expected from the fact that the price signal associated with the ETS would be equalised across all EU Member States.
Given the low demand elasticity in these sectors, critics contend that an extension of the EU ETS to road transport and heating fuels could trigger a surge in the price of emissions allowances – currently at €40/tCO2 – and inflict a damaging price shock on both households and GHG-intensive industries.
This, however, fails to recognise two fundamental features of EU climate policy.
First, by ‘locking-in’ emissions reduction, existing complementary policies such as CO2 performance standards for cars and longer heavier vehicles (LHVs) or energy performance standards in buildings, will play a (price) stabilising role. One only needs to look at the dramatic increase in battery-electric (+89%) and plug-in hybrid (+190%) vehicle registrations in the EU in 2020 to realise that the choice of GHG-free options available to European consumers is expanding, which would both reduce the demand for allowances and cushion the end-user impact of any carbon price.
Second, the prices of emissions allowances that would prove to be, temporarily, too high a burden can be avoided by design. In fact, the EU ETS already has a market stabilisation mechanism in the form of the Market Stability Reserve (MSR), which could be adjusted or transformed to provide more forward guidance to both firms and households with regard to future allowance prices.
Yet, regardless of how efficient the EU climate policy design turns out to be, it will come at a cost and it might hit poorer households proportionally more than richer ones.
This calls for a careful management of the EU ETS extension, possibly through a reduction of national carbon taxes or fuel duties to neutralize the initial impact, and the introduction of robust anti-poverty mechanisms alleviating the regressive effects at both the national and EU level.
Without a binding cap on EU-wide emissions, there is no credible and legally binding guarantee that a carbon budget consistent with the EU-wide target will be met. The extension of the EU ETS would both lower overall climate policy cost and substantially increase the long-term credibility of EU climate targets in ways that no other currently available policy can.
The views expressed in this Op-Ed are attributable only to the authors in a personal capacity and not to any institution with which they are associated. These views do not necessarily correspond either to those of CERRE, or to any other member of CERRE.
