Anticipated Green Deal policies that are intended to reduce carbon emissions could instead lead to increased EU emissions, according to a new research report by Reyer Gerlagh (Tilburg University), Roweno Heijmans (Tilburg University) and Knut Einar Rosendahl (Norwegian University of Life Sciences). Their analysis of the interaction of the Green Deal with the Market Stability Reserve of the EU’s Emissions Trading System (EU ETS) shows how a ‘Green Paradox’ could arise.

The authors propose rethinking the regulation of the EU ETS in way that differentiates two policy targets. The first is to support a smoothly working allowances trading market with sufficient but not excess liquidity. The second is to support a stable carbon price in the market, which should be not too sensitive to economic fluctuations, but importantly should be allowed to depend positively on expected cumulative carbon emissions in the EU ETS.

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In 2018, the European Union’s Emissions Trading System (EU ETS), which aims to reduce EU carbon emissions, was complemented with a Market Stability Reserve (MSR). The MSR successfully stabilises the EU ETS against large economic disruptions such as the Covid-19 crisis. But in the process of solving this problem, it has created another one: the MSR does not blend well with other EU climate policies.

A case in point is the Green Deal, which reduces future demand for allowances in the EU ETS. Firms respond by decreasing allowances in circulation (banking). The MSR in turn responds by reduced cancelling of allowances. As a consequence, emission-reduction policies proposed in the Green Deal have diametrically opposed effects when interacted with the MSR: anticipated Green Deal policies will lead to increased EU emissions.

Figure 1 below presents the numbers. The red dash-dotted line shows the effect of a policy that reduces demand for allowances in some future year, while announced in 2020, on cumulative emissions. If the policy reduces the demand for allowances by 1Mt of emissions in 2040, then through increased cancelling in the MSR, cumulative emissions are reduced by 30%. But if demand for allowances is reduced by 1Mt in 2050, then the MSR reverses the policy: cumulative emissions are increased by above 80% of the intended reduction.

Thus, when a policy reduces demand for allowances over the period 2040-2050, the total effect is the sum of the two: an increase in emissions. This is the interaction effect between the Green Deal and the MSR. If policies are not announced or anticipated, but implemented immediately after their conception, there is no Green Paradox, as the blue line shows.

The researchers find that this is a fundamental design problem of the EU ETS/MSR, caused by the forced doctrine that MSR rules can only use quantity-related information. Under this restriction, an MSR that softens current economic shocks must always lead to a Green Paradox.

Although the EU can correct the harmful feedback mechanisms, for example, by complementing Green Deal policies with a reduction in auctioned or a forced cancelling of allowances, such ad hoc adjustments remain open to debate and are not the preferred option.

The authors therefore propose rethinking the regulation of the EU ETS. They suggest setting up an MSR system that does not need a regular update of its parameters.

Their study does not work out a new system, but it shows the need and suggests a way forward. In the authors’ view, the EU ETS must differentiate between two policy targets:

• The first target is to support a smoothly working allowances trading market with sufficient but not excess liquidity. This requires an exchange of allowances between the EU ETS and the MSR based on the number of allowances in circulation.

• The second target is to support a stable carbon price in the market, which should be not too sensitive to economic fluctuations, but importantly should be allowed to depend positively on expected cumulative carbon emissions in the EU ETS.

Stated the other way around, this analysis suggests that allowances cancelling should increase with lower carbon prices. Such a system could solve the unfavourable interaction between the MSR and other EU climate policies.

‘An endogenous emission cap produces a green paradox’

Authors:

Reyer Gerlagh (Department of Economics, Tilburg University, the Netherlands and Oslo Centre for Research on Environmental friendly Energy, CREE, Norway)

Roweno JRK Heijmans (Department of Economics, Tilburg University)

Knut Einar Rosendahl (School of Economics and Business of the Norwegian University of Life Sciences, Norway, Statistics Norway, and the Oslo Centre for Research on Environmental friendly Energy, CREE, Norway)