Chart of the Month – July 2021

This Chart of the Month shows the price of the EU Emissions Trading Scheme (ETS).

The EU ETS aims to reduce net greenhouse gas emissions within the EU. It is a market-based intervention.

Greenhouse gases have made catastrophic weather events much more likely. This summer, we saw devastating floods across Europe, which killed over 300 people. In the US, wildfires torched almost 1.4 million hectares of land, equivalent to the size of Northern Ireland. Both were undeniably linked to climate change.

Humanity continues to emit greenhouse gases because it is cheap to do so. We do not directly pay for the costs of pollution. In economics, this is called a negative externality, defined as when the external costs of a market transaction exceed the private costs.

The Emissions Trading Scheme raises the cost of pollution. It operates on the “cap and trade” principle.

The EU sets a limit on greenhouse gases emitted by firms. This cap decreases over time, reducing total emissions.

To remain within this cap, companies must reduce their carbon footprint. If they exceed the cap, they must buy an emissions allowance. This allows them to produce a fixed amount of greenhouse gases. Otherwise, they receive heavy fines.

If a firm successfully reduces its emissions, it can save spare allowances for the future. It can also sell them to other businesses. The market finds the optimum price, which improves efficiency and reduces management costs.

In previous years, the EU has been criticised for providing too many allowances. Excess supply lowered the cost of polluting. Officials appeared unwilling to restrict the total number of allowances; indeed, an EU publication confirms that, from 2005 to 2012, “most allowances were given out to participants for free.”

Since 2020, the cost of one emissions allowance has risen above €50. Higher prices will encourage a shift to greener technologies. By placing a price on carbon, businesses will no longer be free to pollute.

However, higher carbon prices may hurt the poorest in society. The emissions allowance acts as an additional cost of production, which results in higher prices. Without government help, many people cannot switch heating systems, or upgrade to electric cars. Public support for the scheme may falter if this happens.

Another potential weakness of the ETS is that it only punishes EU pollution. If prices rise, firms may simply relocate outside of the EU. Although this practise appears to be uncommon at the moment, it will be interesting to see how businesses adapt in the future.

We leave you with today’s Question of the Month:

“Will the EU ETS hold its value? Can policymakers continue to increase the cost of pollution, or will the burden on firms and the poorest households be too great?”