This Chart of the Month revisits the EU Emissions Trading Scheme (ETS). An explanation as to how it works can be found in the July 2021 Chart.
In that article, we asked whether the EU ETS could hold its value, and whether the increase in costs of pollution would prove too great a burden for firms and the poorest households. Now, we can try to answer both of these questions.
In early 2021, the price of one ETS permit had just peaked over €50. Since then, it has increased to an all time high of €101.25 in February 2023. How can this bullish rally be explained?
In December 2021, the EU responded to criticisms that they had provided a surplus of permits. They created a new “Fit for 55” plan, placing a target of reducing net greenhouse gas emissions by 55% by 2030. Legislators increased the annual rate of removal of permits to 4.3% per year from 2024-2027. This reduction in supply has rationed the permits for firms that are most willing to pay for them through the price mechanism; ie through higher prices.
Moreover, in 2022, demand for CO2 permits increased substantially; from the chart, we can see that trade volumes also remained high throughout the year. This was a result of the decrease in Russian gas supply, which made gas so expensive that it was cheaper to use coal to generate electricity. This led to a 7% increase in the usage of coal for power. Coal emits twice as much carbon when burnt, so demand for permits rose as companies stepped away from gas.
The recent price spike (from the start of the year) and low trade volume can be explained by the EU’s April deadline to submit permits to cover last year’s emissions. Most firms had already created a stock of permits beforehand and were unwilling to give them up before they were to be collected, and other firms which had not done so were willing to pay higher amounts for permits to not face legal fees.
The high value of the EU ETS is therefore a result of both structural and exogenous reasons. Nonetheless, it is clear that the EU ETS’ price will hold a lot of its value. Even without the shorter term factors increasing demand, the continuing restriction of supply will lead to continuing higher prices while carbon emission remains in demand.
As mentioned in our previous article, the poorest spend a larger proportion of their income on energy in comparison to the rich, and so the ETS can act as a regressive tax. The impact of the ETS have been compounded by the cost of living crisis. Firms almost completely passed the ETS onto consumers. They could do this because goods produced by these firms are very irresponsive to price, and because during the era of sanctions firms were given leeway to protect their profit margins. This put a heavier burden on the poor when they were already under pressure from inflation.
One policy that has uptake in several countries with carbon pricing is cash transfers. For example, Sweden gave handouts based on how much their carbon tax impacted low and middle income groups’ abilities to afford energy. These can be easily and cheaply targeted as the EU already has social safety nets which have similar eligibility criteria.
If we consider that firms are also switching to more sustainable practices, this could lead to the destruction of fossil-fuel related jobs. Typically, these jobs are geographically concentrated and low skill, and so this could harm small communities. Indeed, the IMF’s Fiscal Monitor predicts that even just a $50 price on carbon per ton would increase employment reduction in the coal sector in Germany by 30% and in Poland by more than 40% between 2015 and 2030. EU policymakers should focus on helping these workers transition to green jobs by providing training.
Even if firms decide not to invest into green technology, jobs may still be lost. Unfortunately, the price of carbon globally is at around 2% of what the EU prices it as, due to the lack of pressure on foreign firms to cut emissions. Whilst few companies have relocated to avoid the ETS, many are losing their international price competitiveness.
In comparison, China’s ETS scheme excludes all sectors except for power generation, allowing most industries to thrive. Although the EU may not be able to U-turn and make so many sectors exempt, it could provide relief to the firms suffering the most from the higher carbon prices. Otherwise, more fossil fuel workers may be laid off without significant reductions in emissions.
Another potential policy would be conditional cash transfers for households, as well as loans, subsidies or tax cuts for firms. Under this system, households would be rewarded for how much non-renewable energy they are saving, and firms for their investment in renewables. This would make transitioning less painful, as they now receive aid to do so.
The long term living standards of the poorest may be improved, should policy help them adjust to higher prices. Low-income households disproportionately live in areas with high exposure to air pollution, and the reduction in pollution that the ETS creates could therefore benefit their health. In addition, the responses of firms to invest more in greener technologies may reduce the price of energy in the long run, giving more access to poorer households in the future.
While government support may protect the vulnerable when carbon prices are solely structurally high, this may not be the case with external shocks, which are by nature impossible to prepare for. In an increasingly geopolitically fractured world, such shocks may become more frequent. It will be important to monitor whether the EU ETS can sustain political pressure if prices rise too high too quickly, from both firms and households.
Our Question of the Month:
Will a more effective ETS permit price alone be enough to curb carbon emissions in line with global temperature targets? If not, what other policies are needed?