In 2005, the EU launched its very own emission trading system (ETS) in an attempt to reduce its greenhouse gas emissions and slow down global warming. Proponents of the system have argued that the scheme has helped lower emissions without distorting the market mechanism whereas critics argue action is too slow and causes unnecessary inflation.
How does the EU Emission Trading System work?
The ETS works on a ‘cap and trade’ basis and covers around 40% of the EU’s greenhouse gas emissions. A cap is set on the amount of greenhouse gases a firm is allowed to emit. Firms can buy or receive emissions allowances which can then be traded with other companies covered by the scheme. As such firms with surplus allowances can sell them to firms in need of permits. After each year the firm must have enough allowances to cover their emissions or else face hefty fines. The cap imposed on firms is gradually reduced to lower total emissions over time. This is hoped to incentivise the transition into clean renewable energy sources using a market-orientated system. In addition, some of the revenues gained from fines and selling emissions allowances are allocated to the EU’s Innovation Fund[i] and Modernisation Fund[ii]. Businesses are allowed to claim money from these funds to invest in innovation and energy transition making them more efficient.
What are the advantages of the EU’s Emission Trading System?
The ETS is believed to incentivise firms to invest in clean energy sources such as solar power and improve their efficiency. Consequently, reduced reliance on fossil fuels means less greenhouse gas emissions and improved air quality. Between 2005 to 2021 firms covered by the ETS reduced their emissions by 35%. This helps protect health by reducing the chance for respiratory diseases to develop and alleviates some pressure on healthcare services. Increased efficiency means firms have less costs and thus make more profit. Extra profits can be used to stimulate further investment which can create a positive multiplier effect[iii] and lead to economic growth. Moreover, efficient firms may have surplus allowances which can be sold for extra revenues making the firm more profitable.
The ETS scheme is a market-based system which avoids distorting the market mechanism. Thus, economic agents receive clearer signals and can allocate resources more effectively. Furthermore, it avoids conventional government regulation which is often fraught with unintended consequences and invoke opportunity costs.
The success of the ETS has led to the creation of parallel programmes in other areas of the world such as certain states in the USA. Many hope this can act as a foundation for a global project that helps reduce global emissions and subsequently slow down climate change. Enhanced cooperation between national governments could make climate goals more realistic and achievable.
What are the disadvantages of the EU’s Emission Trading System?
The success of the ETS has been disputed by various environmental groups. Environmental pressure group Greenpeace has said the ETS “could harm poorer households, with no guarantees of meaningful emissions cuts”. The ETS scheme only covers around 40% of the EU’s total greenhouse gas emissions, thus any reduction in emissions within the ETS is unlikely to substantially the lower overall level of emissions. There is also little evidence that the ETS in itself caused the reduction in emissions. Rather many believe the reduction in emissions were caused by improved energy efficiency and global economic downturn post 2008.
Another criticism of the ETS is the severe fluctuations of the price of emissions permits. In early 2009 the price of pollution permits was traded around €10 per metric ton of carbon. By March 2023, the price had risen to €96.92 per metric ton. These fluctuations create uncertainty for firms looking to invest in cleaner energy sources.
Besides, many critics have argued the ETS has increased costs for businesses and therefore created cost-push inflation, reducing the purchasing power of consumers. Necessities such as fuel and heating could also be more expensive as they are price inelastic[iv] meaning demand is unresponsive to price changes for these products. As such consumers suffer from lower material living standards. Low-income households may be left more vulnerable to a higher cost of living which widens inequalities. Inequalities can lead to severe social problems such as crime and deprivation. There are also fears higher cost of living could lead to social unrest within the EU similar to the “Yellow Vest” movement in France seen in 2018 which started as a protest against proposals for a new diesel tax in France before ballooning to include other political grievances and widespread riots.
Some critics have also highlighted the risk of carbon leakage caused by ETS. This is where firms relocate their production processes away from the EU to avoid environmental regulations and lower costs. This can create structural unemployment[v] within the EU reducing economic growth as well as potentially hurting the current account equilibrium.
On a global scale the ETS is unlikely to make a meaningful impact on reducing the impacts of climate change. Unless more nations also start implementing similar projects global emissions will continue to increase. Some of the world's largest polluters such as China and India are infamous for loose environmental laws and creating copious amounts of greenhouse gases.
Footnotes:
[i] Innovation Fund - one of the world’s largest funding programmes for the deployment of net-zero and innovative technologies.
[ii] Modernisation Fund - a dedicated funding programme to support 10 lower-income EU Member States in their transition to climate neutrality by helping to modernise their energy systems and improve energy efficiency.
[iii] Positive multiplier effect - when an initial injection into the circular flow of income leads to a more than proportionate growth in national income.
[iv] Price inelastic demand - when the percentage change in quantity demanded is less than the percentage change in price.
[v] Structural unemployment - a longer-lasting form of unemployment caused by fundamental shifts in an economy and exacerbated by extraneous factors such as technology, competition, and government policy.
Bibliography:
Participating in the EU Emissions Trading System (EU ETS) - GOV.UK (www.gov.uk)
