Learn from the European ETS experience

Published in Newsroom.co.nz (Wellington), 23 March 2021

As New Zealand discusses the recommendations of the Climate Change Commission, I get a sense of déjà vu. We are now talking about industry-specific regulations, bans on certain technologies (such as petrol and diesel cars) and subsidies for others (such as electric vehicles). And all this now that we have an Emissions Trading Scheme (ETS) which covers 97 percent of the economy and 50 percent of our emissions (the remainder, in both cases, is agriculture).

The discussion of the compatibility of an emissions trading scheme with specific regulatory interventions has a long history. But that history is not properly understood – even though it could help us prevent costly mistakes.

I was in the final stages of my law and economics doctorate when I read a punchy report of the Academic Advisory Council to the German Economics Ministry. In it, some of the most prominent German economists analysed the country’s energy policy – or rather explained what was wrong with it. That was in January 2004.

The report addressed two simple questions: How efficient were then-existing measures to promote renewable energies? And should these measures continue once the European emissions trading scheme (ETS) for greenhouse gases becomes operational?

The Academic Advisory Council’s answers were unequivocal: The regime of feed-in tariffs for renewable energies was an expensive way to cut emissions. The European ETS could achieve such emissions reductions more efficiently. And crucially, once emissions trading had started, there would be no justification for keeping policies like the Renewable Energies Act, which consequently should be abolished. Non-ETS policies in sectors covered by the ETS were a waste of money and did not cut any emissions at all, the Council stated.

Re-reading that old document for this column was equally enjoyable and frustrating. Enjoyable because once there was a time when such statements were well-written and clear. Frustrating because politicians did not heed the Council’s advice.

European climate policy has since been a process of learning how to run an ETS. And as Europe got better at that task, those non-ETS measures became superfluous – just as the Advisory Council predicted.

The initial stages of the European ETS were troubled by design flaws. Over the first trading period from 2005 to 2007, too many emission certificates were issued. Unused certificates could not be transferred to the next emissions period, so the certificate price fell to almost zero after a couple of years.

The next trading period, from 2008 to 2012, fared somewhat better. But due to the Global Financial Crisis and the Euro crisis, the number of emissions certificates turned out to be too high against the backdrop of the recession, and so towards the end of the trading period, the carbon price fell below €5 per tonne.

It was only from the third period of European emissions trading that the teething problems of the system were overcome. The emissions cap became more stringent, unused certificates could be transferred into the future (thereby keeping a value), and market participants expected a future tightening of policy conditions.

The result can be seen in two ways: carbon reductions and carbon prices.

To look at carbon reductions first, between 2005 and 2018, the European Union’s carbon emissions fell by 19 percent. However, this was not a uniform fall across the economy. In those sectors covered by the European emissions trading scheme (electricity, industry and EU-domestic aviation), emissions declined by 29 percent. In non-ETS sectors, the reduction was only 10 percent.

The European ETS worked. And it also worked because market participants rightly anticipated that certificate prices would become more expensive – as they have.

From a level of about €8 per tonne in early 2018, they are currently trading at more than €40 per tonne (approximately $66 – almost double the New Zealand carbon price). As London’s Daily Telegraph reported last week, both industry analysts and the European Commission expect prices to go much higher still, potentially reaching triple-digit figures later this year.

What this means for energy policy is clear: Carbon-heavy forms of energy generation are no longer viable. At €40 per tonne, the European ETS doubles the cost of coal. With a carbon price as high as now expected, coal-fired power plants would no longer be economic to run. Even natural gas, which used to be seen as a transition fuel towards decarbonisation, could be forced out of the energy mix.

To be clear, this is not a design flaw of the ETS. This is exactly how the ETS is supposed to operate – even though it took the European Union more than a decade under its ETS to get to that point.

But now that the moment has come when Europe changes its energy mix as the result of high carbon prices, the Academic Advisory Council’s 2004 report comes to mind again. If coal and gas-fired power stations go off the grid because they are no longer economic, why would consumers still subsidise renewable energies through feed-in tariffs?

The moment the ETS is operational, it affects behaviour through pricing emissions. Provided pricing is seen as permanent, there is simply no need to separately promote alternatives to fossil fuels anymore. In any case, because of the cap on emissions from the European energy sector, no amount of subsidy could change the total emissions outcome – again, the experts identified that in 2004.

Since the German Academic Advisory Council’s 2004 report, other international bodies have come to the same conclusion regarding the compatibility of emissions trading schemes with other measures. Most notably the UK energy regulator Ofgem and the Intergovernmental Panel on Climate Change (IPCC) have said so.

Interestingly, the Climate Change Commission acknowledges this point in its report (chapter 17, page 5):

The Government also has choices around the extent to which it relies on the NZ ETS or other policies to make these emission reductions happen. The more that non-ETS policies are used, the more likely it is that the NZU price in the NZ ETS can be lower while still achieving the same overall amount of emission reductions [my emphasis].

So here we are, 17 years after the German Academic Advisory Council first pointed out the futility of non-ETS measures. We know the European ETS has achieved substantial emissions reductions in its covered sectors. It is shifting European energy towards non-carbon fuels. Where even the New Zealand Climate Change Commission acknowledges that non-ETS measures in sectors covered by the ETS only reduce the certificate price without reducing the emissions outcome. Just as Ofgem and the IPCC have done before.

You might think that given this wealth of experience and evidence, now would be the time to trust the ETS to do its job in New Zealand.

But, as history teaches us, no amount of expert advice and experience can stop politicians hell-bent on making costly mistakes.

Whether to cut emissions is a moral question. How to achieve this cut should be an economic one. The price of getting this distinction wrong is high.

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