Abstract
The EU emissions trading system’s (ETS) invalidation rule implies that shocks and overlapping policies can change cumulative carbon emissions. This paper explains these mechanisms and simulates the effect of COVID-19, the European Green Deal, and the recovery stimulus package on cumulative EU ETS emissions and allowance prices. Our results indicate that the negative demand shock of the pandemic should have a limited effect on allowance prices and rather translates into lower cumulative carbon emissions. Aligning EU ETS with the 2030 reduction target of −55% might increase allowance prices to 45–94 €/ton CO2 today and reduce cumulative carbon emissions to 14.2–18.3 GtCO2 compared to 23.5–33.1 GtCO2 under a −40% 2030 reduction target. Our results crucially depend on when the waterbed will be sealed again, which is an endogenous market outcome, driven by the EU ETS design, shocks and overlapping climate policies such as the recovery plan.
Highlights
The EU emissions trading system’s (ETS) invalidation rule implies that shocks and overlapping policies can change cumulative carbon emissions
We summarize the effect of any change to allowance demand on cumulative emissions as waterbed leakage: Waterbed leakage 1⁄4 Δ cumulative European Union Emissions Trading System (EU ETS) emissions ð1Þ Δ allowance demand which is defined as the final change in cumulative emissions over the lifetime of the EU ETS, caused by a positive or negative change to allowance demand
Waterbed leakage is positive if a coal phaseout decreases cumulative EU ETS emissions
Summary
The EU emissions trading system’s (ETS) invalidation rule implies that shocks and overlapping policies can change cumulative carbon emissions This paper explains these mechanisms and simulates the effect of COVID-19, the European Green Deal, and the recovery stimulus package on cumulative EU ETS emissions and allowance prices. Under an emissions trading system with a fixed cap, these shocks would only affect the price of carbon emissions, not cumulative emissions, which would continue to equal the cumulative emissions cap over the lifetime of the EU ETS—the so-called waterbed effect, as you can push down on a waterbed in any location, but the total volume of water in the bed remains the same6 This situation prevailed in the EU ETS during the 2009 recession, which may have contributed to the decreased allowance prices for almost a decade.
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