Abstract
International carbon markets are an appealing and increasingly popular tool to regulate carbon emissions. By putting a price on carbon, carbon markets reshape incentives faced by firms and reduce the value of emissions. How effective are carbon markets? Observers have tended to infer their effectiveness from market prices. The general belief is that a carbon market needs a high price in order to reduce emissions. As a result, many observers remain skeptical of initiatives such as the European Union Emissions Trading System (EU ETS), whose price remained low (compared to the social cost of carbon). In this paper, we assess whether the EU ETS reduced [Formula: see text] emissions despite low prices. We motivate our study by documenting that a carbon market can be effective if it is a credible institution that can plausibly become more stringent in the future. In such a case, firms might cut emissions even though market prices are low. In fact, low prices can be a signal that the demand for carbon permits weakens. Thus, low prices are compatible with successful carbon markets. To assess whether the EU ETS reduced carbon emissions even as permits were cheap, we estimate counterfactual carbon emissions using an original sectoral emissions dataset. We find that the EU ETS saved about 1.2 billion tons of [Formula: see text] between 2008 and 2016 (3.8%) relative to a world without carbon markets, or almost half of what EU governments promised to reduce under their Kyoto Protocol commitments. Emission reductions in sectors covered under the EU ETS were higher.
Highlights
Background on EU Carbon MarketsAfter the ratification of the Kyoto Protocol in 2002, EU member states were tasked to implement treaty commitments [16]
We argue that as long as at least some firms interpret carbon regulation through the European Union Emissions Trading System (EU ETS) as a credible signal that governments will impose serious costs on carbon emissions in the long run, even low prices today should result in observable carbon reductions
To build our counterfactual using the generalized synthetic control method, we model countries’ carbon emissions as a function of logged gross domestic product (GDP) and logged GDP squared as main variables
Summary
Background on EU Carbon MarketsAfter the ratification of the Kyoto Protocol in 2002, EU member states were tasked to implement treaty commitments [16]. The Protocol gave considerable freedom about how to achieve the EU-wide common target—an 8% reduction of GHG emissions by 2012 relative to 1990 levels. Already in 1999, EU member states agreed on the internal, by-country distribution of carbon reductions [17], but how best to reduce emissions remained contested. Each member state had to submit National Allocation Plans, which detailed a country-wide reduction target together with a list of regulated installations. After the approval of these plans by the European Commission, installations received permits that could be traded. By the end of April each year, installations that hold too few permits to cover their emissions need to buy additional permits from the market or pay a penalty of e40 (2005 to 2007) or e100 (since 2008) for each ton of carbon they fall short
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