Is the high price of emission allowances in the EU good or bad news?

Guest post: The price of EU's CO2 emission allowances has increased dramatically in recent years. In this guest post, Daniel Spiro discusses whether this higher price is something to celebrate or not.

Daniel Spiro is an Associate Professor of Economics at Uppsala University. This post was first published in Swedish on Ekonomistas.

The price of emission allowances within the EU Emissions Trading System (EU ETS) has increased sharply in recent years. From having historically been around €10 per tonne of CO₂ for many years, the price began to slowly rise in mid-2020, see figure. At times, the increase has been significant, and each new record has been noted with a combination of fascination, doomsday preaching, and celebration within political circles and the environmental movement. Recently, the price exceeded €100 per tonne for the first time.

Is it good that the price of emission allowances is high? Here, based on environmental economic theory and the ETS system's function, I will try to speculate on this. For those who do not have the energy to read, my answer in brief is: "Probably bad, at best uncertain."

I start with the simplest model.

There are two principal ways to put a price on emissions: through a CO₂ tax or through a cap on the quantity of emissions combined with emission trading. Both aim to minimize the amount of emissions and the economic damage resulting from the limitation. Here, I assume that low emissions are "good" and that as-low-as-possible economic damage from emission limitations is "good" as well. I will number the sub-conclusions in my reasoning below for clarity.

As is well known, the EU ETS is based on a cap-and-trade system. In such a system, the cap is set first, and then, based on the market’s demand the price of emission allowances is determined. The advantage of such a system is that everyone knows what the total emissions will be – they will simply be equal to the cap. The EU ETS also allows emission allowances to be saved for later years. This means that emissions do not necessarily hit the cap every year, but over time, emissions will add up to the sum of the caps. (Note that the possibility that emissions over the longer term do not reach the cap is not compatible with a price higher than zero) The cap's trajectory within the EU ETS was first tightened at the beginning of 2020 and then sharply in a revision in July 2021 to decrease by 4.2% per year. (A) The cap's level is thus the only thing that matters for total emissions. If "something" does not affect the cap now or later, then this "something" is irrelevant for emissions.

Unlike emissions, the economic damage within a cap-and-trade system is uncertain because one does not know how expensive it will be for firms on the market to jointly comply with the cap. The price of emission allowances is a measure of how difficult it is for the economy to stay below the cap. (B) Today's high emission price thus indicates that the economic damage is high and that it is difficult to find cheap emission reductions. Similarly, the high price indicates that previous green-R&D investments did bear sufficient results to make emission reductions easy.

This is potentially even worse news. Why? When politicians decide on emission caps, they do so to balance emission reductions (which is good for the climate) against the anticipated economic damage, which, as stated, is uncertain in advance. (C) A high price indicates that the economic damage was high, and one can imagine that decision-makers may want to raise the future cap, which increases emissions. Whether this will happen is unclear; we do not know how strongly EU politicians feel bound by previous decisions, but it cannot be ruled out, even though it would come at a high cost in terms of lost credibility on climate issues. In practice, however, this effect does not necessarily mean that the cap will be raised. Instead, it may take the form of exemptions for certain industries or postponing official tightening. There is currently no research on caps that change as one learns about the economic cost, but I have a theoretical project for highlighting this possibility. 

I consider factors A-C to be the primary ones. However, if we take a closer look at the EU-ETS, there are more nuances to consider. A few years ago, there was a revision of the rules of how the cap is determined. It is called "The Swedish proposal" and basically means that the cap is flexible downwards – it is temporarily lowered (during the current year) if the amount of emission allowances saved from the previous year is above a certain level (see formal description here and simpler description here). (D) One possible explanation for the current high price could be that the market expects the cap to become even tighter in the future, and therefore save emission allowances, which would lower the future cap and emissions. This could become a sort of self-fulfilling prophecy (see theory in this direction here). If this is the case, it would be good for emissions but bad for the economy. Expectations that it will be expensive to stay below a future cap are an indication in line with (B) above. Regardless, to my knowledge, there is no data yet on how much has been saved in 2022, so (D) is difficult to verify. There was, however significant saving of allowances mid-2021 to mid-2022, which consequently led to a reduced cap in the current period.

So far, I have described the EU emissions trading system as a closed system. Of course, it is not since there is a world outside too. High emission prices within the EU can then have secondary effects, so-called emission leakage. (E) One effect of this is that the high price of emissions causes companies within the EU to relocate their production to other countries, which is both economically harmful to the EU and would increase global emissions.

Empirical research provides mixed support for such "pollution-haven effects" (see, e.g., here, here, and here). But it is difficult to say what will happen now, when the price is significantly higher; such studies do not exist. However, this problem will probably be limited in a few years when the EU introduces a fee on the CO₂ content of imported goods.

(F) Another secondary effect is that other countries considering limiting emissions now see that the economic cost of doing so is high and choose a less ambitious climate policy. I am not aware of any empirical research on such effects, only theory (e.g., this and this).

To sum up: most of the sub-conclusions provide reasons for sorrow for those of us who want to limit emissions and the economic damage of this policy. But I hope I am wrong.