03 March 2021

Bruegel: Carbon price floors: an addition to the European Green Deal arsenal

As the European Union sets out a more ambitious climate policy, carbon price floors provide an opportunity to place greater emphasis on altering expectations, so that market agents anticipate today higher future pay-offs from low-carbon investment.

This year will be decisive for Europe’s climate policy, with a wide range of new legislation promised to align current EU climate and energy policies with a new emissions reduction target of 55% by 2030. The reform of the backbone of the EU climate policy architecture, carbon pricing, will be of fundamental importance. This will entail reform of the emissions trading system (ETS) and the Energy Taxation Directive (ETD).

One tool currently missing from the European Green Deal arsenal is a carbon price floor, which can set a minimum carbon pricing in both ETS and non-ETS sectors. After years of discussions, the time for its introduction might now have come.

Understanding the rules, their intentions and shortcomings

The ETS is the EU’s main carbon pricing tool and covers emissions from the power generation sector, industry and intra-European flights, amounting to about 40% of total EU emissions. It is a cap-and-trade system. A quantity cap of allowances is set and distributed to participants, including through auctions. However, there the risk of carbon leakage, of firms moving their activities to countries with laxer climate rule to control costs, remains. Carbon leakage distorts the trading system and is counterproductive to the process of reducing emissions. This risk can  be avoided by giving some ETS allowances for free.

Also, the system is designed so that the quantity of allowances reduces in a steady and predictable manner (known as the linear reduction factor). Auction prices are determined by the quantity offered at any given time and the level of demand. Since 2009, a combination of factors (economic crisis and high imports of international credits) has led to a surplus of allowances, which ultimately resulted in a prolonged period of lower carbon prices (from €20-€25/tonne of carbon dioxide from 2005 to 2008, to €10-€15 between 2009 and 2011, and €5-€10 between 2012 and 2018).

A Market Stability Reserve was introduced to address this excess-supply. This is an adjustment system that automatically cuts auction volumes when the surplus of allowances exceeds a certain limit and releases the volume of allowances to be auctioned when the surplus falls. Since the system started in 2019, the carbon price has risen to the current level of around €40.

However, carbon prices will have to keep rising if they are to contribute materially to EU decarbonisation. It is of course difficult to identify a ‘target’ price, but there have been attempts to identify the level of pricing that can cause behavioural change. The Stiglitz-Stern High-Level Commission on Carbon Prices, for example, concluded that the carbon price should be between $40-$80 in 2020 and then between $50-$100 in 2030 if it is to reduce emissions.

The current EU price thus remains too low to reduce emissions in a manner consistent with EU climate objectives. Within the ETS, there are two ways that could be used to engineer the desired reduction in emissions.

The first is to speed-up the reduction of emission permits allocated for free. Manufacturing installations received 80% of their allowances for free in 2013 compared to 30% in 2020. However, sectors identified as at significant risk of carbon leakage continue to receive 100% of their allocation for free. This is inconsistent with the objective of ETS and puts a downward pressure on the price. The risk of carbon leakage should not be dealt with through the ETS but by the introduction of carbon border levies. This shift in policy tools to deal with the competitiveness aspect of carbon pricing would avoid domestic carbon market distortions, while ensuring a level playing field with international competitors....

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