The EU Emissions Trading System (EU ETS) was initiated in 2005 as a cornerstone of the European Union’s policy to combat climate change and reduce greenhouse gas emissions cost-effectively. It covers more than 11,000 power stations, industrial plants, and airlines operating between EU countries, accounting for around 45% of the EU’s greenhouse gas emissions. The system operates in 31 countries, including all 27 EU member states plus Iceland, Liechtenstein, and Norway. The primary goal of the EU ETS is to cap and reduce emissions from the major industrial and power sectors, promoting a shift towards a low-carbon economy.
The economic theory underlying the EU ETS is based on the concept of cap-and-trade and the internalization of negative externalities. Under a cap-and-trade system, a limit (cap) is set on the total amount of certain greenhouse gases that can be emitted by installations covered by the system. Companies receive or buy emission allowances, which they can trade with one another as needed. Each allowance gives the holder the right to emit one tonne of carbon dioxide equivalent.
The cap is reduced over time so that total emissions fall. By creating a market for emission allowances, the EU ETS aims to provide economic incentives for companies to reduce their emissions. Firms that can reduce emissions at lower costs can sell their excess allowances to firms facing higher costs, thus achieving emission reductions in the most cost-effective way.
While the EU ETS has been successful in reducing greenhouse gas emissions, it has also faced several challenges and unintended consequences. One issue has been the volatility of allowance prices, which can create uncertainty for businesses planning long-term investments in low-carbon technologies. Initially, an oversupply of allowances led to lower prices, reducing the incentive for companies to cut emissions.
Another concern is the potential for carbon leakage, where companies might relocate their production to countries with less stringent emission regulations, thereby undermining the environmental benefits of the EU ETS. To address this, the EU has implemented measures such as free allocation of allowances to sectors at significant risk of carbon leakage.
Evaluating the effectiveness of the EU ETS involves examining emission trends, allowance prices, and the uptake of low-carbon technologies. Studies have shown that the EU ETS has contributed to significant emission reductions in the covered sectors. For example, emissions from installations in the EU ETS declined by about 35% between 2005 and 2019. The system has also driven innovation and investments in renewable energy and energy efficiency.
In conclusion, the EU Emissions Trading System is a pioneering initiative in the global fight against climate change. While it has successfully reduced emissions and fostered low-carbon investments, continuous improvements and adjustments are necessary to address price volatility, prevent carbon leakage, and enhance the system’s overall effectiveness.