Does a price floor for the EU Emissions Trading System still make sense?

A new paper authored by Hertie School Professor of Sustainability Christian Flachsland and seven researchers from other institutions, offers evidence that setting an appropriate floor for carbon prices in the European Union’s Emissions Trading System (EU ETS) would provide the market with greater stability.

“How to avoid history repeating itself: The case for an EU ETS price floor revisited,” was published in  the journal Climate Policy on 2 November, and examines the suitability of a price floor in the current trading system. In response to recent EU reforms, the price of carbon allowances, or industry allotments valued in “certificates”, has risen sharply. The EU ETS, a market where companies trade allowances, was introduced in 2005 with the aim of reducing greenhouse gas emissions in Europe. Allowance prices were for many years far lower than expected, prompting calls for a price floor. Now that prices have risen, some argue this is no longer necessary.

“We argue that such a price floor, also adopted in several other greenhouse gas cap-and-trade systems worldwide, remains an important improvement in the design of the system,” the authors say.

In the paper, the researchers identify and analyse four common arguments against introducing a price floor. For their analysis, they conducted a comprehensive review of academic and policy literature on the use of price floors in such “cap-and-trade” systems around the world and looked at the recent EU ETS reform. Between 2016 and 2019, they also held workshops on these topics with high-level participants from academia, EU and domestic policymakers, industry and NGOs, and conducted interviews with stakeholders outside the workshops.

The authors conclude that a price floor would “…correct potential underlying distortions and design flaws, including (i) the political nature of allowance supply and related credibility issues, (ii) potential myopia of market participants and firms, and (iii) waterbed and rebound effects.” The latter happens when one country introduces emissions-saving policies, such as shutting down coal plants, but does not reduce the amount of emissions allowances proportionally, leading to a drop in allowance prices and their use in neighbouring countries, with no net reduction in carbon emissions.

“An EU ETS price floor would be an important institutional innovation enhancing the political and economic stability and predictability of the EUA (European Emission Allowances) price,” they write. In addition, they say, there is growing political support for such a price floor in Europe and, contrary to some arguments, there are also legal grounds for such a mechanism.

The paper is authored by Christian Flachsland, Professor of Sustainability at the Hertie School, Michael Pahle of the Potsdam Institute for Climate Impact Research (PIK), Dallas Burtraw of Resources for the Future, Ottmar Edenhofer of Mercator Research Institute on Global Commons and Climate Change (MCC), Potsdam Institute for Climate Impact Research (PIK) and Technical University Berlin, Milan Elkerbout of the Centre for European Policy Studies (CEPS) , Carolyn Fischer of Vrije Universiteit Amsterdam and Resources for the Future, Oliver Tietjen of the Potsdam Institute for Climate Impact Research (PIK), Lars Zetterberg of the Svenska Miljöinstitut IVL.

Read the paper in Climate Policy here.