Theory and Impact
- Critical Issues in Environmental Taxation series
Edited by Larry Kreiser, Soocheol Lee, Kazuhiro Ueta, Janet E. Milne and Hope Ashiabor
Chapter 8: The EU Emission Trading Scheme: is there a need for price stabilization?
2005 marked the start of the EU Emission Trading System (EU ETS). It is the largest cap-and-trade system worldwide and represents the key instrument of EU climate policy. Several years of experience and various adaptations of the regulatory framework have been accompanied by discussions whether an institutional setting is needed that helps stabilize carbon markets and allowance prices. Prior to the introduction of the EU ETS a number of papers theoretically and empirically addressed the issue of environmental effectiveness and economic efficiency of emission trading systems (see e.g. Vesterdala and Tinggaard Svendsen (2004) and the literature cited therein). These arguments were re-emphasized as advantages of the market-based instrument by the European Commission and economists when the EU ETS came into force: Once the emissions cap is determined, the allowance price is formed on the market and the desired reduction target is achieved at least cost, providing flexibility for regulated entities. Evidence from the first two trading phases, however, sheds doubts on this assumption and a too strong reliance on market forces. The implementation of the instrument was faced with market failures, which undermined its optimal functioning. The regulating bodies’ uncertainty about emissions and abatement options led to an overly generous allocation in Phase 1, resulting in a substantial price drop and a loss of abatement incentives. In Phase 2 the exogenous shock of the global financial and economic crisis had more or less the same effect despite the tightening of the cap.
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