The European and global institutions have recently developed numerous policies and laws addressing climate change mitigation. The SPES Report 7.1 “The functioning and socio-economic impacts of the EU Emissions Trading System: updated evidence and insights” analyse the functioning and socio-economic impact of a particular climate policy instrument, namely carbon pricing.
Carbon pricing
Carbon pricing is one of the ways to deal with high GHG emissions by assigning a value to the carbon content in fossil fuels. The primary rationale or theory underlying carbon pricing takes foundation from the concept of externalities—negative externalities, wherein social and environmental costs
from production and consumption are not internalised or reflected in market prices.
There are two mainstream ways of carbon pricing: carbon taxes and cap-and-trade systems.
- A carbon tax directly charges the user, especially from purchasing fossil fuels, for the carbon content. This sends the price signal for the investments in technologies that are low in emissions and energy efficient practices.
- A cap-and-trade system sets up a market for the number of emissions that can be let out; it is a limitation on the total emissions among sources, with firms buying and selling the needed permits. In such a manner, this is equivalent to a system in which it would be possible for firms to finance emissions over their determined allowance
EU Emissions Trading System 1 and 2
The EU Emissions Trading System is the leading cap-and-trade programme in the world, accounting in 2022 for 44% of global carbon revenues. Its scope is to reduce emissions by providing companies with an incentive to adopt clean alternatives. The mechanism aims to price carbon. The EU sets a total emissions cap, and issues allowances for emissions, with companies exceeding the entitlement being forced to acquire more allowances. Companies reducing emissions can trade unused permits. Over time, the total pollution credit cap decreases, encouraging corporations to reduce emissions and to seek cost-effective cleaner alternatives.
In 2022, stationary sources within the EU ETS contributed to 37% of the total Greenhouse Gas emissions in the European Economic Area. Since the EU ETS started in 2005, emissions from these sources have dropped significantly. This reduction is driven by several factors, including an increasing carbon price, a shift away from coal due to changing fuel prices, and policies promoting renewable energy.
The EU decided to cover further sectors with the new EU ETS 2, with the aim to contribute to tackling climate change. The complementary system, the EU ETS 2, targets emissions from further sectors such as buildings, transportation, and small businesses. While promising, this new system poses socioeconomic and distributional challenges.
Low-income and vulnerable populations may bear a disproportionate burden as they may face adverse economic and social consequences from policy-induced changes in energy costs, employment opportunities, and living conditions. If not properly managed, the transition towards a greener economy can also lead to job displacement in carbon-intensive industries, affecting low-income communities that heavily rely on these industries. The EU ETS as a market-based policy instrument is no exception, as it may have regressive effects if not accompanied by proper compensation measures.
Policy recommendations for fairer carbon markets
- Using EU Emission Trading System 2 revenues to invest in low-carbon technologies can bring substantial benefits. These investments can drive innovation and increase the use of renewable energy, significantly cutting Greenhouse Gas emissions.
- Eco-innovation plays a crucial role in achieving a low-carbon transition by fostering sustainable economic growth through technological, organisational, and behavioural changes. Investments in eco-innovations drive the development of new products and processes that reduce environmental impacts and resource use, aligning with long-term climate goals. These innovations not only mitigate greenhouse gas emissions but also enhance energy efficiency and stimulate economic growth by creating green jobs and fostering new industries.
- Recycling revenues to low-carbon investments could push carbon removal. The EU must integrate novel carbon dioxide removal (CDR) techniques into its climate policies. Technologies like Bioenergy with Carbon Capture and Storage (BECCS) and Direct Air Carbon Capture and Storage (DACCS) offer promising long-term solutions for CO2 storage, especially for sectors that are hard to decarbonise.
- It is important to recognize the flexibility that allows the management of the Social Climate Fund and carbon pricing mechanisms to deal with the problem of price volatility and ensure support for those who need it most
- Improved international cooperation in connecting the carbon markets to reduce volatility, hence stabilising the prices.
Decarbonisation is necessary and achievable. With strategic institutional management, it can be pursued without severe socio-economic consequences or exacerbating inequalities.
The Report 7.1 “The functioning and socio-economic impacts of the EU
Emissions Trading System: updated evidence and insights ” is part of Task 7.1 “Assessment of the functioning of the EU ETS and impacts of its reforms” / Work Package 7. The report has been written by Jacopo Cammeo – researcher of the SPES Project, European University Institute; Albert Ferrari –researcher of the SPES Project, European University Institute; Simone Borghesi – full professor, European University Institute & University of Siena; Gregor Zens – researcher of the SPES Project, International Institute for Applied Systems Analysis; Laura de Bonfils – researcher of the SPES Project, Social Platform.
