Submission to the inquiry by the Energy and Climate Change Committee inquiry on ‘leaving the EU: implications for UK climate policy’

This submission outlines the latest research evidence from the ESRC Centre for Climate Change Economics and Policy and Grantham Research Institute on Climate Change and the Environment focusing on the question: ‘What should be the Government’s priorities on the EU Emissions Trading System when negotiating the UK’s exit from the EU? What would a successful negotiation outcome look like?

Climate policy and power producers: the distribution of pain and gain

Climate policies do not affect all power producers equally. In this paper, we evaluate the supply-side distributional consequences of emissions reduction policies using a simple and novel partial equilibrium model where production takes place in technology-specific sites. In a quantitative application hydro, wind and solar firms generate power combining capital and sites which differ in productivity. In contrast, the productivity levels of coal, gas and nuclear technologies are constant across sites. We parameterise the model to analyse the effects of stylised tax and subsidy schemes. Carbon pricing outperforms all other instruments and, crucially, leads to more equitable outcomes on the supply side. Technology-specific and uniform subsidies to carbon-free producers result in a greater welfare cost and their supply- side distributional impacts depend on how they are financed. Power consumption taxes have exceptionally high welfare costs and should not be the instrument of choice to reduce emissions or to finance subsidies aiming to reduce emissions

Tales from the tails: sector-level carbon intensity distribution

The level of GDP, its sector composition and the carbon intensity of individual sectors together determine a country’s emissions. To evaluate the contribution of changes in each determinant, I construct counterfactual emissions scenarios in a sample consisting of 34 sectors in 37 countries over 1995-2009. I compare these scenarios quantitatively using a novel metric, namely the relative cumulative emissions. I find that the composition of output and the carbon intensity of sectors individually or jointly constrained emissions in a large majority of countries. This motivates an analysis of high- and low-carbon intensity sectors, denoted HCI and LCI, where emissions and value-added tend to be concentrated, respectively. I document the cross-country variation in HCI sectors’ carbon intensity and show it declines over time largely due to improvements in developing countries. HCI sectors tend to account for a smaller share of employment; be more capital intensive; and employ a workforce with a lower average skill level. Employment declined in HCI sectors and increased in LCI sectors with its composition shifting towards high-skilled workers in both. Capital intensity growth was faster but multifactor productivity growth was slower in HCI sectors

ETS Alignment: a price collar proposal for carbon market integration

The global carbon market landscape is fragmented and increasingly complex. The conclusions reached at COP26 in Glasgow on the Article 6 rulebook are expected to achieve further mitigation using market mechanisms, facilitate the coordination of international efforts and increase carbon market integration. Three sets of conditions are necessary for smoothing the linking of emissions trading systems (ETSs). Before negotiations, mutual trust is crucial to respond to unexpected developments in partners’ economic, social and political circumstances. During the linking negotiations, a degree of alignment of core design features of ETSs is necessary to harmonise the systems. After the completion of negotiations, built-in reviews and broad-based consultations, as well as mechanisms for revision, dispute resolution and potential future delinking, are fundamental to ensure that linking works over time. The degree of alignment necessary for linking is a critical issue. Some ETS features (e.g., the price control mechanisms) require compatibility, whereas other key design elements (e.g., the stringency of the cap) may not require strict compatibility if they lead to comparable outcomes. Other ETS design features (e.g., the allocation phases and compliance periods) would benefit from coordination but do not need to be aligned. When ETSs are linked, the efficiency gains from allowance trade are enhanced compared to autarky (pre-link levels), as domestic and foreign allowance prices fully or partially (in case of linking with quotas) converge to an intermediate level. The price risk of linking could be constrained by enforcing a price collar (i.e., a price floor and a price ceiling) for the linked system. The price collar could be specified by the intersection between the two respective intervals representing acceptable post-link allowance prices. Options for enforcing the price ceiling include releasing allowances from a joint cost-containment reserve. To enforce the floor, allowances can be allocated in auctions with a reserve price equal to the floor. Alternatively, a ‘top-up’ carbon tax could be applied to allowances that are auctioned at a price below the floor. The price collar could help jurisdictions to mitigate systemic shocks that may affect allowance prices like recession, unanticipated growth, technological leaps that lower the abatement cost of emissions, as well as changes in companion climate policies. Reducing price risk and uncertainty would be beneficial for regulators, regulated entities and investors. However, reaching an agreement on the parameters and rules of a price collar in the linked system can be difficult. Early and open dialogue between the ETSs is strongly recommended to overcome these challenges

Carbon dating: when is it beneficial to link ETSs?

We propose a theory of the economic advantage (EA) of regulating carbon emissions by linking two emissions trading systems versus operating them under autarky. Linking implies that permits issued in one system can be traded internationally for use in the other. We show how the nature of uncertainty, market sizes, and sunk costs of linking determine EA. Even when sunk costs are small so EA>0, autarky can be preferable to one partner, depending on jurisdiction characteristics. Moreover, one partner’s permit price volatility under linking may increase without making linking the less preferred option. An empirical application calibrates jurisdiction characteristics to demonstrate the economic significance of our results which can make linking partner match crucial for the effectiveness and success of the Paris Agreement

Linking permit markets multilaterally

We formally study the determinants, magnitude and distribution of efficiency gains generated in multilateral linkages between permit markets. We provide two novel decomposition results for these gains, characterize individual preferences over linking groups and show that our results are largely unaltered with strategic domestic emissions cap selection or when banking and borrowing are allowed. Using the Paris Agreement pledges and power sector emissions data of five countries which all use or considered using both emissions trading and linking, we quantify the efficiency gains. We find that the computed gains can be sizable and are split roughly equally between effort and risk sharing

ETS alignment : a price collar proposal for carbon market integration

This report was prepared to inform the Carbon Market Policy Dialogue (CMPD) between the European Commission, as the regulator of the EU Emissions Trading System, and the regulatory authorities for the emissions trading systems (ETSs) of California, Quebec, China, New Zealand and Switzerland. Building on the earlier findings of the LIFE DICET project, this fifth and final report identifies specific ETS design elements requiring specific degrees of alignment/harmonisation and discusses how this can be achieved in linking negotiations. Moreover, with a view to finding ways to facilitate the establishment of direct linkages between ETSs, a proposal regarding the management of allowance prices in the form of a “price collar for the linked system” is presented

State-of-play in international carbon markets in 2024

This policy brief, written in May 2024, provides an overview of the international carbon market landscape and describes the status quo in terms of the degree of its integration and the use of the mechanisms set out in Article 6 of the Paris Agreement. It assesses the linkability of existing emissions trading systems (ETSs) and discusses the emerging topics of sector expansion and the role of removals in compliance markets

State-of-play in international carbon markets in 2023

- This policy brief gives an overview of existing carbon pricing mechanisms and outlines the trends of mandatory and voluntary carbon markets (VCMs) in 2023. It also reviews the integration of carbon markets. - As of April 2023, 73 carbon taxes and emissions trading systems (ETSs) were in operation, covering approximately 23% of global GHG emissions. - 28 of these compliance carbon pricing instruments were ETSs at regional, national or subnational levels and covered about 17% of global GHG emissions. The number of ETSs in force will likely rise in the coming years as 8 systems are currently under development and 11 are under consideration. - After growing rapidly in 2020 and 2021, the issuance of offset credits declined slightly in 2022. Several factors contributed to this decline, including the challenging macroeconomic conditions, public skepticism about the quality of credits, and the absence of commonly accepted guidance on best-practice for the use of credits to support net-zero claims. - Linked ETSs include: the EU and Swiss ETSs since 2020, the California and Québec Cap-and-Trade Programs since 2014, an evolving set of US states participating in the Regional Greenhouse Gas Initiative (RGGI) since 2009, and the Tokyo Cap-and-Trade Program and the Saitama ETS since 2011. - Progress on the integration of compliance carbon markets via linking has not been rapid. Each system is tailored to its domestic circumstances which makes the required level of alignment for successful links difficult to achieve. Moreover, the potential increase in regulatory uncertainty and the expected negative impacts on the robustness of each system act as strong barriers to linking. - Connecting ETSs with VCMs should be treated with great caution due to concerns about credit quality as well as monitoring, reporting and verification issues connected with offsets

ETS alignment : a price collar proposal for carbon market integration

The global carbon market landscape is fragmented and increasingly complex. The conclusions reached at COP26 in Glasgow on the Article 6 rulebook are expected to achieve further mitigation using market mechanisms, facilitate the coordination of international efforts and increase carbon market integration. Three sets of conditions are necessary for smoothing the linking of emissions trading systems (ETSs). Before negotiations, mutual trust is crucial to respond to unexpected developments in partners’ economic, social and political circumstances. During the linking negotiations, a degree of alignment of core design features of ETSs is necessary to harmonise the systems. After the completion of negotiations, built-in reviews and broad-based consultations, as well as mechanisms for revision, dispute resolution and potential future delinking, are fundamental to ensure that linking works over time. The degree of alignment necessary for linking is a critical issue. Some ETS features (e.g., the price control mechanisms) require compatibility, whereas other key design elements (e.g., the stringency of the cap) may not require strict compatibility if they lead to comparable outcomes. Other ETS design features (e.g., the allocation phases and compliance periods) would benefit from coordination but do not need to be aligned. When ETSs are linked, the efficiency gains from allowance trade are enhanced compared to autarky (pre-link levels), as domestic and foreign allowance prices fully or partially (in case of linking with quotas) converge to an intermediate level. The price risk of linking could be constrained by enforcing a price collar (i.e., a price floor and a price ceiling) for the linked system. The price collar could be specified by the intersection between the two respective intervals representing acceptable post-link allowance prices. Options for enforcing the price ceiling include releasing allowances from a joint cost-containment reserve. To enforce the floor, allowances can be allocated in auctions with a reserve price equal to the floor. Alternatively, a ‘top-up’ carbon tax could be applied to allowances that are auctioned at a price below the floor. The price collar could help jurisdictions to mitigate systemic shocks that may affect allowance prices like recession, unanticipated growth, technological leaps that lower the abatement cost of emissions, as well as changes in companion climate policies. Reducing price risk and uncertainty would be beneficial for regulators, regulated entities and investors. However, reaching an agreement on the parameters and rules of a price collar in the linked system can be difficult. Early and open dialogue between the ETSs is strongly recommended to overcome these challenges