Managing interactions with wider energy transition policies

Carbon pricing policies are implemented alongside a wide mix of other companion policies that aim to drive clean energy transitions. The interaction of an emissions trading system with these policies can accelerate or hinder clean energy transitions, depending on the role the system is meant to play within the policy mix, and the impact other policies may have on its functioning. Other policies can support and complement an emissions trading system by:

  • Overcoming market barriers that make carbon price signals less effective (e.g. non-financial barriers to energy efficiency uptake).
  • Pursuing environmental policy goals beyond emissions reductions (e.g. decreasing air pollution).
  • Promoting long-term technology changes that may not reduce emissions in the short term but are needed to stay on track for the long-term clean energy transition (e.g. investing in storage technologies to support integration of high shares of renewables).
  • Enabling business and investment decisions in favour of low-carbon assets alongside an effectively functioning emissions trading system, where the carbon price is not sufficiently high, visible or predictable to shift action (e.g. renewable energy support policies).

However, companion policies can also have unintended effects on the carbon price and functioning of an emissions trading system. The “waterbed effect” is the phenomenon where emissions reductions induced by companion policies take place under an emissions trading system cap. This can reduce allowance demand and, in turn, allowance price. Importantly, the waterbed effect can also result in no net emissions reductions since the overall emissions level (cap) remains unchanged. This applies to both absolute and intensity-based caps.

An emissions trading system can also sit within a country’s overarching, economy-wide climate change mitigation objective, including a nationally determined contribution (NDC) under the UNFCCC, or a long-term mitigation strategy. It is therefore important to understand how emissions trading systems and other policies interact to ensure that together they enable the jurisdiction to meet its mitigation objectives. This section examines experiences in various jurisdictions to shed a light on how to best manage these interactions in different contexts.

The certainty of the allowance price is a key element of emissions trading system effectiveness in driving decarbonisation in all economic sectors. Mechanisms that promote both flexibility and certainty of the carbon price are fundamental to ensure that emissions trading systems can respond to unforeseen or unintended impacts, whether stemming from companion policies or external factors, such as sudden economic downturns.

Policy makers can use several mechanisms to enhance the flexibility and certainty of the carbon price in an emissions trading system. These mechanisms can be quantity-based (e.g. allowances reserves and cancellation mechanisms) or price-based (e.g. an allowance price ceiling and/or floor), indexed regulation (e.g. intensity-based allocation, change of cap trajectory), or time-flexible quantity measures (such as banking and borrowing allowances).1 These mechanisms can be used individually but, in practice, are usually combined, and could be designed to have automatic triggers to further enhance price certainty and minimise active intervention by policy makers.

The examples below demonstrate emissions trading system interactions with domestic companion policies and highlight how carbon price flexibility and certainty mechanisms have been used to address the unintended effects of policy interaction.

Carbon price flexibility and certainty mechanisms in the EU ETS

The EU ETS has experienced a surplus of allowances in its market due to the initial allocation rules, use of certified emissions reductions, and the effect of EU-wide energy efficiency and renewable energy targets. The European Union’s 20-20-20 targets comprise a 20% reduction in emissions, 20% renewable energy in gross final energy consumption and a 20% improvement in energy efficiency from the business-as-usual scenario by 2020. While the renewable energy targets were considered in the initial EU ETS cap-setting of Phase 3 (2013-20), the energy efficiency target and use of Clean Development Mechanism (CDM) credits were not. Furthermore, the renewable energy target is set to be exceeded, creating an additional unforeseen suppression of allowance demand. The renewable energy target was surpassed mainly because: (i) power demand was significantly lower than expected (ii) renewables deployment was useful to achieve other policy objectives, such as reducing air pollution and enhancing regional energy security, and; (iii) cost reductions in renewable energy technologies accelerated unexpectedly. Looking ahead to Phase 4 (2021-30), evidence suggests that fulfilment of the 2030 renewable energy and energy efficiency policy targets alone could be sufficient to reach the current 2030 EU emissions target, leaving the EU ETS with little to no stringency.

In 2019, the European Union introduced the Market Stability Reserve in its emissions trading system to address the challenge of allowance surplus and to provide greater price certainty in the face of unforeseen factors. The total number of allowances in circulation is published by the European Union each year in May. This number is compared with pre-determined threshold levels representing a shortage or surplus of allowances. If there is an allowance shortage, the Market Stability Reserve is designed to release a quantity of allowances from the reserve. If there is a surplus, the Market Stability Reserve will take in allowances from the market. As these thresholds are pre-determined, the trigger is automatic and does not require approval by governments or the European Commission.

The Market Stability Reserve provides a long-term response measure for the market to manage unexpected over- or under-supply, without needing to address or manage the causes of market disruption. For example, as a short-term measure, the auctioning of 900 million allowances was postponed from the first part of Phase 3 (2014-16) to the second part (2019-20). With the Market Stability Reserve, these allowances have been placed in the reserve rather than auctioned in 2019-20. Since the adoption of the EU ETS reform in 2018, and within the first months of the functional Market Stability Reserve, allowance prices increased to reach levels not seen in a decade, signalling the positive impact of the stability mechanism even if the number of allowances in circulation remained high. Market Stability Reserve allowances exceeding the number from the previous year’s auction will be cancelled in Phase 4, preventing the Market Stability Reserve from holding too many allowances. Member states can also cancel allowances if they phase out coal-fired power generation through other policies. For example, at the beginning of 2020 the German government proposed a bill to phase out coal by 2038, which will include cancelling some allowances to avoid a possible waterbed effect from the closure of the coal plants.

To create a more co-ordinated approach to meeting climate and energy goals, the European Commission in 2016 proposed a Regulation on the Governance of the Energy Union. Member states were required to define and submit integrated energy and climate plans to enhance co‑ordination of policies addressing five domains: energy security, energy efficiency, climate action (including EU ETS), energy integration, and innovation. The plans could consider specific interactions between the EU ETS and other policies. The regulation also permits the European Union to intervene with member states where necessary, should the EU energy efficiency and renewable targets be jeopardised.

The carbon price is designed to fluctuate in an emissions trading system depending on the demand for allowances. Demand rises when economic activity is thriving because emissions increase, pushing up the carbon price. Conversely, when the economy slows down, emissions decrease and so does the demand for allowances, bringing their price down.

The global economic crisis induced by the Covid-19 pandemic in 2020 is not the first economic shock that emissions trading systems have experienced. In 2008, when the global financial crisis started, few emissions trading systems were operating. The EU ETS had started in 2005, while the New Zealand and Swiss systems were launched in 2008. In light of this, the EU ETS can offer some insights on the impact of the economic crisis.

In 2008, the EU ETS lacked flexibility mechanisms that could, for instance, permit adjustments of the emissions cap in the face of a sudden exogenous reduction of demand for allowances. This led to a carry-over of oversupply of around 2 billion allowances from Phase 2 (2008-12) to Phase 3 (2013-20). The price of allowances rapidly collapsed, from around EUR 30/tCO2-eq in June 2008 to EUR 9/tCO2-eq in February 2009.

In the first quarter of 2020, global energy-related CO2 emissions declined by over 5% compared with the previous year as energy demand was reduced by the economic slowdown induced by the Covid-19 pandemic. In Europe, emissions fell even more than the global average, by 8%. The difference with the 2008 crisis is that this time the Market Stability Reserve was in place. The reserve stabilised EU allowance prices to around EUR 20/tCO2-eq in May 2020, after a sudden fall from around EUR 24-25/tCO2-eq before the Covid-19 pandemic. Nevertheless, analysts are sceptical about the mid- and long-term effectiveness of the Market Stability Reserve in handling a sustained Covid-19 crisis, as this mechanism was designed to deal with oversupply accumulated over previous years.

Alongside the EU ETS, other emissions trading systems are also being affected by the Covid-19 economic crisis. Allowance prices have declined in California and Quebec, for instance, and jurisdictions elsewhere, including Canada, Korea and some Chinese emissions trading system pilots, have been extending compliance obligation periods.

Carbon price flexibility and certainty mechanisms in California’s cap-and-trade system

The California cap-and-trade system has been conceived to function as a backstop for other policies intended to achieve the majority of emissions reductions to meet the state’s targets. The Renewables Portfolio Standard and electricity efficiency programmes, companion policies for the cap-and-trade system, have been extended to 2030, suggesting that the cap-and-trade system will probably continue as a backstop instrument in the near future. If these companion policies underperform, the cap-and-trade would then be relied upon to fill the emissions reductions gap. However, should these over perform, the cap-and-trade system could experience surplus allowances and low prices. To provide market stability, the system introduced an Auction Reserve Price that sets the minimum allowance price at USD 16.68 in 2020, increasing annually by 5% plus inflation. Moreover, a mechanism was approved to move allowances that remain unsold for two years to an Allowance Price Containment Reserve, where allowances are available at high prices (USD 62-77). From 2021, new provisions will help contain allowance price levels by injecting remaining allowances from the Allowance Price Containment Reserve at specific trigger points, and by introducing a price ceiling at USD 65.

California’s experience also shows that the interactions of an emissions trading system with air pollution policies should be considered carefully. Local air quality is a key social and environmental challenge in many jurisdictions. Previous IEA analysis has shown the importance of analysing potential synergies between air pollution control and greenhouse gas emissions abatement, especially since the interplay between the two may not always be positive. In California, the cap‑and-trade system was originally expected to reinforce air quality regulations and accelerate reductions in air pollution levels. There was also a social dimension, given that facilities with high greenhouse gas and particulate matter emissions in California tend to be concentrated in lower‑income neighbourhoods. In practice, however, neither greenhouse gas nor particulate matter emissions from such facilities significantly decreased with the introduction of the cap‑and‑trade system. This was due to the fact that such facilities made greater use of carbon offsets to comply with the cap-and-trade regulation, rather than investing in direct greenhouse gas mitigation options. As a result, additional measures to address local air pollution were passed in 2017, as part of legislation extending California’s cap-and-trade programme to 2030.

Use of emissions trading system revenues to support other climate and energy policy objectives

Emissions trading systems can be designed to support other climate and energy policy objectives with revenues generated through allowance auctions. For instance, in the EU ETS, auction revenues are used to spur investments in clean technologies. For this purpose, as part of the revision for Phase 4, the European Commission established two funds:

  • Modernisation Fund: Of allowances auctioned in Phase 4 (2021-30), 2% will be reserved for a modernisation fund, intended to support investments in the energy systems of ten EU member states. Of these  funds, 70% are to be used for energy efficiency, renewable energy, grid infrastructure or support for the energy transition in carbon-dependent regions.
  • Innovation Fund: This fund will finance the demonstration of innovative low-carbon technologies to accelerate emissions reductions and boost competitiveness. The fund will focus on energy-intensive industries; carbon capture, utilisation and storage; renewable energy generation; and energy storage. It will aim to bridge the financing gap in the demonstration phase of the innovation cycle where private capital is scarce because project risks are high and returns are uncertain.

Another example is Québec, where the emissions trading system’s revenues are used to implement measures under the climate change action plan, including steps designed to help the industrial sector become more innovative, energy-efficient and low-carbon. Quebec intends to allocate around 9% of the emissions trading system revenues to these programmes. In California, auction revenue is used to fund companion emissions reduction policies, making functioning market important to overall climate policy implementation. Measures to better manage long-standing oversupply can be important in this context; for example, when market surplus led to 35% of available allowances being sold at the May 2020 quarterly auction, only USD 25 million was raised, compared with USD 600-800 million on average per quarter.

Often a major part of a country’s climate policy mix, an emissions trading system is generally embedded within higher-level greenhouse gas mitigation objectives, including those expressed within the country’s nationally determined contribution to the Paris Agreement and its long-term mitigation strategy. Some jurisdictions have worked to align the emissions reductions trajectory and cap of their trading system with these wider mitigation objectives, though in different ways.

Top-down approaches: Experiences from the European Union and Korea

In the EU Emissions Trading System, switching from a bottom-up (i.e. sum of individual member state targets) to a top-down cap (i.e. set at EU level) improved the system’s design. This allowed the European Union to better co‑ordinate its climate governance, align the cap with EU-level mid- and long-term emissions reduction targets, and provide certainty and transparency for the cap trajectory.

During the Phases 1 and 2, the cap was determined in a bottom-up manner by aggregating EU member states’ national targets. There was some top-down intervention by the European Commission, however, which negotiated with member states to ensure cap consistency with economy-wide targets at the EU level. The bottom-up cap approach over Phase 1 and 2 helped the European Union to build its experience while enhancing its member states’ capacity for accounting and evaluating potential emissions reduction actions.

With the start of Phase 3 in 2013, the European Union switched to a top-down determined cap. This provides an example of a top-down determination of policies to meet the overall target, with the cap and targets for sectors outside of the Emissions Trading System determined based on disaggregation of the overall target. The annual cap has been reduced by a fixed factor (“the linear reduction factor”), in line with meeting the 2020 target.

Korea’s overall emissions reduction target of 30% compared with business-as-usual by 2020 was enhanced in its first nationally determined contribution with a 37% emissions reductions target by 2030. The Korea Emissions Trading System plays a central role in achieving this target.

Since the first commitment period (2015-17), the cap for the Korea Emissions Trading System has been determined in a top-down manner in order to link it directly to Korea’s emissions reductions contribution at the international level. The cap was determined using a simple method intended to treat all emitters equally, based on the share of emissions by the covered sectors in the base years 2011-13, with sectoral caps further determined by the share of each sector’s base year emissions. Sectoral caps were removed for the second commitment period (2018-20).

New Zealand emissions trading scheme: Alignment of a system without a cap to Paris Agreement commitments

When launched in 2008, the New Zealand (NZ) Emissions Trading Scheme was designed as a nested system under the Kyoto Protocol. With full links to international carbon markets, it was not intended to define a limit for domestic emissions and operated without a domestic emissions cap. The majority of emitters met their compliance obligations through the purchase of international carbon credits issued by the Kyoto Protocol flexibility mechanisms (e.g. Clean Development Mechanism certified emissions reductions). The absence of a cap accommodated the unlimited generation of emission credits from carbon sequestration by forestry activities. In the absence of an explicit domestic emissions cap, there was no clear link between the level of domestic emissions reductions achieved under the NZ Emissions Trading Scheme and New Zealand’s broader emissions reductions targets.

In its second statutory review in 2015, the NZ Emissions Trading Scheme became a domestic-only system in an attempt to align it with New Zealand’s commitments under the Paris Agreement. As of 1 June 2015, units from the Kyoto Protocol flexible mechanisms became ineligible for surrender in the NZ system. The NZ system therefore had to introduce a new allowance allocation system, which allocated allowances freely to emissions-intensive trade-exposed sectors based on output and intensity-based benchmarks and to forestry activities for emissions removals. Alternatively, New Zealand Units (NZUs) are available for unlimited purchase at a fixed price of NZD 25 per NZU.

To provide a framework to implement climate change policies, in late 2019 New Zealand passed the Climate Change Response (Zero Carbon) Amendment Act, with the ultimate goal to reach net zero emissions by 2050. The New Zealand government considers the NZ Emissions Trading Scheme will be the main tool for meeting its 2030 mitigation targets, and will have a key role in meeting its 2050 net zero emissions target. New Zealand is also considering relinking the NZ Emissions Trading Scheme to international carbon markets (i.e. Article 6 of the Paris Agreement) if these respect high standards of environmental integrity.

Aligning the NZ Emissions Trading Scheme with New Zealand’s nationally determined contribution 2030 target and net zero emission 2050 target, the New Zealand Climate Change Response (Emissions Trading Reform) Amendment Bill passed in June 2020 reformed the Emissions Trading Scheme, introducing a gradually declining cap as of 2021. The cap will be guided by emissions budgets to be recommended by New Zealand’s Climate Change Commission, with a provisional budget set for 2021-25 in line with the 2050 target.

  • Managing the interaction of emissions trading system with wider policies can be challenging.
  • Mechanisms that promote both flexibility and certainty are fundamental to ensuring that emissions trading systems can respond to unexpected or unintended impacts of companion policies and other external factors, such as economic crises.
  • To maximise chances of achieving meaningful reductions, it is important that the emissions reductions trajectory and cap of the emissions trading system are aligned with an overall mitigation objective (e.g. the mitigation component of a nationally determined contribution, or long-term mitigation strategies). Establishing a top-down emissions cap could be an effective way to align the emissions trading system’s emissions reductions with these mitigation goals.
  • Policy overlap is not inherently problematic if the policies other than carbon pricing serve different objectives or address other gaps. The challenge is to understand the overlaps – the extent to which other policies are expected to reduce emissions that are also covered by an emissions trading system – so that the emissions trading system cap and/or design can be adjusted accordingly.

  • How will the emissions trading system interact with other domestic companion policies? What is the best way to minimise the risk that emissions reductions driven by other domestic companion policies suppress the demand for emissions trading system allowances?
  • What mechanisms will be used to promote emissions trading system flexibility and certainty over time?
  • What role will the emissions trading system play in the long-term mitigation strategy? Will a long-term emissions trading system policy trajectory be determined and communicated? What is the best way to align the emissions trading system with national mitigation objectives?