The European Union Emissions Trading System (EU ETS) currently caps emissions of over eleven thousand installations in thirty-one countries, amounting to around 45 percent of EU CO2 emissions. Simultaneously, many European governments aim to replace fossil-fuel power production by renewable energy production, but does this in fact reduce emissions? 

Interference in an emissions trading system, such as the mandatory closure of coal-fired plants or subsidization of renewable energy generation, decreases the demand for emissions permits from the affected participants. As lower demand is expected to translate itself into lower permit prices, emissions become less costly. Hence, the abatement decision of unaffected participants now includes more emission-intense processes. This mechanism is referred to as the waterbed effect in the economic literature, and entails that combining additional policy instruments with an emissions trading system does not further reduce emissions, but merely displaces them within the system.

Surprisingly, empirical tests of the waterbed are virtually absent in the debate. Using a time series analysis of the permit price in the EU ETS from 2008-2016, it is estimated that the deployment of renewable energy generation sources in Europe has negatively affected EU ETS permit prices. Furthermore, a panel data approach to sectoral emissions in the EU ETS confirms that increases in renewable energy generation lead to increases in emissions outside the energy sector. Hence, the presence of the waterbed effect in the EU ETS is empirically demonstrated.

The relationship between the EU ETS and renewable energy policies brings about important policy considerations. A direct implication of the waterbed effect is that it is incorrect to refer to emissions reduction as a rationale for using additional renewable energy policies that interfere with the EU ETS. Subsidies for renewable energy generation can be interpreted as subsidies for all EU ETS participants, as the price of emission permits decreases as a result of these subsidies.

Note:

This blog is written on the basis of my Master Economics thesis ‘The waterbed effect: interaction of renewable energy policies with the EU ETS’ and an article recently published in ‘Economische Statistische Berichten’ written together with prof. Machiel Mulder.

Download the full article here.