Understanding overlapping climate policies: Internal carbon leakage and the punctured waterbed

Understanding overlapping climate policies: Internal carbon leakage and the punctured waterbed

Dr Robert Ritz, University of Cambridge

Europe is seeing increasing unilateral action by individual EU member states wishing to “do more” than what the EU ETS centrally provides. For example, Great Britain has since 2013 imposed an additional Carbon Price Support on electricity generation to “top up” the EUA price; in December 2018, the Netherlands committed to introducing a similar policy. Other examples include a plethora of support mechanisms for renewables and energy efficiency. These share a common feature: they are policies by an individual country aimed at an individual sector within a multi-country multi-sector ETS.

What is the climate benefit of such overlapping policies? In the EU ETS, before the Market Stability Reserve (MSR), the answer was clear. With a binding EU-wide emissions cap, any unilateral emissions reduction is exactly offset by an emissions increase elsewhere: the “waterbed effect” is 100%. The MSR, by canceling a fraction of surplus EUAs, punctures this waterbed. Recent estimates suggest that near-term unilateral action that reduces EU-wide emissions demand by 1 ton of CO2in a given year will, over time, translate into an emissions reduction of .5 tCO2or more. This enables unilateral action to have a global climate benefit. Yet the crucial missing link lies in figuring out how large a unilateral action is actually required to achieve this 1 tCO2reduction in EU-wide emissions demand. The missing link is what we call “internal carbon leakage” within the EU ETS. Given the degree of European market integration, a unilateral policy that reduces an individual country’s emissions will often have knock-on effects on its neighbours.

In this paper, we aim to fill this gap in the literature by providing a simple new integrated framework to understand the climate impacts of such unilateral action. First, we present simple formulae to estimate internal carbon leakage for at the sectoral level for three types of policy: (i) a carbon price floor (perhaps with a border tax adjustment), (ii) an energy efficiency program, and (iii) renewables support. The formulae depend on intuitive characteristics such as the price elasticities of demand and supply and firms’ observed market shares. Second, we present a formula to quantify the puncture of the waterbed effect under the reformed EU ETS—and how it varies over time up to 2030. Our approach also nests a “plain vanilla” ETS with a fixed cap (100% waterbed) and a “plain vanilla” carbon-tax system (zero waterbed).Our theory makes clear how the sign and magnitude of the climate benefit from an overlapping policy varies widely depending on its design, location and timing. Punctured waterbeds raise the stakes: well-designed overlapping policies can be much more climate-effective but others now backfire. We illustrate the empirical implications of our analysis with a range of examples from Europe and North America.