Making the Polluter Pay: The challenges of revising the EU ETS

Making the Polluter Pay

The challenges of revising the EU ETS

Name: Steef den Uijl

UvA-ID: 10799842

Date: 01-07-2019

Supervisor: D. Hollanders

Table of Contents

1.

2. Theoretical side of carbon tax (Ideas) 4

3. Current EU solutions to carbon-related externalities 11

4. The players of the EU ETS (Interests) 18

5.

Introduction

The policy field of climate action is important to the European Union. The well-known Paris Agreement was set up in 2015 by the United Nations Framework Convention on Climate Change (UNFCC). By signing the Agreement, the EU committed itself to a reduction of greenhouse gas emissions. This required reduction of emissions has proven to come at a significant cost, with more expenses expected for the future. However, this economic cost is already being paid indirectly by people suffering from the emissions, be it through impact on health or climate effects. A complete redesign of the economy in order to adhere to the limitations set by the Paris Agreement shifts the economic cost to a direct cost to producers and consumers. This leaves the EU to find an answer to the question who should pay the price for the fulfilment of the goals set in the Paris Agreement.

As of now, the self-proclaimed ‘flagship policy’ of EU climate action is its Emission Trading Scheme (ETS). This means that many of the targets of greenhouse gas (GHG) emission reduction will be attempted to be achieved through this scheme. It also means that the most significant policy changes can be enacted through alterations to the EU ETS as it exists now.

This research will address the question of: ‘What are the factors that influenced the revision trajectory of the ETS on the EU level?’. The work will take a political economy perspective on this topic. Therefore, the main questions revolve around identifying the stakeholders in this field and their interactions with each other. This includes an analysis of the decision- and policy-making processes. The EU has expressed, in its Clean Energy for All-package, an emphasis on ‘cost-efficient’ climate policy. The main challenge for the EU in climate action policy is, in one sentence, finding balance between economic competitiveness and the internationally agreed upon environmental targets. When terms of ‘economic efficiency’ or ‘cost-effectiveness’ are used in this research, it refers to this expression of focus by the European Union itself.

The research will look at the development of the ETS policy through the theoretical lens of “the three I’s”; institutions, interests and ideas. This approach has been used to analyse EU policy decisions before, for example by Peter Hall in his article ‘Varieties of Capitalism and the Euro Crisis’ (2009). Hall argues that this approach is useful to see policy decisions as the ‘product of interactions’ between these three factors. The first chapter will address the previously mentioned theoretical side, the ideas, of carbon-related externalities. This entails theories on externalities and how to address these. For instance, the theory behind the Pigouvian tax, as proposed by Arthur Pigou. This also includes Ronald Coase’ theorem on dealing with externalities. The second chapter describes the workings of the existing ETS, ranging from its original design to its apparent short-comings. This includes an analysis of the Phases 1 through 3 of the ETS. The third chapter focuses on making a Political Economy analysis of ETS revisions, looking at both the institutions and their interests. The various stakeholders will be mapped and their interests analysed. This third chapter includes a qualitative content analysis of policy documents related to the origin and development of the EU ETS. The documents are selected based on relevance, which is motivated in the chapter itself. The content analysis will provide insights in the development of ETS and other policy in the field of EU Climate Action. Chapter 3 will also look at what these interests mean for future reform and improvements of EU climate action policy.

Chapter 1 - Theoretical side of carbon tax (Ideas)

Externalities

The EU deems it preferable to ensure that the transition to a less carbon-intensive economy, as decided upon in the Paris Agreement, happens in a ‘cost-efficient manner’ (European Commission 2018, p. 3). However, the challenge of excessive carbon emissions is a tough one from the perspective of

economic theory that describes the laws of a so called ‘free market’ (markets are never truly free, the term describes a concept of market mechanisms at work with minimal outside interference). The incidental costs that are incurred by a highly diverse group of stakeholders as a result of these

excessive emissions are not necessarily traced back to the actors responsible for this pollution through standard market mechanisms. The existing situation is what is known as an externality. The working definition of an externality in this research will be as follows: “An externality is a cost or benefit that occurs when the activity of one entity directly affects the welfare of another in a way that is outside the market mechanism” (Rosen & Gayer 2014, p. 73). The occurrence of externalities is a form of market failure, as the so called ‘free market’ ends up unable to bring the entities bearing the costs and the entities receiving the benefits together. In the case of carbon emissions, this is caused by what is called a ‘missing market’, denoting the nonexistence of a specific market.

In the presence of externalities, a number of measures can be taken by a governing institution. These possible measures can be sorted under 4 different groups. These groups are: 1) rationing, 2) taxation, 3) regulation and 4) outlawing. The first to be discussed is rationing, based on theory of Ronald Coase, and later the resulting cap-and-trade policies following from this theory. Then, this will be contrasted with measures of taxation based on Arthur Pigou. Both of these measures require a mixing and matching of the third point, regulation, to achieve optimal efficiency. Finally, some alternative measures of outlawing will be mentioned. It is true that the groups have certain levels of overlap between them when looking at specific policy measures and the list is not exhaustive. What follows is a descriptive analysis of various proposed techniques that are targeted at reducing or compensating for the market failure that occurs through externalities.

Coase

The first way to offset the economic inefficiencies that occur as a result of externalities, through a measure with a regulatory aim, is by creating property rights. This is a de facto form of rationing the externalities, as the number of assigned property rights is determined by a central authority. The creation of property rights in attempt to create a market for matters that fall outside of existing markets was proposed by Ronald Coase. Coase’ Theorem, as it is referred to, can be defined as follows: “Provided that transaction costs are negligible, an efficient solution to an externality problem is achieved as long as someone is assigned property rights, independent of who is assigned those rights” (Rosen & Gayer 2014, p. 82). The way it is intended to work is that when property rights are assigned among the entities involved, a negotiation can take place to determine a price that results from consideration of the costs and benefits as it would happen in a market. To return to the topic at hand, in the case of carbon emissions, this would mean that someone would ‘own’ (through created property rights) the right to pollute either ‘clean air’ or ‘the climate’ or something of this nature. The property rights for this ‘property’, being the right to pollute, could be assigned to either the polluting entities or the entities suffering from the pollution for the changes in economic efficiency to come into effect. Looking at this through the example of the allocation of property rights of the commodity ‘climate’ shows the following scenario:

In the case of the polluter getting the property rights, it will likely result in them attempting to sell the commodity of ‘climate pollution’ right to the highest bidder. This way, a market price for the created commodity ‘climate pollution’ can be established. This market price will follow from the polluter being able to gain (for example) €100 worth of produce from the production process polluting. Note that this is the ‘societal worth’ of the produce, meaning the value it offers to society as whole. If some people consider a clean climate worth more than €100 in value (say €150) they will offer this price of €150 to the polluter. The offer of the people wanting to protect the climate is higher than this value of the €100 generated from damaging it, economic theory predicts that the polluter will opt to sell their right to do with the climate as they please (which is damaging it for profit), as the polluter is compensated for the loss in production cost. This leaves us with an overall ‘societal benefit’ of €150 in climate value minus €100 in unproduced goods, adding up to €50 in net benefit. At the same time, if the people wanting to save the climate only value this wish at, say €50, the polluter will decide to continue to produce (and therefore pollute). This example would show a similar sum of €100 worth of goods produced, minus €50 worth of climate damage, again totalling €50 of societal benefit. The allocation of property rights will therefore provide the most economically efficient way to protect the climate. In the reverse case, where the entity whose ‘climate’ currently is being damaged gets assigned the property rights to it, any damages from polluters will become unlawful. The recipients of pollution damages or ‘pollutees’ will be in position to sell off their property of the ‘climate’ to the polluter. Like before, this will create a market price for the commodity ‘climate’ at the price the pollutee is willing to accept for it. Continuing the example, the polluter will likely offer up to €100 (ignoring other costs) to buy the right to pollute, as that is what the produce will be worth. The holders of the right can decide whether or not they deem this offer is

acceptable. As Coase suggested, either scenario results in optimal economic efficiency, as long as certain conditions are met (Coase, 1960).

The most important part of this example is how it contrasts to a Pigouvian tax. A Pigouvian tax would be implemented to discourage the polluter of the example from producing at the least the same, up to possibly even any amount. Consider that, following a Pigouvian tax on pollution per unit, the polluter only decides to produce €50 worth of produce. The net societal benefit is now valued at -€50. As Coase said in his ‘Problem of Social Cost’, avoiding harm to the one party will inflict harm on the other. Coase’ Theorem therefore looks to find out how to avoid the more serious harm.

From the scenario mentioned above, it becomes apparent that there is a numerical logic to Coase’ Theorem. However, what may seem logical in theory is realistically unlikely to be made to work in practice. This is because the conditions alluded to before are highly improbable, not to say impossible, to be met in the real world. One of these conditions is that the entities from the example can in fact come together and negotiate a price (Rosen & Gayer 2014, p. 82). In the case of the climate, this would mean that all polluters would band together as a negotiating party on the one side, but even more unlikely, that all other people affected by pollution (effectively all people) should negotiate as one on the other side. Given that no bargaining process is imaginable, that takes into account all various interests from the highly diverse groups on both sides, the intended economic efficiency that was described by Coase in his theory is not feasible in the case of the externalities of pollution and the climate effects as a result of it. Another condition of Coase’ Theorem, is that the owners of the assigned property rights are able to identify where damages come from and are able to take action to prevent these damages (Rosen & Gayer 2014, p. 82). Meeting this condition for pollution in practice

also proves problematic, as it is difficult to determine which part of a polluter’s actions damaged which part of the pollutees property. Primarily for these reasons, the Coase Theorem in its bare form will not prove to be a viable solution for the issue of ‘climate change’-related externalities in the EU. Contemporary economists attempt to link Coasian principles to modern day challenges. When applied to the externality of carbon emissions, Coase’ Theorem is still able to provide insights into possible solutions. For the case of carbon emissions, some economists, in line with Coase, have proposed to link land ownership rights to a right to pollute (Lai et al. 2018, p. 13). This proposal is based on a set of assumptions that expect a fixed link between carbon emission and a certain form of land exploitation. As an example, the authors assume a determined ratio between keeping cattle (as land exploitation) and methane pollution (as carbon emission). When such a set ratio exists, a Coasian emission trading can be realized based on existing or adjusted land property rights. Furthermore, the authors address that some party should take on the bargaining position at the behalf of future generations, who should not be forgotten in this process. They point to governments as potential facilitators of a defender of future interests. As the authors express, a government should not be expected to take on this role itself. It would indeed be difficult to reconcile this expectation with the reality of very short-term incentives ruling many governments, based on the limited governing periods enclosed by election cycles. The proposal is based on a rejection of the assumption that carbon emissions as an externality are inherently negative. Based on this view of externalities, the authors pose that a Coasian, voluntary exchange-based solution to carbon emission issues is a preferred method in regards to “wealth maximization” (Lai et al. 2018, p. 16).

The EU has to do something different in an attempt to address externalities, and it has looked to enact the policy of ‘carbon pricing’ to do it. Carbon pricing is a term used to describe policy

instruments that work around putting a price on carbon as a direct factor of externalities. By assigning a price to externalities, mechanisms considered to be at work in a ‘free’ market that failed before can be used to find optimal cost efficiencies. This process of ‘market making’ is central to EU carbon emission reduction policies. Two of the most significant forms of carbon pricing are ‘carbon tax’ policies and ‘cap-and-trade’ policies.

Pigou

The second group of anti-externality measures is taxation. Ronald Coase wrote his theorem in his work ‘The Problem of Social Cost’ (1960), partly as an alternative to economist Arthur Pigou’s proposal for a tax that could counteract effects of externalities. In his book ‘The Economics of

Welfare’, Pigou proposed what became known as a ‘Pigouvian tax’. The Pigouvian tax can be defined as “a tax levied on each unit of an externality-generator’s output in an amount equal to the marginal damage at the efficient level of output” (Rosen & Gayer 2014, p. 84). In practice, such a tax may be used to include the cost of externalities in the production cost per unit. This increase in production cost will incentivise producers to produce at a more efficient level. What this tax does not inherently do, is compensate the suffering entities for their damages. Opening up a system of direct compensation by the government out of these tax incomes could result in unrightful claims. Proper distribution of the tax revenues therefore remains a cause for consideration of the government. With a similar outcome as a tax, it is also possible to incentivise producers to reduce carbon emissions through government payments to the polluting parties. If a government decides to pay for producers not to pollute, this will affect the decision of the quantity of production in the same way a tax would. Much like the tax, it is a question of political nature what distribution of the tax burden is more desirable (Rosen & Gayer 2014, p. 86).

Emissions fee

For the case of carbon emissions, a slightly altered tax could prove more effective. It is true that a tax that is levied per unit of production will raise production costs and will therefore likely reduce the

total volume of production, thereby reducing emissions as a result. Still, this is not necessarily the most efficient way of achieving the goal of the tax, which is reducing overall emissions. A more efficient alternative would be a tax on each ‘unit’ of an externality, in this case carbon emission, rather than each unit of output. This is known as an ‘emissions fee’ (Rosen & Gayer 2014, p. 85). On a tax per unit of output, producers would be inclined to reduce the quantity of output. Conversely, with a tax on units of carbon emission, producers have an incentive to create products in a more carbon-efficient way, while not necessarily decreasing total production output quantities. Additionally, an emissions fee is more efficient in the case of multiple polluters with varying costs for emission reduction. In the case of two separate producers, a tax on units of emission will produce the lowest possible cost while still achieving emission reduction. Producers that can reduce the least amount of emissions for a certain price, end up paying the largest part of the emissions tax, rewarding producers that are able to reduce emissions at lower costs (Rosen & Gayer 2014, p. 90).

Unintended consequences

As efficient as a Pigouvian tax can be at reducing emissions, it has to be taken into account that a tax of this sort can result in some unintended consequences. A Pigouvian tax (or subsidy) policy does not exist in a vacuum and as such, its efficiency cannot be considered on its own. A tax that targets a specific part of the production process, like carbon emissions, inherently affects other aspects of the economy. The effects on cost per unit of production will likely have an impact on the labour market in the production line. The existence of a tax causes production costs of a certain production process to rise. In order to maintain maximized profits, producers will react to this change by either raising their prices by reducing the quantity of production, or cutting cost elsewhere in the production line. Both these options have the potential to lower the real wages of workers. Attempting to cut production cost can mean lowering labour cost, meaning a direct lowering of wages. The other option, raising

prices/reducing quantity can also affect the worker, specifically in the case of emission reduction. Taxes aimed at emission reduction (the Pigouvian tax) affect goods like energy and transportation directly, which are things that are not easily replaced and, in most cases, complete necessities. Thus, raising the prices of these goods can be considered lowering the real wages of labourers. This ‘tax-interaction effect’ defined by Rosen and Gayer as “the increase in excess burden in the labor market stemming from the reduction in real wages caused by a Pigouvian tax”, describes an inherent link between the labour market and a tax of this nature (Rosen & Gayer 2014, p. 334). The implication of this effect is that the full extent of the impacts of the various levels of interaction between taxes is difficult to determine, causing the true efficiency of a Pigouvian tax to remain uncertain. The effect described above can potentially be limited in its negative impact on efficiency, by adequate spending of the tax revenues provided by the Pigouvian tax. If the tax revenue is used to compensate workers for their real loss of wages through income tax breaks or subsidies on the affected goods, the inefficiency of the tax-interaction affect can be minimized. Rosen and Gayer call this compensation for inefficiency using the revenue of a Pigouvian tax the “double-dividend effect” (Rosen & Gayer 2014, p. 335).

Apart from these unintended consequences, a large part of the debate among economists about Pigou’s incentive-based tax scheme is based on the efficiency of the measure. Coase was one of the more prominent critics of Pigou, mainly challenging the assumption that it is preferable to impact the actor that is the cause of externalities in such a way that they would be persuaded to not affect the welfare of unrelated entities. Coase argues that the effect of producer on the affected party should be a two-way street, a give-and-take. Impeding producers from producing harms them as much as the negative effects may harm the other. Coase’ alternative, the Theorem discussed prior, resulted from his answer to a slightly altered question which he deemed more accurate. “The real question that has to be decided is: should A be allowed to harm B or should B be allowed to harm A? The problem is to avoid the more serious harm” (Coase 1960, p. 2). Coase objects to the Pigouvian tax on the grounds of it choosing to side with an affected party for no other reason than to fix a perceived gap in the

market resulting in uncompensated damages, rather than attempting to remove the biggest ‘value’ of total harm on society. According to Coase, it is not necessarily true that the lowest cost incurred by a producer to compensate for externalities is equal to the lowest possible social cost. Coase argues that it is possible for the ‘victims’ of externalities to have cheaper options to avoid negative effects available to them, which they should use in regards to optimal cost efficiency (p. 41). He admits that a tax could theoretically include all these factors, but poses that it is seemingly impossible for the taxing entity to gather the data required to adequately determine the optimal tax values. Furthermore, Coase

challenges the distributive effects of a tax. Whereas his Theorem has the polluter pay for any harm directly to any affected parties, the tax revenue is not proposed to directly be paid to the people suffering the damage, so says Coase (p. 41)

Some twenty years after Coase wrote his book addressing Pigou’s tax proposal, economists Carlton and Loury present an additional argument. The economists argue that over the long term, a set Pigouvian tax cannot be used to specifically target output without affecting the total structure of the sector. Changing the tax rate to adapt to developments over an extended period of time influences the number of firms rather than their individual production numbers (for full calculations, see Carlton & Loury 1980, p. 563). Carlton and Loury assert that additional subsidies should be implemented in tandem with a Pigouvian tax to achieve optimal economic efficiency. However, this idea was

challenged by other academics in the field. As long as the tax rate are accurately adapted to changes in the economy and to desired outcomes, a Pigouvian tax on emissions can remain effective over

extended periods of time, so say defenders of a tax scheme (Kohn 1986, p. 629).

UN Emissions Gap Report

The UN publishes an annual report on the progress of greenhouse gas emission reductions across the world compared to the commitments in the Paris Agreement, called the Emission Gap Report. The most recent document, reporting the progress for 2018, revealed the main finding of this year’s report was that the current commitments expressed by the signatories of the Paris Agreement are not enough to achieve the overall Global warming goal of a less than 2 degrees Celsius average temperature increase. All G20 failed to take the necessary steps to adhere to this objective. Even worse, the data the report is based on shows that since 2017, emissions rose for the first time in three years (UN EGR 2018, p. 14). The report describes the importance of fiscal tools such as carbon pricing to get

emissions in check. It acknowledges that the EU has played a big role in carbon pricing systems across the world, pointing to the ETS as the first emission trading system of its kind. However, in line with the findings of chapter 2 of this research, the report argues that the policies in place prioritize

economic interests over environmental effectiveness. This leads to insufficient and inconsistent efforts based on ambition levels that are too low.

The writers of the report go so far as to propose some possible alternatives to replace the current (and seemingly insufficient) policy. Among these proposed alternatives is a Pigouvian style carbon tax. According to the authors, a per tonne carbon tax of $70 could reduce emissions from between 10 to 40 percent in some countries. The writers of the report claim that there is a lack of public support for carbon taxes around the world, and ascribe this to the fact that politicians fail to ease three core concerns people have regarding the policy. Two of these concerns have been discussed already in this chapter; the distributional effects of these kinds of taxes and the international coordination of the policy measures once implemented, specifically as it comes to carbon leakage effects. The third core concern that the report identifies is one of “broader behavioural and political factors” (UN EGR 2018, p. 46). This issue includes things like trust in the government in general and communication between the state and its citizens. Informing the public, including about thing like the previously mentioned co-benefits of policies, is brought forth in the report as an essential part of the alleviation to this concern. All three concerns are claimed to be addressed by proper application of the tax revenues

Cap-and-trade

Another alternative option is cap-and-trade system. A cap-and-trade system can be defined as “a policy of granting permits to pollute, following a Coasian logic of assigning property rights. In this case the property right pertains to the ‘right to pollute’ of a producer. The number of permits is set at the desired pollution level, and polluters may trade the permits” (Rosen & Gayer 2014, p. 92). This works as follows; for a specific sector (or a group of sectors), total allowable emissions are capped, meaning a predetermined limit is placed on it. A governing entity gives out permits to the various producers in the sector(s) that allow emission of carbon, with a value that is equal to this established cap number. After the permits have been distributed up to the limit set by the state, the producers are free to trade these permits amongst themselves. This creates a market structure where the ‘price’ of carbon emissions, expressed in the market rate of the permits, will be established in a cost-efficient way. The EU opted to go with this system, which will be discussed more in depth in the following chapter.

Tax versus Cap-and-trade

Both these previously discussed forms of carbon pricing are often compared by both academic literature and policy-makers in order to determine what policy is optimal. The possible measures are similar in that both can in theory achieve the same specific desired outcomes. However, some

differences exist in the workings and effects resulting from reaching these desired outcomes. The key differences lie in the responsiveness of the policy to changes in the economy in which they are implemented (Rosen & Gayer 2014, pp. 93-94). For instance, a cap-and-trade system has a hard limit on the allowable levels of carbon emission. Changes in inflation have no inherent effect on this limit. Meanwhile, inflation causes a Pigouvian tax per unit of emission to decrease in value, reducing the incentive to decrease emissions unless the tax is actively readjusted to the inflation rate. The tax requires an additional policy step. The same goes for reactions to a change in cost of emission reduction. The hard cap will remain despite these changes in cost, making it more or less costly for firms to maintain allowable levels. The tax will be able to maintain a stable rate for producers to work with, at the cost of effectiveness of the emission reduction incentive as the price of emission reduction changes. A common critique on any tax relates to the establishment of the amount of the tax. It can be a controversial topic to figure out the desirable tax level. However, this should not be held as to strong of an argument against taxation in general, as a similar level of arbitrariness can be found in cap-and-trade policies. Here, the question is rather how many permits should be commissioned. Another area that deserves attention is the factor of distributional effects of the measures considered here. One study, based on research in the US, shows that the relatively highest financial burden ends up affecting the poorest households, in the case of both a Pigouvian tax as well as a cap-and-trade scheme

(Grainger & Kolstad, 2010). It is important to recognize these extended effects of policies. When comparing the first part of the distributional effects of both measures, both raise production cost and therefore will likely direct the prices upwards, which hits the poorest groups in an economy relatively harder, as the study by Grainger and Kolstad suggests. However, the second part of the distributional effects is different. A Pigouvian tax, levied by the state, inherently produces a revenue which the governing entity can redistribute as it pleases. This could be used to compensate the parts of the economy that are hit hardest by the measure, in this case being the poorest households, through a variety of ways. In the case of a cap-and-trade scheme, this is slightly different. While the assigning of allowable emissions could create a state revenue if the permits are sold, this is not automatically the case. In practice, a sale of permits of this kind often does not happen for reasons which will be discussed further in chapter 2. In this case, the distributional effects of a cap-and-trade scheme are potentially and arguably less desirable, as it becomes a factor in increased economic inequalities.

As mentioned before, another possible course of action in combatting externalities is simply outlawing certain practices. One way a state can regulate the negative effects of externalities is through a

‘command-and-control’ policy. The term ‘command-and-control’ is used to describe “policies that require a given amount of pollution reduction with limited or no flexibility with respect to how it may be achieved” (Rosen & Gayer 2014, p. 97-98). The way it often works, is a state entity outlaws certain production processes in favour of alternative options that produce less of a negative externality effect like that of carbon emissions. This way the state obliges producers to work in the least damaging way possible, whatever the cost. This more direct public approach to dealing with externalities is an alternative to incentive-based regulations like a Pigouvian tax or cap-and-trade policies, which create basic market parameters for producers to act within to their interest. As a result, command-and-control is less cost-efficient than incentive-based policies. Nevertheless, command-and-control policies may be preferable in any case where it is not possible for the state to accurately monitor exact emission levels, as that is something that is required for effective implementation of any cap-and-trade scheme or emission tax.

One more possible course of action for state entities looking to address the loss of economic efficiency as a result of unaccounted for externalities, is a less radical approach. Governments can seek to address negative externalities through an emphasis on social conventions. What this means is that desirable behaviours are promoted to the effect of avoiding externalities as much as possible. The state takes the role of ‘teacher’, teaching people to avoid behaviour that negatively impacts others.

Chapter 2 – Current EU solutions to carbon-related externalities

The various ways of dealing with externalities discussed in the previous chapter all have their own sets of advantages and disadvantages. Out of the select number of options, the EU has chosen to go with a system of cap-and-trade. This system is called the ‘Emissions Trading System’ or ETS. The Emissions Trading System of the European Union is a project with a turbulent existence. Since its inception, it has known gradual developments as a combination of environmental policy and market-making. This chapter seeks to answer questions surrounding the ‘what’, ‘how’ and ‘why’ of the EU ETS. After that, the chapter will look at the perceived shortcomings of the ETS, which are twofold. On the one hand, the measures contained in the system fall short of the objectives set by the EU. On the other, the set objective can be considered to be under-ambitious when applied to the overall goal of combatting climate change. There have been changes both proposed and applied by the Commission in an attempt to fix the shortcomings of the first order. This chapter will go into how these attempted corrections imply a change or development in the political reason of the concerned actors.

It is interesting to look at the considerations and conflicting interests that surrounded the design and (pilot) first phase of the ETS, which can all be studied to find the political rationale driving all actors involved. At first glance, looking primarily at the market-based aspects of ETS, it can be argued that the decision of the EU to go with a cap-and-trade system is indicative of a background of neoliberal ideologies at play. ‘Neoliberal ideology’ will hereby be defined through the focus on active market making, but with regulation in order to keep the mechanisms from giving results the EU would deem undesirable. It does not imply a ‘laissez-faire’ attitude towards the created market. The ideology furthermore includes the process of commodification (in a Coasian sense) of matters that were previously not adequately covered by market mechanisms, such as climate objectives.

This chapter will look at the entire development of the ETS, from the original design of the system to the problems it encountered.

How did it come to be?

International agreements

The European Union has committed itself to combatting climate change, based on various international agreements it has taken part in as a Union (as described on the official EU Climate Action webpage). In the field of EU environmental policy, the policy objectives have largely been set in these international agreements. The Kyoto Protocol, concluded in 1997, was one of the first

international agreements with a specific focus on climate change, and as such it significantly impacted the way the EU conducts environmental policy. In 2015, the Paris Agreement was adopted. The Paris Agreement was a recalibration of what had to be done as a response to climate change for all

signatories. In the Agreement, a specific numerical target is set as to what constitutes an acceptable global average temperature increase for all participating countries. This limit is set at 2 degrees Celsius above pre-industrial levels (Paris Agreement document 2015, p. 22). Ever since the EU signed both international agreements, it has expressed a strong willingness to take measures to reach the agreed upon objectives. This can be seen when looking at the projected budgets of the EU between 2014-2020 (EU Commission website on ‘Funding for climate action’). In these budgets, measures for

combatting of climate change make up 20% of the total, including climate-related action across all policy fields.

The focus of EU environmental policy has been placed on greenhouse gas emissions, following the directions set in the Paris Agreement, as these have been proven to have a direct relation with global temperature increase. Of these emissions considered ‘greenhouse gasses’, the most commonly targeted is carbon dioxide (CO2), as this is most easily traced to certain human actions like transport or energy

generation. So-called ‘non-CO2 greenhouse gasses’, like methane in agricultural processes are more

difficult to get data on (AEA report 2009, p. 13). This difficulty in obtaining data makes it more difficult to propose and monitor policy measures aimed at combatting these emissions. As mentioned in chapter 1, the ways of introducing economic instruments to cost-effectively decrease greenhouse gas emissions, two primarily considered options are generally price-based regulations and quantity-based regulations. With price-quantity-based regulation a regulator sets a price on emissions of greenhouse gasses, for instance in the form of a Pigouvian taxation on units of carbon emission. The EU went with the alternative option of a market-based, quantity-based regulation.

Political reason behind ETS

This chapter will look into why the European Commission opted to go with the ETS as a primary form of environmental policy. Scholars studying the developments in the field have proposed several possible motivations. This research will address three plausible explanations. These reasons are not mutually exclusive and could also have added up to bring the Commission to the decision. The first reason of the EU adopting emissions trading can be found during the Kyoto Protocol negotiations. An international market for emissions trading was brought up to ease the concerns of the United States of a too rigid and strict agreement. At this point, the possibility of an international emissions trading system was included in the Protocol as an option for the future. The EU, wanting to be ahead of the curve, started working on emissions trading within its borders so it and its firms would have practical experience with the measure before it got introduced worldwide (Skjærseth and Wettestad, 2009). A second explanation points out the fact that the Commission did in fact propose to establish a European carbon tax prior to the creation of the ETS, but that this plan failed to get passed the member states (Braun, 2009). Any proposal for a European-level taxation needs to have a unanimous support in the European Council (due to the lack of competence of the EU in the area of taxation), which the carbon tax proposed at this time failed to achieve. The third reason is more directly an estimation of the political rationality of the actors within the EU. This explanation suggests that the Commission, but also the member states, were interested in the economic efficiency that could be achieved with emissions trading, prioritizing it over the ambitiousness of its environmental policy(Braun, 2009). Many aspects of the ETS can be considered ‘neoliberal’in a broad sense. First of all, the idea that the industries with high emissions can regulate their own carbon emission limits through a market, and do this better than government regulation can, is in essence a neoliberal assumption. As stated before, the expected improvement regarding efficiency and cost-effectiveness made the ETS an attractive option in the eyes of the Commission, the member states and the industrial sector. A classic liberal view on governance that includes strict regulation of markets can be said to have been replaced by a more neoliberal method of governance, where markets merely have to be made for the market mechanisms to work. Still, supervision of these markets will continue to be maintained by the European Commission to ensure outcomes are in line with set objectives. For a market in emission allowances to be considered useful and workable, it takes a certain perception towards the way greenhouse gas emission works. Specifically, it requires the commodification of the capacity of our planet to deal with greenhouse gasses (Vlachou & Pantelias, 2017). The Earth’s ability to negate emissions of carbon dioxide is considered a tradable good by proponents of emission trading, including the EU. This commodification of natural processes is in line with the ideological

consideration stemming from Coase’ Theorem. It follows the logic of Coase’ vision for property rights and matches it with the way humans interact with the planet, which is required for a market-based

environmental policy like the ETS. The ‘right to pollute’ becomes a commodity to be exchanged and private ownership of this commodity is then the solution to what would otherwise be externalities. However, there are also some other possible reasons for the establishment of an emission trading measure to be considered, that are more political rather than economic in nature.

One example of such a political reasoning is that a market-based system can be presented as an apolitical vehicle of change. It can be explained as apolitical in the sense that there is no top-down decision being made as to who wins and who loses in the developments that lead towards reaching the environmental goals as they are set in international agreements. This could be an appealing advantage in the eyes of a democratic institution, for any measure that is expected to be painful (as in, costly). This argument works even stronger in the European Union, where questions of a democratic deficit within the Union as a whole have been rising. This can make it interesting for member states to opt for measures that can be presented as apolitical, by referring to a system as ‘up to the markets’. This is not necessarily true as a lot of the market’s parameters are set through political decisions. The potential benefit for member states of this representation of the system lies in the possibility of denying responsibility for the effects towards the national electorate.

In the case of European emission trading, the initiator was the European Commission with its proposal for the ETS. The member states where interested in the system for the aforementioned reasons, but did not accept the proposal without some alterations. The most significant demand regarding the eventual operation of the ETS, was the implementation of ‘Nationalized Allocation Plans’. These plans gave the ability to determine the number of allocated emission allowances to the member states, who had the interest of their national industries in mind (Skjærseth and Wettestad, 2009). Including the member states as the key actor of the ETS that they are is essential. This will be elucidated further on in this research. Last, but not least, is the discussion of the role of companies and specifically private sector coalitions in the initial design of the ETS. Large firms, mostly in the oil and power industries, realized that they had a significant stake in any policy measures aimed at reducing carbon emissions. They realized that emission trading would prove the most cost-effective for them and initiated a lobby for the implementation of an emission trading system (Meckling & Jenner, 2016). More on the ‘lobby side’ of the process will follow in chapter 3. Not all firms that were to be affected by the ETS were eager to join the lobby. Manufacturing industries that use a lot of energy in their production processes were opposing emission trading policies. However, some scholars have argued that they mobilized their opposition when it was already too late, which lead them to be ineffective in stopping the ETS (Meckling & Jenner, 2016).

How does it work?

Design of ETS

Next up is the question of what led the European Union to leave a significant pillar of climate change policy to the markets, back in 2005 when this decision was made. The EU considers the Emission Trading System (ETS) to be “a cornerstone of the EU's policy to combat climate change and its key tool for reducing greenhouse gas emissions cost-effectively” (from the European Commission website on ETS). Interestingly enough, this description already contains a message regarding the prioritization of climate action. Reducing greenhouse gas emission is an objective of the Commission, but an emphasis has to be placed on the maximization of ‘cost-effectiveness’ of any measures. The

Commission’s attitude towards climate action, as well as its attitude towards ‘cost-effectiveness’ (or competitiveness, or growth) shape the type of policy that is made. Chapter 3 will come back to the balancing of interests the EU has continuously faced. The ETS is a result of this balancing act, and is a significant part of this policy, covering almost half of the EU's greenhouse gas emissions. This makes it an interesting subject to study the EU’s ideas on environmental policy.

The EU ETS is a ‘cap-and-trade’ system, because it works by capping the amount of allowable greenhouse gas emissions and assigning ‘EU Allowances’ (or EUA), thus creating a market were these ‘rights to emit’ can be exchanged. The creation of the EUA market lead to the development of ‘future emission’ and ‘option’ markets. Proponents of the ETS could argue that a market-based system will achieve sustainability goals in the most cost-efficient way possible. This view on emission reduction policy is ideologically in line with the previously mentioned ground principles laid out by Ronald Coase in his ‘Problem of Social Cost’. In this case the EUA, or emission allowances, represent the allocation of property rights. This EUA allocation process provides polluters in the involved sectors with the right to pollute up to a certain ‘capped’ level. The two main operating mechanisms of the ETS are the allowance allocation mechanism (who gets to emit how much greenhouse gasses) and the price mechanism (determining the cost of additional rights to emission). The system is used in four sectors that are responsible for 46% of the total CO2 emissions of energy-intensive industries in the EU. These

are the energy sector, the ferrous metal sector, the mineral sector and the paper and pulp sector. The ETS was designed to have four phases. The first phase spanned from the start of the project in 2005 to 2007. The second phase started in 2008, which is when the agreements made in the Kyoto Protocol officially came into action and ended in 2012. The third phase started in 2013 and goes on until 2020, when many intermediate goals of emission reduction have been set. The fourth phase is planned to start in 2021 and will go on until 2030.

ETS at work

The first phase of the ETS started with the National Allocation Plans that were carefully negotiated, not to say demanded, by the member states. These allocation plans are central to the entire

effectiveness of the ETS, as they largely determine the ambitiousness of the project (Skjærseth and Wettestad, 2009). What needs to be taken into account, is that a decentralized system like the one effectively created by the demands of the member states, increases the risk of over-allocation. This is because all member states will focus primarily on national interests while establishing their allocation plans, causing them to fail to take the bigger picture into account. The competition of interests of national firms will cause a ‘race to the bottom’ for emission reduction, where each member state will be overly generous to national companies (Skjærseth and Wettestad, 2009). The limiting factor to this ‘race to the bottom’, which the policy-makers behind the ETS were smart enough to add to the design, was the ability of the Commission to reject any allocation plans that would not produce the needed emission reductions as agreed upon in the international agreements. However, it more than likely meant that this lowest level of acceptable ambitiousness would be the one that the member states would attempt to reach in their allocation plans.

Failure of the ETS

Having seen the way the setting of the emission allowance works, it should come as no surprise that the ETS failed to maintain a stable market, meaning a market with stable pricing. A stable market is desirable in a system like the ETS, because part of its effectiveness comes from providing an incentive to firms to invest in emission reduction in their production process. These investment incentives work best when based on a level of certainty, which comes from predictable and stable prices. Because of the requirement for several sectors of industry to either incur the costs of actively decreasing emissions or the costs of buying EU Allowances on the market, the EU ETS was expected by many economists to have a negative impact on competitiveness of companies within the system. However, empirical evidence shows that this loss of competitiveness relative to companies outside of the EU ETS did not materialize (Koch et al, 2014). According to part of the literature, one of the main reasons the firms in the ETS have not suffered a loss in competitiveness, is an over-allocation of EUA in general and in particular an over-allocation of free EUA (Skjærseth and Wettestad, 2009). This is expected to change in Phase III when auctioning becomes more important. This over-allocation of EUA creates additional revenue streams for ETS firms who received more EUA than they use, since

they can sell the rights they got for and make a profit. The firms that need additional EUA benefit from the low prices in the market, created by the over-allocation.

It could be considered a good thing that European competitiveness was not hurt by the ETS over the first few years, while the goals of reduced greenhouse gas emissions were achieved. A rise in cost is expected to hurt the competitiveness of businesses, even when costs are shifted to the consumer directly. However, it is considered likely that the costs that were not incurred now, will have to be paid later. The reasoning behind this assumption is that the prices of EUA have been kept artificially low due to over-allocation of (free) allowances. These low carbon prices have meant that the incentives for sustainable investments have been small. When the price of EUA picks up following the auction procedures of Phase III, these investments will still have to be made, possibly leading to the expected loss in competitiveness in the European sectors. In addition, the lack of a loss in competitiveness of firms corresponds with a lack of effectiveness of the system as a whole. Some figures have the first year of the first phase were only four percent lower than the total number of allowances that was given to the firms within the system (Skjærseth and Wettestad, 2009). This is an indication of a low level of ambitiousness. This could be the result of lobbying from the business sector, which the EU would listen to with preservation of European competitiveness in mind. This type of thinking comes back in the European Commission’s reasoning, as will be detailed further in the next chapter. The market showed a similar development around that time with EUA prices dropping from 30 euros per tonne CO2 in 2006 to 50 cents per tonne in 2007 (Skjærseth and Wettestad, 2009).

The United Nations Environment Programme is concerned about this limited effectiveness when it comes to European policies regarding carbon emissions reduction. According to UN monitoring, the 28 member states of the EU as whole fall short of their cumulative unconditional ‘Nationally Determined Contributions’ (NDC), which are goals or ambitions submitted by the countries themselves with the in the Paris Agreement established limit of 2 degrees Celsius long-term global temperature rise in mind (UN 2018, p. 17). The EU submitted an ambition of a 40 percent reduction of carbon emissions compared to 1990 levels. These unconditional NDCs are expected to be the more attainable goals in comparison to the conditional NDCs, which can be affected by external factors. As such, the fact that these NDCs are not being fulfilled is a significant indicator that the EU28 as a whole is not yet doing enough to reduce carbon emissions. Furthermore, the UN data shows that after a steady decline in the period between 2004 and 2014, the EU has seen an increase in carbon emissions with an average of 1 percent per year (UN 2018, p. 31). The EU is however aware of this shortcoming of the emission reduction policies and seems determined to implement changes, as will be discussed below.

Figure 1 comes from the UN Environment Programme “Emission Gap Report 2018’, showing the ‘top greenhouse gas emitters (excluding land-use change emissions due to lack of reliable data)’. As is apparent from the figure, the EU has shown a steady decline in greenhouse gas emissions, expressed in CO2 equivalents, after a peak around the 1980’s. This is as opposed to the trends for other large

economies like USA and in a significant way also China, where emissions have grown compared to 1990 levels. Again, the 1990 level is important because it is used as a base level for reduction ambitions in the NDCs submitted to the UN. However, it is worth noting that in the very recent past, since 2014 or so, the emissions have slowly increased again.

Source: EDGAR v5.0/v4.3.2 FT2017 CO2 (Olivier et al., 2018) and Global Carbon Project (Le Quéré et al., 2018). Another point to consider when discussing weaknesses of the EU ETS, is the vulnerability of the system to some form of fraud. The specific type of fraud that negatively impacts the effects of the ETS is called the ‘value added tax (VAT) carousel fraud’. The value added tax entered into the ETS process when the EU had to decide on an adequate taxation of the transactions on the EU Allowance market. The European Commission, in cooperation with the member states, determined that the best way to handle this taxation within a member state was through the seller of EUA owing money to national tax authorities, and the seller passing this cost on to the buyer through the inclusion of a value added tax on top of the asking price. If the transaction were to pass member state borders, the buyer would be required to pay the VAT to a tax authority in its own country. The seller would not owe any taxes to their own national tax authority in this case. With this taxation mechanism in place, soon some of the affected companies within the ETS started to look for ways to minimize the part of their income paid to the tax authorities.

What follows is a brief description of how VAT carousel fraud works in theory. A minimum of three companies are generally involved; one ‘supplier’, one ‘broker’ and what is called a ‘missing trader’. The supplier sells his goods, in the case of the ETS these are EUA, to the missing trader in another member state. The tax authority of the country of the missing trader does not collect VAT on this international transaction as part of the EU Single Market agreements. Then, the missing trader sells to the broker company in the same country, charging the VAT. The missing trader does not pay this VAT to the national tax authority, as it poses it has never been part of the transaction. The broker company in turn collects the refund for the charged VAT from the national tax authority. The process is illustrated in simplified form in figure 2 below. The EU ETS is especially vulnerable to fraud of this kind, as the ‘goods’ that are exchanged are the digitally kept EUA, which greatly increases the possible speeds at which the transactions can occur (Efstratios 2012, p. 43). The delaying effects of factors like transportation and storage are also not of any influence on this market.

The effect of this specific type of fraud is not to be ignored. For 2009, data from the European law enforcement agency Europol showed that a staggering number (ninety percent) of ETS transactions were part of a scheme of fraud. From the same source, the loss for the national tax authorities was estimated to be up to five billion euros (Efstratios 2012, p. 44). It should be mentioned however, that this type of fraud is not inherent to the ETS, or caused by any side-effects of the policy. It is simply an amplifier of the flaws that exist in the current taxation and VAT laws that are applied within the EU.

Figure 2.

Based on source: Efstratios, P. (2012). Halting the Horses: EU Policy on the VAT Carousel Fraud in the EU

Emissions Trading System. EC Tax Review, 21(1), 39–51.

Fixing the ETS

The aforementioned failure of the ETS to produce a stable market with stable prices asked for a response by the governing authority. The question is, what could they do? The European Commission has taken the lead in the attempt to correct the design flaws that lead the ETS to its troubled start. This correction was primarily enacted through cuts in the national allocation proposals that the member states would submit, in order to combat the problem of over-allocation. On top of this active correction, the Commission has proposed an amendment to the plans for the third phase of the ETS, spanning from 2013 to 2020 (European Commission website on EU ETS). This gives the Commission the power to set an EU-level cap over all allocation plans, which will lead to the EU having a better insight into and better control over the ambitiousness of its total emission cap.

Another proposal by the Commission for a measure that reduces over-allocation in the short term is called ‘backloading’. The measure received some opposition from a number of member states and concerns voiced by the European Parliament. With backloading, the auctioning process that was introduced in the third phase of the ETS, gets altered. The auctioning of a certain (significant) amount of EUA is delayed. EUA worth 900 megaton of CO2 were kept from the auction for the 2013-2015

period and will be injected back through the auctioning process into the 2019-2020 market (De Perthuis & Trotignon, 2014). The overall emission cap for the third phase remains the same, but the EUA are ‘backloaded’ towards the end of the phase. The goal of the measure is to a short-term price increases by decreasing the supply in the short term. However, a risk remains that the market price will collapse when a significant amount of EUA are returned to the market at the end of the phase (Richstein et al., 2015).

Whether they will work as stated by the Commission or not, the proposals for fixes indicate a lack of trust in the self-regulating of the market. The political decision-making process of the Commission seems to have settled at a willingness to actively intervene in and regulate the emission allowance market. While it is true that the ETS cannot be considered ‘self-regulating’ when political decisions have determined its workings from its original design through its initial operation, there is still a definitive perspective of a trust of the EU governing authorities in marketization solving the problems in the most efficient manner. The belief in the commodification of the planet’s emission cycle is an indication of this. This is ideologically consistent with the rest of the ‘Coasian’ view on the

finding the optimal benefit to society as a whole, which would require a market to exist in order to work. ‘Commodifying’ previously uncommodified things like the ‘right to pollute’ is a requirement for a market to be created. This neoliberal ideology might be chosen, because it best fits the interests of retaining competitiveness in combination with climate action policy. It seems that the member states politicized the ETS in order to protect their own national interests. In response, the EU has had to put stricter regulations on the emission allowance market.

Chapter 3 will go into the various differences in interests between the member states within the European Union, both as it pertains to how the EU ETS works, as well as how alterations to the system and alternatives could come to be. These differences in political vision and/or political reasonings have played a large part in the establishment of the current system of emission reduction and they will likely continue to do so. This will be made clear using some alternatives, which will be looked at in more depth in the next chapter.

Chapter 3 – The players of the EU ETS (Institutions/Interests)

Introduction

This chapter consists of a political economy analysis of carbon pricing in general, with the specific example of an EU-level carbon tax. The analysis is focussed on a mapping of the various interests of relevant stakeholders. The aim is to address how certain policy ideas are brought to the table or why certain policies are not implemented, based on economic principles applied to political decision-making.

The chapter consists of three parts: First, a mapping of the various actors in the field and their interests. Second, an analysis of terms used in various policy documents across three relevant Phases of the ETS to concretize the findings of the first part. Finally, a look at a possible revision or a replacement of the EU ETS, including what an EU carbon tax could look like and why it could or could not be feasible.

Political economy analysis

The interest analysis of carbon pricing in the European Union, including the idea of a (Pigouvian) tax on carbon, contains a number of aspects. In line with other political economy analyses on the topic of climate change mitigation policies, these aspects will be divided into the following ‘actor groups’: 1) mapping the interests of the three majorinstitutions of the European Union that are most closely connected to the policy-making process, 2) discussing the international componentof the coordination of policy-making among member states within the EU and outside of it and 3) looking at the interests, for example from the industry sector and NGOs, seeking to influence this core policy-making

mechanism from the outside through lobbying. Furthermore, the analysis will include a look at some other economic effects like distributional effects, co-benefits and long-term commitment.

European Institutions

First, international coordination both within the EU and externally is a significant factor in the

exactly line up. The existing institutions of the EU are functionally there to ensure that these varying and sometimes conflicting interests are ultimately brought together in concrete policy measures. Within the European Union, any and all policy proposals start with the European Commission, which has the so-called legislative initiative. The European Parliament and the European Council have the right to offer proposals to the Commission in order to get them officially submitted, but the institutions have no such legislative initiative of their own.

However, the process does not end at the proposal stage. After the Commission proposes a new policy, the EP and the Council go over it and decide on any changes they wish to see. This mechanism of ‘co-legislation’ between the EP and the Council was established by the EU to the end of increasing democratic legitimacy, but it also slows down the legislative process. The co-legislation phase can go back-and-forth between the institutions a couple of times, with outside parties hoping to influence decisions at any stage.

With the proposal of the ETS, the first steps came from the Council in response to a growing concern of heads of state about the effect of human action on global warming. The Council saw the importance of the EU’s place as a leading group in the world regarding moving towards climate action policy (Nordstrom 2009, p. 7). A growing number of international climate commitments, most notably the Kyoto Protocol and the Paris Agreement, laid out the legal framework for the EU to operate its climate action in. These commitments, together with the desire for an image of a forward-thinking power, have been some of the major interests of the EU institutions. Opposed to this, the Commission is concerned with the economic effects of these policies, ranging from international competitiveness to welfare loss of its citizens. This opposition is at the core of the EU climate policy interests. The Commission has not obliged itself to fully commit to either one side or the other, instead trying to find a point of economic efficiency between the two. The interplay of both interests is seen clearly when it comes to allocating the emission permits. The over-allocation (that can occur when focusing too much on economic welfare) has the effect of lowering permit prices, rendering the ETS as a whole less effective in regards to emission reductions (Mathys & De Melo 2011, p. 1946).

Member states

Secondly, the group of the most powerful stakeholders within the European Union is represented by the Council, this being the member states. The member states have similar concerns as the EU institutions, but with a much larger variation among them. The member states’ concerns range from aforementioned economic effects to environmental concerns, but with questions of competence added to the mix. The questions of competence are asked out of a hesitation to ‘give up’ sovereignty to the EU. This is relevant to the ETS, as a carbon tax required a unanimous acceptance by all member states based on the competence of taxation remaining with them. A significant part of demands from the member states regarding the ETS, was an active role in the selling of the emission permits. The Commission gave in to these demands, with the member states acquiring 12 percent of the ETS auction rights (Mathys & De Melo 2011, p. 1946). Still, the other interests at play are held in order of importance to varying degrees among different states. A so-called ‘rich and green’ (Nordstrom 2009, p. 21) coalition can be identified in Northern Europe (Austria, Denmark, Finland, Germany, the Netherlands and Sweden), whereas on the other side a ‘fossil’ or ‘poorer and least green’ (Ringius 1999, p. 154) group can be pointed out, which is headed primarily by member states in the Balkan area. These groups are not self-assigned by the member states, but rather based on a study by Ringius (1999), who in turn based his groupings on research on the leaders in environmental policy within the European Community (Skou Anderson and Liefferink 1997). The first group lays an emphasis on environmental effect (like reductions of greenhouse gas emissions), while the second group feels more strongly about limiting loss of competitiveness and maximizing cost-effectiveness of the policy measures.

On the external side, carbon pricing measures invoke risks of free riding and what is known as ‘carbon leakage’ (Baranzini et al. 2017, p. 7-10). The term free riding is used to describe someone, or in the specific case of the ETS other countries, profiting disproportionately from a common objective.

It is important for all benefactors of a certain measure to be ‘pulling their weight’ in order to ensure continuous support for it. It is expected to be very costly for the EU and its companies to implement carbon pricing measures. Meanwhile, the entire planet benefits from the reduced emissions. It could be regarded as unfair to the EU if other countries no longer pursue similar policies because they want to benefit from the EU’s efforts, effectively free riding of these efforts. More importantly, carbon leakage is one of the most significant aspects to consider when implementing carbon pricing policy of any sort. ‘Carbon leakage’ is used to describe the effect of carbon pricing policies on policy of local companies, specifically as it relates to these companies moving away to places where these costly measures do not affect them. Competitiveness seems to be seen by the EU as the limiting factor to carbon reduction policy. While it is true that the EU has committed itself to international agreements of greenhouse gas emission limitation (to the point of achieving a less than two-degree Celsius average global warming), there seems to be no intention to adhering to these by any means necessary.

The best way to combat these external risks for the EU, would be to form a strong coalition with external partners also determined to reduce emission, with the aim of holding a significant enough level of leverage over reluctant countries. This leverage could come in the form of economic sanctions or tariffs for non-compliant, free riding countries. While a trade policy of this kind could be seen as protectionism, it is possible for the EU to avoid these accusations. The EU could implement “revenue-recycling offsets”, which comes down to outright returning any tariff revenues to the countries they were levied on, to stress that the measure is solely used to emphasise climate action (Baranzini et al. 2017, p. 9).

Industry and NGOs

The third group of stakeholders, while influential on the policy-making process, holds no formal decision-making role. Nevertheless, these actors still attempt to and actually do affect the policy decisions that are made. Several methods of influence are applied to this end. Among these are active lobbying by stakeholders, as well as the occurrence of ‘revolving door’ and ‘cognitive capture’ phenomena. In short, the term ‘revolving door’ refers to legislators moving to positions within industry in the related sectors, or vice versa. This opens up the possibility for conflicts of interest over an extended period of time. ‘Cognitive’ or ‘regulatory capture’ refers to a part of a governmental agency acting to strongly in favour of the sector it is supposed to regulate, resulting in inefficient outcomes for society at large.

This chapter will focus on the effect of direct lobbying, as lobbying has played an active part in the establishment of, revisions for and possible alternatives to the EU Emissions Trading System.

Competitiveness of European businesses remains of significant interest to the Commission. This is the main reason industry is directly involved with climate action policy-making. This has already been pointed out in chapter 2. The Commission has actively tried to get any stakeholders involved through (semi-)transparent means, seemingly to combat the image of shady backroom discussions. Actors directly affected by the ETS, mainly companies, have sought to get their interests protected in stakeholder consultations. Among these are BusinessEurope, Cefic, Eurofer and FuelsEurope, European federations representing employers, chemical industry, steel industry and fuel industry respectively. However, the lobbying is not limited to the sectors of industry directly affected by carbon pricing policies. On the “opposite side”, environmental protection organizations are working hard to influence the policy-making process in favour of stricter climate action measures (Baranzini et al. 2017, p. 7-10). At the same time, there are groups representing non-company actors tied to company interests. These groups are concerned with employment and affordability of the policy measures. As far as lobbying goes, basic economic theory would suggest that any form of carbon pricing would result in a loss of surplus for producers, while transferring this loss to the government. It would seem obvious that all industry would try to oppose measures to this effect. However, it is interesting to note that not all producers are created equal in this regard. Certain carbon-intensive industries will be hit harder than others. In the case of the ETS, this is especially visible as only specific sectors of industry are targeted by the policy. The same thing goes for industries that have high investments in