To Tax or to Trade
An Economic and Political Analysis of Market-Based Measures in EU Environmental Policy
MA Thesis in European Studies: Governing Europe Graduate School for Humanities University of Amsterdam Author: Floris de Regt December 2018
Table of contents
1. Introduction Page 3
2. Background on the EU ETS Page 6
3. Economic Dimension Page 9
3.1 Market developments Page 9
3.2 Impact of the EU ETS on Emissions Page 12
3.3 Carbon Tax Page 13
3.4 Economic Debate Page 15
3.5 Competitiveness Page 19
3.6 Conclusion Page 20
4. Political Dimension Page 22
4.1 Decision-Making Process Page 22
4.2 Linking Systems Page 25
4.3 Use of Revenue Page 27
4.4 Political Debate Page 29
4.5 Conclusion Page 32
5. Case Study: Aviation Page 34
5.1 Economic Implications Page 36
5.2 Legality of the EU ETS Page 41
5.3 Conclusion Page 43
6. Conclusion Page 44
7. Bibliography Page 47
1. Introduction
Today climate change is an important aspect of every state’s agenda within the European Union. Multiple states are trying to reduce climate change to the least possible. To reduce the buildup of greenhouse gases, it is important to take immediate action. Different measures such as emission standards for cars and for the transport of goods are already in place. Other measures such as the increased use of renewable energy are also becoming more prominent.
These measures are a promising start, but they are hardly sufficient. Many of these measures are being implemented on a national level. For example, by creating wind turbine parks. Attempts to create international agreements are also becoming more prominent, since the signing of the Kyoto Protocol and the Paris Climate Agreement.
The EU is one of the frontrunners in abating greenhouse gas emissions. In order to become a frontrunner, they have developed the largest carbon market currently in existence, the European Union Emission Trading System, henceforth called the EU ETS. The EU ETS is a market-based solution to the environmental crisis. However, it is not without its
controversies and opposition, as will become apparent in this thesis.
The EU ETS is a cap and trade system that puts a price on carbon by creating a carbon market. In the early phases allowances to emit greenhouse gases were allocated for free, but in later phases were to be auctioned off. Firms will have to buy these allowances in order to be allowed to emit greenhouse gases. A cap and trade system however, is not the only method that puts a price on carbon. Another method has gained a lot of traction as well in recent times, which is a carbon tax. This has become evident through the abundance of new research and articles about a carbon tax. A carbon tax puts a price on carbon through taxing the
emissions of greenhouse gases. The choice between a carbon tax or a cap and trade system is obviously a complicated one. Two main dimensions are at play when making this decision. The first one is the economic dimension. Both measures are market-based measures.
However, within the economic dimension there are differences between both measures such as the costs to implement them. These differences will be brought to light in this thesis. The other dimension is the political dimension. This dimension is just as important, especially within the EU as Member States have to reach a consensus. In this dimension the differences between both measures will be analyzed from a political point of view. This thesis will study what role these dimensions have played within the decision-making process.
Within the EU the choice has been made for a cap and trade system. But how has this choice been made. Is it because a cap and trade system was favorable from an economic point
of view, a political point of view or from both point of views? And if not from both, then which point of view has been more important. This thesis studies whether political factors have been prevalent over economic factors within EU decision-making from the conception of the EU ETS until now. This thesis will compare a carbon tax and the cap and trade system that is the EU ETS from an economic perspective and also from a political point of view. This enables the possibility to see which measure is preferred from their respective points of view.
It is also important to note that the EU ETS is an ambitious project that eventually aims to link their system with other compatible systems, thus creating a global carbon market.1 This can be done through the Clean Development Mechanism (CDM) and the Joint
Implementation (JI), which have been introduced under the Kyoto Protocol. These
mechanisms allow the EU ETS and other environmental measures to comply with any climate change mitigation commitments that have been made. Global aspiration might have impacted the decision for either solution. However, one can debate whether the global aspirations of this project are reasonable. In order to analyze the global possibilities of the EU ETS a case study has been included in this thesis about the aviation industry. The reason for choosing the aviation industry as a case study, is that attempts have already been made to include
international aviation into the EU ETS.
In order to find out whether the EU ETS or a carbon tax is preferred from an economic point of view, a theoretical framework is developed. This framework is used to analyze the effectiveness of the EU ETS, the costs for both industries and governments as well as for costumers. The economic viability of a cap and trade system goes side by side with its overall effectiveness. The system hinges on having a healthy market. If the market behaves
irrationally or if the price of carbon is not right, the system collapses. For example, if the price of carbon is set too low, the system is both not effective and not economically viable. The same will be analyzed for a carbon tax. In order to find out whether a carbon tax or a cap and trade System is preferred this thesis will use multiple sources that have opposing views to come to an unbiased conclusion.
For the political section another theoretical framework will be used to analyze the political viability of both the EU ETS and a carbon tax. Which of these is preferred from a political point of view? This will be answered through a wide arrange of sources from
opposing views as well as more general sources. The decision making within the EU will also be discussed. How do decisions get made and did that process have an influence on the
1 European Commission: Climate Action. 2018. “The EU Emissions Trading System (EU ETS).” Accessed on 30/11/2018.
https://ec.europa.eu/clima/policies/ets_en#tab-0-decision to go with the EU ETS instead of a carbon tax? Within the political dimension the dangers of both measures will also be discussed. Is fraud a potential issue within one or both of these measures and how do international groups and organizations fit in?
Through comparing the political and the economic dimension it becomes apparent which measure is preferred from their respective points of view. This will then show whether the political and the economic factors conflict with each other and if so, which factor is more important within the EU. Are the political factors more important within the EU or the economic factors?
At last a case study is included that will show the practicalities of adding an
international sector to the existing EU ETS. The aviation industry has been a first attempt to use the EU ETS on a global scale. Has this inclusion gone according to plan, or are there too many issues when trying to create a global carbon market? This case study provides a unique possibility to see how the world has reacted to the EU ETS. The economic and political dimensions are also applicable to the aviation industry, which enables a practical analysis of a cap and trade system with regards to the aviation industry. A theoretical carbon tax will also be analyzed.
There are multiple lessons to be learned within this thesis. It will become evident how successful the current iterations of the EU ETS have been both in the case of the aviation industry as well as in general. The EU ETS already consists of multiple phases. Has progress been made to improve upon the system or has the situation changed and is a carbon tax currently preferred? Also, the conclusion whether the political or the economic dimension has been more important during the decision-making process of the EU ETS is interesting. That conclusion might also be applicable to the decision-making process of other policies. However, further research has to be done in order to determine this with certainty.
2. Background on the EU ETS
The EU ETS has an interesting backstory which will be briefly discussed. It has had a relatively long history and has known multiple phases in which a lot of revisions have been made. The decision to establish the EU ETS was not expected. It came relatively sudden and its roots lie in the Kyoto Protocol. The EU ETS was designed to combat climate change. Because of the increasing globalization the world is becoming ‘smaller’. Firms often relocate to other states or regions that are more favorable for them to conduct their business. Usually, trying to combat climate change means that regulations are imposed upon these firms and that could be a reason for a firm to relocate. If multiple firms leave a state or a region such as the EU, this could be economically harmful for these states and regions. However, climate change is something that must be taken seriously and must be combatted. The Member States of the EU have accepted this and created the EU ETS. The EU ETS is the world’s first major carbon market and is also currently the largest.2
The goal of the EU ETS is to reduce greenhouse gas emissions and the challenge is to maintain competitiveness on a global scale. The EU ETS functions via a so-called principle of ‘cap and trade’. This means that on the EU level a cap is created that sets a maximum amount of greenhouse gases that can be emitted into the air in a certain year. This cap can never be exceeded and therefore the amount of greenhouse gas emissions is controlled. In order to stay beneath this cap, a certain number of allowances are given out and auctioned off to firms. Firms have to be in possession of allowances in order to emit greenhouse gases. One
allowance is the equivalent of one tonne of carbon dioxide.3 At the end of the year firms have
to surrender allowances equal to the amount of carbon dioxide they have emitted. If they are unable to surrender the correct amount of allowances, they are subject to heavy fines.4
The EU ETS consists of multiple phases. The phases will now briefly be described but a more extensive look at certain aspects of these phases will come in a later chapter. The first phase lasted from 2005 until 2007. This period was mostly used as trial and error. Since the European Commission was the first to start a major cap and trade System, the results were unknown beforehand. It turned out that too many allowances were given out during the first phase. This led to the price of allowances during this period to reach virtually zero in 2007.5
The second phase lasted from 2008 until 2012 and the number of allowances given out was reduced by 6,5%. This did not improve the situation because of the economic depression that
2 European Comission. 2018. “The EU Emissions Trading System (EU ETS).” Factsheet. 2. 3 Ibid.
4 Ibid. 5 Ibid.
occurred during those years. The depression had as a result that firms emitted less greenhouse gases, which in turn reduced the demand for allowances. There are also the third, which we are currently in, and the fourth phase, but these will be discussed at a later stage.
As stated before, firms are required to surrender allowances. There are multiple ways to get hold of allowances. Especially during the first phases the governments were providing allowances mostly for free. If the allowances the governments provided were not enough, companies had to take a different approach to gain extra allowances. The first method to gain extra allowances, is to use any reserve allowances the firm still has from the previous year. If a firm does not have any reserve allowances, they have to buy allowances.6 These allowances
can be bought from other firms that have allowances that they do not need. The possibility to sell allowances is an incentive for firms to reduce greenhouse gas emissions as much as possible, because in that way they are able to turn a profit by selling their allowances. The possibility for firms to sell allowances, or in other words sell the right to emit greenhouse gases, is a feature that is unique to cap and trade systems.
An important question is how the allocation of allowances takes place. A portion of the allowances are distributed amongst firms equally, while the remaining allowances are put up for auction. Firms can place bids on allowances. Naturally, this leads to the biggest polluters offering the most money for allowances because they have the most need for them. Because these firms have to pay a lot of money for allowances, the idea is that the next year they will have decreased their emissions. This way they have to spend less money on allowances and thus increasing their profits. The amount of free allowances that are being allocated is decreasing annually. Free allowances were used in order to let firms get used to the new system. Since the EU ETS was a new project, the amount of allowances that should be allocated for free was unknown and a trial and error system was used.
In 2020 free allowances will only amount to 30% for manufacturing industries and in the aviation sector there will still be a high percentage of 82%.7 The allocation of free
allowances is done by rewarding the most efficient firms. So, firms that innovate the most and put in the most effort at reducing emissions need to have less allowances and on top of that, receive more free allowances and therefore the EU ETS financially rewards innovation.
To make sure that every firm complies with the rules of the EU ETS, firms have to provide emissions reports yearly. Along with this report they surrender the amount of allowances that are equal to the amount of greenhouse gases emitted. These allowances are
6 Ibid. 7 Ibid, 4.
then destroyed, so that they do not exist anymore and can never be used again. If a firm does not have enough allowances, as stated before, they get fined. Another punishment is that the name of the company that does not have enough allowances gets published publicly.8 This is
used as an extra incentive for firms because they do not want to get in a bad spotlight. The EU ETS also provides the possibility of a global carbon market. cap and trade systems can be linked together if the governing bodies desire to do so. It is not hard to imagine an independent body assessing the annual reports of multiple firms.
In 2013 the third phase came into effect and this phase is supposed to last until 2020. This phase is mostly used to strengthen the current system and harmonize rules. Also, the EU ETS has had issues with a surplus of allowances in the first phases because too many were allocated for free. This means that the carbon market cannot function properly. During phase 3 it was decided to remove 900 million allowances and put them in a newly created market stability reserve.9 By doing so the demand for allowances, and therefore the price, should rise.
From this basic overview of the EU ETS it has become clear that the EU ETS
functions through a system of allowances. It has been created to combat climate change and it has been a project of trial and error. It has the potential to become a global phenomenon but it is still in its infancy. Every new phase tries to fix the problems that existed in the previous phase. Through this method eventually a successful system will emerge. The functioning of a carbon tax will be introduced later in this thesis.
8 Ibid. 9 Ibid, 6.
3. Economic Dimension
Because the EU ETS is already in place within the EU, the EU ETS will be analyzed using concrete data and information. A potential carbon tax will be analyzed using more theoretical data and information. The economic dimension consists of two critical issues. The first one is the effectiveness of the EU ETS and the potential effectiveness of a carbon tax. The second issue is the costs and also the benefits of both measures. This chapter will find out which of the two measures is preferred from an economic point of view. Is the EU ETS the prime measure to combat climate change from an economic point of view or does a carbon tax have the upper hand. The answer to this question is of importance because it gives insight into whether the choice for the EU ETS has been an economic one. If a carbon tax is preferred from an economic point of view it becomes apparent that economic factors are not the deciding factor in the decision to go with the EU ETS instead of a carbon tax. This chapter is divided into a number of subchapters in order to allow this question to be answered.
3.1 Market Developments
Since the EU ETS is a market-based measure it is reliant upon the market to give the
appropriate price for allowances. In order for the EU ETS to be effective, the market must be healthy and rational. This sub chapter aims to answer the question of how the carbon market and the price of carbon have developed themselves. Has the market behaved rationally and does the price of carbon accurately reflect supply and demand?
In some ways the EU ETS is just like any other market. It responds to supply and demand. However, it is also different in other ways. An ordinary market functions solely through supply and demand. In the case of the EU ETS there is the added desire to lower emissions. If the market decides the price of allowances is too cheap, then the amount of emissions being put out by firms will not become less. The first phase of the EU ETS will be used to look at the development of the carbon market. The reasoning behind this is that the first phase has the most accurate data available.
An important factor of the EU ETS is that it allows for a lot of flexibility concerning the use of allowances. As mentioned before, companies have to hand over allowances annually and also have the ability to save allowances to use them in a future year. Another interesting aspect of the EU ETS is that firms are able to borrow allowances from future years. For example, if a firm does not have enough allowances in a certain year, they can
borrow allowances that they will receive in the next year.10 This has its limitations though.
The ability to borrow and save allowances from future years is only possible within the same phase. It is not possible to borrow allowances from a new phase. Possible reasons for this limitation are the fact that it otherwise becomes possible to infinitely borrow allowances from future years which effectively eliminates the entire purpose of allowances. Another reason is that when transitioning between phases new legislation is made which change the way allowances work or the amount of allowances that are available.
Because of the infancy of the project it was unclear how the first phase would end. It might have ended with a surplus of allowances or a shortage across the board. When the end of the first phase was near it became apparent that there was a massive surplus of allowances. The end of the first phase also showed how volatile the market was.11 One of the reasons for
this volatility was that there was a surplus of allowances. There was a low demand of allowances which drove the price down. Another reason for the volatility of the price is that when the end of a phase is nearing, every firm will want to get rid of any surplus allowances they still have because they will become worthless in the following year. This was solved by allowing firms to save allowances over multiple phases, whereas borrowing remained prohibited.12
A potentially dangerous way in which the market could have developed, is one in which a certain number of firms hold the majority of allowances and thus creating a
monopoly. This would lead to price manipulation. Ellerman has found that the top ten firms with the largest amount of allowance allocation accounted for 33% of the allocation total.13 At
first glance this seems like a significant number. However, an analysis that used the so called Herfindahl-Hirschman Index (HHI) has shown that this does not equal to a potential
monopoly or excessive market power.14 This means that the allowances are being allocated in
such a way that it is not harmful for the market. It does remain important to keep an eye on the HHI index and keep evaluating whether certain firms are garnering too much power. This is potentially a negative effect of the EU ETS. If a situation were to arise in which a few firms hold too much power, the market becomes unhealthy and the EU ETS will become less effective as a result. This is however preventable by keeping an eye on the HHI index. The price of carbon is an important factor for the EU ETS’s goals. When the EU ETS 10 Denny Ellerman and Frank J. Convery, Christian de Perthuis. 2010. Pricing Carbon: The
European Union Emissions Trading Scheme. Cambridge: University Press. 124. 11 Ibid, 126.
12 European Commission: Climate Action. 2015. “EU ETS Handbook.” 133.
13 Ellerman, Convery, de Perthuis, “Pricing Carbon.” 127. 14 Ibid.
launched on January 1st 2005, the price of an allowance (EUA) was 8 euros.15 The price
surged to 20 euros over the next six months and went as high as 30 euros. At the end of the first phase it became apparent that many firms had leftover allowances which caused the price of allowances to plummet and reach 0.02 euros at the end of 2007.16 During the second phase
the price of carbon has been between 15 and 25 euros. In figure 1.1 the price of carbon can be seen from the 26th of October 2009 till June 13th 2018.
Figure 1.1 Historical prices of one Tonne CO2 in Euros17
The price of carbon is not solely driven by supply and demand. There are also other factors such as weather conditions. During a cold summer the demand for heating will rise, which impacts the price of carbon. The amount of electricity generated through solar energy and wind turbines is also different each year. These unpredictable events are a cause of the
volatility of the carbon price. Firms dislike this volatility because they do not know how much they will have to spend on allowances beforehand.18 However, it can also be argued that these
firms already deal with the volatility of energy markets such as the markets for gas, crude oil, coal and electricity.
It has become clear that the carbon market behaves rationally and that the price of carbon accurately represents supply and demand. Because of leftover allowances during the first phase the demand for allowances was low and therefore the price was also low. This is
15 Ibid, 141. 16 Ibid, 142.
17 “Markets Insider,” CO2 European Emission Allowances History, Accessed on 08/10/2018.
http://markets.businessinsider.com/commodities/historical-prices/co2-emissionsrechte/euro Graph directly copied from source.
18 Reuven S. Avi-Yonah and David M. Uhlmann. 2009. “Combating Global Climate Change: Why a Carbon Tax Is a Better Response to Global Warming Than Cap and Trade.” Stanford Environmental Law Journal 28, no. 1. 42.
how the market is supposed to behave, but in the case of the EU ETS a low carbon price is not desirable.
3.2 Impact of the EU ETS on Emissions
In the previous section the price of carbon and the way the market behaves itself has become clear. This section will answer the question whether the EU ETS has had an impact on reducing emissions during its first phases even though the price has been volatile and relatively low.
The general consensus is that the price of an allowance needs to reach 40 euros per tonne CO2 in order for the EU ETS to be effective at combatting emissions.19 Apart from the
price of carbon being volatile, it also never reached the previously established 40 euros mark that is needed for the EU ETS to be effective at combatting emissions. While this implies that the EU ETS has not been effective, Jan Abrell, Anta Ndoye Faye and Georg Zachmann argue that this is not true. They retrieved firm-level data from 2101 firms regarding emissions. 20
Their results were that during the first phase emissions from these firms increased by two percent. The reason for this increase is that during the first phase too many allowances were allocated for free, meaning that these firms did not have to purchase any themselves.
However, during the second phase emissions from the same firms dropped and at the same time there was a shortage of allowances.21 They analyzed whether this decrease in emissions
was due to the EU ETS or because of different factors such as the economic environment. The reduction in emissions was significant even after accounting for economic activity and
therefore they concluded that the reduction in emissions has been a direct result of the shift from the first to the second phase of the EU ETS.22
These results are positive regarding the future of the EU ETS. The success during the second phase was mostly due to the lower amount of free allowance allocation. It is widely recognized by scholars such as Barry Anderson and Corrado Di Maria that the overallocation of allowances is detrimental to the success of the EU ETS.23 If the allocation of allowances
19 “Prices in the EU ETS: Internal briefing note.” 2017. Sandbag. Accessed on 01/12/2018.
https://sandbag.org.uk/wp-content/uploads/2017/03/Prices-in-the-EUETS-Sandbag.pdf. 1.
20 Abrell, Jan, Anta Ndoye Faye and Georg Zachmann. 2011. “Assessing the impact of the EU ETS using firm level data.” Working Papers of Bureau d'Economie Théorique et Appliquée. No. 37. 21 Ibid, 5.
22 Ibid, 9.
23 Barry Anderson and Corrado Di Maria. 2011. “Abatement and Allocation in the Pilot Phase of the EU ETS.” Environmental and Resource Economics. Vol 48, no. 1. 83-103.
were to drop even lower, the effectiveness of the EU ETS will rise accordingly.
Other parties believe that the EU ETS is ineffective. Olivier Gloaguen and Emilie Alberola researched the effects of the EU ETS during the first and second phases. Unlike Abrell, Ndoye Faye and Zachmann they attribute the reduction in emissions to different factors. The first factor being the European targets that included a 20% contribution of renewable energy.24 By increasing the use of renewable energy a reduction in emissions is
inevitable. Another factor being the economic downturn during the second phase. Gloaguen and Alberola claim, unlike Abrell, Ndoye Faye and Zachmann, that the economic downturn did in fact play a role albeit not a very significant one.25
The answer to the question whether the EU ETS has had an impact on reducing emissions during its first phases remains unclear. Multiple studies argue the opposite of each other. In order to provide a conclusive answer, the third phase has to be analyzed when it has come to its conclusion (2020). If the EU ETS has in fact been effective, it has not been effective in a significant way. What both studies do agree upon is that the first phase has not been effective due to the overallocation of allowances.
3.3 Carbon Tax
A carbon tax is an alternative to cap and trade systems like the EU ETS. In some ways they are similar such as the fact that both measures place a price on carbon. They also both attempt to achieve a reduction in emissions. The method through which they try to achieve this goal is different however. This section answers the question of how a carbon tax functions and how it is different from the EU ETS. The debate between scholars about both solutions will be discussed in the chapter following this one.
A carbon tax is a tax that is levied on fossil fuels.26 A carbon tax is flexible in the sense that it
applies to firms, but it can also be extended to be applied to households. By levying a tax on fossil fuels firms will be incentivized to reduce emissions. The carbon tax, like the EU ETS, encourages energy saving and investments in energy efficiency improvements.27 The higher
24 Olivier Gloaguen and Emilie Alberola. 2013. “Assessing the factors behind CO2 emissions
changes over the phases 1 and 2 of the EU ETS: an econometric analysis.” CDC Climate Research Working Paper. No. 15. 29
25 Ibid, 29/30.
26
Lin Boqiang and Xuehui Li. 2011. “The effect of carbon tax on per capita CO2 emissions.” Energy Policy. Vol 39, no 9. 5137.the level of the tax the more likely it is that firms abate emissions. The level of the tax is set by the governing body. It is of importance that the level of the tax is just right. If it is too low the same issues that plague the EU ETS arise, which are that firms do not need to abate emissions. If the price is too high however, firms will pass on extra costs to customers and in doing so put extra strain on society.
An advantage a carbon tax has over cap and trade systems is that by using a tax the price of emitting carbon is clear and does not change. Firms know exactly how much they have to pay for their emissions. On the other hand, under a carbon tax there is no way to know how much greenhouse gases will be emitted during a certain year. A cap and trade system has a hard cap that determines the maximum amount of possible emissions. A carbon tax has no such feature and as such it is possible that no abatement of emissions takes place. Having a hard cap like the EU ETS has seems like an advantage, but it also has a downside. Because of the hard cap overachieving emissions abatement is unlikely. The reason for this is that if multiple firms overachieve, they will have an abundance of allowances through allocation. The market will then be flooded with these allowances and thus driving down the price of allowances. Instead of abating emissions, other firms will buy these cheap allowances. This will cause the hard cap to be reached basically every time. The only way to lower emissions below the hard cap is to lower said cap. Under a carbon tax there is more financial stimulation to keep abating emissions because the less a firm emits the less they have to pay.
According to Reuven and Uhlmann a carbon tax has more benefits over cap and trade systems. They argue that a tax brings in more revenue than a cap and trade system does.28 The
reasoning behind this statement is that all the costs incurred through the tax goes towards the governing body. In the case of a cap and trade system however, the allowances that are allocated for free do not yield the governing body any revenue. If no allowances were to be allocated for free, both systems would theoretically yield the same amount of revenue, but this situation is unlikely according to Reuven and Uhlmann.29
Both measures are viable and economists often debate each other over which the preferred solution is. An argument that often comes up is that a carbon tax is preferred because there are less incentives to abate emissions under a cap and trade system because of the freely allocated allowances.30 This is not necessarily true because firms can sell their allowances, so if they are
unable to do so, they will still incur an opportunity cost. 28 Avi-Yonah and Uhlmann, “Combating Global Climate Change.” 40. 29 Ibid, 41.
30 Lawrence H. Goulder and Andrew Schein. 2013. “Carbon taxes vs. cap and trade: a critical review.” NBER
A carbon tax is different from the EU ETS in a lot of respects, but in a sense, it functions the same way. The main feature of both systems is that it places a price on carbon and in doing so provide a permanent incentive to abate emissions, something regular
regulations have lacked to do. There are even parties such as Lawrence Goulder and Andrew Schein, that believe that a carbon tax and a cap and trade system can be designed almost exactly the same.31 It does however appear that a carbon tax would yield more revenue than a
cap and trade system would, because it is unlikely that the governing body would cease to hand out any free allowances. From an economic point of view the carbon tax is preferred. There are however more aspects to both measures. In the next section the debate between scholars and academics about both measures will be highlighted.
3.4 Economic Debate
Within the academic community there is a lot of debate whether a carbon tax or a cap and trade system is preferred. It is of importance for this thesis to highlight this debate. This section will answer the question of which measure is preferred by academics and why that is the case. This question will be answered by using sources from academics from both sides. Their arguments will be put side by side in order to come to an objective conclusion.
Academics disagree with each other on the subject of carbon markets. Some question the efficiency of carbon markets in general. Benjamin Stephen and Matthew Paterson for example, they call the current situation regarding carbon markets “bleak” and “gloomy”.32
Regarding cap and trade systems they fear that the demand for allowances will remain low because of the voluntary aspect of a lot of cap and trade systems. In the case of the EU ETS they have their doubts about the efficiency because of the overallocation of allowances.33 Six
years after their publication it can be concluded that Stephen and Paterson have been right in their prediction. The EU ETS still suffers from overallocation and therefore demand for allowances has remained low. Another prediction Stephen and Paterson have made, was that carbon markets were not going to disappear, which is another prediction that has proven to be true.34 Carbon markets are still here and are called ‘the new politics of pollution’, which was
coined in 1992 by a scholar named Albert Weale. Weale believed that end-of-pipe regulations were no longer enough and economic incentives needed to be implemented in order to
31 Ibid, 28.
32 Benjamin Stephan and Matthew Paterson. 2012. "The Politics of Carbon Markets: An Introduction."
Environmental Politics. 546.
33 Ibid. 34 Ibid.
achieve environmental goals.35
Both a carbon tax as well as a cap and trade system, like the EU ETS, are regulations that have their fundamentals in economic incentives in order to reach environmental goals. Historically speaking, cap and trade systems have existed since the 1970s and the 1980s on a very small scale and in the 1990s a cap and trade system on a larger scale was created after amendments were made to the Clean Air Act in the United States of America.36 One hundred
coal-fired power plants joined this new system and this experiment was a success. The power plants reduced their emissions faster and by a larger amount than required by law.37 This has
shown that cap and trade systems can be successful and afterwards cap and trade systems were often proposed as the solution for the environmental crisis.
Even though a cap and trade system has had the aforementioned success, multiple academics favor a carbon tax. Bruce Lippke and John Perez-Garcia for example, are confident that a carbon tax is more efficient in reducing emissions.38 Their argument is that under a
carbon tax every tonne of CO2 has to be paid for, nothing is given out for free. At the same
time the tax must be adaptive. This means that the level of the tax varies in accordance with external factors. Even though this creates a very efficient measure to combat emissions, it also eliminates a large feature a carbon tax has. Namely, by using a carbon tax instead of a cap and trade system firms know exactly how much they have to pay. Furthermore, an adaptive tax requires an institution that constantly analyzes external factors that could influence the tax level. This adds administrative costs.
Almost universally agreed upon by academics is that a market-based solution is the best measure in order to reach environmental goals. Some of the most famous authors in favor of a carbon tax are Gilbert Metcalf and David Weisbach. They wrote an extensive article
concerning the carbon tax called: ‘The design of a carbon tax’.39 In this article Metcalf and
Weisbach discuss extensively how a carbon tax must be designed and they argue that a carbon tax is preferred over a cap and trade system. To back their claims, they refer to multiple different authors. Two of these authors are Michael Hoel and Larry Karp. They created models that calculated the effects of both a tax and of quotas, such as a cap and trade system,
35 Ibid, 547.
36 Gerald R. Visgilio and Diana M. Whitelaw. 2007. Acid in the Environment: Lessons Learned and Future
Prospects. New York: Springer Science & Business Media. 228.
37 Ibid.
38 Bruce Lippke and John Perez-Garcia. "Will Either cap and trade or a Carbon Emissions Tax Be Effective in Monetizing Carbon as an Ecosystem Service." Forest Ecology and Management. 2162.
39 Gilbert E. Metcalf and David A. Weisbach. 2009. “The Design of a Carbon Tax.” University of Chicago
on greenhouse gas emissions.40 They concluded that a tax is more beneficial than any system
that uses quotas. Furthermore, Hoel and Karp deem it unlikely that quotas can overcome the benefits of a tax from an economic point of view.41 An important side note is that Hoel and
Karp have used estimations in their models as there is not enough practical data available. Their estimations have been generous for systems using quotas, but once there is more practical data available their model should be reused using this data.42 Another major
proponent of a carbon tax, who is also mentioned by Metcalf and Weisbach, is William Nordhaus. Nordhaus has written: ‘To Tax or Not to Tax: Alternative Approaches to Slowing Global Warming’.43 Nordhaus states that in a situation of uncertainty a tax is preferable to a
cap and trade system.44 The argument is that uncertainty causes the price of allowances to
fluctuate, which has already been shown in a previous chapter to be a negative effect. Nordhaus also states that the volatility of allowance prices cannot be controlled as that requires the possibility of borrowing and banking of allowances.45 Nordhaus wrote his article
in 2007 and in the meantime the EU ETS has been allowing the banking and borrowing of allowances. This suggests that some form of price control is now possible.
An issue concerning a carbon tax is also brought up by Nordhaus. This issue is the issue of administration. David Victor agrees with Nordhaus on this issue. Victor argues that every state that has applied a carbon tax, has at the same time also added a loophole for this tax.46 An example of such a loophole is the use of subsidies. If a state applies a carbon tax to
the coal industry, this state can at the same time create a subsidy for the coal industry. This creates a situation wherein it appears as if a state is reducing greenhouse gas emissions, but in practice nothing has changed. In order to create an effective carbon tax without these
loopholes it must be internationally checked by an independent organization. Nordhaus believes this is possible, but Victor states that enforcing a tax on an international level will be difficult because of the weakness of international law.47 It is compelling to agree with Victor,
since enforcing an international tax seems difficult, if possible at all.
Apart from the aforementioned proponents of a carbon tax there are also well-known
40 Michael Hoel and Larry Karp. 2002. "Taxes Versus Quotas for a Stock Pollutant." Resource and Energy
Economics. Vol. 24. no. 4. 367-384.
41 Ibid, 80. 42 Ibid, 382/383.
43 William D. Nordhaus. 2007. "To Tax or Not to Tax: Alternative Approaches to Slowing Global Warming." Review of Environmental Economics and Policy. Vol 1, no. 1. 26-44.
44 Ibid, 37. 45 Ibid, 37/38.
46 David G. Victor. Collapse of the Kyoto Protocol and the Struggle to Slow Global Warming. Princeton: Princeton University Press, 2001. 86.
academics that are proponents of a cap and trade system, such as Nathaniel Keohane who has written: ‘cap and trade, Rehabilitated: Using Tradable Permits to Control U.S. Greenhouse Gases’.48 Even though Keohane’s article is meant to be applicable to the US, it is also
applicable to the EU since it discusses cap and trade systems in general. Keohane recognizes that multiple respected economists favor a carbon tax over a cap and trade system. Keohane does not understand why this is the case since the current method, cap and trade, is more than capable of reducing greenhouse gas emissions.49 A key element in Keohane’s article is the
fact that under a carbon tax the amount of greenhouse gas emissions that is being reduced is uncertain.50 Furthermore, Keohane does not believe that the price volatility causes a major
problem for cap and trade systems. Oftentimes carbon tax proponents argue that the price volatility causes firms to be reluctant to make large investments in abatement technologies. Keohane argues that firms are reluctant to make these investments whether there is a carbon tax or a cap and trade system. Investment decisions are solely based on the potential return on capital.51 Following this reasoning, the volatility of the return on capital is important rather
than the volatility of emission prices. Keohane himself describes it best: “Volatility in
investment returns is not unique to cap and trade: it will also arise under a carbon tax. This is because the return from investing in abatement depends not only on the price of emissions, but also on the marginal costs of alternative abatement techniques.”52 The issue that firms are
not willing to invest in abatement techniques does not apply solely to a cap and trade system but also to a carbon tax. While Keohane’s arguments are strong, it is difficult to deny that the price volatility of allowances is a negative aspect of cap and trade systems and as long as overallocation takes place, there is no need for firms to invest in abatement techniques at all.
Keohane also has a reply to Nordhaus’s argument that price volatility has major disruptive effects on markets.53 According to Keohane this concern is not valid. The argument
being that Nordhaus bases his belief upon markets that are bad examples of carbon markets. An example of such a market is the RECLAIM market in Southern California. In this market allowance prices rose in such a fast and high fashion that the program had to be temporarily suspended.54 The issue in this market was that price was not driven by supply and demand but
by market power. The price did not grow organically and as seen in a previous chapter the EU
48 Nathaniel Keohane. 2008. "Cap and Trade, Rehabilitated: Using Tradable Permits to Control U.S. Greenhouse Gases." Review of Environmental Economics and Policy. Vol 3. No. 1. 42-62.
49 Ibid, 42. 50 Ibid, 47. 51 Ibid. 52 Ibid, 51. 53 Ibid. 54 Ibid.
ETS has already been proven to not be driven by market power through the HHI index. Market power however, is a valid concern for cap and trade systems in general.
Economists are divided on the subject of a carbon tax versus a cap and trade system. The majority does lean towards a carbon tax, but others, such as Keohane, argue for a cap and trade system. The carbon tax has some negative features such as the administration and enforcement of it. This is especially true if it becomes international or even global. However, within the EU it is possible to establish an independent organization in charge of the
administration of the carbon tax. Furthermore, some cap and trade systems that have been discussed by carbon tax proponents have been relatively small, such as in the RECLAIM case. Still the price volatility of cap and trade systems have a large impact upon the desirability of cap and trade systems. Most academics agree that this is a cap and trade system’s largest issue. A carbon tax is mostly preferred by economists and scholars.
3.5 Competitiveness
Firms often dislike new regulations because it causes them to incur more costs. Both a carbon tax and a cap and trade system cause this. This can potentially cause for competition issues with firms that are in states that do not have these regulations in place. This section will answer the question whether a carbon tax or a cap and trade system cause issues with competitiveness and whether one or the other suffers from more issues.
The danger of a decrease in competitiveness is that firms will likely relocate to a different region with more favorable regulations.55 This phenomenon is called carbon leakage.
For example, a steel company that resides within the EU has to pay for allowances in order to create steel. In order to have the same profit as they did before the EU ETS, they have to put a higher price tag on their steel. If another firm wants to buy their steel, they have to pay this higher price tag. In order to avoid this, that firm will buy their steel from a firm outside of the EU. This has a negative effect on firms residing within the EU and as a direct consequence also on the EU itself. This issue also applies to a carbon tax.56
Finding a solution to this problem is complicated. A potential solution is to impose higher import tariffs on goods that fall under the EU ETS. However, this would create a new problem. The prices of goods will still rise and likely be imposed upon the consumer. Also, if
55 Julia Reinaud. 2009. “Trade, Competitiveness and Carbon Leakage: Challenges and Opportunities.” Energy,
Environment and Development Programme Paper. Vol 9, no. 1. 6.
firms decide to relocate, it influences the effectiveness of the EU ETS, since these firms now emit the same amount of greenhouse gases elsewhere.57
The threat of carbon leakage is one of the larger problems both a carbon tax and cap and trade systems face. Neither measure is preferred from this point of view. The only solution that fully resolves the issue is to create either a global carbon tax or a global cap and trade system. This resolves the issue because if all states are bound to the same regulations, carbon leakage will cease to exist.58
3.6 Conclusion
This chapter has discussed how a carbon tax as well as the EU ETS and cap and trade systems in general fit in the economic dimension. Within the EU it has become apparent that the EU ETS has to date not functioned at a level that is acceptable. It has largely been ineffective at combatting greenhouse gas emissions. A major reason for this ineffectiveness has been the price volatility of allowances, as well as the overallocation of allowances. Both of these issues have improved over the span of the second and third phase, but it is not yet at an acceptable level. While some authors have argued that the EU ETS has in fact been effective at
combatting greenhouse gas emissions this has been disputed by others. Even if it has had an effect it is not very significant.
A carbon tax does not suffer from these issues. There is no price volatility under a carbon tax since the price never changes. This means that firms have a clear grasp on how much they have to pay towards emissions reductions. Since they know exactly how much they need to pay, they are also more inclined to put more resources towards abatement research. Furthermore, it has become apparent that overachieving does not happen within a cap and trade system because there is no incentive to do so. In the case of a carbon tax overachieving will always be profitable.
Also, while scholars argue amongst themselves about which the preferred measure is, most favor a carbon tax. Their arguments are convincing and while Keohane manages to give convincing counter-arguments the carbon tax is still clearly the preferred choice. From an economic point of view this becomes even more clear when looking at the revenue both measures provide. Because of the free allocation of allowances, a lot of potential revenue goes to waste under a cap and trade system. Under a carbon tax no revenue would be lost. This
57 Julie Reinaud. “Trade, Competetiveness and Carbon Leakage.” 6. 58 Ibid.
revenue can be reinvested in abatement techniques or renewable energy. While a carbon tax is difficult to administrate, it is possible within the EU. Within the EU it is possible to set up an independent institute that checks all Member States.
Both measures suffer from competitive issues that cannot be resolved until a global solution is found. A global carbon tax or a global cap and trade system both seem difficult to achieve, but this will be discussed in the next chapter. While it is widely agreed upon that a market-based solution is the best solution to combat greenhouse gas emissions, it can be concluded that a carbon tax is the preferred measure as opposed to a cap and trade system. However, within the EU the choice has been made for a cap and trade system regardless. Since economics point towards a carbon tax there must be political reasons to choose for a cap and trade system. The next chapter will discuss the political aspects of a carbon tax and a cap and trade system.
4. Political Dimension
The previous chapter has highlighted the EU ETS, cap and trade systems in general and a carbon tax from an economic point of view. It has concluded that from an economic point of view a carbon tax is favorable. This suggests there have been different reasons for the founding of the EU ETS. This chapter aims to answer whether this has been because of political implications. In other words, is a cap and trade system preferred to a carbon tax from a political point of view? The political aspect of every decision is especially important in the EU because of its many Member States. Oftentimes Member States disagree on the direction the EU needs to take. This causes for lengthy debates about all kinds of subjects. These lengthy debates make it difficult to create new legislation, especially large projects such as the EU ETS or a potential carbon tax. That being said, the need for a measure to combat climate change has been on the agenda since the end of the 1980s and the beginning of the 1990s.59
This chapter will highlight the decision-making process that has led to the establishment of the EU ETS and its future revisions. It will also look at the potential for the EU ETS to become a more international or even global phenomenon. Other political implications that will be discussed are the use of revenue gained through the EU ETS and, like in the previous chapter, the political debate about both solutions between academics.
4.1 Decision-Making Process
The decision to create a carbon market has been an interesting and sudden one. Up until the 1997 Kyoto Protocol the EU has been one of the leading skeptics towards international emissions trading.60 Afterwards they changed their position. Why did they change their
position and what was the decision process to go for emissions trading rather than a carbon tax or another measure? Those are the questions this section will answer. These answers are valuable because they will give insight into the reason for the choice of the current system instead of a carbon tax. Perhaps a carbon tax was discussed but deemed impossible?
Discussions about a potential pilot scheme within the EU for emissions trading started in June 1998.61 The European Commission wanted the EU to be able to show climate policy
progress by 2005, which was also outlined in the Kyoto Protocol. Originally their ideas for the 59 Benjamin Stephan, Richard Lane. 2014. The Politics of Carbon Markets. New York: Routledge. 118.
60 Skjærseth, Jon. B. and Jørgen Wettestad. 2009. “The Origin, Evolution and Consequences of the EU Emissions Trading System.” Global Environmental Politics. Vol 9, no 2. 101.
EU emissions trading system were fairly narrow in scope, but this changed in the ETS Green Paper of 2000.62 It is curious as to why the Commission changed its mind regarding emissions
trading because before the Kyoto Protocol they opposed this idea and were in favor of domestic actions.63 The reason for this is that during the Kyoto Protocol the EU and the US
clashed on certain subjects, such as a binding target. The US did not favor a binding target and also demanded that emissions trading was to be included in the Kyoto Protocol.64 The US
got what they wanted and emissions trading was included.
The Commission committed themselves that between 2008 and 2012 emissions had to be reduced by 8 percent since 1990.65 The Commission and the Member States of the EU felt
that this target was mandatory and in order to hit the target new policies needed to be created. The commission figured that using emissions trading was going to be the most cost-efficient method to reach that target. While the Kyoto Protocol only gave a vague description of an emission trading system without a specific design, the Commission created their own version which was far more extensive and complex.
So, while the Commission was at first skeptical of emissions trading, they later
became one of the frontrunners. Interestingly enough before emissions trading became on the Commission’s agenda, they proposed a carbon tax in the early 1990s.66 A carbon tax is a
financial measure and therefore has to be adopted unanimously by all Member States in the Council. This required unanimity proved to be an important political aspect as to why a cap and trade system is preferred to a carbon tax within the EU. There was strong opposition from both industries as well as from Member States that made it impossible to achieve a consensus regarding a potential tax.67 If such a tax were to be agreed upon this also mean that the tax
competence of Brussels had to be elevated. A cap and trade system however, requires no anonymity. Being an environmental policy measure, emissions trading only requires a qualified majority, which is based on Art. 175 (1) of the EU Treaty.68
It has become clear that it was easier to go for emissions trading rather than some form of a tax, because of the required unanimity to create a tax. However, why did Member States
62 ibid. 63 Ibid.
64 Marcel Braun. 2009. “The evolution of emissions trading in the European Union – The role of policy networks, knowledge and policy entrepreneurs.” Accounting, Organizations and Society. Vol 34, no. 3. 472. 65 Skjærseth and Wettestad. “The Origin, Evolution and Consequences of the EU Emissions Trading System.” 107.
66 Atle Christiansen and Jørgen Wettestad. 2003. “The EU as a frontrunner on greenhouse gas emissions trading: how did it happen and will the EU succeed?” Climate Policy. Vol 3, no. 1. 6.
67 Ibid.
68 Braun “The evolution of emissions trading in the European Union – The role of policy networks, knowledge and policy entrepreneurs.” 473.
oppose a tax? Initially the EU ETS was established as a decentralized system.69 Decisions
regarding the amount and the allocation of allowances were made by Member States themselves, rather than on a supranational level. This decentralization makes emissions trading have a larger appeal to Member States than a tax does. Member States can themselves decide how many allowances will be allocated and to which industries. As Jon Birger
Skjærseth and Jørgen Wettestad state: “Participants who feel a sense of ownership of the process are more likely to abide by the rules than those who do not feel such ownership, because they perceive the process to be fair and equitable.”70 Under the cap and trade system
Member States felt like they had a say in what was going on. In other words, a cap and trade system is flexible whereas a carbon tax is not.
In the economic chapter a large problem that was found was the overallocation of allowances. When looking at the EU ETS from a political perspective it becomes clear why there is overallocation. The Commission decided that the initial allocation of allowances would go via ‘grandfathering’.71 ‘Grandfathering’ means that allowances are distributed based
on historical emissions. The reason the Commission chose for ‘grandfathering’ is because it would lead to the least resistance from Member States, lobby groups and firms.
Emissions trading was established rather than a tax because a consensus for a tax did not get reached. Emissions trading was more decentralized and therefore had more appeal to Member States. Ironically, in 2007 a review was done that concluded that a more harmonized emissions trading system was necessary.72 The EU ETS started as a decentralized measure,
but it became apparent that it needed to be more centralized. In 2008 multiple changes were adopted that created a more harmonized system. A single EU-wide cap was created and allowances had to be allocated based on harmonized rules for the third phase.73 Furthermore,
allowances were to be mostly allocated through auction.74 Member States also changed their
stance and called for more harmonization.75
It has become clear how the EU ETS came to be. The Kyoto Protocol had an
important part in that it established the need for new policies. While a carbon tax had already 69 Jon. B. Skjærseth and Jørgen Wettestad. 2010. “Fixing the EU Emissions Trading System?
Understanding Understanding the post-2012 changes.” Global Environmental Politics. Vol 10, no 4. 101.
70 Skjærseth and Wettestad. “The Origin, Evolution and Consequences of the EU Emissions Trading System.” 104.
71 Christiansen and Wettestad. “The EU as a frontrunner on greenhouse gas emissions trading: how did it happen and will the EU succeed?” 11.
72 Skjærseth and Wettestad. “Fixing the EU Emissions Trading System? Understanding Understanding the post-2012 changes.” 105.
73 Ibid, 105. 74 Ibid.
been proposed in the early 1990s, it was shut down by Member States and lobby groups. Emissions trading, unlike a carbon tax, required no unanimity from all Member States. Apart from that, emissions trading was also preferred by Member States as it was less centralized. It is interesting that later the Commission and Member States alike, called for more
harmonization. Reasons behind this shift is that the political agenda of these Member States changed. Climate change has become more important during the last twenty-thirty years. This chapter has explained why emissions trading was preferred above a carbon tax in the 1990s. However, since the political landscape has shifted since then, an interesting thought is whether a carbon tax would currently be a possibility.
4.2 Linking Systems
In the previous chapter it has become clear that due to political reasons a cap and trade system was favored above a carbon tax during its initial establishment. In this section the possibility of a global cap and trade system will be discussed. It will focus solely on a cap and trade system because a global carbon tax is in the current era unthinkable. The reason for this is that in order to create a global carbon tax, this tax would have to be harmonized. It is nigh
impossible that all states will agree upon such a tax. Large superpowers like the USA or China will not give up sovereignty for such a tax. A cap and trade system however, functions differently as in that it gives the opportunity to link multiple systems together. Therefore, rules can be flexible and states will not have to give up as much sovereignty. The question this section will focus upon is whether it is possible to link multiple cap and trade systems together and how that could lead to an international cap and trade system exceeding the scope of the current EU ETS.
The linkage of multiple cap and trade systems has already taken place within the EU ETS. For example, the EU ETS has been linked with the Norwegian and Swiss ETS’s.
Norway and Switzerland both had their own version of a carbon market before they joined the EU ETS. Norway’s ETS was founded in 2005 and during the first phase of the EU ETS Norwegian installations were already allowed to purchase EUAs from the EU ETS, but not the other way around.76 At the start of the second phase the EU ETS and the Norwegian ETS
were linked together and full trading of allowances between both systems became a reality. The linkage of the Norwegian ETS and the EU ETS is different from for example a linkage
76 “Brexit & The EU ETS: Greater as the sum or in parts?: Annexes.” 2017. Sandbag. Accessed
between a US ETS and the EU ETS because Norway is a member of the EEA and therefore linkage was relatively straightforward.
The linkage of the Swiss ETS with the EU ETS is more interesting because
Switzerland is neither a member of the EU or the EEA. Prior to the linkage of the Swiss ETS with the EU ETS, the Swiss ETS had almost no trading happening within their carbon market, which is a major reason why they wanted to link their system with the EU ETS.77
Furthermore, Switzerland predicted that through linkage emission reduction will become cheaper, the price of allowances will become more stable and the market will gain more liquidity. If one continues this line of reasoning that means that the more systems will be linked with the EU ETS, the better these benefits will become.
The linkage of the Swiss ETS and the EU ETS was more difficult than in the case of Norway. Early talks started in 2008 and negotiations eventually started in 2010.78 Originally
both systems were supposed to be linked in 2013, but this was halted due to a Swiss referendum regarding immigration.79 Talks however continued, and in early 2016 an
agreement was made. On the 23rd of November 2017 the agreement was officially signed by
both parties and is currently waiting to be approved by the European Council and the European Parliament.80
The example of Norway shows how easy it can be to link multiple ETS’s together. However, as mentioned, Norway’s case is unique since Norway is a member of the EEA and therefore has less concerns when giving up some regulatory control. Other states outside of the EEA might not be inclined to do so. Switzerland does show that it is possible for a state outside of the EEA to link their ETS with the EU ETS. Even though Switzerland does have a lot of connections with the EU already.
An attempt to link the Australian ETS with the EU ETS has also been made. This fell through because the at that time governing party, the Australian Labor party, was defeated and the new government had no intention to link both systems together.81
This section has shown that linking the EU ETS with another ETS is possible. It has happened with Norway and is happening with Switzerland. It is unfortunate that the linkage of the Australian ETS with the EU ETS fell through. Otherwise there would be more substantial
77 Ibid, 2. 78 Ibid, 3. 79 Ibid.
80 European Commission: Climate Action. 2017. “EU and Switzerland sign agreement to link emissions trading systems.” Accessed on 01/12/2018. https://ec.europa.eu/clima/news/eu-and-switzerland-sign-agreement-link-emissions-trading-systems_en.
prove that a truly international linkage is possible. The deal with Australia did not fall through because of economic or political barriers, which is important to keep in mind. There are, so far, no reasons why the EU ETS cannot link with an ETS overseas. A cap and trade system provides a unique opportunity to create a global carbon market through linkage. A carbon tax must be completely harmonized in order to function properly, whereas linking cap and trade systems together is a lot more flexible.
4.3 Use of Revenue
A key talking point about the EU ETS and also about a potential carbon tax is the use of revenue. With both suggested measures, a carbon tax or a cap and trade system, extra revenue is gained for the governing bodies. An important question is what this revenue is used for and whether the current regulations must be altered. Firms will be hesitant to pay for
environmental measures if their money goes towards national treasuries or directly to the EU. If the revenue is used for environmental measures this will lead to less resistance.
Furthermore, if this revenue is used for subsidies for the industries that are affected by the environmental measure, no progress against climate change will be made.
Within the directive for the EU ETS it is already determined that at least 50% of the revenue must be spend on climate action.82 During the period from 2013 till 2015, around
8.691 million Euros, which was most of the revenue, was spend domestically.83 Only around
9% was spend on international climate action, which amounts to 1.048 million Euros. Most Member States exceeded the 50% requirement with the exception of Hungary and Italy, who spent 36 and 47% respectively.
Apart from the 50% requirement, Member States are also required to report what the revenue is used for. These reports have shown that of the revenue that is spend domestically 39% is used for cross-cutting activities, 32% on renewable energy and 18% on energy efficiency.84
The revenue that is spent internationally is harder to track. The reason behind this is that 41% of these funds go towards international programs that are not specified.85 This is worrisome
because these funds remain unchecked. It is unknown what these funds are used for. It is
82 EUR-Lex. 2014. “Directive 2003/87/EC of the European Parliament and of the Council of 13 October 2003: establishing a scheme for greenhouse gas emission allowance trading within the Community and amending Council Directive 96/61/EC.” 18/19.
83 Eike Karola Velten, Matthias Duwe, Elizabeth Zelljadt, Nick Evans, Marius Hasenheit. 2016. “Smart Cash for the Climate: Maximising Auctioning Revenues from the EU Emissions Trading System.” Commissioned by WWF European Policy Office as part of the MaxiMiseR project: www.maximiser.eu. 3.
84 Ibid, 4. 85 Ibid.
theoretically possible that these funds go towards industries that are damaging for the environment. It is paramount that the use of revenue can be tracked, both in the case of the EU ETS or in the case of a potential carbon tax.
The required 50% that must be spend on climate action is relatively low. Originally the Committee on Environment, Public Health and Food Safety (ENVI) of the European
Parliament intended that 100% of the revenue must be spend on climate action. 50% of this had to be used on international climate action.86 Due to constitutional concerns and political
disagreement this target was not reached.
There are improvements necessary regarding the use of revenue. There are multiple options to improve. The first one is to make earmarking of revenues mandatory. Earmarking funds means that fund will be put aside and used for a certain purpose. The benefit of
earmarking revenues is that the flow of capital becomes transparent. Furthermore, it provides a consistent stream of capital towards a certain purpose. This option is politically difficult because Member States have budgetary sovereignty and multiple Member States have already stated that they are unwilling to earmark their revenue.87
The second option is to create an EU fund for climate action. All revenue gained from the EU ETS or from a carbon tax will go directly into this fund and will never reach a
Member State’s treasury. These funds are then earmarked and this provides transparency. It will also not affect Member States’ budgetary sovereignty, but only because the revenue never reaches the Member States. A negative aspect is that it creates more administrative issues. An institution must check that all revenue goes to where it belongs. This will create extra costs. Furthermore, the question remains who will be in charge of this fund. It must be an independent body consisting of multiple people from multiple nationalities. This institution must also be tasked with the responsibility to decide what funds must go towards. This means Member States no longer have any direct control over which climate action measures will be supported.
The final option is to increase the mandatory 50% use of revenue on climate action to 100% as was originally envisioned by ENVI. While this has been rejected in the past, it is worth revisiting the idea. Since 2008 the political landscape has changed significantly, meaning that Member States are likely more willing to provide more funds towards climate action.
All options are viable. The second option is the most effective since all revenue is in
86 Ibid, 11. 87 Ibid, 54.
one fund and clear goals can be created and achieved. This is also the most difficult option to achieve. The third option is the most likely option to become reality, but this must also be combined with earmarking revenue in order to create transparency. To answer the initial question of this section, it has become clear that more than 50% of the revenue is being spend on climate action, which is according to the current regulation. This regulation however, must be changed in order to increase the effectiveness of the EU ETS. In the case of a potential carbon tax the same arguments apply. Earmarking revenue is a must as it creates transparency and thus legitimacy for the environmental measure in place.
4.4 Political Debate
In the economic dimension the debate between scholars about a cap and trade system versus a carbon tax has already extensively been discussed from an economic point of view. In this section the same debate will be discussed, but from a political point of view. It is important to be able to answer the question what scholars believe is the better solution from a political point of view. The answer to this question will allow for a better understanding of the reasons why the EU ETS is currently in existence instead of a carbon tax.
It has become clear in the economic chapter that a carbon tax is preferred from that point of view. However, from a political point of view it is different. As has been shown in section 4.1, the founding of the EU ETS was easier accomplished than a potential carbon tax. This is recognized by carbon tax proponents such as Kathryn Harrison, who states multiple advantages of a carbon tax. Examples of these advantages are that it is easier to implement, it can readily be applied to small and large polluters, price certainty and greater transparency.88
At the same time Harrison notes that cap and trade systems have clear advantages over a carbon tax from a political point of view.89 These advantages are, according to Harrison, that
free allocation of allowances appeals to firms. Furthermore, the costs for the consumers from a cap and trade system are less visible than in the case of a carbon tax. This will lead to less resistance from the public.90
Also worth noting is that some of the most notable proponents of a carbon tax, such as Metcalf and Weisbach, refuse to talk about the political implications in their articles. They state in their article: “We do not generally consider the political concessions that will be
88 Harrison, Kathryn. 2010. "The Comparative Politics of Carbon Taxation." Annual Review of Law and Social Science. Vol. 6, no. 1. 508.
89 Ibid. 90 Ibid.
