THE EU 20/20/2020 targets: An overview of the EMF22 assessment

Abstract

Three computable general equilibrium models are used to estimate the economic implications of a stylized version of EU climate policy. If implemented at the lowest possible cost, the 20% emissions reduction would lead to a welfare loss of 0.5–2.0% by 2020. Second-best policies increase costs. A policy with two carbon prices (one for the ETS, one for the non-ETS) could increase costs by up to 50%. A policy with 28 carbon prices (one for the ETS, one each for each Member State) could increase costs by another 40%. The renewables standard could raise the costs of emissions reduction by 90%. Overall, the inefficiencies in policy lead to a cost that is 100–125% too high. The models differ greatly in the detail of their results. The ETS/non-ETS split may have a negligible impact on welfare, while the renewables standard may even improve welfare. The models agree, however, that the distortions introduced by total EU package imply a substantial welfare loss over and above the costs needed to meet the climate target. The marginal, total and excess costs reported here are notably higher than those in the impact assessment of the European Commission.

Introduction

The European Union is committed to limiting the rise in global average temperature to 2 °C above pre-industrial levels (CEC 2008). It has set ambitious targets for greenhouse gas emissions reduction. At the same time, the EU has adopted equally ambitious targets for the portfolio for energy supply. The EU aims to meet these targets through a range of policy instruments at the Union, Member State and even subnational level. (Tinbergen 1952) cautioned policy makers over the welfare losses that are likely if the number of instruments and targets do not match. This paper provides some estimates of the size of such welfare losses and some insights into the mechanisms behind the inefficiencies.

Roughly, the EU has set the following targets: Greenhouse gas emissions should be reduced to 20% below their 1990 levels by 2020. About half of these emissions – essentially all energy-intensive industries¹ – are to be regulated under the European Trading Scheme (ETS). The target is − 21% below 2005 levels.

The EU ETS is the first large-scale, international market for emissions permits (Convery, 2009, Convery and Redmond, 2007, Ellerman and Buchner, 2007). It is a landmark environmental policy. The rationale of emissions trading is straightforward: The direct costs of meeting an exogenous emissions constraint (cap) would be minimized if all the emitters covered by the cap faced the same marginal abatement costs. In this case, there is no arbitrage in trading abatement efforts across emitters. Within a cap-and-trade system, cost-minimizing behaviour by individual emitters leads to a single price. Decentralized market interactions of economic agents assure the collective least-cost attainment of the system's emissions constraint.

The other half of greenhouse gas emissions are currently unregulated at the EU level, but subject to emissions control measures by individual Member States. The average target is − 10%, but Member State targets range from a 20% decrease to a 20% increase relative to 2005; the average target is − 18% relative to 1990. Achieving these targets is left to the Member States, but these are allowed to trade their non-ETS allocations among one another (Tol 2009b). Three percent emissions reduction may be achieved by investing in CDM-like projects in developing countries. The 3% limit is applied at the Member State level, but the access rights (CDM warrants) are again tradable among governments (Gorecki et al. 2009).

Although the four markets (ETS, non-ETS, CDM, CDM warrants) could jointly lead to a uniform price for all greenhouse gas emissions in the European Union, this is not guaranteed as it would be by a comprehensive market (Tol 2009a). Besides, the non-ETS and CDM warrant markets are untested, while the CDM market is less than perfect (Michaelowa and Jotzo 2005). Cost-effectiveness at the EU level would require cost-effective implementation of non-ETS emissions reduction at the Member State level (see below). The costs of meeting the EU emissions target raise a further concern.

The second headline target is a 20% penetration of renewable energy by 2020. There are targets for every Member State, but these obligations are also tradable (Bertoldi and Huld 2006). Some of the Member States have adopted separate targets on the penetration of renewable energy in specific markets, such as transport and residential heating.

There is also an EU-wide aspiration to improve energy efficiency by at least 20% between 2005 and 2020, and perhaps there will be a market for this too (Oikonomou et al. 2008).

From the perspective of climate policy, these additional targets create excess cost. If targets for renewable energy and energy efficiency become binding, they produce an outcome different from the cost-effective solution generated by comprehensive emissions trading. This implies additional costs (Boehringer et al. 2008). The relative contribution of renewables and energy efficiency to emissions reduction should be determined by the markets and not by bureaucrats.²

Besides the various markets that operate at EU level, there are other instruments as well. Chief among these is the fuel efficiency target for passenger cars (European Parliament and Council of the European Union 2009), although one could also argue that this is a bilinear tax. Symbolically, incandescent light bulbs will be banned (Ecodesign Regulatory Committee 2008). The European Parliament has also considered other options, including banning patio heaters (European Parliament 2008) and the abolishment of daylight saving time (Doyle 2009). The EU has 27 Member States, and many of these have a wide variety of additional measures, including carbon taxes, appliance subsidies, tax breaks for bicycle owners, standards for tyre pressure, tests for efficient driving, and many others. At the same time, a number of Member States continue to support fossil fuels, car transport, agriculture, and other activities that emit disproportionate amounts of greenhouse gases.

Against this background, the primary objective of the EMF22 model analysis on EU climate policies is to provide quantitative estimates of the potential excess costs from restricted trading and overlapping regulation. The economic models used in this study cannot possibly reflect the true complexity of climate and energy policy in the European Union. Instead, we designed a set of stylized scenarios that (1) highlight the main inefficiencies and (2) attribute these to the various elements of the regulation.

The three models included in this analysis are multi-regional, multi-sector general equilibrium models. A key advantage of these models is that they provide a comprehensive representation of price-dependent market interactions based on microeconomic theory. The simultaneous explanation of the origin and spending of agents' incomes makes it possible to address both economy-wide efficiency as well as distributional impacts of policy interference. Policy measures in open economies can influence both domestic markets and international prices via changes in exports and imports. The changes in international prices, i.e., the terms of trade, imply secondary effects which can significantly affect the welfare impacts of the primary domestic policy.

The paper proceeds as follows. Section 2 details the study design. Section 3 discusses the shared results of the three models included in the study. Section 4 reviews the additional results from the individual papers. Section 5 concludes.