Ups and Downs. How Economic Growth Affects Policy Interactions.

Emissions trading is key to climate policy in an increasing number of countries. Besides the emission trading system of the European Union (EU ETS), several similar systems in China, California, Australia, and South Korea are planned or are already operating. In reality, emission trading is often supplemented with an additional quota for renewables in energy production. The European Union is one example of such a combined policy regime aiming for a 20% reduction in greenhouse gas emissions and a 20% share of renewables in energy production by 2020. This policy regime has to operate currently under an ex-ante unforeseen economic crisis. An obvious consequence was the collapse of the carbon price. However, this price collapse may have been amplified by the interaction of the emission cap and the renewables quota. The static interaction between climate and renewable policies has been discussed extensively. This paper extends this debate by analysing the interactions between an emissions trading scheme and a renewable quota subject to differeces in economic growth rates.

Making use of a simple partial equilibrium model, we ask how differences in medium to long-run growth rates affect the eficiency and effectiveness of such a policy portfolio. We model a power sector that has two abatement options. One is a relatively cheap fuel switch from coal to gas. The other, which is more expensive, is a replacement of carbon emitting power generation capacities with non-emitting renewables. If economic growth is low, then emissions are low, and the fuel switch is suficient to stay below the cap of the ETS. However, if the ETS is combined with a minimum renewable share target, abatement efforts are forced towards the more expensive use of renewables. Put differently, the minimum renewable share target becomes particularly binding if economic growth is low. Furthermore, prices for emission allowances become more sensitive to changes in electricity demand if the ETS is combined with a quota for renewables. Reversely, if economic growth is high, then electricity demand is also high, and the minimum renewable share target becomes less binding, as energy production by renewables becomes more and more necessary to stay below the emissions cap. If economic growth is very high the renewable share target may also become completely ineffective, as the emissions cap is suficient to force the necessary switch to renewables.

Two main lessons can be derived from this analysis: First, prices for emission allowances become more sensitive to changes in electricity demand if the ETS is combined with an instrument that aims for a minimum renewable share. If policy makers value a clear and stable carbon price signal as crucial for encouraging investments in low-carbon technologies the combination of the two policy targets may have unintended negative consequences. Second and following from our first lesson, we show that while the carbon price is always lower if an ETS is combined with a renewable quota, this gap is particularly pronounced if economic growth is low. This leads to additional excess costs during situations when funds are particularly scarce and opportunity costs of climate policies are particularly high.

Flues, Florens, Andreas Löschel, Benjamin Johannes Lutz and Oliver Schenker (2013), Ups and Downs. How Economic Growth Affects Policy Interactions., ZEW Discussion Paper No. 13-066, Mannheim.