The 2018 Reform of EU ETS: Consequences for Project Appraisal

Abstract

The European Union's Emissions Trading System is the largest system in the world for trade in greenhouse gases. It used to be a cap-and-trade scheme with a fixed supply of permits. However, a recent reform of the system "punctures the waterbed" by making the supply of permits endogenous. The current paper discusses how to handle permits in economic evaluations. It considers both schemes with a fixed cap and schemes with an endogenous cap. The paper also derives a rule when the project causes an induced intertemporal change in the supply of permits under an endogenous cap. An induced reduction in emissions, what we term a "permit multiplier", is associated with benefits but comes at a cost as production is displaced when the number of available permits decreases. The permit multiplier implies that emissions within the EU ETS are valued differently from emissions occurring elsewhere even under an endogenous cap. A further novel result is that an endogenous cap could increase the social profitability of abatement efforts. By replacing purchases of permits, abatement could cause a reduction in the endogenous supply of permits and hence emissions.

Keywords: Cost-benefit analysis, permits, waterbed puncture, endogenous cap, ETS, climate gases, social cost of carbon

JEL Classification: H23, H43, Q51, Q54