The 2018 reform of EU ETS: consequences for project appraisal

The European Union’s Emissions Trading System 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 such as cost–benefit analysis. It derives general equilibrium rules for schemes with a fixed cap as well as schemes with an endogenous cap.The paper also derives a cost–benefit rule to use when an exogenous reduction in emissions causes an induced intertemporal change in the supply of permits, what is termed a (positive or negative) permit multiplier, under an endogenous cap. For example, an induced reduction in emissions is associated with climate-related 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.