Linking Emissions Trading Schemes: An Economic Impact Assessment for Europe and Brazil using EPPA6 model

This research provides an investigation into the economic impacts of linking the European Emissions Trading Scheme (EU ETS) - the largest and most consolidated scheme in the world - with an emerging non-EU scheme, a proposed Brazilian Emissions Trading Scheme (BRA ETS). Linkage is described as a multi-faceted policy decision that is envisaged to play an important role in future international climate policy architecture. In the context of the Paris Agreement, provisions for carbon pricing are likely to become even more common in the post-2020 world. This is due to the fact that Article 6 allows for the use of international mechanisms to comply with Nationally Determined Contributions (NDCs). As a consequence, the more interest in implementing carbon trading mechanisms the more linkages are expected to emerge among participants. The main goal of linkage is to achieve emissions reductions across different jurisdictions at a lower cost by allowing regional carbon regulations to interact. Evidence from the published literature has highlighted opportunities from the use of market instruments for addressing climate change problems, particularly in relation to the linkage of carbon trading schemes. Linking cap-and-trade schemes is expected to create larger international markets and hence opportunities for coordinating efforts across jurisdictions. Besides, linkages can contribute to greater cost-efficiency, enhancement of market liquidity, and potentially lower the risk of carbon leakage. Engaging in linkage may therefore increase mitigation ambition as well as promoting sustainable development. Several studies have been carried out in order to evaluate linking with the EU ETS, including the possibility of linking with non-EU schemes such as South Korea, China, Australia and California. This paper is conducted along the same lines but focuses on the Brazilian case. Among developing countries, Brazil has taken on a pioneering position when it comes to commitments to mitigate climate change. However, the movement towards the adoption of carbon pricing mechanisms is still at an incipient stage in Brazil. Discussions in this regard have increased significantly since the enactment of the National Plan for Climate Change Mitigation in 2009, which has considered economic instruments also as a means of achieving national targets by 2020. In the light of the Paris Agreement arrangements, Brazil should be encouraged to design a carbon trading scheme. Linking it to other systems would thereafter be an option. Under this perspective, we propose an economic evaluation of the feasibility and effectiveness of a linkage between the EU ETS and BRA ETS. Moreover, the study compares the impact from a national and linked perspective, highlighting differences with regard to relevant factors such as carbon price, distribution of allowances, stringency of targets, level of emissions, GDP and welfare. Simulations show how the linkage would operate so that we can understand if a linkage policy would be the appropriate strategy for helping both jurisdictions to achieve a low carbon economy. For this quantitative assessment, we use the Economic Projection and Policy Analysis (EPPA) model in its most recent version - EPPA6 (CHEN et al., 2015). It is a computable general equilibrium model developed by the MIT Joint Program on the Science and Policy of Global Change. EPPA6 was developed as a nonlinear complementarity problem in the General Algebraic Modelling System (GAMS) programming language (BROOKE et al., 1998), using the syntax of the MPSGE (Mathematical Programming System for General Equilibrium) algorithm developed by Rutherford (1999). EPPA6 is a dynamic recursive model that provides a representation of the global economy (CHEN et al., 2015), which includes the regions here investigated (European Union and Brazil). This version is based on the social accounting matrixes from the Global Trade Analysis Project Version 8 (GTAP 8) database, with a benchmark year of 2007 (Narayanan et al., 2012). The data is aggregated into 18 regions, 14 sectors and 14 technologies for generating sustainable energy. It also incorporates additional data sources on energy use (IEA, 2012a), energy consumption (IEA, 2012b), CO2 emissions related to cement production (Boden et al., 2010) and CO2 emissions related to land use change (Riahi et al., 2007). This model is able to project long run scenarios of world economic development and emissions along with the evaluation of the economic impact of proposed mitigation policies, welfare and equity measures. The model is solved at 5 yearly intervals from 2010 to 2100, which has 2007 as the base year. In this paper we simulate 3 scenarios for the 2020-2050 period as well as a reference scenario where no climate policy takes place. The policy scenarios consider emissions trading mechanisms to reduce CO2 emissions in Europe and Brazil in energy-intensive sectors. The first policy scenario (NATIONAL) is based on the EU ETS targets for Europe and from a Brazilian perspective accounts for half of Brazil's pledges under the Paris Agreement. We assume that both Europe and Brazil implement national cap-and-trade schemes to comply with their mitigation commitments. In this case, there is no formal agreement between them to establish a linking of the schemes. The second policy scenario (LINKING) represents an international tradable CO2 permit system formed by the EU ETS and BRA ETS with the same cap as the NATIONAL scenario. Finally, the third scenario (LINKING FULL) simulates the link between EU ETS and BRA ETS considering the full Brazilian emissions target under the Paris Agreement as being imposed on energy and industrial CO2, without constraints on emissions from deforestation. For measuring direct economic impacts and other general equilibrium effects of setting up a market for trading emissions allowances we use GDP and welfare as indicators. Preliminary results indicate that the climate policy induces higher GDP losses in the BRA ETS if participating in a common emissions trading scheme with the EU ETS. The LINKING scenario seems to be a better policy option in minimising welfare losses in the EU ETS but only turns out to be preferable in the BRA ETS in the long run. In the LINKING FULL scenario there is an intensification of the mitigation target, impacting even more on the Brazilian activity level and Welfare. For the EU ETS, the LINKING scenario diminishes the negative effects on GDP and Welfare, reaching higher economic efficiency. When the climate policy is in operation, there is a total equalisation of CO2 price among the systems. The level of effort required for Brazil to mitigate emissions in a linked scheme appears higher than in Europe. This is due to the fact that the linkage brings a higher mitigation target than Brazil would have with the domestic policy. In this case, linking reduces economic activity and generates emissions allowances that can be sold to the EU ETS. For Europe, the integrated system decreases economic costs since Brazil presents cheaper mitigation options. This allows the EU ETS to buy emissions allowances at a lower cost. The costs of linking would therefore impact regulated sectors in the BRA ETS. The results indicate that the BRA ETS gains from linking to the EU ETS are moderate and should be carefully analysed by policymakers as an alternative emissions reduction policy.