Enhancing Emissions Trading Systems with Renewable Subsidies and Electricity Taxes

This study by Fischer, Qu, and Goulder explores how overlapping policies like renewable energy subsidies and electricity taxes impact emissions trading systems (ETS), highlighting that well-designed overlaps improve the cost-effectiveness of rate-based systems like China’s DEPS. While CAT systems remain inherently efficient without overlaps, tailored integrations can bridge performance gaps in rate-based models.

A groundbreaking working paper by Carolyn Fischer of the World Bank Group, Chenfei Qu of Tsinghua University, and Lawrence H. Goulder of Stanford University delves into the complex interplay between emissions trading systems (ETS) and overlapping policies such as renewable energy subsidies and electricity taxes. Using a combination of theoretical frameworks and a detailed numerical general equilibrium model tailored to China, the study sheds light on how policy overlaps can affect the cost-effectiveness and emissions reduction capabilities of ETS designs. Particularly, the research evaluates China’s differentiated emitter performance standard (DEPS), exploring how renewable portfolio standards (RPS) and indirect emissions pricing (IEP) influence its performance and economic efficiency.

How Policy Overlaps Shape ETS Outcomes

The study reveals that overlapping policies have a profound impact on ETS effectiveness, varying significantly by design. Traditional cap-and-trade (CAT) systems, with fixed emissions caps, ensure that overlapping policies have minimal influence on total emissions but can increase costs unnecessarily. In contrast, rate-based ETSs like DEPS allow emissions to fluctuate with production, making them more susceptible to policy interactions. For instance, the study finds that in China, overlapping policies like RPS and IEP can reduce the cost per ton of abatement for DEPS by nearly two-thirds, narrowing the efficiency gap with CAT systems. RPS encourages renewable energy production, correcting DEPS’s exclusion of renewables from free allowances, while IEP imposes indirect costs on electricity consumption, enhancing price signals and promoting conservation. Together, these policies make DEPS more cost-effective by addressing its inherent inefficiencies.

China’s ETS Rollout and the Role of Renewable Support

China’s national ETS, designed as a DEPS, is being rolled out in three phases, starting with the electricity sector and expanding to other industries. The numerical simulations in the study show that overlapping policies like RPS and IEP can significantly improve the performance of DEPS during these phases. RPS, which functions as an electricity-consumption-tax-funded renewable subsidy, boosts renewable shares and aligns them with emissions reduction targets. Meanwhile, IEP helps reflect the true carbon cost of electricity consumed by industrial sectors, reducing emissions and promoting efficiency. These policies also help mitigate emissions leakage, a common concern in carbon pricing, by incentivizing emissions reductions within China’s borders. Importantly, the overlapping policies reduce carbon prices under DEPS, easing the cost burden on consumers while still achieving meaningful emissions reductions.

Challenges with Overlapping Policies in CAT Systems

While overlapping policies improve the performance of rate-based ETSs like DEPS, they can undermine the cost-effectiveness of CAT systems. The study finds that CAT systems inherently provide efficient emissions reductions, and adding policies like RPS and IEP can unnecessarily increase abatement costs by up to 10%. Unlike DEPS, which benefits from additional measures to correct its inefficiencies, CAT systems already achieve optimal outcomes without overlapping interventions. This demonstrates the importance of tailoring overlapping policies to the specific design of the ETS to avoid counterproductive outcomes. For CAT systems, the focus should remain on maintaining cost-effective emissions caps without introducing unnecessary complexities.

Optimizing Policies for Cost-Effective Emissions Reductions

The study emphasizes that optimizing overlapping policies can further enhance the cost-effectiveness of ETSs, particularly rate-based systems. Aligning renewable energy targets with DEPS benchmarks could reduce abatement costs by approximately 10%, ensuring that renewable subsidies address DEPS’s inefficiencies without overburdening the system. Additionally, pricing emissions embodied in electricity consumed by industrial sectors could lower costs by another 8%. These adjustments would leverage the strengths of overlapping policies while minimizing their drawbacks. The researchers also highlight the potential for transitioning from DEPS to a uniform emitter performance standard (UEPS), which could further improve efficiency by eliminating the distortions caused by differentiated benchmarks for high- and low-emitting sources.

Implications for Global ETS Design

The findings of this research are not only relevant for China but also for other countries exploring or implementing rate-based ETSs, such as Indonesia, Kazakhstan, and India. These nations can benefit from the study’s insights into optimizing policy overlaps to achieve emissions reduction targets efficiently. The research underscores the need for careful coordination between ETS designs and complementary policies to balance environmental and economic objectives. While CAT systems remain the most cost-effective option in the absence of overlapping policies, well-designed overlaps can make rate-based systems like DEPS nearly as effective while addressing their inherent inefficiencies.

A Future Path for Emissions Trading and Policy Integration

The study concludes that the choice of ETS design and the integration of overlapping policies must be considered together to maximize cost-effectiveness and achieve emissions targets efficiently. Future research could expand on these findings by exploring additional complexities, such as pre-existing market distortions, regulatory constraints, and flexibility mechanisms like banking and borrowing. By incorporating these real-world factors, policymakers can refine ETS designs and overlapping policies to better address the challenges of transitioning to low-carbon economies. This research offers a robust framework for understanding the dynamics of emissions trading and policy overlaps, providing valuable insights for jurisdictions worldwide as they strive to combat climate change.