EU carbon prices signal high policy credibility and farsighted actors

Abstract

The EU emissions trading system (EU ETS) is a key driver behind Europe’s decarbonization. Coinciding with two major reforms to tighten the cap, prices have increased tenfold between 2017 and 2021 to 80 €/tCO2 and above, completely changing the investment decisions in electricity and industry sectors. But can price movements be explained through these reforms alone? We here argue that the emission cap changes are not sufficient to explain the price jumps and offer a more comprehensive explanation: Our results suggest that the price increase was strongly driven by actors becoming more farsighted when policymakers signaled high long-term commitment to climate targets by implementing ambitious reforms. With these assumptions, our model reproduces the historic price path and shows present prices to be consistent with EU reduction targets. To underline the role of credibility, we test what would happen if a crisis undermines policy credibility such that actors become myopic again, demonstrating that carbon prices could plummet and endanger the energy transition.