1 Macroeconomic Impacts of EU Climate Policy in AIECE November 5, 2008 Olavi Rantala - Paavo Suni The Research Institute of the Finnish Economy ETLA

2 Macroeconomic baseline scenario  Financial crisis dampens strongly world economic growth in United States falls into recession, Japanese growth is slow - Developing countries, esp. China hit hard, but continue growing relatively rapidly - Commodity producers’ surpluses diminish, which lags their investments  EU countries face a severe slowdown - Many EU countries going into recession as EU as a whole  Growth getting stronger in the course of 2010, but slowly - Previous 5-year period was especially strong  After the current turmoil growth rates recover back to potential but below the recent record strong growth

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5 Primary energy prices  Energy prices have peaked in 2008 at record levels - Oil: peaked at close to 150 USD/b, by mid-October below 70 USD/b - Coal: fiscal year prices doubled in case of steam oil - Gas: prices follow oil and oil product price decline with a lag  In the longer term, the availability of energy is one of the key risks for global growth

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7 The baseline scenario of CO 2 emissions  In the forecasting model the baseline scenario of CO 2 emissions is based on energy demand in four sectors: industry, transport, households and the rest of the economy  CO 2 emissions reflect electricity supply generated by fossil fuels and other consumption of fossil fuels  CO 2 emissions of electricity generation are increased by the demand for electricity in the four sectors and decreased by the clean electricity generated by means of renewable energy sources and nuclear power  Recent Eurostat data indicates a rebound in electricity consumption and estimated CO 2 emissions in the EU in spring 2008

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11 Climate policy and the electricity market  The cornerstone of EU climate policy is the reduction of CO 2 emissions in electricity generation and industry under the European Union Emission Trading Scheme (EU ETS)  CO 2 emissions result largely from electricity generation  More than 50 % of electricity is produced by fossil fuels in the EU  There are hardly any substitutes for fossil fuels in electricity production in the short run  The price of emission allowances creates an extra marginal cost in electricity production  Increases in the price of emission allowances are largely passed through to the price of electricity

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13 Channels to macroeconomic developments  The price of emission allowances has become an important determinant of the price of electricity  The price of electricity is the main channel of the impacts of climate policy on macroeconomic developments  The price elasticity of the demand for electricity is rather low (-0.1 for industry and -0.2 for households)  The downward adjustment of the demand for electricity and CO 2 emissions may necessitate a large increase in the price of emission allowances and in the the price of electricity  This leads to increasing costs in industry, higher consumer prices for households and decreasing macroeconomic activity  The macroeconomic adjustment finally leads to lower demand for energy and reductions in CO 2 emissions

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15 Baseline scenario of CO 2 emissions in EU ETS  CO 2 emissions in the EU emission trading sector under the EU ETS grew by about 4 per cent in 2007  According to our baseline scenario the emissions will decrease in  CO 2 emissions will exceed the emission allowances on average by about 100 million tonnes annually in  Uncertainties in the baseline EU ETS emission scenario: - macroeconomic developments and energy demand - clean electricity supply

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18 Assumptions in policy scenarios  Emission allowances for the Kyoto period have been cut by some 10 percent as compared to the first emission trading period  Our most stringent policy scenario - “maximum impact policy scenario” - assumes that the CO 2 emissions of EU ETS must be reduced to the allowed cap in  Emission trading and other Kyoto mechanisms (Clean Development Mechanism, CDM, and Joint Implementation, JI) allow flexibility in the adjustment of the CO 2 emissions  The other extreme policy scenario - “minimum impact policy scenario” - assumes a perfectly elastic supply of emission reduction units (Certified Emission Reductions, CER) from developing countries at the minimum price of 10 €/t (roughly the minimum price set by China)  Our forecast for the emissions of the EU emission trading sector in 2012 lies in the middle of the two extreme scenarios

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20 Emission allowance price and electricity prices  The increase in emission allowance price will be gradually passed on to electricity prices  In the minimum impact policy scenario the emission allowance price is assumed to be only 10 €/t and the impact on electricity prices is rather small  The maximum impact policy scenario implies a sharp rise in emission allowance price and electricity prices

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24 Macroeconomic impacts of EU climate policy  The increase in emission allowance and electricity prices will weaken export competitiveness and export performance especially in export markets outside the EU area  Rising electricity prices will also raise consumer prices and slow down household real income and consumption growth  The negative impact on exports and domestic demand will be reflected on GDP and employment  Macroeconomic impacts may be stronger in the small open energy-intensive EU countries than in the major EU countries

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26 Differences in the macroeconomic impacts between countries  Exports in relation to GDP, especially exports outside EU  Energy-intensity of industry  Impact of temperature on energy demand

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30 Greenhouse gas developments in EU  EU total greenhouse gas emissions meet the Kyoto commitment target in according to our baseline scenario  Emissions will fall clearly below the Kyoto target according to our policy scenario  EU climate policy seems to be unnecessarily stringent in

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32 Conclusions  EU climate policy dampens the medium-term economic growth in the EU area  EU climate policy seems to be unnecessarily stringent in in terms of the Kyoto commitment target on greenhouse gas reductions  Uncertainties in the scenarios: - The baseline macroeconomic scenario - The flexibility in CO 2 emissions allowed by the Kyoto mechanisms, especially the supply of clean development (CDM) credits from China and other developing countries