Additional actions to reduce greenhouse gas emissions are being taken across the EU in sectors covered by the EU Emissions Trading System (EU ETS). These include implementing energy efficiency programmes, deploying renewables, replacing lignite and coal plants with less carbon intensive generation, and introducing national carbon pricing.
It is sometimes argued that these additional actions do not reduce total emissions because total emissions in the EU ETS sectors are set by the fixed cap, irrespective of what other action is taken. This is sometimes referred to as the “waterbed effect” by analogy with the fixed volume of water in a waterbed – squeezing a waterbed in one place immediately leads to it bulging out in another.

Sandbag’s new analysis shows that the waterbed effect largely does not hold true in the EU ETS sectors. It is more carbon market myth than established fact. In practice the vast majority of emissions reductions from additional actions are permanent.
Modelling the waterbed effect
Sandbag has modelled the impact of additional measures on the supply and demand balance in the market. From this we’ve looked at allowances prices and then at emission abatement. This analysis shows that only 2-8% of allowances (EUAs) freed by additional action will be used. The remaining 90%-plus will add to the surplus of allowances that has developed over the last few years. These will almost all eventually end up in the Market Stability Reserve (MSR), which is due to operate from 2019.
Sandbag’s findings are consistent with current market behaviour, where annual emissions were 10% or more below the cap in 2015 (and are likely to be 13% below the cap this year). Present emission reductions are thus manifestly not being replaced in full by emissions elsewhere. It also corresponds with current market condition – prices are low, so even a large percentage fall is quite small in absolute terms. A small absolute price fall in turn leads to only a small increase in emissions. As prices gradually recover the effect of price reductions becomes greater – towards the top end of the range shown in our analysis – but it remains a relatively small effect.
Adam Whitmore, Sandbag’s Head of Policy, said:

Additional actions are likely to result in long term emissions reductions additional to those delivered by the EU ETS, particularly while there continues to be a surplus of allowances over at least the next 10-15 years. This remains true even if the reforms of the EU ETS currently being discussed are adopted.

Furthermore, contrary to the assumption underlying the waterbed effect, the supply of allowances to the market is not fixed in the long term, but is set by future policy decisions which can respond to circumstances. While in theory there is the possibility of a long term waterbed effect (if surplus allowances created by additional actions and held in the Market Stability Reserve (MSR) are returned to the market in the future) in practice this is most unlikely to happen. Decisions on the supply of allowances will reflect the prevailing circumstances, including international commitments to emission reductions and the size of a surplus.
This is especially the case given the very long time – several decades – it will take the additional surplus created by additional actions to return. It seems unlikely that allowances returning after a period of decades would be allowed to result in additional emissions. Allowing additional emissions would, for example run counter to the Paris Agreement, including its provisions to aim for net zero emissions in the second half of the century. The waterbed effect would thus not occur, at least not in full, even over the longer term. Emissions reductions would be permanent.
There are various ways in which supply of allowances could be reduced, and the waterbed effect thus avoided over the long term, including the following:

  • arrangements are put in place for retiring allowances from the MSR, or elsewhere once the MSR reaches a certain size limit;
  • decisions are taken post-2050 not to return allowances from much earlier surpluses, given prevailing policy circumstances;
  • Member States choose to retire allowances, and hence reduce the cap, in order to neutralise surplus allowances resulting from other policy actions;
  • the additional surplus gives confidence to policy makers to enable tighter caps to be set for future phases, by reducing the perceived cost;
  • the EU ETS is replaced by another mechanism, or fundamentally modified, before the additional surplus is returned to the market and the new arrangements do not recognise EUAs in full; and
  • vigorous additional policy actions, and new low-emitting technologies to replace current ones, result in emissions always remaining below the cap and the surplus never being used.

The future supply of allowances, and so any waterbed effect, is thus under direct policy control.
Even when the market returns to scarcity, these policy responses enable any benefits of additional action to be captured in full. It seems likely that the effect of additional actions will continue to shape policy through such mechanisms. The waterbed is therefore unlikely to apply even for additional actions taken when the market is short of allowances.
In practice a large majority of the emissions reductions from additional actions are thus likely to be permanent. The often repeated claim that additional policy actions “do nothing to reduce emissions because the EU ETS cap is fixed and emissions will take place elsewhere up to the level of the cap” is seriously misleading, reflecting an outdated view of the EU ETS.  It should not be used as an excuse for inaction.
Policy makers can be confident that most of the emissions reductions from additional actions they take will be permanent and so make a valuable contribution to reducing climate change.

Motel photo by Rusty Clark (used under Creative Commons License)