A coordination failure between EU climate policies exemplified by the North Sea energy island

ABSTRACT

We highlight a coordination problem between the EU Emissions Trading System (ETS) and the EU's offshore renewable energy strategy. We exemplify this coordination failure by analyzing carbon leakage effects associated with Denmark's planned North Sea energy island. The Danish energy island project will not start production before 2033, implying a long interval between project announcement and production. Using a dynamic model of the EU ETS, we show that the large time gap between announcement and production likely results in a ‘Green Paradox’, where the energy island increases aggregate EU ETS emissions. The mechanism leading to the emission increase is complicated and works through the Market Stability Reserve (MSR). The estimated 2050 leakage rate is 145 percent in our main scenario and not below 100 percent in any alternative scenario. We discuss how to improve the climate benefits of the energy island or similar large-scale renewable energy projects. This includes possible revisions to the EU ETS and the role of Power-to-X technologies.

Key policy insights:

• There is a coordination failure between the EU ETS and the EU's offshore renewable energy strategy, as projects intended to fulfil the offshore strategy are likely to result in substantial carbon leakage due to the EU ETS.

• In ETS-covered sectors, there are averse leakage effects associated with emission abatement projects with significant time lags between project announcements and emission abatement like the Danish North Sea energy island.

• For the North Sea energy island and similar projects, leakage effects can be diminished through policies that mitigate the impact on EU ETS allowance demand.

• The coordination failure can be eliminated by removing MSR cancellations or the entire MSR mechanism while adjusting the emission cap to hold expected emissions constant.

• However, removing MSR cancellations amplifies leakage effects for abatement projects with short time lags between announcements and emission abatement, which currently have weak leakage effects due to MSR cancellations.

KEYWORDS:

• Cap-and-trade
• EU ETS
• market stability reserve
• overlapping policies
• Green Paradox

Acknowledgments

We would like to thank Peter Birch Sørensen, Reyer Gerlagh, Roweno Heijmans, Frederik Silbye, Esben Bak Larsen, Mads Dalum Libergren, August Emil Twile Nielsen, Pernille Birch, Frederik Læssøe Nielsen, Mette Dalsgaard, Mikael Bjørk Andersen, Peter Mogensen, Jørgen Søndergaard, and Ulrik Beck as well as seminar participants at the Danish Environmental Economic Conference 2022 for useful comments, discussions, and suggestions. Additionally, we want to thank four anonymous reviewers and the editor for valuable comments. Any remaining errors are our own. The article is partly based on chapter 3 in the report ‘The North Sea Energy Island: Arguments, Auctioning and Climate Impact’ (original Danish title: Energiøen i Nordsøen: Argumenterne, udbuddet og betydningen for klimaet) by Kraka Advisory, 2022.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 Sinn (2008) coined the term ‘Green Paradox’ to describe a situation where climate policies that are designed to reduce emissions end up increasing them.

2 The 2018 reform determined the MSR cap as the number of auctioned emission allowances the previous year.

3 See Green (2021) for a review of ex-post evidence on carbon pricing.

4 The agreement states that the energy island should have a capacity of 3 GW but aiming towards 10 GW by 2040.

5 Emissions of this magnitude can be offset through negative emission technologies. The Green Paradox mechanism is only strengthened if we tighten the system further as illustrated in Scenario I.3.

6 The EU ETS is climate-neutral from 2045 in this scenario.