Linking the emissions trading schemes of Europe and China - Combining climate and energy policy instruments

Abstract

Both Europe and China have announced targets for greenhouse gas emissions reduction and renewable energy development. To achieve their emissions targets, Europe has introduced emissions trading scheme (ETS) since 2005 and China has planned to establish a national ETS in 2015. We assess the impact of a joint Europe-China ETS when both climate and energy policy instruments are simulated in a multiregional general equilibrium model. Our results show that a joint ETS markedly increases total carbon emissions from fossil fuels even though global mitigation costs are reduced. Moreover, a joint ETS helps China achieve its renewable energy target, but for Europe, it works opposite. While the renewable energy target does not help Europe achieve additional abatement, the renewable energy target in China reduces mitigation costs and emissions, and increases renewable energy consumption and sales of carbon allowances. Financial transfer through a joint ETS remains marginal compared to China’s demand for renewable energy subsidies. We conclude that as long as an absolute emissions cap is missing in China, a joint ETS is not attractive for mitigation and China’s renewable energy target can reduce emissions.

Appendix A. Description of the GRACE model

As a recursively dynamic model, GRACE finds a static general equilibrium solution for a period given exogenous settings, which can be updated from one period to another. For example, total returns to capital of all regions are allocated to regions proportional to shares of regional savings at the beginning of a period. After receiving its share of returns to capital and other income, a region allocate a fixed share of its income for investment in the global economy such that the changes in expected rates of return to capital are equalized for all regions. The investment forms new capital stock available for the next period. In a region, productivity of labor and natural resources increases at the same rates as GDP growth while productivity of capital keeps constant over time. The effective supply of labor and capital is updated such that economic growth approximately follows a plausible projection.

Interregional commodity flows may include international trade and transboundary flows of capital, labor, natural resources, and greenhouse gas emissions. This version of GRACE does not allow transboundary flows of labor and natural resources. Capital existing already at the beginning of the previous period is immobile even between production activities though its depreciation together with investments forms new capital at the end of the previous period. The new capital is fully mobile across production activities and regions to equalize expected changes in the rates of returns to capital.

International trade is modeled through a nested constant elasticity of substitution (CES) function (Fig. 7). The parameters starting with small letter ‘e’ indicate the elasticities of substitution at the level where they stay. An Armington good combines domestic production and an aggregate of imports from all other regions. Exceptions of the elasticities are made for the following sectors: (a) refined oil (eARM = 6), (b) electricity (eARM = 0.5; eIMP = 0.3), and (c) gas and coal (eIMP = 4). With the trade of a good, the importing country pays a fixed unit cost to the international transport sector. The international transport is provided by a Cobb-Douglas composite of regional transport services.

Fig. 7

Bilateral imports and the Armington aggregate. The parameters starting with small letter “e” indicate the elasticities of substitution at the level where they stay

Figure 8 illustrates the economic activities of a region. Together with intermediate inputs of goods and services, available productive resources – capital (CAP), labor (LAB), and natural resources (RES) – are utilized to produce goods and services, which can export to other regions and meet final demand for domestic private and public consumption and investments together with imported substitutes. Investments form new capital for the next period. As by-products, greenhouse gas emissions accompany with these economic activities. CO₂ emissions from fossil fuels (Lee 2008) are linked to fossil fuels used by producers and households by fixed emission factors.

Fig. 8

Economic activities of a region

Sectoral production is simulated by two types of nested CES functions. One type is illustrated in Fig. 9 for production of primary energy, i.e., crude oil, coal, and gas. To highlight the dependence on natural resources, the top level is a combination of the natural resource and an aggregate of remaining inputs. At the middle level, the remaining inputs are a Leontief composite of intermediate goods and value added, where the value added combines capital and labor.

Fig. 9

Production structure of primary energy goods. The parameters starting with small letter “e” indicate the elasticities of substitution at the level where they stay

The other type of production functions (Fig. 10) is for goods and services other than the primary energy. The top level is a Leontief composite of intermediate non-energy inputs and an aggregate of value-added and energy inputs (VA-Energy). The next level is a combination of value-added and energy inputs. The value added is further a combination of capital and labor. The energy inputs are a combination of electricity (ELC) and other energy inputs as a Cobb-Douglas aggregate of crude oil (CRU), coal (COL), refined oil (REF), and gas (GAS).

Fig. 10

Production structure of goods/services other than primary energy. The parameters starting with small letter “e” indicate the elasticities of substitution at the level where they stay

Figure 11 Illustrates the demand structures of consumers and investors. At the top level, substitution can be made between energy and non-energy goods. At the bottom level, the energy combines five energy goods and the non-energy combines all the other goods.

Fig. 11

Final demand structure. The parameters starting with small letter “e” indicate the elasticities of substitution at the level where they stay