A Two-Sector Model of the European Union Emissions Trading Scheme

As the largest greenhouse gas emissions trading scheme in the world, the European Union Emissions Trading Scheme (EU ETS) is a benchmark for carbon prices worldwide. A price for carbon represents a cost for emissions-intensive activities under the EU ETS, which must be taken into account by constrained actors in their (emissions-generating) technology operation and investment decisions. A carbon price also represents an incentive for non-EU ETS actors who, through the international Kyoto credits market, are able to exploit emissions reductions generated from investments in lower-emitting technologies. It also indicates to the environmental authority the extent to which the environmental objective is taken into account by the polluter in his economic decisions. The European carbon price is therefore a crucial indicator for a wide cross-section of actors: EU ETS market participants, international emission reduction project developers and policy makers worldwide. The subject of this paper is a model which has been developed to estimate EU-ETS constrained emissions and consequent EU ETS permit market equilibrium prices in the medium term. The model, in its current stage, is conceived for the case of a permit market composed of two EU27-aggregated sectors: electric and non-electric, and for the specific case of full banking and borrowing. The paper presents the conceptual approach of the model, its main features and quantitative relationships, together with the method of resolution under perfect foresight. It also highlights the role that the model fills with respect to other models currently being developed