Currently, the European Union operates the world’s largest emissions trading program (and the first of its kind). As part of its efforts to comply with the Kyoto protocol, which sets emissions reduction targets, the EU Emissions Trading Scheme (ETS) puts a limit on carbon dioxide emissions by individual factories, power stations and other installations.

Firms within the EU unable to get their emissions below the cap can take advantage of allowances granted to them by their own governments or purchase them at auction for a market price. Ecologically conscious firms who “under-pollute” can likewise sell allowances to “over-polluting” firms to raise revenue.

Critics of emissions trading who oppose a similar program for the United States have pointed toward potential negative effects of the ETS on private enterprise: rising electricity costs, off-shoring manufacturing to countries without carbon taxes or emissions trading programs, and declining revenue, buying allowances with money earmarked for investment instead.

Doomsday Not Today

According to new research published by the World Bank, however, the statistics about the EU economy do not support a doomsday interpretation of the economic impact of the ETS.

The authors (researchers from the University of Maryland, Cornell University and the World Bank) look at unit costs for firms, employment and turnover (revenue, in non-European parlance) for the three highest-polluting industries in the Eurozone—power generation, cement, iron and steel—and find these industries are managing to survive the ETS.

Because many entities in the EU are exempt from the ETS based on size, it is easy to compare data on exempt and non-exempt firms within single industries. As the report is quick to point out, if you run a power plant smaller than 20 megawatts or a cement factory producing less than 500 metric tons per day, you can proceed as if the ETS does not exist.

By looking at the costs and practices of a variety of firms within specific industries, the authors can reasonably conclude whether or not the ETS has a significant impact as opposed to other extraneous factors (the health of the overall economy, for example).

Cutting Costs

The report finds for those firms operating under the ETS, the effects are not negative in a statistically significant way. Power plants experienced higher input costs due to fuel-switching (conversion from dirtier coal to cleaner natural gas for power plants), but were able to pass on the costs to consumers, thereby increasing the firms’ revenue.

There seems to be no rush for EU firms to move operations overseas to avoid compliance with the ETS. As it turns out, for cement, iron and steel firms, there was no statistically significant effect on any of the three variables, either.

The report authors conclude:

“…the findings do not substantiate concerns over carbon leakage, job loss or industry competitiveness during the study period.”

That last phrase is a key one. These results are only preliminary. Phase II of the ETS finished in 2009, and the economic recession in the Eurozone certainly contributed to less pollution, compared to an alternative hypothetical growth scenario. Phase III begins this year and includes much more stringent emissions caps as well as the introduction of an auction system for additional pollution allowances (instead of the free allocation of allowances by EU governments to firms).

It seems clear the tiered approach undertaken by the European Union is, on balance, working. Now, European firms are innovating to reduce exposure to penalties.

This is exactly the response governments want from companies: the private sector responding to a price signal, namely the scarcity of permission to pollute and the cost of purchasing credits to do so.

There are many factors pulling down the Eurozone economy (debt, sluggish growth in the U.S. and developing world, and aging populations), but this research shows the EU’s aggressive move to police carbon emissions is not producing a significant drag.