ISTP Colloquium: Climate policy and finance - Interplay between interest rates and the politics of emissions trading

Abstract

Mitigating dangerous climate change requires a rapid transition of economies towards low-​carbon technologies, and emissions trading is widely thought to be a fail-​safe instrument for achieving it. In emission trading policies, a cap serves as backstop that ensures emissions never exceed a certain level, and allowance prices automatically adjust to changes in economic and policy conditions. However, if prices become hockey stick-​shaped, the resulting political pressure may soften the cap, implying the transition will not be followed through. Combing economics and political science, we conceptualize the feedback between allowance price and politics, and underline the importance of the discount rate (which closely links the general interest rate level in the economy).

Applying our framework to the European Union, we then quantify risk indicators for a softening of the cap. Particularly, we assess a scenario with market risk exposure for renewables and rising interest rates. Compared to a scenario extrapolating current conditions, we find that allowance prices double in the long-​term. Moreover, renewable capacity deployment is substantially delayed in the mid-​term, and fossil fuel plant profits surge rather than decline. This suggests a considerable risk that the cap will be softened.