Systematic Analysis of Fossil Fuel and Carbon Price Correlation Under Emission Trading Schemes

Abstract

Emissions trading is at the forefront of the effort to price greenhouse gas (GHG) emissions. Yet all existing emission trading schemes (ETS) exclude sectors of the economy, leading to sometimes counterintuitive correlations between the carbon price and fuel prices. We examine the dynamics of fossil fuel use, fuel price, and carbon price and investigate the impacts of integrating different economic sectors under a comprehensive ETS on fuel prices. Under the current European Union (EU) ETS, the carbon price has a strong positive correlation to the relatively volatile price of low carbon-content fossil fuel, such as oil and natural gas. This positive correlation is primarily driven by power generation facilities switching their input fuel between high and low carbon-content fossil fuels. However, the limited coverage of the EU ETS as well as the dominance of power facilities within the current framework mask a second underlying process which promotes negative correlation between the carbon price and fuel prices. This process is driven by GHG emitters decreasing fuel consumption in response to higher fuel prices, which consequently should decrease demand for GHG emission permits. Roughly half of all EU emissions are unaccounted for under the current ETS framework, and it is believed that this hidden segment is dominated by the aforementioned negative correlation process. This study uses a system dynamics simulation model to test whether a comprehensive ETS would reverse the observed dynamics that result in a positive correlation between the carbon price and low carbon-content fossil fuel. We segment the economy into four sectors: power, industry, transportation and other (commercial, residential, etc). Our model confirms that an ETS that covers the power sector alone or the power and industry sectors combined results in the observedpositive price correlation. However, our model predicts that all other combinations of sectoral coverage result in the reverse dynamic, and suggests that a more stable effective fuel price could be achieved by increasing the EU ETS's sectoral coverage. Furthermore, we find that a more stable effective fuel price can be obtained if the EU ETS expands its sectoral coverage, thus leading to a more stable economic environment and improving voters' perception of carbon mitigation policy.

Date of Award	2011
Original language	American English
Supervisor	Sgouris Sgouridis (Supervisor)