ESG Economist - EU ETS Price Scenarios: Economic impact the Netherlands
In September, ABN Amro Group Economics published projections for EU ETS prices under various scenarios. This note builds on those scenarios, analysing their potential impact on key macroeconomic variables in the Netherlands.
We consider four scenarios based on how ETS revenues are allocated: retained by the government, invested, or returned to households
The inflation rate rises over the next ten years in all scenarios
However, GDP outcomes vary depending on how ETS revenues are used
The most favourable GDP results occur when all ETS revenues are invested
Conversely, the economy performs the worst when revenues are solely used to reduce government debt
If households are compensated for their loss of real income, a positive outcome for GDP growth is still possible
Carbon pricing is the main policy tool to control emissions and to achieve climate ambitions. The EU is a world leader in climate policies through its emission trading system (EU-ETS) which is currently the world’s largest carbon market covering emission-intensive sectors. The price of the EU carbon allowances (EUAs) is the main driver of the energy transition process. Recently, our team published a note outlining our long-term projections for EUA prices across various scenarios (see here). In this note, we aim to build upon those scenarios by assessing the model outcomes of these EUA prices on key macroeconomic indicators in the Netherlands, including the consumer price index (CPI), gross domestic product (GDP), and households’ real disposable income.
Exploring different scenarios
In our analysis, we compare the results of a scenario with EU ETS prices based on stated policies, and one with ABN Amro’s own scenario for EUA prices. As outlined in the previously referenced note, the ABN baseline scenario incorporates the existing EU ETS market dynamics of supply and demand while factoring in a linear reduction factor set to increase to 4.3% starting from 2028, as indicated by current legislation. Additionally, in this scenario the start of the Carbon Border Adjustment Mechanism (CBAM) in 2026 is taken as given. Under these assumptions, EUA prices are projected to reach 145 EUR/tCO2 by 2030 and 200 EUR/tCO2 by 2035. The chart below illustrates the trajectory of EUA prices across four scenarios: ABN’s baseline scenario, the stated policies scenario, a pessimistic ABN scenario, and an optimistic ABN scenario.
Total auction revenues generated under the ETS system amounted to 43.6 bn EUR in 2023 (equal to 0.3% of nominal EU GDP), according to the European Environment Agency. Approximately 76% of this revenue was directly allocated to EU Member States. Under EU regulations, Member States are required to utilize all ETS income for climate-related purposes. These purposes range from government investments in renewable energy technologies, enhancing energy efficiency, and facilitating the transition to a low-carbon economy. Additionally, a portion of the income can be directed towards supporting lower- and middle-income households to offset the economic impact of climate policies, through measures such as income transfers or tax reductions. The way carbon revenue is used can impact GDP growth in different ways.
In a previous note (see here), we examined different scenarios and established that recycling carbon revenues through fixed investment yields the most favourable outcome in terms of GDP growth.
In this note, we aim to calculate the effects of three ABN EUA price scenarios and analyse the outcomes of four distinct approaches to utilizing government revenues:
Scenario 1 (Govt. in the graphs’ legends): The government retains all ETS revenues to reduce its budget deficit and lower government debt. This scenario is unlikely due to the legal obligations for the use of these funds (see above).
Scenario 2 (HH in the graphs’ legends): All ETS revenue is returned to households through measures such as tax reductions or income transfers.
Scenario 3 (50/50 PI/GI in the graphs’ legends): No revenue is returned to households. Instead, all proceeds are invested. We assume that half will be invested directly by the government, while the other half will be used to subsidise and encourage private sector investment.
Scenario 4 (HH, PI & GI in the graphs’ legends): A portion of the revenues is allocated to households to compensate their loss of real income, while the remainder is invested.
These scenarios will help to shed light on the potential macroeconomic implications of the projected EUA prices and the different ways of spending the revenue.
Results
Since the results across the various ABN Amro EUA price scenarios (base, optimistic and pessimistic) show only very small differences, this note focuses solely on the findings from the ABN’s baseline EUA price scenario.
When EU-ETS prices rise, the cost of emitting carbon increases in the ETS sectors. This increase drives up production and operational costs. These costs are subsequently passed on to consumers in the form of higher prices for goods and services. As expected, CPI steadily increases across all four scenarios over the ten-year period. In the scenario where all revenue is redistributed to households, the impact on inflation is highest, as the additional private consumption demand drives prices up further. In contrast, the lowest impact on inflation occurs when all ETS revenue is retained by the government, as this leads to the greatest reduction in GDP (see below) and, therefore, generates offsetting deflationary forces.
The impact of higher EU-ETS prices on GDP is more nuanced, as we can in the graph above on the right. To begin with, the higher inflation rate will reduce households’ disposable income, limit private consumption growth and reduce GDP growth. Also, the increased costs of emitting carbon can reduce business profit margins, discourage investments, or result in lower production levels, thereby affecting economic growth even further. However, if the government’s ETS revenue is either invested directly by the government or used to subsidise and encourage private sector investments, higher ETS prices could drive innovation and stimulate investments in green technologies or renewable energy sectors, potentially boosting productivity and fostering economic growth in the long term. Ultimately, the overall effect on GDP depends on the balance between these opposing forces and the economic policies implemented.
As shown in the graph above on the right, GDP takes varying trajectories depending on how the government uses the ETS revenues. For instance, GDP reaches its lowest value in Scenario 1, where the government uses all ETS revenues to reduce government debt. Conversely, GDP growth is most robust in Scenario 3, where the revenues are fully used for investment in green technologies and renewable energy. In Scenario 4, a portion of the ETS revenue is used to compensate households for their loss of real disposable income (the necessary compensation would gradually rise from around 5% of revenues in 2026, to around 15% of revenues in 2035) and the rest is used for fixed investment. This scenario also demonstrates stronger GDP growth. Therefore, Scenarios 3 and 4 emerge as the most favourable options for GDP growth.
In the graph below, households' real disposable income over the next ten years is depicted across the four scenarios. As anticipated, Scenario 2 is most beneficial for households' disposable income, as the government returns all ETS revenues directly to them. However, this scenario does not yield the same positive results for GDP. In Scenario 4, households will maintain their real disposable income throughout the entire period due to receipt of part of the ETS revenues (see above).
Conclusion
ETS prices are expected to rise in the coming years, which will inevitably put some upward pressure on consumer prices. However, governments play a key role in determining how to mitigate the broader economic impact.
Our analysis indicates that the scenario with the most favourable impact on GDP is Scenario 3, where ETS revenues are either invested directly by the government or used to subsidise and encourage private sector investment. However, in this case, households’ disposable income is negatively affected due to higher inflation.
If governments choose to compensate households to ensure their disposable income remains unaffected, GDP growth would be slightly lower compared to Scenario 3. However, this approach would leave households better off while still resulting in higher GDP growth than the other two scenarios, where ETS revenues are not invested in the transition.