EU-type carbon regulation and the waterbed effect of green energy promotion

Highlights: • Waterbed effects are analyzed in a stylized model of the European Union. • Countries participate in an ETS, set national caps on non-ETS emissions, and subsidize renewable energy. • We elaborate waterbed effects with respect to ETS emissions and welfare. • When a country increases its feed-in tariff, its ETS emissions decrease whereas the other countries' ETS emissions increase. • When a country increases its feed-in tariff, it suffers a welfare loss whereas the other countries gain welfare. -- Abstract: This paper studies waterbed effects in a stylized model of carbon regulation, in which all countries participate in an emissions trading scheme (ETS), implement national emissions caps on non-ETS emissions, and support green electricity. Since a change in some country's ETS emissions is exactly offset by opposite changes in the other countries' ETS emissions (waterbed effect), allocative disturbances in one country affect all other ETS countries. We analyze the allocative displacement effects on inputs, outputs, prices and trade that a country, say country A, triggers at home and in the other ETS countries, when it unilaterally increases its support of green electricity via raising its feed-in tariff. ETS emissions turn out to decline in country A and to rise in the other countries. Another remarkable waterbed effect is that country A suffers a welfare loss, whereas the other countries are better off. Country A's welfare loss is larger than it would be if there would be national ETSs instead of the joint ETS. If green electricity support takes the form of subsidies on the electricity price instead of feed-in tariffs, we get another waterbed effect: green electricity production increases in country A, but declines in the other countries. Various decarbonization indicators improve in country A, but tend to point into the opposite direction in the other countries.