The zero lower bound

What happens when EU ETS emissions approach zero?

Photo by Jason Pischke on Unsplash

Strange things start to happen when you approach zero.

In nature the obvious example is when the temperature of water approaches zero degrees centigrade.

Most liquids contract as they are cooled. Water is one of the few exceptions. When liquid water is cooled, it contracts until a temperature of approximately 4 degrees centigrade is reached. As its cooled further it expands slightly, until it reaches zero when it expands by about 9%.

Strange things happen in macroeconomics too as zero nears.

The “zero lower bound” problem occurs when the short term nominal rate of interest approaches zero. At this point the central bank has little in the way of tools to stimulate economic growth - it cannot cut interest rates any further.

The end result, and the reason why many central bankers fear deflation, is a liquidity trap. When this happens everyone prefers to hold cash rather than assets. A negative spiral can develop whereby real interest rates increase, causing a contraction in investment and lower economic growth.

The only way out of it is to flood the economy with liquidity: quantitative easing, higher government spending, and direct cash handouts to individuals. The prospect of a liquidity trap forces government and the central bank to resort to extreme policies, less they become frozen.

This article explores what it may mean to approach net-zero emissions focusing on the EU carbon market. In the same way that zero interest rates result in a change in how market participants behave, the same could be true when we approach the zero bound on EU ETS emissions.