A wealth of ideas about wealth funds

There are many ways of designing a wealth fund based on revenues from carbon pricing.  Debate about these is necessary, but should not distract from the merits of the broader proposal. 

Last month I outlined the value of the carbon emissions, and the possibility of establishing a wealth fund based on revenue from carbon pricing.  This post provides some brief responses to questions that have been raised in response to this proposal.   There are many good design options to choose from.

Would the fund necessarily be national?

No.  There are many national wealth funds in operation, and national carbon wealth fund may well be a pragmatic way forward in many cases.  However, the Alaskan wealth fund is an example of a state based scheme, and others would be possible.  In the EU a fund could also be established either at EU or Member State level.  An international fund would be difficult and perhaps impossible to establish, but would appropriately reflect global nature of the climate change problem.

How would such a fund be governed?

There are many options here.  The most important criterion is that governance should benefit the ultimate owners of the asset, namely citizens, rather than the state or special interest groups.  This implies some independence from government.  Other criteria such as transparency and ethically sound investment will also be important[1].  Some have advocated a fully independent trust fund.  However in practice some degree of government oversight is likely to be required[2].

How would this global public good be allocated internationally?

The distribution between nations of access to the atmosphere has proved a major point of contention in global negotiations on limiting climate change, and this situation appears unlikely to change[3].  However existing carbon pricing regimes – or simply emitting free of charge – already use up a global public good.  Giving citizens and governments a greater stake in increased carbon prices is likely to decrease the quantity of emissions, and so the proportion of the global commons used[4].  This makes the approach I have proposed more compatible with good stewardship of the global commons than existing arrangements, at least for the next 50 years until revenues start to decline.

What would the macro-economic effects be?

These effects would probably not be large, at least for a national UK fund.  The payment into a UK fund would be around £16 billion p.a. at present, a little under 1% of GDP per annum[5].  This would be unlikely to cause major economic dislocation, especially if phased in over a few years.  The fund would grow large over time, reaching around £860 billion by the end of the century[6].  However this is not vastly larger than the Norwegian fund today, which is for a very much smaller economy.  Furthermore any fund would have the effect of redirecting revenue from consumption to investment, which would probably have a positive macroeconomic effect in the context of historic UK underinvestment.

Would such a measure be socially regressive?

The concern here is that poorer households spend a larger proportion of their income on energy than richer households, and so energy taxes, and thus carbon taxes, tend to hit them disproportionately harder.  However poor households still spend less on energy, and therefore carbon, in absolute terms than richer households, so an equal dividend, as I’ve proposed, would have a net progressive effect.   Furthermore, households account for only a minority of energy use, but would get the full benefit of dividends (or at least a large proportion), increasing the extent to which it is progressive.

However there are some important intergenerational issues to consider.   The proposal for a fund takes the view that present generations should safeguard capital assets so they retain value to future generations.  This is in line with the standard definition of sustainable development[7].  However there are distributional issues here which need to be addressed.  Some present citizens will be worse off.

How would it fit with other green taxes?

The proposal is clearly consistent with using green taxes more widely as a policy instrument.  What’s different from the standard approach to green taxes is the suggestion of placing revenue in capital fund rather than using revenue to fund current expenditure.  The landfill tax to which I referred in my original post currently raises around a billion pounds per annum[8].  It would be natural to add this revenue to a UK wealth fund.

Would distribution to citizens be the only use for funds?

There is no reason some of dividends from the fund should not be used to fund things like R&D.  As I have previously discussed there are many legitimate calls on revenue from carbon pricing.  However there are many compelling arguments for allocation direct to citizens, and this should in my view be a priority for the fund.

Each of these questions requires further elaboration of course, and there are many other questions to be resolved.  The design of any major new institution such as a carbon wealth fund will require a great deal of consideration of a range of issues.  However further examination appears to strengthen rather than weaken the case for such a fund.

Adam Whitmore – 22nd  March 2017

Thanks to John Rhys for raising some of these issues.  A variant of this post, responding to John’s points, was published on his website. 

 

[1] See Cummine (2016) cited in my original post for further details For a specific proposal for a UK wealth fund:  http://www.smf.co.uk/press-release-conservative-mp-calls-for-uk-sovereign-wealth-fund-to-address-long-term-and-structurally-ingrained-weaknesses-of-the-economy/

[2] See Barnes, Who Owns the Sky (2001)

[3] This problem does not arise for the conventional resources (such as oil and gas) that typically provide the income for sovereign wealth funds of the nations where the resources are located. There is an interesting question as to whether countries should have full property rights to natural resources within their territories, as is often assumed at present, but this is too large a subject to go into here.

[4] The assumption here is that increasing prices from current low levels will increase revenue.  Carbon prices would increase by a factor of say five or more in many cases, and it is unlikely that emissions would decrease by an equal factor – though if they did it would be very good news.

[5] This assumes 400 million tonnes of emissions are priced, compared with 2015 totals of 404 million for CO2 and 496 total greenhouse gases (source: BEIS), implying a high proportion of emissions are priced.  The carbon price is assumed to be £40/tonne, roughly the Social Cost of Carbon at current exchange rates and well above current levels.  This would give total revenue of £16 billion in the first year, less than 1% of UK GDP of approximately £1870 billion in 2015. (source: https://www.statista.com/statistics/281744/gdp-of-the-united-kingdom-uk-since-2000/ )

[6] Assuming that the UK reduces its emissions in line with the Climate Change Act target of an 80% reduction from 1990 levels by 2050, and then to zero by the end of the century, and that 80% of emissions are priced at the Social Cost of Carbon as estimated by the US EPA, converted at current exchange rates of $1.25/£.

[7] Sustainable development is usually characterised as meeting the needs of present generations without compromising the ability of future generations to meet their own needs.

[8] https://www.uktradeinfo.com/Statistics/Pages/TaxAndDutybulletins.aspx

Reform of the EUETS has at last made significant progress

The effective limit on the size of the MSR proposed by Council is an extremely welcome strengthening of the EUETS.  However it will still take a long time for the EUETS to become fully effective.

This post updates last week’s post to reflect the important agreement on the EUETS reached in Council earlier this week.  On Tuesday the Environment Council endorsed more ambitious EU ETS policy changes than those agreed by the European Parliament.  This surprised many observers (including me) and is a very welcome change.

The most important change is an effective limit on the size of the Market Stability Reserve (MSR).  Allowances held in the MSR will be cancelled if the MSR contains more than the previous year’s auction volumes, although the precise interpretation of this remains to be defined.   In effect this change means that the number of allowances in the MSR is unlikely to be more than about 500 -700 million after the limit takes effect in 2024.  Indeed the volume limit is tighter than I had previously expected to be possible when I was advocating a size limit on the MSR last June (see here).

The huge size of the MSR during Phase 4 means that this reform will likely result in a cancellation of about 3 billion tonnes from the MSR over Phase 4 (see chart).  Much of this 3 billion tonnes will go into the MSR in 2019, and will be cancelled in 2024 if the reform is finally adopted.

Chart:  The proposed reform will likely lead to cancellation of around 3 billion tonnes from the MSR

chart

Notes:  Uses base case emissions (see previous post), assumes 57% auctioning, and assumes all unallocated Phase 3 allowances go into MSR in 2020.  EP MSR is the MSR under the European Parliament proposals.  New MSR is with the new proposals from Council.  Source: Sandbag

Despite this proposal the market is likely to remain weak for a long time.  Emissions will remain below the cap until the middle or the end of the next decade, and perhaps for longer.  Volumes are not in any case likely to begin returning from the MSR until close to 2030, so the size limit will probably begin to bite in the 2030s.  Tightening the cap to reflect actual emissions remains essential for a well-functioning EUETS over the next few years, and additional measures to complement the EUETS will continue to be necessary (see my previous post for more on these points).   Indeed this reform increases the value of additional action as it implies that additional surplus allowances will indeed be cancelled, leading to greater reductions in cumulative emissions.

Nevertheless, despite its limitations, this reform is a substantial and very welcome strengthening of the EUETS.  Even though the market will still take many years to tighten, this reform is likely to have some influence on earlier prices as traders anticipate a tighter market.  Indeed, in contrast to the measures coming out of Parliament, the market responded immediately to the vote (prices temporarily increased €1/tonne, about 20%).   It is highly desirable that this reform is retained through the remainder of the legislative process.

Adam Whitmore  – 3rd March 2017

Thanks to Boris Lagadinov at Sandbag for useful discussions and providing the chart for this post.

With a weaker EUETS other policies must be stronger

The recent vote in the European Parliament and continuing discussions in Council make it clear that the EUETS is likely to remain weak for many years.  In this context, other climate change policies in Europe will need to be strengthened if Europe is to make a smooth and successful transition to a prosperous low carbon economy. 

The EUETS looks likely to continue with low prices and a large surplus for at least the next 10 years, and probably beyond …

The EUETS has been running a surplus since its early years.  This trend continued last year.  On preliminary estimates for 2016 emissions were around 11% below the cap.  By 2020 (the end of Phase 3 of the EUETS) the cumulative surplus of allowances will have reached nearly 4 billion tonnes, the equivalent of more than two complete years of emissions.  A little over half of this will be in the Market Stability Reserve (MSR), with the rest available to the market (see Chart 1).

Chart 1:  The surplus will have grown to nearly four billion allowances by 2020

capture

Source: Sandbag

Furthermore, there does not look likely to be any scarcity of emissions in Phase 4, which runs to 2030.  Total emissions over Phase 4 (2021-2030) look likely to be below the total cap (and perhaps greatly below) even with little abatement due to the carbon price (see Chart 2a).  The reason for this is that emissions start well below the cap – indeed emissions are already below the cap for 2020[1].  Consequently it takes a while for the cap to fall below emissions (see Chart 2b).  Indeed, the cap may not fall below emissions until after 2030, especially if there are significant reductions in generation of electricity from coal, which currently accounts for 40% of all emissions under the EUETS.  This type of case is illustrated by the low emissions scenario in the charts.

Chart 2a: There is no scarcity on average during Phase 4, and perhaps a large surplus

chart-2a

Source: Sandbag

Chart 2b: Emissions compared with the cap for Phase 4

chart-2b

Source: Sandbag

The reforms recently voted on by the European parliament do not significantly affect this situation …

The measures passed in the European Parliament last week include a doubling of the rate of transfer from the MSR for four years, so removing surplus allowances from the market more quickly.  This is welcome, but does not have much effect.  The surplus available to the market is so large that by the time it has been largely moved to the MSR the slower rate has had a chance to largely catch up (see Chart 3).  In both cases a substantial surplus persists for most of the decade even under the Base emissions case.

Chart 3: Effect of the MSR withdrawal rate

chart-4

Note:  This analysis assumes all allowances are allocated.  In practice some allowances may remain unallocated.   Source: Sandbag

The decision to cancel 800 million allowances from the MSR is also welcome.  Indeed much more cancellation will be required in future, and ideally the size of the MSR should be limited, for example to a billion tonnes.  However without further reform this will only have an effect in the very long term.  The MSR will be so large by the end of Phase 4 that allowances will take several decades to return at the maximum allowed rate of 100 million per annum (see Chart 4).  The 800 million allowances due to be cancelled would anyway have returned only in the about the 2050s.  They thus have almost no effect on the market over the next decade and a half.

Chart 4: Cancelled allowances from the MSR would anyway only return after decades

chart-5

 Source: Sandbag

As a result the EUETS seems likely to remain weak for the foreseeable future…

With such an oversupply of allowances the price seems likely to remain weak.  How weak is impossible to say, but the price has not perceptibly moved as a result of the recent vote in the ENVI committee and the Parliament.  Prices have remained at around €5/tonne, and the forward curve currently shows prices essentially flat at this level to 2020.  It is also hard to see scarcity of allowances being sufficient to drive substantial abatement for several years beyond 2020, and perhaps much longer.

This implies that the EUETS will fail to deliver adequate or efficient signals for either short term abatement or longer term investment in low carbon technologies. The EUETS looks likely to become mainly a backstop mechanism and an accounting and MRV framework, rather than the primary driver of action many wish it to be.

This in turns requires other policies to provide most of the incentives to decarbonise if low cost abatement opportunities are to be realised now, and if the European economy is to be put on track for a prosperous low carbon future.

The weakness of the EUETS is likely to represent a marked shift in climate policy in the EU …

The continuing weakness of the EUETS is likely to trigger a range of actions.  Some of these may be at the EU level but many are likely to be at the national level.  They are likely to include some mix of the following:

  • National carbon pricing initiatives, perhaps along the lines of UK carbon price floor and similar measures proposed in France, with perhaps groups of countries adopting similar or even co-ordinated policies.
  • Additional restrictions on coal plant, including closure in some cases.
  • Assistance with selected low carbon technologies, including CCS, for industry, especially as low EUA prices are likely to mean that the EUETS’ Innovation Fund will not be worth very much.
  • Emissions performance standards for certain sectors.
  • Continuing emphasis on energy efficiency and renewables.

This in turn risks further weaken the EUETS unless opportunities are taken to fix it in future.  Indeed it risks a reinforcing feedback of weaker price signals from the EUETS leading to more additional actions, leading to yet weaker price signals, and so forth unless action is taken.  Action to correct the EUETS and avoid this is certainly desirable, but now looks unlikely on any substantial scale for at least the next several years.

There is another possibility that might emerge.  One of the changes in the current package allows Member States to cancel allowances rather than auction them.  It is possible that a group of larger Member States could collaborate and cancel substantial number of allowances.  Such an approach would be to be most effective once the MSR has absorbed more of the current surplus.  This could lead to a group of Member States doing what Parliament has been unable to do, and Council appears unlikely to do.  This may not be a model of Europe wide decision making, but may be the as good a chance as any for the EUETS to succeed.

Yet such action by multiple Member States at a large scale still seems distant, and may never occur.  The priority must be to put in place other policies which help put the EU on track to meeting its long term decarbonisation goals, and which work towards delivering the Paris Agreement commitments.

Adam Whitmore – 24th February 2016

Notes:

This post is in part adapted from a talk I gave at the Dutch PermRep in Brussels on 7th February, modified to take account of the subsequent vote in the Parliament.

Thanks to Boris Lagadinov and others at Sandbag for providing the charts for this post.  Further material can be found on the Sandbag website.

[1] Emissions in 2016 were 1754Mt (preliminary estimate) compared with the 2020 cap of 1816Mt.

How not to squander $130 trillion

Carbon pricing should be used to establish wealth funds from which current and future citizens can benefit. 

The world has a limited carbon budget …

Climate change depends on the cumulative total of emissions of greenhouse gases, so total cumulative emissions globally must be limited by the need to limit climate change.  This limited total of cumulative emissions is sometimes referred to as a global carbon budget.  Specifically, if global mean surface temperature rises are to be limited two degrees centigrade, as now mandated in the Paris Agreement, total cumulative CO2 emissions from now on must be limited to around 1600 billion tonnes of CO2[1]. From this perspective the atmosphere is a finite resource that can only be used once, rather like any exhaustible natural resource, with the important caveat that (unlike many natural resources) no more atmosphere remains to be discovered.

But currently the value of this resource is being squandered …

At the moment only a very small proportion of greenhouse gas emissions is priced adequately.  Most emissions remain unpriced, and the growing proportion that is priced is mostly sold at well below both the cost of damages, and well below the value of an increasingly scarce resource.  A valuable scarce resource is thus being given away or sold below cost, subsidising emitters.  Huge natural wealth is being squandered.  And once gone it can never be replaced[2].

It would be better to use revenue from carbon pricing to create a wealth fund to benefit both current and future generations …

So is there a better approach to managing this precious resource?  It seems to me that there is. It would be much better to realise value of emissions in the form of a fund for citizens, with proceeds from carbon pricing (the sale of allowances or taxes) at adequate levels paid into the fund.  Carbon pricing should be comprehensive, with prices at adequate levels.  The finite volume of the resource implies it is best used to establish a wealth fund, where financial capital is built as natural capital is used up.  The fund would belong to all citizens.  Granting its value to citizens would surely encourage better management of the atmosphere, and thus the climate, and higher carbon prices than generally prevail at present.

Such a fund would be analogous to a sovereign wealth fund based on oil and gas reserves, of which the Norwegian fund is the leading example[3].  Wealth is invested in productive activity, with the income from this available to fund pensions and other expenditure. So, how much might this resource be worth in purely financial terms?

Such a fund could be enormously valuable …

Each tonne of CO2 emitted to the atmosphere should be priced at a minimum of the cost of damages from climate change – the social cost of carbon. This is currently around US$50/tonne, and rising over time.  Emissions may be more valuable than this, either because of the limitations in estimates of the social cost of carbon (see here), or because the value of the emissions in terms of the economic activity they enable is greater than their cost in environmental damage.  But evaluating the resource at its cost at least puts a lower bound on its value, unless the economic value of those emissions is below the cost assumed here, which seems unlikely with such a constraining budget[4].

The profile of emissions also matters.  For simplicity I’ll assume current emission levels to 2020, then a linear decrease to the end of this century[5].  This is broadly similar to many emissions tracks that have been modelled as consistent with 2 degree warming, and (consistent with this) the cumulative total is close to the 1600 billion tonnes budget I mentioned above.  It is also consistent with the Paris Agreement goals of reaching net zero emissions at some point in the second half of the century[6].

The annual value of emissions is then estimated from multiplying the (rising) cost of emissions with the (falling) quantity of emissions.  This is shown in the chart below.  The effects of rising prices and falling emissions roughly balance over the next 50-60 years or so, with revenues remaining roughly similar at close to $2 trillion p.a..  Revenues then fall rapidly in the last quarter of the century as emissions fall to zero.  The eventual value of the fund, excluding investment returns and dividends paid out, is the sum of these annual revenues (the area under the curve).

Chart: Potential annual revenue into carbon funds globally … chart

On this basis, the total value of the remaining carbon budget is a staggering $130 trillion.  This is equivalent to $13,000 for each person in the world, assuming world population of 10 billion people later this century.  A 3% annual dividend from this would generate about $400 p.a. for everyone .

Towards a citizens’ dividend …

Dividends from the fund could be used in many ways.  One approach with a range of advantages is distributing benefits to all in the form of a “citizen’s dividend”.  There is already a feature of the Alaskan wealth fund derived from oil revenues, where distribution is in the form of a Permanent Fund Dividend to all citizens.  This is widely considered to have helped build and maintain public support for the scheme[7].

This approach is closely related to the idea of “tax and dividend” carbon pricing.  I have previously argued that such approaches have merit, and indeed tax and dividend has recently been advocated by senior Republicans in the USA[8].  However, there is an important difference between a fund and tax and dividend as often presented, in that revenues are used to establish a fund that is intended to be permanent, whereas tax and dividend proposals often assume revenues to be distributed in full.

There is also a relationship between the idea of a citizen’s dividend and a universal basic income, which is much discussed at the moment and subject to a few trials.  However, there is a crucial difference in that the citizen’s dividend does not seek to provide an adequate income.  Rather it is simply a return on funds invested.  Instead, it is likely to be one component of any universal basic income.

Who would benefit?

There is a natural case for distributing dividends equally, as all have equal rights to the atmosphere.  The atmosphere is a global resource, and climate change knows no borders, so it is natural to make any fund global.  However establishing such an arrangement is likely to be too great a political challenge.

A bottom up approach with individual nations pricing carbon and establishing their own funds is likely to be much more tractable.  Such a national approach would have other advantages.  For example, it would allow other environmental taxes, such as those on landfill, and indeed other sources of revenue to contribute to the fund.  A series of national funds would not stop any fund being used to finance activities of international benefit – indeed such uses would be highly desirable.

Establishing national funds will have many challenges.  However the prize seems large enough to be worth pursuing.  The current system of simply allowing emissions to be dumped into the atmosphere, often free of charge and almost always too cheaply, is a waste of a unique and irreplaceable asset.  Irreplaceable natural wealth such as the atmosphere should be managed carefully, not squandered recklessly.

Adam Whitmore – 13th February 2017 

[1] Based on “Warming caused by cumulative carbon emissions towards the trillionth tonne”.  Allen et. al. Nature vol. 458 (2009), adjusted for emissions since the publication of that paper.

[2] Many people, including me, would also wish to note the ethical dimension here.  It is not appropriate to treat the atmosphere only as mere resource for people to use as they wish, and all decisions about its management must reflect ethical considerations, including responsibilities to future generations, and the duty of care to the world’s natural heritage.  I am simply arguing here that treating it as valuable resource would be a major step forward from treating it as a resource to be used as though it were unlimited and emissions were inconsequential, as is often the case at present.

[3] For an excellent review of Sovereign Wealth Funds and how they could be better managed and used for the benefit of citizens see Angela Cummine, Citizens’ Wealth, Yale University Press, 2016.

[4] If the price would be lower than the SCC with this emissions track it implies that the 2 degree target is too loose and 1.5 degree or lower would be preferred.

[5] This is a rough and ready calculation, taking CO2 emissions from energy and industry only.  It ignores the effect of other gases and effectively assumes other sources of CO2, mainly deforestation, are approximately net zero cumulatively over the century after taking into account the role of sinks and deforestation.  This may be optimistic.  Adjusting for these would lead to a higher starting point and steeper decrease in emissions, reducing somewhat the value of the fund.

[6] In this scenario emissions are low enough to be balanced by a small quantity of negative emissions by the last decade of the century.

[7] See Angela Cummine, Citizens’ Wealth, Yale University Press, 2016., p.140-2.

[8] See “US Republican elders push for carbon tax”, Carbon Pulse, 8th February 2017

Can emissions trading produce adequate carbon prices?

Prices under emissions trading schemes have been low to date.  Sometimes this may be because systems are new, but the EUETS is long established and needs to demonstrate that it can now produce adequate prices. 

Prices under emissions trading systems around the world have so far remained low.  The chart below shows carbon pricing systems arranged in order in increasing price, with prices on the vertical axis shown against the cumulative volume covered on the horizontal axis.  Carbon taxes are shown in purple, emissions trading systems in green.  It is striking that all of the higher prices are from carbon taxes, rather than emissions trading systems.

Prices under Emissions Trading Systems and Carbon taxes in 2016

capture

Source:  World Banks State and Trends of carbon pricing report[1].  Prices are from mid-2016.

Prices in the largest emissions trading system, the EUETS have been around $5-6/tonne, and prices in the Chinese pilot schemes have been similar and in some cases even lower, although with little trading.  The price under the California and Quebec scheme (soon to be joined by Ontario) is somewhat higher.  However, this is supported by a floor set in advance and implemented by an auction reserve price.  If this price floor were not present a surplus of allowances would very likely have led to lower prices.  The Korea scheme has had very low trading volumes, so does not provide the same sort of market signal found under more liquid schemes.

In contrast, a wide range of carbon taxes are already at higher levels and in some cases are due to increase further.  The French carbon tax, which covers sectors of the economy falling outside the EUETS, is planned to reach €56/tCO2 (US$62/tCO2) in 2020 and €100/tCO2 (US$111/tCO2) in 2030[2].  In Canada a national lower limit on carbon prices for provinces with an explicit price-based system (not shown on the chart) is due to reach $50 per tonne in 2022[3]. The UK carbon price floor, which covers power sector emissions, was due to rise to substantially above current levels, but is currently being kept constant by the Government, mainly because the price under the EUETS is so low.

Increases such as those due in France and Canada will bring some carbon taxes more in line with the cost of damages, and thus to economically efficient prices.  The cost of damages is conservatively estimated at around $50/tonne[4], rising over time (see here for a discussion of the social cost of carbon and associated issues).  The increases will also bring prices more into line with the range widely considered to be necessary to stimulate adequate low carbon investment[5].

Low prices under emissions trading systems have been attributed to a range of factors, including slower than expected economic growth and falling costs of renewables[6].  However these factors do not explain the consistent pattern of low prices across a variety of systems over different times[7].

While it is difficult to derive firm evidence on why this pattern should be present, two factors seem plausible.  The first is systematic bias in estimates – industry and governments will expect more growth that actually occurs, costs will be overestimated, and these tendencies will be reflected in early price modelling, which can often overstate likely prices.

But the second, more powerful, tendency appears, based on anecdotal evidence, to be that there is an asymmetry of political risk.  The political costs of unexpectedly low prices are usually perceived as much less than those of unexpectedly high prices, and so there will always be tendency toward caution, which prevents tight caps, and so leads to prices being too low.

This tendency is difficult to counteract, and has several implications for future policy.

First, it further emphasises the value of price floors within emissions trading systems.  Traditional environmental economics emphasises the importance of uncertainty around an expected level of abatement costs or damages.  If decision makers are not in fact targeting expected average levels, but choosing projections of allowance demand above central expectations then the probability of very low prices is increased, and the case for the benefits of a price floor is stronger.

Second, it implies that it is even less appropriate than would anyway be the case to expect the carbon price alone to drive the transition to a low carbon economy.  Measures so support low carbon investment, which would in any case be desirable, are all the more important if the carbon price is weak (see here for a fuller discussion of the value of a range of policy measures).   While additional measures do risk further weakening the carbon price, they should also enable reduced emissions and tighter caps in future.

Third, it requires governments to learn over time.  Some low prices may reflect the early stage of development of systems, starting slowly with the intention of generating higher prices over time.  However this does require higher prices to eventually be realised.

The EUETS has by some distance the longest-established system, having begun eleven years ago and with legislation now underway for the cap to 2030, by which time the system will be 25 years old.  The EU should be showing how schemes can be tightened over time to generate higher prices.  However it now looks as though the Phase 4 cap will be undemanding compared with expectations (see previous posts).  The recent vote by the European Parliament’s ENVI committee failed to adopt measure that are adequate to redressing the supply demand balance, with tweaks to the market stability reserve unlikely to be enough.  This undermines the credibility of cap-and-trade systems more generally, rather than setting the example that it should.  Further reform is needed, including further adjustments to supply and preferably auction reserve prices.

The advantages of cap-and trade systems remain.  Quantity limits are in line with the international architecture set by the Paris Agreement.  They also provide a clear strategic signal that emissions need to be reduced over time.

However there is little evidence to date that emissions trading systems can produce adequate prices. The EU, with by far the most experience of running an ETS, should be taking the lead in substantially strengthening its system.  At the moment this leadership is lacking.  Wider efforts to tackle climate change are suffering as a result.

Adam Whitmore – 23rd January 2017

[1] https://openknowledge.worldbank.org/handle/10986/25160

[2] World Bank State and Trends in Carbon Pricing 2016.  See link in reference 1.

[3] http://news.gc.ca/web/article-en.do?nid=1132169  Canadian provinces with volume based schemes such as Quebec with its ETS must achieve emissions reductions equivalent to these prices.

[4] $40/tonne in $2007, see https://www.epa.gov/climatechange/social-cost-carbon, escalated to about $50 today’s dollars.

[5] See this recent discussion: https://www.weforum.org/events/world-economic-forum-annual-meeting-2017/sessions/the-return-of-carbon-markets

[6] Ref: Tvinnereim (2014) http://link.springer.com/article/10.1007%2Fs10584-014-1282-1#page-1

 

[7] The South Korea ETS may be a partial exception to the pattern.  However it is unclear due to the lack of liquidity in the market.

When carbon pricing works

The UK’s carbon price floor mechanism has proved very effective at securing cost-effective emissions reductions.  It offers lessons for other carbon pricing schemes.

I have previously pointed out some of the flaws with carbon pricing schemes, notably the EUETS, so it seems appropriate for balance also to look at an example of carbon pricing working well.

There are few more successful examples of carbon pricing, or indeed of climate change policy generally, than the UK’s carbon price support (CPS), which in effect tops up the carbon price set by the EUETS for UK power generation.  It has been an essential element in securing large scale, cost effective emissions reductions over the last few years, mainly by incentivising a switch from coal to gas.

Emissions from coal generation in the UK have fallen by around 80% in the last four years (see chart).  The net reduction in emissions less than that, as much of the generation from coal has been replaced with gas, but this still amounts to a net reduction of around 10-15% of total UK emissions of greenhouse gases.  (Gas generation remained almost constant between 2012 and 2015, as demand fell and renewables grew rapidly, although it may increase this year.  However it would have almost certainly fallen in the absence of the CPS, with coal declining much less rapidly than it has.)

Emissions from coal generation in the UK have fallen rapidly …

fall-in-uk-coal-emissions

Source:  EUETS data, 2016 estimate by Sandbag.

The reduction in emissions from coal has been due to a range of factors, including the age of the UK’s coal plant, almost all of which dates from the 1960s, regulation of other pollutants, falling demand, the growth of renewables and low gas prices.  But a good deal of the reduction has been due to the CPS, especially in the last two years, when its level has been increased significantly.

The carbon price floor (EUETS plus carbon price support) has led generation from gas to be cheaper than that from coal.  This is shown in the chart below from Cornwall Consulting.  The red crosses show the costs of generation without carbon price support.  Coal is cheaper than gas (around £30/MWh vs. £38/MWh).  However with the carbon price in the order is reversed.  Gas becomes cheaper than coal, so tends to run more.  Coal stays on the system due to the capacity price, providing system security, but runs much less.

cornwall-consulting-graphic

Source: Cornwall Consulting  

This has been achieved with a carbon price that remains quite moderate.  It is little more than half the cost of the damages caused by emissions (the social cost of carbon, see here and reference therein), and in line with or lower than a range of other carbon taxes (see the recent World Bank Report p.27 ).

The carbon price floor also has a number of other advantages.  For example, but increasing the price of fossil generation it makes onshore wind more competitive.  Onshore wind is the cheapest form on low carbon power in the UK, and receives no subsidy at present.

It has been argued that the emissions reductions due to carbon price support are not retained due to the presence of the EUETS cap, but this is not true in practice (see previous post here), with the vast majority of the reductions retained in full.  However it would be much better still if there were an EU wide floor price, and the EUETS price were at or above the current UK carbon price.

This UK experience shows a number of things.  Firstly carbon pricing can be effective even at fairly moderate levels.  Second, fuel switching can indeed offer substantial, low cost abatement in the short to medium term even if it is not enough in the long term.  Third, a lower bound on price is useful in an ETS – these reductions would not have happened as a result of the EUETS alone.  Fourth, system security is consistent with emissions reductions if coal is kept on the system for a while, but does not run much.

The UK government is understood to be reviewing the role of the carbon price floor at the moment.  In view of its effectiveness and the example this sets for other jurisdictions, the government needs to ensure that the price is maintained at a minimum of its current level, and extended beyond 2020.

Adam Whitmore – 9th November 2016

 

Additional actions in EUETS sectors can reduce cumulative emissions

It is often claimed that additional actions to reduce greenhouse gas emissions in sectors covered by the EUETS are ineffective because total emissions are set by the level of the cap.  However this claim is not valid in the current circumstances of the EUETS, and is unlikely to be so even in future.  Additional emissions reduction measures in covered sectors can be effective in further permanently reducing emissions.

This post is longer than usual as it deals with a very important but relatively technical policy issue.

The argument about the effectiveness of additional actions to reduce emissions …

Many additional actions are being taken to reduce greenhouse gas emissions in sectors covered by the EUETS.  These include energy efficiency programmes, deployment of renewables, replacing coal plants with less carbon intensive generation, and national carbon pricing.

It is often argued that such additional actions do not reduce total emissions because the maximum quantity of emissions is set by the EUETS cap, so emissions may remain at the fixed level of the cap, irrespective of what other action is taken (see the end of this post for instances of this argument being used publicly).

However, this argument does not stand up to examination.

Assessment of the argument needs to take account of the current circumstances of the EUETS.  Emissions covered by the EUETS were some 200 million tonnes (about 10%) below the cap in 2015.  This year emissions are likely to be 13% below the cap.  The EUETS currently has a cumulative surplus of almost three billion allowances, including backloaded allowances currently destined for the Market Stability Reserve (MSR), and the surplus is set to grow as emissions continue to be less than the cap.

In these circumstances emissions reductions from additional actions will mainly increase the surplus of allowances, with almost all of these allowances ending up in the (MSR).  These allowances will stay there for decades under current rules, and so not be available to enable emissions during this time.

Indeed, in practice these allowances are unlikely ever to enable additional emissions.  The argument that they will assumes that the supply of allowances is fixed into the long term.  In practice this is not the case.  Long term supply of allowances is determined by policy, which can and does respond to circumstances.  Additional surpluses and lower prices are likely to lead to tighter caps than would otherwise be the case, or cancellation of allowances from the MSR or elsewhere.

The remainder of this post looks at these issues in more detail, including why the erroneous view that additional actions don’t reduce cumulative emissions has arisen.

Why current circumstances make such a difference

The argument that additional actions to reduce emissions will be ineffective reflects how the EUETS was expected to operate when it was introduced. It was assumed that demand for allowances would adjust so that the quantity of allowances used would always equal to the cap, which was assumed to be fixed.

This is illustrated in stylised form in the diagram below.  The supply curve is vertical – perfectly inelastic supply.  Demand for allowances without additional actions leads to prices at an initial level.  Additional actions reduce demand for allowances at any given price, effectively shifting the demand curve to the left by the amount by which additional actions reduce emissions.  This leads price to fall until the lower price creates sufficient additional demand for allowances, so that total demand for allowances is again equal to the supply set by the cap.  Because the supply curve is fixed (vertical) the equilibrium quantity of emissions is unchanged, remaining equal to the cap[1].

Chart 1: A price response to the change in demand for allowances can lead to emissions re-equilibrating at the cap when allowances are scarce …

first-chart

However, at present, large increases in emissions (such that emissions rise to the cap) due to falling prices are clearly not occurring, and they seem unlikely to do so over the next few years.  As noted above, the market remains in surplus both cumulatively and on an annual basis.  The price would be close to zero in the absence of banking of allowances into subsequent phases, because there would be a cumulative surplus over Phase 3 of the EUETS, and so no scarcity[2].

If demand were further reduced in the absence of banking there would be no price fall, because prices would already be already close to zero.  Correspondingly, there would be no increase in demand for allowances to offset the reduced emissions from additional actions.  The emissions reductions from additional actions would be retained in full. This is again illustrated in stylised form in the diagram below. 

Chart 2: With a surplus of allowances and price close to zero (assuming no banking) any reduction in demand for allowances will be retained in full …

chart-1

In practice the potential to bank allowances and the future operation of the MSR supports the present price.  It is expected that in future as the cap continues to fall allowances will become scarce.  There is thus a value to allowances set by the cost of future abatement.

Additional actions now to reduce emissions increase the surplus, and so postpone the expected date at which the market returns to balance.  This reduces current prices.  This will in turn lead to some increase in emissions.  However, this increase will be small – much smaller than if the market were short of allowances now.

Quantifying this effect 

Modelling indicates that if additional actions are taken over the next 10-15 years, then the increase in demand for allowances due to falling price will be less than 10% of the size of the reduction in emissions[3].  Correspondingly more than 90% of the emissions reductions due to additional actions are retained, adding to the surplus of allowances which, which end up in the MSR.  Modelling parameters would need to be in error by about an order of magnitude to substantially affect this conclusion.

This effect arises in part because of the low level of prices at present.  This means that even a large percentage change in price leads to a small absolute change, and thus a small effect on demand for allowances.  Even a 50% price fall would be less than €3/t at current price levels.  It also reflects that the shape of the Marginal Abatement Cost curve, with price falls only increasing abatement by a small amount.  This means that even if prices are higher than current levels the effect of price falls on demand for allowances is still relatively small.

The relatively small response to price changes is consistent with the current market, where there is a lack of sufficient increase in demand to absorb the current yearly surplus (or even to come close to doing so).

The 90%-plus of the allowances freed up by additional actions are added to the surplus end up over time in the MSR.  They then stay there for several decades.  This is because even without additional actions, and even with some reform of the current proposals for Phase 4 (which covers 2021 to 2030), the MSR is likely contain at least three billion allowances by 2030, and perhaps as much as five billion.  This will take until 2060 to return to the market, and perhaps until the 2080s, at the maximum rate written into the legislation of 100 million per annum.

Any additional surplus will only return after this.  Even if the return rate of the MSR were doubled the return time for additional surplus would still be reckoned in decades from now.

This will be even more the case if proposals for the EUETS Phase 4 are not reformed, and the surplus of allowances being generated anyway is correspondingly greater.

The implications of the very long delay in the return of allowances

It seems unlikely that allowances kept out of the market for so long would ever lead to additional emissions.  It would require policy makers to allow the allowances to return and enable additional emissions.  This would be at a time when emission limits would be much tighter than they are now, and indeed with a commitment under the Paris Agreement to work towards net zero emissions in the second half of this century.

There are several policy mechanisms that could prevent the additional surplus allowances enabling emissions.  Subsequent caps tighter as unused allowances reduce the perceived risk of tighter caps, and additional actions now set the economy on a lower carbon pathway.  Furthermore, with a very large number of allowances in the MSR over several phases of the scheme, allowances may well be cancelled.  Indeed, over such long periods the ETS itself may even be abolished or fundamentally reformed, with allowances not carried over in full.  Or a surplus under the EUETS may persist indefinitely as additional actions succeed in reducing emissions.

As the market tightens towards 2030 it is likely that a higher proportion of any additional emissions reductions will be absorbed by the market via a price effect, but it still seems unlikely to be as much as 100% given the long term trend to lower emissions and the lack of additional sources of demand, especially in the event of large scale additional actions[4].  Some of the policy responses described would still be expected to reduce the supply of allowances.

Conclusions

The argument that emissions will always rise to the level of the cap manifestly does not hold at present, when emissions are well below the cap. and there is a huge cumulative surplus of allowances.

In future, it seems likely that more than 90% of reductions in emissions from additional actions will simply add to the surplus, and eventually end up in the MSR.  They at least stay there for several decades, because of the very large volume that will anyway be in the MSR.

While there is in principle a possibility that they will eventually return to the market and allow additional emissions this appears most unlikely in practice.  Policy decisions will be affected by circumstances and this can readily prevent additional emissions, through some combination of tightening of the cap and cancellation of allowances.

Even when the market returns to scarcity these policy responses are likely to hold to a large extent, for example with lower prices enabling more stringent caps.  The hypothesis of no net reductions in emissions from additional actions thus seems unlikely ever to hold true.

Spurious arguments about a lack of net emissions reductions should not be used as a pretext for failing to take additional actions to reduce emissions now.

Adam Whitmore – 21st October 2016

 

Note:  A more detailed review of the issues raised in this post, and the accompanying modelling can be found in this report.

 

Examples of statements invoking the idea of fixed total emissions

For example, in 2015 RWE used such arguments in objecting to the closure of coal plant:

“The proposals [to reduce lignite generation] would not lead to a CO2 reduction in absolute terms.   [The number of] certificates in the ETS would remain unchanged and as a result emissions would simply be shifted abroad.” [5]

Similarly, in 2012 the then Chairman of the UK’s Parliament’s Energy and Climate Change Select Committee, opposed the UK’s carbon price support mechanism for the power sector arguing that:

“Unless the price of carbon is increased at an EU-wide level, taking action on our own will have no overall effect on emissions”[6]

Neutral, well-informed observers of energy markets have also made this case.  For example, Professor Steven Sorrel of Sussex University recently argued that:

“Any additional abatement in the UK simply ‘frees up’ EU allowances that can be either sold or banked, and hence used for compliance elsewhere within the EU ETS[7]

 

 

[1] This is analogous to the well-established rebound effect for energy efficiency measures.  Improved domestic insulation lowers the effective price of energy, so consumers take some of the benefits as increased warmth, and some as reduced consumption.  The argument here is that in effect there is a 100% rebound effect for emissions reductions under the EUETS.

[2] Such a situation occurred towards the end of Phase 1 of the EUETS (2005-7), which did not allow banking into Phase 2.  Towards the end of the Phase there was a surplus of allowances and the price fell to close to zero.

[3] The price change is modelled by assuming the price is set by discounting future abatement costs, with a later date for the market returning to balance leading to greater discounting and so a lower price.  The increase in demand for allowances is modelled based on a marginal abatement cost curve and consideration of sources of additional demand.  See report referenced at the end of this post for further details of the modelling.

[4] There are likely to be path dependency and hysteresis effects in the market which prevent a full rebound.

[5] See RWE statement, “Proposals of Federal Ministry for Economic Affairs and Energy endanger the future survival of lignite”, 20 March 2015. http://www.rwe.com/web/cms/en/113648/rwe/press-news/press-release/?pmid=4012793

[6] http://www.parliament.uk/briefing-papers/sn05927.pdf

[7] http://www.energypost.eu/brexit-opportunity-rethink-uk-carbon-pricing/