Flawless floor prices?

The recent failure of the backloading proposal in the European parliament focusses attention on longer term structural changes to the EUETS.  The EU may be able to learn something about effective carbon pricing from the USA, where floor prices are already in place in state-level schemes.  If agreement cannot be reached at EU level, then national floor prices, such as that recently introduced in the UK, may become increasingly attractive to governments.

Although there has been much recent debate about its future, in many ways the EUETS is working well.  Emissions reduction targets have been reached, and as emissions are now below the capped levels allowance prices are low.  However, it is clear with hindsight that much more ambitious emissions reduction targets could have been achieved at moderate cost, making a much greater contribution to sustaining EU leadership on mitigating climate change.  Since the European Parliament rejected the proposal to postpone the sale of some EUAs (“backloading”), which anyway was never intended as more than a temporary adjustment, attention has focussed again on changes that will have a longer lasting effect on the supply of allowances and thus prices.

The European Commission published a review of the EUETS in November last year[i] that included longer term options for reform.  Several of the options reviewed involved making one-off adjustments to the supply of allowances.  Such measures would have benefits, but they would do little to prevent similar situations of oversupply arising again.  And they could increase perceived political risk by creating precedent for similar arbitrary interventions in future, which may deter those looking to invest in reducing emissions.  But the review also mentioned the possibility of continuing adjustments to the quantities of EUAs made available to the market, either by creating a managed reserve of allowances, or by introducing a floor price (and possibly a ceiling price), which would create a more systematic change to the EUETS.

An effective floor price could easily be introduced by setting a reserve price in EUA auctions.  This would automatically lead to a reduced quantity of allowances being made available in the market, and thus a greater reduction in emissions compared with the original cap in the event of excess supply.  (A further design choice would then need to be made as to whether any unsold allowances would be permanently removed, for example at the end of each phase of the scheme.)  A reserve price could create greater certainty for investors in low carbon technology, and greater stability for the scheme itself.  Indeed there is a tradition in the policy literature going back to the mid-1970s advocating the economic advantages of such hybrid approaches, combining elements of both price and quantity setting, when damage and abatement costs are uncertain, as they inevitably are.  Reserve prices could also make for more stable government revenue, and for this reason alone they are likely to attract continuing attention from governments.

Reserve prices are already in place in auctions in North American trading schemes.  In the Regional Greenhouse Gas Initiative (RGGI) the auction reserve price, which is currently around $2/tCO2 indexed to inflation, has been effective in maintaining the price at the floor, despite a chronic surplus of allowances.  More recently the California scheme has been introduced with a reserve price at the much higher level of $10/tCO2 escalated at inflation plus 5%, and the Quebec scheme has similar arrangements.  Although California allowances are now trading at prices significantly above the floor it does seem to have influenced the price in the first auction, which cleared at only a little above the floor price.  The Australian scheme also had a planned floor price, due to apply from the start of the floating price phase of the scheme in mid-2015, but this was abolished following the link to the EUETS.  However it has retained a fixed price for the first three years, at an initial level of $23/tCO2, escalated at 5% p.a. nominal for the first three years of the scheme.

Such provisions could easily be extended to create a stepped floor by setting different reserve prices for different tranches of allowances.  This would in effect offer a supply schedule into the market, representing different prices and quantities of abatement.  Indeed something like this already exists in the California scheme where successive additional tranches of allowances are available at prices of $40/tCO2, $45/tCO2 and $50/tCO2, which like the floor price are indexed to increase over time.

Some object that floor prices are “interfering with the market”.  However this concern does not seem well founded.  They are a feature of market design rather than an interference with it, and one which has a very long history.  Reserve prices feature in many types of auctions, whether they are there to prevent your favourite Rembrandt selling for a few pounds, or your latest e-bay offering selling for a few pence.  Such measures aid the functioning of a market, rather than interfering with it.    Stronger arguments apply to limiting the effect of price ceilings, where there may be good reasons on environmental grounds for a hard cap on emissions at some level, even in the event of high prices.

If agreement cannot be achieved across the EU, national governments may seek to impose a floor price in their own jurisdictions.  Putting in place a national auction price floor would not be effective as it would not do enough to restrict total EU supply.  However there is another possibility in the form of a tax that in effect tops up the EUA price, and such a mechanism has recently been introduced for the power sector in the UK.  A similar scheme was proposed in Australia for putting a floor on the price of international allowances by charging a surrender fee, but this will not now be introduced as the floor price was removed with the establishment of the EUETS linkage.

At present the UK tax is set around two years in advance (the 2015/16 value has recently been announced, with indicative values for the subsequent two years[ii]), targeting a total price comprising the tax plus the EUA price.  There is no guarantee that it will set a true floor price, as EUA prices can change a good deal in the interim.  Indeed, for this year the price is set at £4.94/tCO2, reflecting previous expectations of higher EUA prices, and unless there is a recovery in EUA prices the total carbon price for this year looks likely to be around £8/tCO2, well below the original target for the year of £16/tCO2 in 2009 prices (around £17.70 in 2013 prices). In this respect the original proposal for a rebateable tax seems a much superior design.  The tax would have been charged at the level of the floor price but the out-turn EUA price for the year could have been used to set a rebate on the tax, thus creating a floor at the level of the tax irrespective of where the EUA price ended up.  This would have made it much closer to a true hybrid of a tax and trading than the measure that has been introduced, which to some extent is simply two separate carbon prices added together, albeit with expectation of one influencing the other[iii].

The standard objection to a floor in one country is that it does not change of the overall cap at an EU level so does not decrease emissions.  However, the tax does make a contribution to reducing the UK’s emissions themselves, thus enhancing UK leadership.  The UK can also meet its own legally binding emissions reductions objectives with less use of trading and offsets (although these are allowed for under the targets).  Furthermore, it signals low carbon investment that would make a more ambitious Phase 4 EU cap achievable, and thus make such a cap easier to negotiate.  It should help position the UK to meet a future cap more easily.  As things have turned out, the EU cap is not binding in Phase 3, so the UK floor price will indeed reduce total EU emissions, simply creating a larger surplus than there would be in its absence.  It thus does not seem likely to lead to higher emissions elsewhere in the scheme, which are currently not constrained by the cap, and it may even strengthen the case for reform.  So such a national floor price has a sound rationale, although it remains very much a second best option compared with an EU wide price floor.

There are thus well established ways of setting a minimum level (or minimum levels) of carbon price either at the EU level or nationally.  And the USA has much to teach the EU about carbon pricing in this respect.  Floor prices may become increasingly attractive to national governments faced with volatile revenue from auctions, and seeking to provide consistent signals for emissions reduction.  If the EU does not introduce something to limit price ranges it seems quite possible that other national governments will follow the UK’s lead and introduce their own national mechanisms, whether these are floor prices or something else.

Adam Whitmore      2nd May 2013

[i] The State of the European Carbon Market in 2012 Com (2012) 652 final, Brussels 14.11.2012  http://ec.europa.eu/clima/policies/ets/reform/docs/com_2012_652_en.pdf

[ii] Carbon price floor: rates from 2015-16,exemption for Northern Ireland and technical changes.  HMRC http://www.hmrc.gov.uk/budget2013/tiin-1006.pdf

[iii] I should declare an interest here in that I proposed this mechanism during work for DTI in the mid-2000s, and subsequently published an outline of the proposal (see e.g. Carbon Finance September 2007).  I believe that when I proposed it the idea of using this sort of approach to impose a price floor that was not co-extensive with an emissions trading scheme was entirely novel.  It made its way into the Conservative Party’s policy document published before the last election following discussions I had with the then shadow Secretary of State for DECC.  It is perhaps not surprising that I think it was a far better design than that which was finally introduced.

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