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

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 – 23^rd 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.

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 …

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 …

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 – 21^st 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/

The EUETS and the need for price floors (and maybe soft ceilings)

Standard objections to introducing price containment mechanisms into the EUETS carry little weight.  It’s time to give price containment more serious consideration.

With the price of allowances in the EUETS currently down at around €4/tCO₂ the question of whether direct price containment (price floors and ceilings) should be introduced has naturally been the subject of renewed debate, especially in the light of the French proposal earlier this year to introduce a price corridor.

The debate tends always to feature a standard set of objections to price containment.  Most of these lack validity when applied to well-designed mechanisms.  Here I take a look at why this is so, in the hope that the debate can become more realistic and constructive, focusing on the benefits and design challenges around price containment.

The broad themes underpinning the rationale for price containment are as follows:

1. All emissions of GHGs are damaging, not just those above the cap. Reducing emissions below the cap and further tightening the cap thus have benefits.
2. The financial cost of damages emissions (the social cost of carbon – SCC), although uncertain, is well above current prices[1]. This implies that further emissions reductions with a cost between the current price and the cost of damages have a net benefit.  However these are not currently being incentivised by the carbon price.  This is one reason why a floor prices is beneficial.
3. The market structure and parameters are set by regulatory decisions. These decisions are inevitably taken under uncertainty, and market design is about optimising outcomes under uncertainty.  Design is more robust to uncertainty with both price and quantity targets than with either alone.
4. Supply adjusting in response to price makes the EUETS more like a normal market.
5. It is essential for reasons of international obligations and environmental integrity that the cap is maintained[2], so moving to a pure carbon tax is not a good idea.

Based on these premises the following responses to standard objections to price management can be made.

“Price management is interfering in the market”

The form of the market is a politically determined construct. Modifications to this construct are appropriate to correct shortcomings in the current design, where supply is too rigid to accommodate uncertainties. The cap does succeed in limiting the total emissions but fails to produce adequate signals for additional abatement.   Modification is required to reduce supply of allowances if prices become too low, in order to retain efficient price signals.

Allowing the supply of allowances to respond to price is not interfering with the day-to-day operation of the market. On the contrary, it is designing it to function more like a normal market.  In most markets supply varies with price (elasticity of supply is not zero in most markets[3]).

 “There is no environmental benefit to a floor price because the cap does not change” or “it does nothing to reduce supply or increase ambition towards targets in the Paris Agreement”

The critical question here is what happens to unsold allowances. There are many possibilities for dealing with unsold allowances, including cancelling them at the end of a phase, cancelling a proportion at the end of a phase, or cancelling them on a rolling basis.

Provided that there are appropriate provisions for cancelling unsold allowances, total emissions over time can be reduced, and so there is a clear environmental benefit.  Even if this is not the case, allowances may simply stay in the reserve, or caps may be tighter in future due to emissions reductions achieved, also creating an environmental benefit.

“If the EU is meeting its target at low cost the price should be correspondingly low”

No it should not.  The low price signals that the target is not stringent enough to adequately reflect damages.  All emissions are damaging, even those within the cap, and if more abatement can be achieved at lower cost than the damage caused this is what should happen.

Measures which further decrease emissions in response to lower cost of abatement also help reinforce the EU’s international leadership position on climate change.

“It goes against the quantity based nature of the EUETS” or “it’s introducing a carbon tax”

Prices can managed by automatically adjusting supply in response to price, for example by putting a reserve price in auctions.  This is entirely consistent with the quantity based nature of the EUETS, in that it works by adjusting quantity.  Indeed, as noted, it makes the EUETS more like almost all other markets where the quantity of supply varies in response to market prices.

It is possible to use tax-based measures to impose a floor, as the UK does and France will do from January 2017, but it is not necessary to do so.

Characterising price floors  as a tax appears often to be used as a way of creating political momentum against the idea.  An EU tax requires unanimity among Members States and attempts to introduce a carbon and energy tax in the 1990s were notably unsuccessful, and similar efforts would doubtless prove challenging.  Characterising floors as a tax may also help develop political opposition to a floor.  Branding the Australian ETS as a tax (which it was not) was successful in helping build opposition there, with eventual repeal of the scheme.  Price management through adjusting quantities should not be misrepresented in this way to artificially discredit it.

“It reduces market efficiency”

This confuses efficiency of trading with efficiency of the price signal.  If you were never to change the number of allowances, trading alone might indeed remain the most efficient way of meeting the cap.  However this has created prices which failed to adequately signal efficient abatement (in effect the market is telling you that the current cap is too loose).  There is thus a misallocation of resources towards to many emissions and too little abatement.

“The price may be set at the wrong level”

Having both price and quantity limits increases robustness to the unexpected.  If the cap has been set at appropriate levels then prices will anyway lie within the range of any  price containment, and price limits will not bind.  However the existing EUETS cap has been set at a sub-optimal level –too many allowances have been issued and the price is too low.

Limiting the price simply recognises that future demand for allowances may be mis-estimated, or the level of the cap may be subject to biases, for example due to asymmetries of political risk from setting the cap too high or too low.

 “It will never be possible to agree a price”

Price will doubtless be contentious but there are several reference points, notably the following:

• estimates of the SCC, which represents the financial cost of damages, although calcualtions typically exclude important costs of damage. The SCC is highly uncertain, but well above the €4/tonne currently prevailing in the EUETS under almost any reasonable set of assumptions.
• prices under other schemes, especially those with price management;
• prices consistent with those needed to signal abatement sufficient to reach climate targets.

This gives a framework of negotiation.  The level of the cap, which is always set with a view to abatement costs and prices, is anyway contentious.

There are many difficult issues to resolve in designing appropriate price containment mechanisms for the EUETS and setting price boundaries at appropriate levels.  Spurious objections such as the ones discussed here should not be allowed to form an obstacle to much-needed debate about the best way forward.

Adam Whitmore – 14^th September 2016

Note:  The advantages of hybrid price quantity instruments have been extensively reviewed in the environmental economics literature, going back to the original paper on the subject by Roberts and Spence Effluent Charges and Licenses Under Uncertainty (1976).  Understanding the need for prices to fully reflect the cost of environmental damages goes back further, to Pigou “The economics of welfare” (1920).  See standard texts on environmental economics for a fuller treatment.  These conclusions are not uncontentious, in particular because some observers continuing to favour a carbon tax.  My own view remains that including a cap on emissions is preferable, and that many of the advantages of a carbon tax can be realised by a well-designed floor price.

[1] Furthermore there are other non-priced damages which imply the benefit of abatement is greater than implied by the SCC.

[2] Also, any ceiling should be soft to allow prices to rise above the ceiling rather than allowing emission to go above the cap, for example with allowances in price containment reserve taken from within the cap.

[3] Almost the only markets with completely fixed supply are the markets for tickets to major sporting events and for authentic works by dead artists.  For example the number of tickets to the men’s final at the Wimbledon tennis championships is limited by the number of seats, and the number of authentic Picasso’s cannot now increase with price (although the number of fakes can).

 

Reflecting reality in the EUETS Phase 4 cap

The cap for Phase 4 of the EUETS, which runs from 2021 to 2030, needs to start at a level that matches the reality of emissions in 2020, rather than starting where the Phase 3 cap finishes.   

The EUETS surplus will continue to grow through under current proposals …

The surplus of allowances in the EUETS looks to set to get worse with the Commission’s current proposals for the Phase 4 cap, which covers the period 2021 to 2030.   In 2015 emissions covered by the EU ETS were already below the level of the cap for 2020^[1].  Emissions are expected to continue falling through the remainder of this decade, driven mainly by increasing deployment of renewables and weak electricity demand.  By 2020 emissions look likely to be over 10% below the cap at the end of Phase 3 (see chart).   This will lead to additional surplus allowances generated from the start of Phase 4, continuing through all or most of Phase 4.   This will in turn lead to the EUETS remaining weak even in the presence of the Market Stability Reserve (MSR).

Chart 1:  Currently proposed cap against emissions forecasts and 2020 gap to cap

This problem arises in large part because the starting point for Phase 4 cap is out of date.   It was effectively set in 2010 as part of the cap for Phase 3, because the EUETS Directive implicitly assumes that the Phase 4 cap will simply continue from where the Phase 3 cap finishes.   However the Phase 3 cap was set before many subsequent trends were known, including the growth of renewables and the length and depth of the economic recession.  Consequently it does not form a suitable starting point for Phase 4, and now looks far too loose.

This problem can be mitigated by changing the starting point of the Phase 4 cap …

The Phase 4 cap needs to start at a level that reflects actual emissions (if this is, as expected, below currently proposed level, which would act as an upper bound in any case).   Rebasing the cap in this way would lead to a much more effective EUETS that delivers effective signals for emissions reductions and investment.  Without this sort of reform the EUETS risks being reduced to little more than an accounting tool, with a chronic surplus and individual Member States increasingly taking their own action to ensure the necessary investment.

This increases the robustness of the mechanism and is more effective than changing the Linear Reduction Factor ….

Rebasing to actual emissions increases robustness of the system by making it dependent on actual outcomes.  Aligning the cap with actual emissions also tightens the cap more quickly and more effectively than changes to the Linear Reduction Factor (LRF – the amount of annual emission reductions built into the EU ETS during the phase).   This is shown in the chart below.

The LRF would need to approximately double from the currently proposed value of 2.2%, to 4.2%, to have the about the same effect on cumulative number of allowances over Phase 4 as rebasing the cap, even in a high emissions case.  And an even greater LRF would be needed to match the effect of rebasing if emissions by 2020 are low.  Even then, changing the LRF reduces the level of the cap more slowly than changing the starting point of the cap.  However increasing the LRF in addition to rebasing the cap helps ensure that surpluses are eroded and do not re-emerge through Phase 4, and so increasing the LRF remains a useful complement to rebasing the cap.

Chart 2.  Decrease in the total Phase 4 cap relative to the current proposal

Rebasing the cap is consistent with a range of precedents …

This approach of adjusting caps to reflect the reality of actual emissions, where these diverge from earlier expectations, has been applied elsewhere.  For example, in the Regional Greenhouse Gas Initiative (RGGI) in the USA, the cap was reduced from 165 million short tons in 2012-3 to 91 million short tons in 2014 to more closely reflect actual emissions^[2].  As a result, prices have moved away from the auction floor price, where they were had previously been stuck.

Looking beyond carbon markets, incentive-based regulation of electricity, gas and water network charges in the UK in the 1990s imposed price caps typically lasting five years.  In practice, costs fell more rapidly than was expected when the price cap was set, leading to high margins of price over cost.  One-off cuts in the level of prices, referred to as P₀ cuts, were implemented at the start of the next phase of the price control to realign the price cap with outturn costs, and thus capture the benefits of efficiency gains for consumers.

The new starting point for Phase 4 would also be closer to that which was envisaged under the December 2008 European Council Conclusions[3] in case an international agreement was reached and the EUETS would start from a reduction of 30% from 2005 levels by 2020.  A 30% reduction from 1990 would, assuming the EU ETS cap to have been reduced in line with the reduction in other sectors, have led to a starting point for the Phase 4 EU ETS cap of approximately in line with emissions now expected.  This was made conditional on action by other countries.  Commitments to such action have now been made under the Paris Agreement.

Conclusion

With the cap proposed by the Commission the EUETS seems likely to continue providing a largely ineffective signal for abatement well into the 2020s and possibly beyond.   This would mean that by 2030 the  EUETS will have been in existence for a quarter of a century, but will have provided an effective price signal for only a short period in the early part of Phase 2 (around 2009).

A simple adjustment to bring the cap at the start of Phase 4 into line with the reality of emissions would go a long way towards solving this problem by reducing the Phase 4 cap, likely by around 2 billion tonnes or more over the 10 years of the phase.   There are few easier and more natural adjustments to the scheme which could have such an impact.

Adam Whitmore – 20^th  June 2016

Thanks to Boris Lagadinov for providing the analysis shown in this post.   This post is based on a recent paper Boris and I wrote for Sandbag – see http://www.sandbag.org.uk

[1] The cap for 2020 is 1816 MtCO₂ excluding the effects of backloading.  Emissions were 1802 MtCO₂ in 2015.

[2] https://www.rggi.org/design/overview/cap

[3] http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/104692.pdf

Uses of revenues from carbon pricing

There are many worthwhile uses for revenues for carbon pricing.  In practice a mixture of uses is likely to be found. 

My previous post estimated that carbon pricing will raise around $22 billion worldwide this year, and suggested that this has the potential to grow by an order of magnitude.  This post looks at how revenues might be used.

Revenues from carbon pricing can be used for both climate change related purposes and more general purposes.  The main categories are summarised in the table, and described briefly below.

Summary of potential uses of revenue raised by carbon pricing

General fiscal and social goals	Climate change related purposes
Support for vulnerable groups	Adaptation
Reduction of other taxes	Distribution to those affected by climate change
Government retention of revenues	Support for further emissions reduction, including for innovation
Returned to citizens

Support for vulnerable groups

The introduction of carbon pricing is often accompanied by concerns about the effects on energy prices on lower income households.  Rises in electricity prices to households due to pricing of power sector emissions are of concern even under schemes such as the EUETS which do not directly cover households.

Some proportion of revenue can be set aside to compensate vulnerable households.  This was a feature of the now repealed Australian scheme.

Reduction of other taxes

Other taxes can be reduced by an amount equal to the revenue raised from carbon pricing.  If this is done in full the carbon pricing scheme is usually referred to as revenue neutral.  This is a feature of the British Columbia carbon tax.

Government retention of revenues.

Governments can retain some or all of the revenue for general expenditure or deficit reduction.  This is, for example, the case in the UK, where the Treasury has a long history of viewing taxation and expenditure as a whole, and there is resistance to earmarking (“hypothecation”) of funds.

Returned to citizens.

An equal payment can be made to all citizens in a jurisdiction (see previous post).  The Swiss carbon tax currently returns a portion of revenue equally to all citizens.  Such an approach has been proposed as part of bills at federal and state level in the USA.

Adaptation

Measures to adapt to climate change can be funded either within the jurisdiction that raised the revenue or internationally.  For example, in its July proposals for the next phase of the EUETS, the European Commission included provisions for Member States to use some of the revenues from the EUETS to finance actions to help other countries adapt to the impacts of climate change.

Funds could be channelled through international institutions to provide funds to match national expenditure, potentially making a substantial contribution to meeting any funding shortfalls.

Distribution to those affected by climate change

Funds could be provided to those adversely affected by climate change.  There is a continuing debate on this issue and how it relates the “loss and damage” agenda within the UNFCCC process, including the large overlap with the issue of adaptation.  However there has been little practical progress on this to date.

Support for further emissions reduction and for innovation

Funds may be provided for measures such as retrofitting homes and businesses for greater energy efficiency, and the installation of renewable energy technologies.  Revenues may also be used to fund research, development and deployment of new low carbon technologies.  A number of schemes in North America include provisions of this type, including California, RGGI and Alberta.  The EUETS has also included support for new technology from the sale of 300 million allowances from the new entrant reserve (the “NER 300”).  However funds raised from this were less than originally expected due to lower allowance prices, and the allocation process has been delayed.  The EU is now planning an Innovation Fund in the 2020s, again to be funded by the sale of allowances.

So which should be preferred?

Many uses of funds have merit, and the choice will depend on local political and economic circumstances.  However some seem to have particular arguments in their favour, with a mixture of often likely to be preferred.

Supporting adaptation and potentially also providing recompense to those adversely affected by climate change has a strong appeal on grounds of justice, and may form a valuable element of some programmes.

Returning funds equally to citizens has advantages covered in my previous post.  This could be accompanied by providing additional support to some vulnerable groups.

Finally, using revenue to fund additional emissions reductions, especially with a component of assistance for the disadvantaged, has proved understandably attractive in a number of jurisdictions in North America and to some extent in the EU.  Deeper emissions cuts will require new technologies and large-scale investment.  This in turn requires progress to be made now, increasing in scope and extent over time.  Increased use of funds from carbon pricing to support such efforts seems likely to prove worthwhile.

Adam Whitmore – 10^th November 2015

Material in this post, as well as my previous one, can also be found in the Carbon Markets Investment Association (CMIA) paper at http://cmia.net/forums/climate-finance-forum/climate-finance-forum-docs

Revenue from carbon pricing

Carbon pricing already raises over $20 billion p.a. worldwide.  This has the potential to grow by an order of magnitude.  What to do with this money will be an increasing important issue.

As carbon pricing spreads around the world (see here) substantial amounts of money are now being raised.  The amounts depend on:

1. The coverage of each scheme
2. The number of allowances allocated free of charge (under an emissions trading scheme) or the extent of tax exemptions and rebates (under a carbon tax).
3. The level of the price in each scheme

Estimating these parameters for each scheme around the world indicates that about $22 billion will be raised globally this year, excluding the value of free allowances, tax exemptions and rebates.  The breakdown of this total is shown in the chart below.  (The data is a rough estimate in some cases because summary data on coverage and rebates is not readily available for some schemes, especially carbon taxes in Europe.  Also, average prices for allowances over the whole of this year are not yet known.)

About three quarters of the revenue raised is in Europe.  Interestingly, revenues from auctioning of allowances under the EUETS are lower than those from other carbon pricing in Europe, which includes carbon price support in the UK and carbon taxes in France and Scandinavia.  This is in part because EUETS revenues have been reduced this year by the postponement of some allowance auctioning (backloading).

The remainder of revenues raised worldwide are from the various North American schemes and the (rather low) carbon tax in Japan.  There is no auctioning of allowances under the New Zealand or South Korean schemes, or in China, so they don’t yet contribute to the total.

Indicative estimates of revenue from carbon pricing in 2015

Notes: Estimates based on prevailing prices multiplied by volumes covered, excluding freely allocated allowances and tax exemptions and rebates.  Data is estimated from a variety of sources and totals may be lower or higher or than shown as assumptions have been adopted for coverage and rebates where data is not readily available.  Small variations in coverage can affect estimates significantly in individual jurisdictions because of high prices.The Mexican carbon tax is excluded as it does not price emissions from natural gas so more resembles an energy tax on some fuels.  Other Europe includes Portugal, Switzerland and Iceland.

Revenue is significantly higher this year than it was last year, when the total raised worldwide was around $15 billion.  This mainly reflects increases in:

• prices and volumes of EUAs auctioned;
• the level of UK carbon price support;
• the price and coverage of the French carbon tax; and
• the coverage of the California and Quebec schemes, which expanded to cover transport and other sectors in January this year.

The total revenue raised has the potential to increase vastly if:

• new schemes are introduced, especially nationally in China as planned and in the USA, or coverage of existing schemes is expanded;
• the amount of auctioning is increased, with the amount of auctioning in the planned national scheme in China especially important; and
• prices rise under the major schemes, including the EUETS.

Indeed, over time revenue raised globally could increase by an order of magnitude or from current levels to reach into the hundreds of billions in the longer term.  However even if revenue grows to approximately ten times current levels over the next decade or more it would still represent only perhaps 0.2% of global GDP, and so remain only a small proportion of total flows within the world economy.

This is nevertheless a substantial amount of money, and there is likely to be increasing debate about how it might best be used.  I will return to this in my next post.

Adam Whitmore – 26^th October 2015

A paper on revenues from carbon pricing including much of this material has been published by the Climate Markets and Investment Association (CMIA), see http://cmia.net/forums/climate-finance-forum/climate-finance-forum-docs

Carbon prices around the world are consistently too low

Carbon pricing is spreading rapidly around the world [i].  However prices almost everywhere are far too low at the moment to price emissions efficiently.  The chart below summarises carbon prices in those jurisdictions with pricing.  The horizontal axis shows volumes, the vertical axis shows prices, as in a conventional commodity supply curve.  The vast majority of priced emissions – about 90% of the total – are priced below $14/tCO₂.  Higher carbon prices are invariably for small volumes, and are found only in Europe and British Columbia.  They include prices under the French carbon tax, which covers sectors outside the EUETS, the UK carbon price floor, where the EUA price is topped up, and longstanding carbon taxes in Scandinavia.

The chart also shows the social cost of carbon – which represents the cost of the environmental damage caused by emissions – as estimated the US EPA.  This is almost certainly an underestimate[ii] of the true cost, and the concept has other limitations that imply it is no more than a lower bound to what it is worth paying to avoid emissions.  Carbon prices are thus too low even compared with a likely underestimate of the cost of emissions.  Taxes are too low and caps are too loose to price carbon adequately.  Consequently efficient abatement is not happening[iii].

Prices and volumes of carbon pricing around the world

Price data is from May 2015.  I have excluded the Mexican carbon tax on the grounds that it does not apply to natural gas and so does not fully tax carbon.  The Chilean carbon tax is included although it does not come into force until 2018.  The South African carbon tax is scheduled to be introduced next year, but may be postponed, or may not be introduced at all.  The EUETS price would be somewhat higher but for the weakness of the Euro against the dollar at the moment.   The Social Cost of Carbon is the US EPA estimate at a 3% discount rate and converted to $2015 – see reference 2.

Prices may increase in future.  However this process looks likely to be too slow in most cases.  For example, under the California and Quebec scheme prices are currently at the floor set by the auction reserve.  This escalates at 5% p.a. real terms.  However at the present rate this will take until around 2050 to catch up even with the EPA’s estimate of the social cost of carbon[iv], which also shows increases in real terms over time.  Prices elsewhere in North America are mostly lower still.  In the EU there is little evidence from forward markets that allowances will reach significantly closer to the social cost of carbon over the next few years, and it seems unlikely that China will seek to price emissions at much above levels that prevail in the EU and North America.  It therefore seems likely on present trends to be a long time before prices in major jurisdictions reach levels that reflect the cost of damage from climate change, or are sufficient to limit temperature rises to two degrees.

This implies that further action is needed to make higher prices more politically acceptable.  Doing this will be a huge challenge, but two strands of any solution appear clear.  Ensuring that industry that is genuinely vulnerable to carbon leakage is appropriately safeguarded from competitive distortions will help mitigate political obstacles to higher pricing.  And efficient carbon pricing may further be helped by more explicit recycling of revenue to citizens, including ideas such as cap-and-dividend, in which the proceeds of sale of allowances under a cap-and-trade scheme are returned directly to citizens.  This in effect defines citizens as owners of the right to emit and so gives everyone a stake in higher prices (more on this in a future post).  Elements of such an approach are evident in British Columbia and were part of the former Australian scheme.

Measures other than carbon pricing are in any case necessary to bring about the required transformation of the energy sector[v].  And while carbon prices remain too low there will be an even greater need for such approaches, even if these may sometimes themselves help keep the carbon price low.  Funds to subsidise deployment of low carbon technologies may come from the proceeds of carbon pricing, especially in jurisdictions such as North America where earmarking of revenues is common.

The spread of carbon pricing is a success story, but a limited one in view of the prices prevailing to date.  Efforts both to strengthen the carbon price and enhance complementary policy approaches are needed if climate change is to be limited to acceptable levels.

Adam Whitmore – 2^nd June 2015

 

Notes

[i] See  here

[ii] See  here

[iii] The marginal price signal is at too low a level, so some economically efficient abatement is not being signalled.  It is possible that an inefficient mix of abatement is being purchased, even though the level of abatement is efficient.  This could be the case if, for example, there was too much expensive abatement through renewables programmes.  However for a number of reasons this does not seem plausible.  For example, abatement is currently insufficient to meet the agreed 2 degree target, and support for renewables globally is clearly not excessive in view of their present share of generation and the required speed of reduction (although it may well be desirable for more of the support to be in the form of a higher carbon price on fossil fuel use).

 

[iv] Escalating the current carbon price at 5% real terms to 2050 gives a price of about $74/tCO₂, roughly in line with the EPA’s central estimate of the Social Cost of Carbon at that date of 2011$76/tCO₂.

[v] See here

Making climate change policies fit their own domain

A new framework acts as a sound guide for policy formation.

There is a widely held narrative for climate policy that runs something like this.  The costs of damage due to greenhouse gas emissions are not reflected in economic decisions.  This needs to be corrected by imposing a price on carbon, using the power of markets to incentivise efficient emissions reduction across diverse sources.  Carbon pricing needs to be complemented by measures to address other market failures, such as under-provision of R&D and lack of information.  Correcting such market failures can help carbon markets function more efficiently over time.  However further interventions, especially attempts by governments to pick winners or impose regulations mandating specific solutions, are likely to waste money.  This narrative, even if I have caricatured it a little, grants markets a central role with other policies in a supporting role.  Its application is evident, for example, amongst those in Europe who stress and exclusive or central role for the EUETS.

While this narrative rightly recognises the important role that markets can play in efficient abatement, it is incomplete to the point that it is likely to be misleading as a guide to policy.  A better approach has recently been characterised in a new book by Professor Michael Grubb and co-authors.  He divides policy into three pillars which conform to three different domains of economic behaviour.  Action to address all three domains is essential if efforts to reduce emissions to the extent necessary to avoid dangerous climate change are to succeed.  These domains and the corresponding policy pillars are illustrated in the chart below.

Three domains of economic behaviour correspond to three policy pillars …

In the first domain people seek to satisfy their needs, but once this is done they don’t necessarily go further to achieve an optimum.  Although such behaviour is often characterised by economists as potentially optimal subject to implicit transaction costs this is not a very useful framework.  Much better is to design policy drawing on disciplines such as psychology, the study of social interactions, and behavioural economics.  This domain of behaviour relates particularly to individuals’ energy use, and the corresponding policy pillar includes instruments such as energy efficiency standards and information campaigns.

The second domain looks optimising behaviour, where companies and individuals will devote significant effort to seeking the best financial outcome.  This is the domain where market instruments such as emissions trading have the most power.  Policy making here can draw strongly on neoclassical economics.

The third domain is system transformation, and requires a more active role from governments and other agencies to drive non-incremental change.  The policy pillar addressing this domain of behaviour includes instruments for technology development, the provision of networks, energy market design, and design and enforcement of rules to monitor and govern land use changes such as deforestation.  Markets may have a part to play but the role of governments and other bodies is central here.  The diversity of policies addressing this domain means that it draws on a wide range of disciplines, including the study of governance, technology and industrial policy, institutional economics and evolutionary economics.

As one moves from the first to the third domain there is increasing typical scale of action, from individuals through companies to whole societies, and time horizons typically lengthen.

This framework has a number of strengths.  It is both simple in outline and immensely rich is its potential detail.  Each domain has sound theoretical underpinnings from relevant academic disciplines.  It acknowledges the power of markets without giving them an exclusive or predominant role – they become one of three policy pillars.  It implies that the vocabulary of market failures becomes unhelpful, as I’ve previously argued.  Instead policy is framed as a wide ranging endeavour where the use of markets fits together with a range of other approaches.  While this may seem obvious to many, the advocacy of markets as a solution to policy problems has become so pervasive, especially in Anglo-Saxon economies, that this broader approach stands as a very useful corrective to an excessively market-centric approach.

The framework is high level, and specific policy guidance needs to draw on more detailed analysis.  The authors have managed to write 500 pages of not the largest print without exhausting the subject.  However, the essential framework is admirable in its simplicity, compelling in its logic, and helpful even at a high level.  For example it suggest that EU policy is right to include energy efficiency, emissions trading and renewables – broadly first, second and third domain policies respectively – as well as to be active in third domain measures such as improving interconnection, rather than relying exclusively on emissions trading (although as the EUETS covers larger emitters, so first domain effects are less relevant for the covered sector).

The framework in itself does not tell you what needs to be done.  In particular the challenges of the third domain are formidable.  But it provides a perspective which deserves to become a standard structure for high level guidance on policy development.

Adam Whitmore – 31^st October 2014

Could rising aviation emissions be good for the environment?

The international aviation sector is likely to require a substantial number of offsets to meet its goal of achieving carbon neutrality above a 2020 baseline.  If these offsets are forestry related there is the possibility of generating substantial biodiversity co-benefits.

Emissions from international aviation are around 2% of total emissions, and are expected to roughly quadruple by 2050, well above the expected growth rate of other sectors.  Faced with this prospect, and challenged by measures attempting to include international flights within the EUETS, the governing body for aviation the International Civil Aviation Organisation (ICAO) last year decided to look at using market based measures to cap net international aviation emissions at 2020 levels globally, with agreement to be reached by 2016.  The chart below illustrates the scale of the action needed to achieve this.  The blue line shows a scenario with high growth in emissions, which already includes efficiency gains from introducing new aircraft.  The dashed green line represents a lower emissions growth scenario.  The light blue area shows the potential contribution of new technologies and processes such as additional maintenance.  There is also a contribution from running the system more efficiently, with improved air traffic management and airport operation, shown by the brown area.  Such measures can in total probably reduce emissions growth by about 40%.  However this still leaves around 60% of emissions growth which is difficult to avoid by technology changes except in the long term.   (Reducing the growth in aviation services would also reduce emissions of course, but any set of policies that severely caps the number and length of journeys is likely to prove politically intractable.)

Source:  ICAO CAEP A38-WP/26, 2013

For this remaining emissions growth the only realistic option for capping net emissions at 2020 levels over the next few decades is likely to be the use of offsets.  Demand for offsets from aviation could reach some hundreds of millions of tonnes p.a. in the 2030s, and this demand would be reliable as well as large, given the steady growth in demand.  It could provide a much needed source of demand for international offsets, which is currently weak.  The cost of this to passengers is likely to be small.  Emissions from a transatlantic flight are very roughly around a tonne of CO_2e per passenger, so this would add about $10 to the price of an economy class ticket assuming an offset price of $10/tonne, and less at current international offset prices, which are in the low single figures of dollars per tonne.

One source of offsets that looks particularly promising is reduced emissions from deforestation and degradation (REDD).  There has been a marked reduction in the rate of deforestation in Brazil (and some other jurisdictions) in the last decade, despite a slight increase last year.  The reductions in Brazil have been achieved through a variety of measures, including improved monitoring by remote sensing, new legal frameworks with better enforcement, more intensive agriculture and so forth.  But funding from governments, including Norway, Germany and the UK, has also played a useful role in reducing deforestation.  Future programmes will likely benefit from the additional funding that REDD offsets can provide. , although this funding will never be enough on its own.  And the scale of offsets available is potentially large.  For example, 500 million tonnes p.a. is equivalent to avoiding over 8,500sq. km of Amazon forest loss each year, compared with about 5,800 sq. km of forest currently lost in the Amazon region of Brazil last year (and an average annual loss of about 11,500 sq. km over the last ten years).

For a satisfactory scheme any offsets will of course need to be high quality, including meeting the usual tests of additionally, permanence and so forth, with adequate governance a prerequisite.  Buffers, exchange rates or risk premiums may be necessary to account for residual risks around permanence, leakage and other factors, or to realise an explicit goal of generating net benefits, with (for illustration) 1.5 tonnes of REDD offsets required for every tonne of aviation emissions.  This would somewhat increase the area protected for a given number of aviation emissions, assuming that REDD offsets are available at an appropriate price.

REDD programmes have the advantage that they help conserve biodiversity.  Indeed biodiversity benefits can be made an explicit criterion in programme design and selection.  This may, for example, include building on the current Climate, Community and Biodiversity (CCB) standard that is widely used in voluntary markets.  This would potentially allow an overall net gain for the environment if net carbon emissions were zero.  Reduced emissions from deforestation would match increased airline emissions, and biodiversity would additionally be preserved – hence the (deliberately provocative) title of this post.  Programmes can also provide opportunities for local communities, and the CCB standard is again relevant here.  Indeed appropriate community involvement in projects, ensuring local communities also benefit, is likely to be essential to any successful REDD programme.

Establishing that offsets issued now can be used after 2020 would provide valuable early demand for credits.  However given the early stages of development of proposals by ICAO it may be difficult to attract investors at present.

So far REDD has struggled to find adequate funding from carbon markets, despite discussion of allowing limited volumes of REDD credits under the California emissions scheme.  And significant challenges remain in any circumstances.  In particular, governance often remains difficult given the requirements for monitoring and permanence of REDD projects and programs.

Eventually some technical solution will be needed to enable aviation emissions to be reduced at source.  However in the meantime the chance to generate substantial additional benefits for biodiversity and other environmental goals by the judicious choice of forestry offsets to help meet aviation goals is an opportunity well worth further exploration.

Adam Whitmore – 10^th July 2014

Thanks to Ruben Lubowski of Environmental Defense Fund for useful comments on this post.

Notes

The 1 tonne CO_2e per transatlantic flight per economy class passenger figure is indicative, and depends on the multiplier applied to the CO₂ emissions to represent other atmospheric effects of emissions at altitude.

 

Types of Carbon Pricing (Part 1 of 3)

This post is the first of three summarising the differing features of carbon pricing instruments – emissions trading (cap-and-trade), carbon taxes, and hybrids – and commenting on some of the implications for existing carbon pricing schemes.  The three together can be found as a pdf file under the carbon pricing pages of this site.

These posts focus on the differences between types of carbon pricing.  However there are many commonalities, and any type of well-designed carbon pricing is usually preferable to none.   Political circumstances will often play a major role when choosing the best approach in practice – a scheme which cannot be introduced for political reasons cannot be regarded as optimal in any practical sense – and a pragmatic approach to carbon pricing is likely to be the most productive.  Furthermore carbon pricing has quite a short history compared with many forms of regulation (the EUETS, the first large scale carbon pricing scheme, started less than 10 years ago).  For now there should not be undue concern about a wide diversity of approaches to carbon pricing, because this variety enables more to be learned about how different designs work in practice.

The role of uncertainty

The standard theory on the choice between a cap and trade scheme and carbon taxes(1) frames the problem as maximising total net benefits of pricing under uncertainty.  If the behaviour of the market were known in advance setting prices or quantities would yield the same result – one could set quantity knowing the price that would result, or vice versa.  However when market responses are uncertain, as they always are in practice, the two instruments have quite different properties.

When the abatement costs differ greatly depending on the amount of abatement required (high slope of the marginal abatement cost curve) a tax will tend to be preferred.  This is because setting a cap a little too high or a little too low could result in either excessively high prices for little benefit or missed opportunities if the tax is set too low.  In contrast when the damage costs are rapidly increasing as emissions rise (there is high curvature of the damage function) a cap will tend to be preferred.  This is because under a tax the price might be set too high, proving economically costly for little benefit, or too low, leading to very high damages as threshold levels of pollution are reached.

The problems caused by uncertain outcomes have been highlighted by the emergence of a large surplus of allowances under the EUETS, in which a fixed cap has led to unexpectedly low prices.

A long term cumulative cap to prevent dangerous thresholds being crossed

The prospect of rapidly increasing damages implies that globally and over the long term an emissions cap may have significant advantages for limiting greenhouse gas emissions, especially as avoiding severe damage requires deep cuts in emissions compared with business as usual.  The costs of the damages from climate change cannot be known in advance with any certainty, but seem likely to increase very rapidly (and highly non-linearly) as the concentration of greenhouse gases in the atmosphere increases and large irreversible damages, such as the melting of ice caps, are locked in.   This requires a limit on cumulative emissions (a global cumulative carbon budget) to prevent such large damages being realised, including those from natural thresholds being crossed.  There is inevitable scientific uncertainty about exactly where each threshold is, so attitudes to risk will also be important in setting the cap.

Addressing such rapidly increasing damages ideally requires a global annual cap reducing over time to be set, such that the cumulative total cap (area under the curve) corresponds to a limit on the cumulative emissions above which dangerous thresholds may begin to be crossed.  (The situation is complicated by the need to take account of sinks and other forcings such as aerosols, and further by the dependence of damage on the path of the stock over time.)   This type of approach informs the analysis of the limits of the cumulative amount of fossil fuel that can be burnt (see the recent Fifth Assessment Report from the IPCC (ref 2)).

The effect of decisions taken now on the stock of a pollutant over time is particularly relevant for climate change.  Much energy infrastructure has a very long life, so a decision now will influence emissions for decades.  Furthermore a larger proportion of CO₂ emitted stays in the atmosphere for centuries, so emissions determined by current investment decisions will affect the stock in the atmosphere over all relevant timescales.

There is no binding global agreement to establish such a cumulative cap (nor does there appear likely to be).  However an increasing number of emissions trading schemes in major economies with stringent long term emissions goals are being established, and may provide over time the best approximation to the ideal of a global emissions limit that is likely to be available.  For example the EU has cap decreasing at 1.74% p.a. with a goal of 80-95% reduction by 2050, California also has a clear 2050 goal of 80% reduction from 1990 levels, and China is increasingly expressing emissions reduction ambitions and implementing them in the form of emissions caps, regionally at present but with ambitions to move to national limits.  In contrast a series of carbon taxes would give much less certainty of staying below any threshold.

Flexibility

Emissions trading may also allow more flexibility in how and when emissions are reduced.  Banking provisions and multi-year compliance periods, which feature in most scheme designs, can allow firms to make choices about when to abate and how much, giving them flexibility in reducing costs in ways which are difficult to replicate under a tax.

Strategic signals

Emissions caps can have the further advantage of giving a stronger strategic signal that emissions will have to decrease to much lower levels in the long term.  The changes required to achieve this often fundamental and transformational rather than marginal.  The signal provided by a long term quantity limit may prove effective in stimulating investment in technology development, physical infrastructure, grid operating regimes and other longer term elements of a low carbon economy.   These will require many other policy interventions, and will not be achieved by carbon pricing alone.  However a cap can be useful in making the case for these measures by defining the scale of the challenge (although it can have the weakness of not incentivising measures that go beyond the cap, which is a point I’ll return to in looking at hybrid instruments).

In contrast a tax, even if effective in signalling marginal changes, may not signal more fundamental change to the same extent, although a defined escalator on a tax may go some limited way towards this.  For example, very high fuel taxes have played a role in incentivising improved fuel efficiency in vehicles, but fleet efficiency standards (in effect a declining cap on emissions intensity) have also played an important role, and the expectation of the need to move to very low levels of emissions seems to have been important in stimulating the world motor vehicles industry to put vast resources into developing electric vehicles.  Similarly the expectation of very substantial decarbonisation of the power sector created by quantity targets appears to be driving necessary discussions and early action on grid design, trading arrangement reform, and system operation.

Addressing competitiveness concerns

There may also be some advantage from greater administrative ease in addressing concerns about competitiveness of emissions intensive trade exposed industry through the allocation of free allowances.  In principle the same outcomes can be achieved with a tax by setting thresholds above which the tax is payable, as, for example, under the proposed South African carbon tax.  However providing such shielding under an ETS may be politically, legally or administratively simpler under an ETS.  For example, it may be politically difficult to be seen to “give tax breaks to big polluters”.

Offsets and linking

Other proposed advantages of emissions trading are less compelling relative to a carbon tax.  For example, offsets can be included under a tax, as is proposed in South Africa and Mexico, as well as under an ETS.  There may be potential to link emissions trading schemes.  However at present trading schemes remain diverse with wide dispersion of prices and limited prospects for direct linkage.  And under a tax governments can easily look to the levels of taxes elsewhere and take that into account in setting their own tax rates, with some potential for linking taxes by means of credits if this is desired.

Quantity limits as an expression of non-monetary values

Among the most compelling reason for choosing caps is that the consequences of climate change imply choices about issues that are not captured by an economic cost benefit analysis looking at maximising net benefits.  Choices are ultimately about the effects some people now impose on others, the legacy current generations leave for the future and how can this be balanced against the needs of the present.  This necessarily requires the debate to address how acceptable we find the risk of melting ice caps or the loss of the Amazon forest.  While economic analysis may inform some of these choices it cannot make them, because in the end they are not only about money.  Under this framework an emissions trading scheme is an instrument to achieve a goal that is necessarily specified outside the framework of net monetary benefits.  This is represented much more directly by limits on cumulative emission than by a carbon, even though uncertainties about the effects of a particular atmospheric concentration remain.

Drawbacks to quantity limits

However an ETS also has drawbacks.  Prices can be very volatile, because abatement is typically a small proportion of emissions making the price the result of a small difference between two numbers (the cap and business as usual emissions), one of which is rigidly fixed and the other of which is highly uncertain(3).  Such volatility is likely to persist, even with provisions to bank allowances, which are intended to smooth out price fluctuations, and with other provisions such as overlapping or rolling compliance periods.  For example, banking is a feature of the EUETS, and prices have still been volatile, although banking has helped sustain Phase 3 prices above zero.

Highly volatile prices are undesirable because they increase the risk of investments in abatement, and hence their costs, leading to decreased economic efficiency.  Volatile prices may also bias the form of abatement towards shorter term expenditure, such as fuel switching, rather than longer term investment.  They also make government finances more difficult to plan where auctions are used, and make a revenue neutral carbon pricing scheme, often an objective of policy, more difficult to sustain.

More fundamentally, an emissions trading scheme may fail to price emissions correctly in some circumstances because it fails to give any incentives to reduce emissions further below the cap.  If emissions are below the cap, allowances are not scarce, and the price drops to close to zero.  However emissions below the cap impose a cost and so should be priced(4).  This is evident under the EUETS at the moment where further abatement would clearly have value not signalled by the current price.  This problem of under-pricing damage is especially severe given the limited time horizons and incomplete commitment that are part of emissions trading schemes in practice.

Such drawbacks may carry particular weight where the advantages of an ETS seem less compelling.  My next post will look at what the alternative of carbon taxes might deliver, and the circumstances in which this might be a more appropriate policy choice.

Adam Whitmore – 28th April 2014

Notes

1 This basis of the choice between price and quantity instruments was first laid out clearly in by Martin Weitzman  in one of the most widely cited papers in the environmental economics literature (Weitzman, M.L. 1974 Prices vs. quantities, Review of Economic Studies 41 (4) 477 -491).     A good recent survey of the merits of different approaches is in Carbon Taxes vs. Cap and Trade: A critical Review, Lawrence H. Goulder Andrew Schein  Working Paper 19338 http://www.nber.org/papers/w19338

2  http://www.climatechange2013.org/images/uploads/WGI_AR5_SPM_brochure.pdf

3.  See Grubb, M. (2009). Reinforcing carbon markets under uncertainty: the role of reserve price auctions and other options for a discussion of this point.

4  This is measured by the Social Cost of Carbon.  There are large uncertainties in estimating what this is, and it is difficult to account for non-market impacts, but it nevertheless provides a useful indication of the cost of damage, at least as a lower bound – see page below in this section for a discussion of the social cost of carbon.