Tag Archives: carbon taxes

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

Carbon supply curve

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 – 2nd 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

Costing damages from climate change offers only a partial guide to choice of policy

Estimates of the cost of damages from greenhouse gas emissions are more use for ruling in policy measures than ruling them out.

Estimates of the cost of the damages caused by greenhouse gas emissions (often referred to as the social cost of carbon) are widely used to assess the cost effectiveness of policies to reduce emissions.  Broadly speaking, emissions reductions that are cheaper than the cost of damages are judged cost-effective, while emissions reductions more expensive than the cost of damages risk being deemed not cost effective.  For example, the US EPA uses an estimate for the social cost of carbon of $39/tonne of CO2 (in 2015 at a 3% discount rate) as its benchmark, with policy measures leading to emissions reductions at a cost lower than this being considered cost effective.  Such estimates also act as a benchmark for carbon prices, on the grounds that an economically efficient carbon price should equal the expected cost of damages [1].

Detailed modelling is used to estimate the additional costs of damage per tonne of additional emissions (see notes at the end of this post for a short summary of this process).  The modelling is often thorough and elaborate, and attempts to be comprehensive.  However there are several factors which tend to lead to estimates of the cost of damages being below what it is really worth paying to avoid emissions.

Omitted costs

Many of the costs of climate change are omitted from models, essentially assuming that they are zero.  For example, knock-on effects, such as conflict from migration, are often not modelled, but may be among the largest costs of climate change.  Other costs are dealt with only partially, because they are difficult to estimate reliably [3], or difficult to measure as a financial loss.  For example, it is difficult, and in many ways impossible, to develop adequate costings for the loss of major ecosystems.

Difficulties in estimating the effects of large temperature changes

Models designed to estimate the cost of damages for a temperature change of one or two degrees may be become highly misleading if used to estimates the costs of larger temperature changes.  Damages may increase only quite slowly with small temperature changes, but are likely to increase quite rapidly thereafter, and perhaps catastrophically when certain thresholds are reached [4].  This is often not represented adequately in models.  For example, the widely used DICE model shows GDP only approximately halving with a temperature rise of 19 degrees centigrade.  This is unlikely to be realistic, and indeed the model’s author has cautioned against its use for temperature changes above around 3 degrees.  But temperature changes above 3 degrees would be very likely under a business as usual emissions scenario, and the effects of such large temperature changes are a major cause for concern.

Treating GDP growth as exogenous

Most models assume that the drivers of GDP growth are largely unaffected by even very severe climate change.  Over a century, even slow growth (anything above 0.7% p.a.) more than doubles GDP, and so more than offsets the costs of warming even if GDP is assumed to halve from the level it would otherwise reach.  Even with a temperature rise of 19 degrees over a century people appear, on average, better off than today, because the benefits of growth (more than doubling GDP) outweigh the costs of climate change (halving GDP).  Calling this result counterintuitive is something of an understatement.

Role of risks

Analysis often excludes some risks which are difficult to model, for example some types of climate feedbacks.  This effectively assumes that they won’t happen and so won’t cause any damage, ignoring the risks.  Indeed, even attempting to set a single average cost of damages fails to address the question of willingness to tolerate the chance of a cost much larger than the estimated average (due to low probability high impact events).  The EPA does estimate of the cost in the upper tail of the damage distribution, and some other modelling explicitly includes a range of sensitivities.  However these approaches, at best, go only part way towards addressing the problem of the risk of catastrophe outcomes, especially in view of the other limitations I’ve outlined.

Finally, the process of assessing policy measures needs to take account of all costs and benefits.  Measures to reduce emissions often have valuable co-benefits for health which need to be factored in to decision making.  And analysis needs to take account of future benefits for emissions reduction, for example in promoting early stage technologies.

Estimates of the cost of damage from greenhouse gas emissions remain useful inputs into decision making.  They can be useful in ruling policy measures in – if a policy measure has a cost per tonne below even a cautious estimate of the cost of damages then it is very likely cost-effective.  But they are much less useful for ruling measures out.  It is probably worth paying a good deal more to reduce the risks of large changes to the climate than the conventional estimates of damage costs suggest.  And in any case judging which risks are acceptable will always be a matter of political and ethical debate, rather than a simple matter of costings.

Adam Whitmore – 13th October 2014

Notes

[1] This principle that pricing of pollutants should reflect the cost of damages is commonly discussed in terms of Pigovian taxes or the Polluter Pays Principle.  

[2] The cost of damages, commonly referred to as the social cost of carbon (SCC), is usually estimated by modelling the cost of damages from additional emissions.  A base case emissions track is specified.  The changes to the climate and the resulting impacts associated with this base case emissions track are modelled.  The financial costs of the damages resulting from the impacts, for example due to rising sea levels, are estimated.  This process is repeated, adding an additional (say) billion tonnes of extra emissions, and calculating the costs of the additional damages that result.  The (discounted) additional cost of damages per tonne of additional emissions is derived from this.  These calculations are usually done using elaborate models known as Integrated Assessment Models (IAMs).  Estimates of the Social Cost of Carbon such as those used by the US EPA can refer to estimates from several different IAMs.  The uncertainties involved in the modelling lead to a wide range of estimates for the SCC. 

[3] A good survey of omissions from calculations of the SCC is given by a recent report co-sponsored by the US NGOs the Environmental Defense Fund and National Resources Defence Council:  http://costofcarbon.org/blog/entry/missing-pieces

[4] A good review of the limits of modelling can be found in Nicholas Stern, The Structure of Economic Modelling of the Potential Impacts of Climate Change, Journal of Economic Literature 2013.  This includes the reference to damages at very large temperature changes, quoting work by Ackerman, Stanton and Bueno: Fat tail, Exponents, Extreme Uncertainty: Simulating Catastrophe in DICE, Ecological Economics 69, 2010

 

Types of carbon pricing (part 2 of 3)

This post is the second 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 here.

Carbon taxes define a set price for all emissions from a jurisdiction and a particular time.  For jurisdictions accounting for a small proportion of emissions and looking at limited time horizons – for example British Columbia over the next 5 years – variations in emissions will have little effect on the stock of GHGs in the atmosphere, so there is little likelihood that any incremental emissions will lead to a dangerous threshold being reached.  Consequently the cost per tonne of damage is quite constant over different levels of emissions (the marginal damage function is very flat).  In contrast, an excessively high price under a cap may prove economically damaging.  This implies a constant price set by a tax may price damage appropriately.

Indeed given the dependency of damage on the stock of emissions such arguments apply to quite large jurisdictions over quite long timescales.  The limited variation in damages per tonne as emission vary over quite large ranges compared with annual emissions from any one jurisdiction is among the main reasons that many favour taxes rather than quantity limits [1].

Price stability

A carbon tax also addresses many of the drawbacks of an ETS by providing price stability.  This may stimulate investment more efficiently than a volatile price, because it can be built into companies’ financial models with greater confidence.  It also provides governments with greater revenue stability.  It is likely to make revenue neutrality for governments,(i.e. no change in total tax burden) easier to manage.  Revenue neutrality is often stated as an objective of carbon pricing, and appears to be an important factor in continuing political support for the carbon tax in British Columbia.

Furthermore, some of the other advantages of emissions trading may also prove less compelling for smaller jurisdictions.  They are more likely to be technology takers, playing a limited role in stimulating new technology, which will frequently be deployed globally, implying any strategic signal for technology development created by a cap is less relevant.  And appropriate measures for shielding of emissions intensive trade exposed industries against carbon leakage remain entirely possible under a tax.

Administrative simplicity

A tax may also prove administratively simpler than an ETS, because an ETS requires allowances to be tracked whereas a tax simply requires emissions to be monitored.  This is intrinsically simpler than tracking allowances in any case, and may be made more so by the existence of existing systems for taxing energy use.  For large economies the administrative costs of an ETS are likely to be a small proportion of the total scheme costs, but this may not be the case in smaller economies.  Simplicity may also be an appealing feature for jurisdictions with less developed administrative capacity, which may struggle to implement an ETS.

Fit with complementary measures

A carbon tax may also fit better with complementary measures, such as those to encourage deployment of renewables.  Unanticipated increases in renewables deployment can reduce the carbon price under an ETS in a way that is not possible with a tax, and indeed this is one of the factors that has contributed to lower prices under the EUETS [2].  (A related argument that the unilateral UK carbon tax, known as carbon price support, does nothing to reduce emissions because the cap is set at the EU level is less clear-cut, for example because of current surpluses under the EUETS, the potentially endogenous nature of future caps, and the risk of lock in from investment). [3]

Drawbacks to carbon taxes

However there are also drawbacks to taxes.  Setting the price of emissions at the level of damages is sound in principle.  However there is an order of magnitude uncertainty about what that cost of damage is.  Even if the damage is fairly constant (the slope of the curve is almost flat) there is still a risk of (greatly) over-pricing or under-pricing the damage, although If taxes are primarily intended to reach a certain target level of emissions by adjusting them over time this may be less of a concern.

And for larger jurisdictions the advantages of emissions trading remain – there is, by design, no limit on emissions under a carbon tax, so there is a risk of crossing thresholds of atmospheric concentration with consequences of very high damage costs.  In principle this risk may be mitigated by the possibility of increasing taxes rapidly as the threshold is approached.  However it may not be possible for governments to signal such an increase, or to implement it, especially as there would need to be an increase across all major jurisdictions to avoid crossing a global threshold of atmospheric concentration.  Furthermore such an increase may not be anticipated by investors in infrastructure, leading to difficulties in making large, rapid reductions in emissions even in the case of very high taxes.

Similarities between taxes and quantity limits

Under both a tax and an ETS learning is possible.  If the tax is not producing sufficient abatement then it can be increased, if a cap it producing low prices it can be tightened.  A tax may have some advantages in this respect as it can be adjusted annually, but something like the five year rolling cap introduced in Australia appears to offer opportunities for an ETS to show similar flexibility, so there does not appear to be a clear cut advantage for either type of instrument.

And in both cases it may be politically difficult to set the carbon price at an adequate level.  Taxes are rarely popular, although the British Columbia carbon tax seems to have done better than most.  And there will always be concerns about setting a cap too tight, risking higher prices and distorting growth.  This will be exacerbated by the interest of both governments and companies in being optimistic about economic growth and industrial production.

Comparison of properties of price and quantity instruments

The circumstances which favour emissions trading and taxes are summarised in the table below.

Factors where higher values favour caps (and lower values favour taxes) Because …
Share of global emissions covered Increased proportion of atmospheric GHG stock covered
Time periods for which policy is committed (including future targets) Increased proportion of atmospheric GHG stock covered
Length of life of investments Increased emissions lock-in, so larger contribution to GHG stock
Importance of strategic signal for technology and infrastructure development A cap can give clearer signals on longer term abatement
Variation in abatement costs over time The flexibility on timing offered by an ETS may help firms abate at lower cost
Administrative capacity Jurisdictions with higher administrative capacity will find the additional administrative burden of an ETS less onerous
Factors where higher values favour taxes (and lower values favour caps) Because …
Rate of decay of atmospheric GHG stock A higher decay rate of the gas in the atmosphere diminishes the effects of uncertain emissions on outcomes.
Discount rate A higher discount rate diminishes the importance of future damage from with uncertain emissions.
Frequency of policy review Adjustments to taxes can reduce expected deviations in emissions trajectories.
Importance of stable price signal for current investment A tax gives a constant price signal (though subject to amendment)

 

Some of the drawbacks of both an absolute cap and a pure tax come from the rigidity of either the quantity or price that is set.  In almost all markets supply and demand both vary with price.  However under a pure ETS the supply of allowances remains constant irrespective of the price (zero elasticity of supply), whereas under a carbon tax the variation of emissions is unlimited at the same price (infinite elasticity of supply).   Very few markets function this way, and a carbon market need not.  It is perfectly possible to set a price schedule which varies with the price of allowances.  Schemes which include both price and quantity limits are referred to as hybrid schemes, and these are reviewed in the next section.

Adam Whitmore – 5th May 2014

 

References

[1] For a detailed analysis of this issue see Newell and Pizer, Regulating Stock Externalities Under Uncertainty Resources for the Future, May 2000

[2] The recession appears to have been the main factor leading to lower prices under the EUETS.  However renewables deployment also appears to have played a a role.

[3] Separately it is also been argued that there are circumstances in which a tax may prevent capture of rents by oligopolistic fuel producers better than an ETS.  However it is not clear that the conditions in which such considerations prevail apply in practice given the current structures of gas and coal markets in particular.  See Goulder reference quoted in my previous post for a discussion of this issue.

The continuing spread of carbon pricing

Carbon pricing continues to spread around the world, with major schemes in Chinese provinces now in place.

For my first post this year it seems timely to review progress on implementing carbon pricing around the world.  As I’ve previously noted, the spread of carbon pricing during the past decade has been remarkable.  Once confined to a few small economies in northern Europe, it has become a worldwide phenomenon, with more than a dozen major carbon pricing schemes either in place or under development around the world.  The major step forward in last year has been the start of five regional pricing schemes in China, although trading in these markets remains relatively illiquid.  The expansion of carbon pricing in China is set to continue this year as two more trial schemes go live.  A year from now, assuming current programmes run to schedule, carbon pricing will be in place in jurisdictions that together account for between a fifth and a quarter of total global CO2 emissions from energy and industrial processes. 

Not all emissions in these jurisdictions are priced, as governments use other policy instruments to reduce emissions in particular sectors, for example surface transport in the EU.   Nevertheless, by next year over 10% of the world’s energy and industry CO2 emissions are likely to be priced.

On the Chart below the top (blue) line shows how the percentage of emissions in jurisdictions with pricing has grown over the last decade.  The total includes all energy and industry CO2 emissions taking place in each jurisdiction with carbon pricing.   Thus, if all jurisdictions in the world had carbon pricing in place the total coverage would be shown as 100%.  The lower (green) line shows the percentage of energy and CO2 emissions that are actually priced.  For example, the EU accounts for around 11% of emissions, but only a little under half of these are priced by the EUETS.  The gap between the blue and the green lines is the proportion of emissions covered by other policies, or by no policy.  Even if carbon pricing were to be extended to 100% of jurisdictions it is likely that some emissions would remain unpriced. 

CO2 emissions from land use and emissions of other greenhouse gases are excluded from the calculations.  Including these would reduce the proportion of emissions in jurisdictions with pricing, in part because of a large volume of emissions from deforestation in countries without national carbon pricing, notably in Brazil and Indonesia.  Nevertheless the trend is remarkable, and implies that any country considering carbon pricing is very much part of the worldwide policy mainstream.

Coverage of carbon pricing is increasing …

Coverage chart January 2014

By far the most significant new development over the next few years is likely to be the extension of carbon pricing across all of China, which the Government has indicated it wishes to see in the next few years.  This alone would raise global coverage of carbon pricing to over 40%.  Indonesia is also looking at carbon pricing with a prospective voluntary market potentially leading to a compulsory market in due course. 

We may also see somewhat more widespread carbon pricing in the USA.  EPA regulation of existing power plants under the Clean Air Act will oblige states to put in place implementation plans.  This may lead states to establish emissions trading schemes, or (more likely) join the Regional Greenhouse Gas Initiative (RGGI), which covers the power sector only.  Indeed some states are understood to have already expressed an interest in doing so, although it is not yet clear in which states interest is strongest.  Expansion of Western Climate Initiative trading schemes beyond California and Quebec also remains possible.

There also appears to be a trend towards carbon pricing in Latin America.  Mexico may strengthen its currently very limited carbon tax (excluded from the chart) over time.  Provinces in Brazil have looked at emissions trading schemes, and discussions on an ETS are now underway in Chile.

Future trends are, however, far from clear, and the commitment by the Australian government to repeal its carbon pricing legislation is an indication that consistent progress is far from guaranteed.

For those involved with carbon pricing day-to-day it is often easy to forget just how recent it is, and just how much progress has been made in a short time. There is still only a single decade of experience, compared with many decades, and in some cases centuries, for other types of regulation.  As a regulatory “technology” large scale carbon pricing remains more recent than the ipod, and there is still much to learn and a long way to go.  But the achievement to date is both substantial and encouraging.

Adam Whitmore – 16th January 2014

Notes on inclusion and exclusion from the chart:    The small carbon tax introduced in Japan in 2012 by modifying energy taxes is excluded, as is the carbon tax in Mexico, which is small and has limited scope.   The Tokyo emissions trading scheme is excluded as its current status is unclear.  The Swiss scheme is included in the total for the EU.  The status of the Kazakhstan scheme is currently uncertain and I have allowed for a year’s delay to 2015.  For simplicity the California and Quebec schemes are shown with full coverage from their introduction in 2013, although they do not reach this in practice until next year.  Question marks indicate measures which have yet to be enacted. 

Comparison with World Bank study:  The results here are similar to those from a World Bank Study of carbon pricing from 2013, but on a slightly different basis.  The World Bank study quotes just over 10Gt out of 50Gt of emissions taking place in jurisdictions with pricing.  This is for all GHGs.  The total shown here is around 8Gt out of 34Gt (2012 data) for carbon dioxide emissions from energy and industry.  The main difference in the total Gt of emissions in jurisdictions with pricing appears to be due to the inclusion in the World Bank study of a number of jurisdictions where pricing is at an earlier stage than shown here, notably Turkey, Ukraine and Brazil.  However South Africa is excluded from the World Bank total, as is British Columbia.  The total emissions actually priced is quoted by the World Bank as 3.3 Gt, which is 10% of carbon dioxide from energy and industry and 7% of total GHGs, but this excludes some of the China pilots for which no data was available.  I have included estimates in these cases.  If the other pilot Chinese schemes were included  in the World Bank totals their estimates of coverage would likely increase by about a percentage point (to 11% of energy and industry and 8% of total GHGs), roughly in line with the totals quoted here.  The World Bank study can be found at

http://documents.worldbank.org/curated/en/2013/05/17751166/mapping-carbon-pricing-initiatives-developments-prospects.

 

Data: Emissions data is for 2012, from the EDGAR database, with no adjustment for changes in relative volumes over time.  Shares at subnational level are estimated based on a range of data.  Data sources include  http://edgar.jrc.ec.europa.eu/  and Zhao et. al., China’s CO2 emissions estimated from the bottom up: Recent trends, spatial distributions, and quantification of uncertainties  Atmospheric Environment, Volume 59.

The EUETS stands alone in not managing price – time to change?

The EUETS stands alone in currently excluding any element of price management from its basic design.  In this respect it can learn from other schemes.

The current debate on whether the backload the sale of EU allowances is in many ways a distraction from the more important issue of structural reform.  The Commission’s review of the EUETS published last year mentioned price management as an option for structural reform (Option f in the document)i.  I have previously talked about the way in which carbon pricing lies on a spectrum between pure emissions trading and pure taxes (27th March 2013), and looked at the role of floor prices in emissions trading schemes (2nd May 2013).  In the context of the current debate on EUETS reform it seems worth further emphasising how exceptional the EUETS is in not already including some element of price management in its design.

Every other carbon pricing scheme in the world contains some element of price management or fixed pricing, or (for those schemes still being designed) seems likely to put something in place, with the only possible exception I am aware of being Kazahkstan.  The measures that have been introduced or are being considered – floors, ceilings, market interventions, and carbon taxes – are summarised in the table at the end of this post.

There are many reasons why governments may wish to introduce such mechanisms.  They may be concerned about the economic damage of very high prices, or that low prices will fail to stimulate the necessary long-term investment, or that they do not wish to see the price fall below the range plausible estimates of the likely cost of the damage due to additional emissions.  In any case, pervasive uncertainties in advance about both the effects of climate change and the cost of mitigation imply that simultaneous attention to both prices and quantities is appropriate.  (A review of the reasons for this will need to await another post, but it is a well-established principle.)

There will of course be political challenges in negotiating the form and level of any price thresholds in the EUETS, with some eastern European member states likely to favour lower values than some in western Europe.  But whatever form and level of price containment in the EUETS proves achievable, the presence of such mechanisms in every other scheme in the world surely at least warrants a close look at how such mechanisms might benefit the EUETS.

The EUETS was a pioneering scheme, and other schemes have learnt much from it.  Now other schemes are up and running, and the EUETS can learn from them in return.  And one of the things it can learn is that price containment mechanisms are an appropriate component of emissions trading schemes.

Adam Whitmore – 25th June 2013

Scheme Price floor Price Ceiling Notes
California, $10 + 5% p.a. real escalation auction floor $40/45/50 + 5% p.a. real. Reserve tranche volume increasing over time. The floor appeared to influence the first auction and some future tranches
Quebec C$10 + 5% p.a. real escalation, auction floor c$40/45/50 + 5% p.a. real Linked to California as part of the WCI
RGGI c. $2 constant real, auction floor price Increased offsets at price thresholds.  Moving to Cost Containment Reserve, at $4 in 2014 rising to $10 by 2017, 2.5% p.a. nominal  increase thereafter The floor has been effective in sustaining prices despite chronic oversupply
Alberta No $15/tonne buyout price, may rise to $30-40/tonne following review A hybrid baseline and credit scheme and tax
British Columbia Carbon tax fixed at C$30 May adopt emissions trading in future as part of WCI, but does not appear likely at present.
Australia (pre EU link) A$15 + escalation (abolished with EU link) $20 above EU price, rising annually Fixed price of A$23 rising at 5% nominal p.a. for first three years
New Zealand No Price ceiling at NZ$25 Effective ceiling lower due to 2 for 1 surrender provisions
Prospective schemes
China pilot schemes Likely to have some kind of price management through buying/selling of allowances, perhaps in a “central carbon bank” type model
South Korea Understood to be examining a wide variety of options, including a review committee with powers to implement measures such as increased supply and price floors
South Africa Carbon tax at Rand120/tonne

 

[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

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.

A spectrum of possibilities for carbon pricing

Carbon taxes and emissions trading are two ends of a spectrum of possibilities for carbon pricing.  One or other end of the spectrum may not be the best place to be.

As carbon pricing spreads around the world (see post from 7th March) governments are differing in whether they choose to pursue emissions trading or carbon taxes.  For instance, South Korea is getting ready to implement its emissions trading scheme, for which legislation was passed last year, while the South African Government has recently reaffirmed its commitment to a carbon tax.   There many reasons for these differences in approach, which I’ll return to in future posts, but for the moment I want to look at how existing schemes illustrate that the distinction between the two types of instrument is not absolute.  Emissions trading schemes can have fixed price components or limits to price ranges, which introduce an element of price certainty, while taxes may allow a degree of trading in the form of offsets or credits generated from outperforming a baseline.  Emissions trading and carbon taxes are thus at two ends of a spectrum of possibilities.  The best policy choice is not necessarily at either end.

The chart shows major carbon pricing schemes around the world on a spectrum from pure emissions trading on the left to pure carbon taxes on the right.  The first thing that’s apparent is that there is a clear preponderance of emissions trading schemes, especially by volume of emissions covered.  But many ETSs contain some element of price certainty, and taxes may include elements of trading, so many schemes do indeed in practice lie somewhere between the two extremes.

A spectrum of possibilities between an emissions trading schemes (ETS) and a carbon tax

spectrum chart

The EUETS and the Regional Greenhouse Gas Initiative (RGGI) in the Northeastern USA are almost pure emissions trading scheme, with minimal limits on price, although RGGI does have a low reserve price in its auctions (currently $1.98, indexed to inflation), and there are also some very limited auction reserve provisions available in the EUETS.  The prospective Beijing ETS appears to likely to follow this model quite closely, although there appears to be a possibility that the regulator will seek to exercise some influence on the price by buying and selling allowances centrally, rather analogous to the role a central bank might play in currency markets, or by some other means.  However, the Beijing scheme remains to be finalised and it is not yet clear what form this or the other trial Chinese schemes will take in practice.

Several other schemes diverge from the model of a pure ETS by having elements of fixed pricing.  The Australian scheme includes an initial 3-year fixed price period.  Before the link to the EU ETS was established late last year it was intended that after the 3-year fixed price period it would include a floor price in the auction and a ceiling related to the international carbon price.  (The price ceiling remains in principle following the EU linkage, but in practice will never be triggered).  This made its original design much closer to the California and Quebec schemes, both of which contain reserve prices in the allowance auctions to give a price floor, and also price ceilings in the form of reserve tranches of allowances.  Floor prices are currently just over $10/tonne, well above the levels found in RGGI, and indexed to rise at above the rate of inflation.

The Alberta scheme is a hybrid between a tax and an ETS.  It sets a baseline for emissions from an entity per unit of output (emissions intensity), rather than a fixed emissions cap.  If emissions are below this baseline then credits are generated.  If emissions are above the baseline then the entity has several options: it can buy credits from those in surplus, it can purchase offsets, or it can pay a fixed price of $15/tCO2 which goes into a fund for clean technology investment.  It thus resembles a carbon tax payable above a threshold level of emissions intensity, but with some element of trading allowed.

The proposed South African carbon tax would, if introduced in its currently proposed form, allow some of any remaining obligation to be met through offsets.

At the other end of the spectrum the British Columbia carbon tax is a solely a tax, with no element of trading at present (and only very minimal provisions for offsets).

Political processes introduce dynamics which may ultimately limit the extent to which a carbon pricing scheme focus is exclusively on price and quantity.  Decisions about the level of the cap are likely to be influenced by expectations of the prices that will result.  And if a surplus of allowances leads to low prices a tightening of the cap may be considered, as in both the EUETS and RGGI at present.  Similarly the level of a tax may be adjusted over time to meet an environmental goal, or other policy objectives such as raising revenue.

So policy debates should perhaps be less about a preference for taxes or emissions trading in their pure form, and more about where a scheme should be positioned on the spectrum of possibilities, and how outcomes can be managed over time as the scheme develops.  And even if a scheme starts at one end of the spectrum, events may force changes that recognise that in practice there is always a balance to be struck between prices and quantities.

Adam Whitmore        27th March 2013

Where the price of emitting carbon is $700/tonne

 Taxes on petrol can be the equivalent of nearly $500/tonne.  The UK’s annual tax on cars can bring the total up to over $700/tonne with typical mileage.  This is around two orders of magnitude greater than the carbon price that other sectors face at the moment under the EUETS, and one indicator of the challenges involved in decarbonising road transport.

With the UK budget due next week there is, as usual, debate about whether planned increases in petrol taxes should be abandoned.  Although emissions from cars are not subject to a carbon price under the EUETS at the moment, existing taxes put an effective price on emissions – the more petrol a car burns the greater the emissions and the greater the tax paid.  There is a price signal to reduce fuel burnt, and hence CO2 emissions (although fuel duty is not labelled a carbon tax, and may, of course, also price other externalities associated with burning petrol or diesel).  Looking at this price signal gives important insights into how the transport sector would be likely to react to an explicit carbon price, and says much about whether proposed increases in fuel duty can be justified on the grounds of incentivising reductions in CO2 emissions.

Fuel duties are strikingly high compared with carbon prices prevailing under emissions trading schemes.  The current excise duty on petrol in the UK is 61p/litre, with VAT of 20% also payable on the duty.  A litre of petrol emits around 2.3 kg of CO2, so the duty plus VAT is equivalent to a tax of £318/tonne CO2 ($484/tonne CO2).  Tax levels are roughly similar in Germany and several other European countries.  Even in California, where fuel excise taxes are much lower, the equivalent carbon price is around $65/tonne, higher than under any emissions trading scheme or carbon tax at present.  (The California emissions trading scheme is due to be extended to transport in 2015, which will add at least around an extra $12/tonne – the 2015 floor price for the scheme – to the price of gasoline, assuming no accompanying change in excise taxes.)

Excise taxes on petrol (Fuel Excise Duty) expressed as a tax per tonne of CO2 emitted are in the hundreds of dollars per tonne in some European countries …

 comparison fo fuel duty across countries

VAT charged on the excise tax is included, but that on the petrol is not, as this is not a tax specific to petrol.  Emissions factor assumed is 2.3 kgCO2e/litre.  Federal and state taxes are included in California, no sales tax is included.

This calculation excludes the effect of UK Vehicle Excise Duty (VED), sometimes called road tax.  This annual charge per vehicle depends on the vehicle’s emissions of CO2 per km.  Although it does not vary with actual emissions, which depend on distance travelled and other factors such as traffic conditions, it nevertheless makes vehicles with higher carbon emissions more expensive to own on an annual basis.

Increasing vehicle emissions from just over 100g/km to just over 200g/km adds £250 p.a. of VED to the annual cost of a vehicle.  Assuming the vehicle clocks up 16,000 km (around 10,000 miles) per year, and emissions per km are at the standardised level used to set VED, the additional emissions are 1.6 tonnes p.a., so the change in VED adds another £156/tonne ($238/tonne) to the effective carbon price, to give a total effective price of over $700/tonne (see chart).  This figure is lower for those who travel more, higher for those who travel less than the 16,000km p.a. assumed, but it’s a large number for any typical car owner, and leads to a total effective carbon price about a 100 times greater than the current carbon price under the EUETS.

Taxes on emissions from cars in the UK including both fuel and vehicle taxes are over $700/tonne, assuming 10,000 miles per year …

 UK duty components

There are additional policy measures to encourage lower emissions vehicles in place in the UK designed.  Vehicles’ CO2 emissions are clearly labelled in advertisements for cars.  EU regulation sets limits to average fleet emissions over time.  Electric vehicles receive a subsidy to encourage their uptake, and there are efforts to create a grid of charging points.

Yet people still choose to drive conventional internal combustion engine cars.  A carbon price of several hundred dollars per tonne is not enough to reduce emissions from cars to anywhere near zero with present technologies.  People have a high willingness to pay for personal mobility and the alternatives to internal combustion engine cars are not available at the price and travelling range that would lead people to switch.

Furthermore, despite high oil prices as well as high taxes, many people continue to drive cars with much higher emissions than others on the market.  People place a high value on many of the features that go with additional emissions, whether it’s better acceleration, increased size, or greater social prestige.  Continuing innovation will be needed from the world’s car makers if the transport sector is to be decarbonised, even with an effective carbon price vastly greater than that currently found in emissions trading schemes.

And whatever justifications there may be for increases in petrol duty in the forthcoming budget, creating a carbon price signal comparable with that prevailing in other sectors is certainly not one of them.

Adam Whitmore     15th March 2013

 

References and data sources

http://ec.europa.eu/taxation_customs/taxation/excise_duties/energy_products/rates/index_en.htm

http://ec.europa.eu/taxation_customs/resources/documents/taxation/excise_duties/energy_products/rates/excise_duties-part_ii_energy_products_en.pdf

http://www.boe.ca.gov/sptaxprog/spftdrates.htm

The continuing spread of carbon pricing

Within the next two or three years some form of carbon pricing will be in place in jurisdictions accounting for nearly a quarter of the world’s CO2 emissions from energy and industry (although not all emissions in those jurisdictions are priced).  This will have been put in place in little more than a decade, a remarkable achievement.

For the first post on this blog, it seems appropriate to take a look at how far carbon pricing, a central tool of climate change policy, has spread.

There are now more than a dozen major carbon pricing schemes either in place or under development around the world.  Two or three years from now, assuming current programmes run to schedule, carbon pricing will be in place in jurisdictions accounting for just under a quarter of total global CO2 emissions from energy and industrial processes.

This will have been achieved in little more than a decade (see chart).   In the early 2000s carbon pricing was in place in just a few jurisdictions, mainly in northern Europe, accounting for less that 1 % of world emissions.  The first major increase in the coverage of carbon pricing was the introduction of the EUETS in 2005.  Since then several countries and provinces have introduced pricing.  Schemes in Australia, California and Quebec have all gone live in the last year.  The next big step up in coverage is just beginning, with seven trial emissions trading schemes being introduced in China, in provinces and cities which account for around a sixth of China’s emissions.   The South Korean scheme, for which legislation was passed last year, will go live two years from now.  If South Africa implements a carbon tax, as announced in the recent national budget statement, this will add about another 1% of world emissions, bringing the total proportion of emissions in jurisdictions with pricing to around 24%.  If China were to introduce a national emissions trading scheme or carbon tax the proportion of world emissions in jurisdictions with carbon pricing would rise to over 40%.

The proportion of world energy and industrial carbon dioxide emissions taking place in jurisdictions with carbon pricing is increasing rapidly

Chart of emissions coverage revised May 2013

Source:  Emissions data is for 2010, from the EDGAR database[i], with no adjustment for changes in relative volumes over time.  Data for North American states and provinces is taken from official statistics.  Data for China is from Zhao et. al.[ii] Timings for regional schemes in China are estimated.  The Tokyo scheme is excluded as its current status is unclear.  The small carbon tax introduced in Japan last year by modifying energy taxes is also excluded.   The Swiss scheme is included in the total for the EU.  There is also some uncertainty around the Kazakhstan scheme, although this is included.

The percentages on the graph include the total energy and industry CO2 emissions for each jurisdiction with carbon pricing, although not all of the emissions in these jurisdictions are priced.  For example, the EUETS prices a little under half of its energy and industrial CO2 emissions, focusing on large point sources, with other sectors targeted by other policies.  Thus, if all jurisdictions in the world  had carbon pricing in place the total coverage would be shown as 100%.  A chart showing the proportion of world CO2 emissions that are priced would show a lower percentage.  A recent study by the World Bank estimated around 3.3 Gt of GHGs will be priced, around 10% of world energy and industry emissions, although this total appears to exclude some of the regional Chinese schemes for lack of data [iii].

Also, CO2 emissions from land use and other greenhouse gases are excluded from the calculations.  Including these would reduce the proportion of emissions in jurisdictions with pricing, in part because of emissions from deforestation in countries without national carbon pricing, notably in Brazil and Indonesia.  There are also issues to be resolved with some of the schemes, and it remains to be seen how effective the Chinese and Korean schemes, which have yet to go live, will prove in practice.  Nevertheless the trend is remarkable, and implies that any country considering carbon pricing is very much part of the worldwide policy mainstream.

The picture of increasingly widespread action extends beyond carbon pricing.  The legislators’ policy network Globe International recently published the third edition of its climate legislation study recently [iv].  It found significant progress on climate legislation in countries as diverse as Chile, Indonesia, Mexico, Pakistan and Vietnam.  Indeed, examining policy in 33 countries, it found substantial progress 18 countries and limited progress in a further 14.

Policy was found to have regressed in only one country, Canada.  And even this was because the methodology looked at the national level only.   There has been significant progress in Canada with carbon policy at the regional level, with three separate provinces having introduced carbon pricing, one of which (Quebec) is new this year and another of which (British Columbia) has a higher carbon price than found anywhere else, at C$30/tCO2.  Even at the national level Canada has now finalised a national emissions performance standard for new power plant at 926lb/MWh (420 kg/MWh), similar to that in place in California and being legislated in the UK, which effectively prevents new unabated coal plant from being built [v].

The challenge for the future will be to maintain this momentum, but the extent of progress on climate change policy to date, although falling far short of what is needed to prevent dangerous climate change, gives a cautiously hopeful perspective with which to start this blog.

Adam Whitmore      7th March 2013  (Updated 30th May 2013)


[ii] Zhao et. al. China’s CO2 emissions estimated from the bottom up: Recent trends, spatial distributions, and quantification of uncertainties  Atmospheric Environment, Volume 59.

[iii]  The World Bank Study quotes just over 10Gt out of 50Gt of emissions in jurisdictins with pricing.  This is for GHGs.  The total shown here is 8Gt out of 33Gt (2010 data) for carbon dioxide emissions from energy and industry.  The main difference in the total covered appears to be due to the inclusion of a number of jurisdictions where pricing is at an earlier stage than shown here, notably Turkey, Ukraine and Brazil.  However South Africa is excluded from the World Bank total.  The total emissions actually priced is quoted as 3.3 Gt, which is 10% of carbon dioxide from energy and industry and 7% of total GHGs.  If the other pilot Chinese schemes were included this coverage would likely increase by about a percentage point (11% and 8% respectively), and thus a little under half the emissions in the jurisdictions with carbon pricing on average are estimated to be priced.  The World Bank study can be found at: http://documents.worldbank.org/curated/en/2013/05/17751166/mapping-carbon-pricing-initiatives-developments-prospects

[v] http://ghgnews.com/index.cfm/canada-unveils-softened-final-ghg-performance-standard-for-coal-units/

This post deliberately does not say much about the current status of the UNFCCC process, which must await future discussion.  In the meantime coverage of this can be found on other forums, for example see http://climatestrategies.wordpress.com/