Tag Archives: emissions trading scheme

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 – 14th 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

Chart 1

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

Chart 2

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 – 20th  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 – 10th 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

revenue chart

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 – 26th 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

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

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.)

chart

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 CO2e 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 – 10th July 2014

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

Notes

The 1 tonne CO2e 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

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.

The EU’s recent proposal for a 2030 EUETS target does not look very ambitious

The EU’s recently announced greenhouse gas emissions target for 2030 looks like just enough to keep the 2050 target credible, but seems unlikely to be perceived as highly ambitious by other jurisdictions.  

The European Commission has recently proposed a target of reducing EU greenhouse gas emissions to 40% below 1990 levels by 2030.  Sectors covered by the EUETS (power generation and large industry) will be required to reduce emissions to 42% below 1990 levels.  This post takes a look, using some rough-and-ready analysis, at how onerous the EUETS target would be if implemented.   The Commission also announced a proposal to establish a “market stability reserve” for the EUETS.  I will return to this proposal in a future post, but for now the analysis excludes its effect.  The analysis also excludes the temporary delay of allowances sales over the next few years (backloading), which does not affect cumulative totals to 2030 in the absence of the stability reserve.

A target of a 40% reduction by 2030 is on a straight line track from the 20% mandated by 2020 towards the least stringent end of the 2050 target, which is an 80-95% reduction from 1990 levels.  This appears to be the minimum reduction likely to retain the credibility of the 2050 target, especially given the current surplus of allowances in the EUETS.  A smaller reduction by 2030, requiring deeper cuts to be achieved more rapidly towards 2050, would likely have increased the perceived probability that the 2050 targets would not be adhered to.

There is currently a surplus of EU allowances of around 2.2 billion tonnes, equivalent to about one full year of emissions covered by the scheme.   This scale of surplus has arisen mainly due to the severity of the recession in Europe.  Emissions currently remain below the cap, and even as the cap tightens it will take more than a decade for the surplus to disappear.

This is illustrated in the chart below.  The cumulative cap on emissions between now and 2030 (green line) starts at level of the current surplus.  It then increases, but less rapidly each year as the annual cap comes down.  This is compared with the illustrative case of annual emissions are constant at 2012 levels (solid blue line), so cumulative emissions grow linearly.  In this case, with no reduction in annual emissions, the surplus disappears in around 2026.  However in practice power sector emissions are expected to fall over the period (see below), reducing cumulative emissions (dashed blue line).  This leads to the surplus disappearing only in 2029, and reduces the cumulative shortfall by 2030 to quite low levels, assuming emissions from industry are constant.  Aviation is excluded from these totals.  Although internal flights remain covered by the EUETS, the associated cap remains unclear.

Cumulative emissions (excluding aviation) and the cumulative cap (including current surplus) show a deficit emerging only in the late 2020s …

 Cumulative surplus

The power sector is the largest source of emissions covered by the EUETS, so is crucial to demand for allowances.  There may be some increase in electricity demand over the period, and hence in demand for allowances.  The increase may be smaller with strong efficiency measures, or larger if there is very rapid uptake of electric vehicles, and will also vary more generally with GDP growth over the period.  There is also likely to be a decrease in nuclear generation to 2030 as older plant comes to the end of its working life and is not replaced by an equal amount of new plant.

However the growth in demand and fall in nuclear output seem likely to be more than offset by continuing growth in generation from renewables.  This implies a net decrease in the need for fossil generation, leading to lower emissions in the absence of changes to the fossil fuel mix.  However there may be some increase in emissions from internal EU  aviation, although any increase is likely to be much smaller in absolute terms than the decrease from the power sector.  Trends in emissions from industry, assumed to stay constant here, will also affect the total.

Together these trends might lead to a cumulative excess of expected emissions over the cap of around a billion tonnes by 2030 (about 3% of the total), including some growth in emissions from domestic aviation.   Projections of emissions over more than a decade and a half are obviously uncertain, and the cumulative total could easily vary by a billion tonnes or more from this total.  Nevertheless, it seems likely that the shortfall in allowances cumulatively over the period will be somewhere in the low- to mid- single figures percent of the total over the period, with the market remaining in surplus until the late 2020s.   The additional abatement required to eliminate the shortfall in this case could be achieved by a moderate amount of fuel switching.  And scenarios where a surplus of allowances persists through to 2030 are not hard to construct.  (The shortfall is somewhat increased if you take the view that there is a permanent stock of allowances needed to enable hedging in the market,  Some estimates indicate that this is around a billion tonnes, which would increase the shortfall to around 6% in the scenario above.  However it is by no means clear that this is needed through the 2020s, and anyway it remains easily accommodated by fuel switching,  Conversely around an extra 800 million allowances unused from the New Entrant Reserve  may come into the market at the end of Phase 3 in 2020, further reducing any shortfall )

Any substantial scarcity that does emerge seems likely to be as a result of banking of allowances into the period after 2030, either as a result of private sector banking or the operation of the market stability reserve, which effectively mandates a certain amount of banking of any large surplus.

The EU’s apparent intention to (just about) keep on a track towards its 2050 targets is surely welcome.  However the proposed 2030 target for the EUETS thus does not seem very demanding.  It seems unlikely that such a cap will be to be taken by other countries as a sign of strong EU leadership on emissions reduction.  It also seems unlikely that the EUETS alone will become effective at stimulating large scale investment in low carbon technologies over the next decade and a half.  This risks endangering progress to reduce emissions after 2030.  Additional policy instruments will likely be needed if the EU is to succeed in building the low carbon infrastructure needed to put itself on a path to largely decarbonising its economy by the middle of the century.

Adam Whitmore  –  14th February 2014

Notes on data and assumptions  

The 40% target requires a 20% point reduction by 2030 from the already mandated 20% cut due by 2020.  If this were followed by 40% points (40% down to 80%) over the subsequent two decades an 80% cut would be achieved by 2050.   20% of 1990 levels per decade thus takes the cap towards the top end of the 2050 target range of an 80-95% cut by 2050.

2012 emissions include the industrial emissions additionally covered in Phase 3.  Emissions from large industry are assumed to remain constant over the period.  The linear reduction factor is assumed to increase from 1.74% p.a. to 2.2% p.a. in 2021.

The estimates of power sector trends are based on the IEA 2013 World Energy Outlook New Policies Scenario.  This scenario shows demand growth in EU power generation of 0.4% p.a. over the period, leading to an additional 260TWh of generation by 2030 compared with 2011.  It also shows a decline of 10% in nuclear, but his may include optimistic assumptions about new build.  A decrease in nuclear generation of 20% (180 TWh p.a.) seems plausible, and I’ve used this estimate.  This leads to potential additional demand from fossil generation of 440TWh (260TWh + 180TWh).  The IEA estimates that generation from renewables, including hydro, will approximately double between 2011 and 2030, increasing by 730TWh p.a..  This leads to a net reduction in demand for fossil generation of around 290TWh (730TWh – 440TWh) by 2030.  The estimate of the saving takes account of the profile of these trends, for example the more rapid fall-off in nuclear in the 2020s.  Additional TWh of low carbon power are assumed to reduce emissions by 0.4t/MWh, equivalent to displacing mainly gas. 

The electricity sector projections take their base year as 2011 while the emissions data base year is 2012, but this is taken account of in the calculations. 

Internal aviation emissions are currently around 84 mtpa, but the position of aviation within the EU post-2020 is currently unclear.  The calculations assume that international aviation is dealt with under a separate agreement through ICAO, or not at all. 

The calculations exclude any additional reductions if other jurisdictions take action.  Any reductions in the cap due to international action may in any case be accompanied by increased use of offsets within the EU.

Can the EUETS combine intensity-based and absolute emissions caps?

An innovative reserve mechanism for the EUETS is being considered that moves allowances to and from the reserve based on the level of economic activity.  This would give the EUETS elements of an intensity based cap (limiting emissions per unit of output) within an absolute cap (limiting total tonnes emitted).   Although potentially less economically efficient than managing reserves based on prevailing prices it may prove politically more tractable. 

The prevailing surplus of allowances in the EUETS is leading to the scheme lacking effectiveness as a signal for abatement, and especially for low carbon investment.  The EU is considering a range of reform options to address this.  One option is to cancel allowances currently due to be auctioned, although this is likely to face substantial opposition.   Another option, not mutually exclusive, is to establish a reserve of allowances to stabilise the market.  Options for the reserve now under discussion are all volume based, as they seek to stabilise the market by using a reserve to manage the volume of available allowances.  But they differ in the basis for the trigger mechanism used to determine the timing and number of allowances transferred to or from the reserve.  There are three main types of basis for a trigger mechanism: volume of allowances, levels of economic activity, such as GDP, and allowance prices.  I assume here that the mechanisms applies automatically, but it would be possible for it to be administered on a more discretionary basis, analogously to the types of functions performed by a central bank.

I have previously written about the advantages of allowance reserves that use price based triggers to implement soft floors and ceilings on the price, such as those already implemented in California.  However, even if such mechanisms represent the best way forward in principle they may prove politically impossible to introduce in Europe at the moment.  So what about the other two possible types of trigger?

A volume based trigger in which allowances are put into the reserve when the cumulative surplus exceeds a specified upper threshold, and moved back into the market when the surplus (although still present) falls below a lower threshold, is essentially a form of temporary set-aside.  If allowances thus automatically come back into the market as it tightens, the timing and extent of the market’s return to cumulative scarcity appears likely to remain largely unaffected.  Market participants will anticipate the return of allowances to the market and factor it into their pricing.  Such a mechanism thus seems unlikely to add significantly to market stablility.

An economic activity based trigger is quite different.  It seeks to make the supply-demand balance more stable by adjusting the supply of allowances in response to the level of economic activity.  Allowances are placed into the reserve if economic activity is lower than expected and withdrawn from the reserve if activity is higher. This can result in supply being reduced into the long term after a recession, because allowances only come back into the market when a period of higher than expected economic growth leads to economic activity above expected levels.  This may not occur, or may return only a proportion of allowances.  It turns the scheme into something more like an intensity based scheme, where emissions per unit of activity are limited, but in this case still subject to an overall cap.

Such a mechanism does not address all of the causes of over or under supply.  Consequently it may not prevent price falling very low or rising very high in some circumstances, and so inefficiently low or high prices remain a possibility.  However a price-based trigger would probably be needed to avoid such risks completely.

This type of mechanism requires the measure of economic activity used as a basis for the trigger to be defined.  This may be GDP, which measures (however imperfectly) activity in the economy as a whole, or it may be something that represents activity in the sectors covered by the EUETS, for example a mix of electricity consumption and industrial output.

The expected level of economic activity that corresponds to no transfers to and from the reserve needs to be set.  It will likely be appropriate to reset this from time to time to take account of changed expectations, at least at the start of a new phase of the scheme.

The number of allowances that are transferred to or from the reserve in response to changes in the level of economic activity (elasticity) also needs to be defined.  For example if economic activity is 1% lower than expected then 1% of the cap may be put into the reserve, or some other proportion such as 0.75%.  The response may include limits on the number of allowances transferred in any one period, for example a quarter of auctioned volumes in any one year.  And it would be possible to specify no transfer in the event of small changes in economic activity relative to the expected level.

The way that such a mechanism might have worked had it been in place since the start of Phase 2 is illustrated in the chart.  For simplicity it uses GDP as an indicator of economic activity.  Expected GDP at the start of Phase 2 in 2008 was 2.3% p.a, with rising economic activity over time (dashed blue line).  Actual GDP has been well below this (solid blue line), and is currently around 12% below expected levels.  This leads to allowances being put into the reserve (green bars and lines which show annual and cumulative totals, assuming an elasticity of 0.75).  This is close to the cumulative surplus due to lower emissions shown on the chart (dotted black line).  The surplus is defined as the difference between the annual cap and actual emissions (dashed and solid grey lines), and excludes any surplus due to other factors such as the use of offsets.  In a hypothetical future the reserve continues to grow as GDP remains below expected values.  Then, after expected GDP is reset at the start of Phase 4 in 2021, a period of more rapid than expected growth begins to reduce the size of the reserve.  However a large volume allowances remains in the reserve even though the cap has significantly tightened and the market is likely to have returned to scarcity.

reserves chart corrected v2

It is not clear whether or not such a reserve mechanism, in effect providing an intensity based limit subject to an overall absolute cap, is a good idea.  It may fail to meet policy objectives in some circumstances, and other options for reform may be preferable.  But it seems worth further consideration.  If nothing else it may at least help remove at least some allowances from the market if permanent set-aside (cancellation) of allowances is not politically feasible.  And as an innovation among emissions trading schemes it could go some way to restoring the reputation of the EUETS, and would provide a signal to others around the world that the EU is willing to take action to address the problems with the EUETS as it now stands.

Adam Whitmore – 24th October 2013

To follow this blog click on the button in the bottom right hand corner of the screen.

ETS price floors and ceilings

A more up-to-date review of this topic can be found on the price floors and ceilings page of this site – page number 3 under the Carbon Pricing tab above, which can also be reached via this link:

https://onclimatechangepolicydotorg.wordpress.com/carbon-pricing/price-floors-and-ceilings/

Mechanisms that limit prices under an ETS (price floors and price ceilings) are already in operation in North America.  Similar arrangements can easily be adopted elsewhere, including in the EU.

In previous posts I have alluded to the benefits for an ETS of price floors in the form of auction reserves and soft ceilings in the form of a price containment reserve taken from within the cap.  In this post I take a look at how such arrangements work in North America to demonstrate that they are not esoteric theoretical ideas, but existing practice that can easily be adopted in similar form in the EU or elsewhere.  California, Quebec and the Regional Greenhouse Gas Initiative (RGGI) have a soft price floor in the form of an auction reserve price.  Prices can fall below this floor, but if bids are below this level in the auction allowances are not sold, so supply quickly tightens to maintain the price at the floor.  When prices rise, allowances can be released from a reserve acting reducing upward price pressure, although California and RGGI differ in the extent to which allowances additional to the cap can be offered into the market.   They also have mechanisms to limit price rises in the form of allowance reserves, but differ in the extent to which additional allowances can enter the market.

Price floors

Under the California ETS (Quebec has very similar arrangements) there is an auction reserve price of $10/tonne in 2012, which rises at 5% p.a. plus an inflation adjustment, and is currently $10.71/tonne.  Any allowances that are not sold at auction are retained by the regulator, the Air Resources Board (ARB), in an Auction Holding Account. The holding account allowances are not made available again through the auction until the price has exceeded the floor price for two consecutive quarterly auctions, and return is subject to a limit of 25% of the total allowances available at each regular quarterly auction. As a result, a surplus in the Auction Holding Account may take time to be drawn down.   In practice all 2013 allowances were sold out at the first four auctions, and the market price is above the floor level, though only by a little in the first auction.

RGGI, which covers power sector emissions from several states in the north eastern USA, also includes an auction reserve price.  However, the reserve price is much lower than in California, at $2/short ton in 2014 rising at 2.5% p.a., approximately in line with inflation.  In the past the floor has often been binding, but the current price is above the floor.  Allowances unsold at auction prior to 2014 are retained by the authorities and can be auctioned again, but allowances unsold at the end of each 3 year control period (the current control period is 2012-2014) may be retired permanently at the discretion of individual states.  This gives a possible mechanism for automatically tightening the cap if there is a surplus allowances at the floor price over an extended period.

Price ceilings

In California there is an Allowance Price Containment Reserve (APCR) from which allowances are released at prices of $40, $45, and $50/tonne in 2013, rising at 5% p.a. plus inflation thereafter.  This is entirely separate from the Auction Holding Account used for the floor.  Allowances are sold from the APCR on a quarterly basis if there is demand.  The sale is held six weeks after the regular quarterly auction of allowances, allowing buyers to make up a shortfall after the auction. Buyers specify the number of allowances they want at any of the three fixed prices.

122 million allowances have been put into the APCR for the period to 2020 equal to 4.5% of the overall cap across all years (including the maximum allowed offsets), and relative to a single year (2015) is 29% of the cap including the maximum allowed offsets.  The APCR allowances are taken from within each year’s capped total.  The reserve is divided equally among the three price tiers.   ARB has proposed that the number of allowances in the APCR be increased to 207 million tonnes, which would be 7.6% of the overall cap.

RGGI also has a costs containment reserve (CCR) of additional allowances that can be released into the auction when the auction clearing price crosses a certain threshold.  As with the floor, the prices at which allowances are released are much lower than in California, being $4/short ton in 2014 rising at $2/short ton p.a. to reach $10/short ton in 2017, escalating at 2.5% p.a. thereafter. The CCR allowances are in addition to the cap, and balances are re-set annually to 10 million tons (which is just over 10 percent of the 2014 cap) if allowances are drawn down from the CCR.  Unlike California, the cap is thus effectively loosened if there is continuing demand for allowances from the reserve, and so functions much more like an absolute ceiling.  (These are the revised the rules for RGGI to apply from 2014 forward, which has yet to be fully enacted by all individual states, but I understand that adoption is expected to be completed shortly.)

Similar arrangements could readily be made for the EUETS.  A price containment reserve of the same proportion of the 1013-2020 cap as Californian (4.5-7.6% of the total cap for Phase 3 excluding aviation) would be approximately 690 to 1170 million allowances, very much in line with the quantities that have been discussed for set-aside or backloading.  A market stabilisation reserve would be, in effect, somewhere between backloading and permanent set aside.  This is because allowances placed into the stabilisation reserve could potentially return to the market (in contrast to permanent set-aside).  However, they would do so only in response to prices reaching threshold levels, rather than automatically (as is intended with backloading).  This type of reserve could be accompanied by an auction reserve price to stabilise the price at the lower end of the range.

Some in the EU continue to oppose price containment mechanisms.  Whatever objections may be advanced against price containment – and none seem compelling to me in principle, at least for an auction reserve price – a lack of practical examples elsewhere on which to draw is certainly not one of them.

Adam Whitmore –  2nd October 2013