With the contraction of their economic output in a grim economy, many European installations found themselves sitting on an unexpectedly valuable treasure trove of carbon allowances that they had received free of charge from their governments. Since the most carbon-intensive industries are the largest beneficiaries of the profit-taking from the sale of surplus granted allowances in the current downturn, this raised questions earlier this year about free allocation and the setting of allocation levels. Memories of a long EU ETS Phase I returned and the debate on market intervention was re-opened. This discussion has relevance to the current U.S. deliberations for the Waxman-Markey bill, where the projected shortfall in 2020 is highly sensitive to assumptions of economic growth.
Level of Market Prices
There are those that point to generally lower EUA prices in the second half of 2008 and early 2009 as evidence that the carbon market is not working since there is an insufficiently low price signal to promote abatement.55 Sustained high prices certainly would send a signal to the market to invest urgently in abatement. In volatile markets, including oil, gas and other energy markets, players are known to take a long-term view about their expectations into the future and factor that view into their investment and business decisions. There is no reason to expect that carbon is any different from other markets in this regard.
Others point to the low prices and suggest that there is no better evidence that the market mechanism is working logically because of the demand-supply imbalance caused by the recession.56 In other words, the market has shown that it has worked logically so far and it will deliver the overall level of reductions mandated by policymakers. They also argue that it is a strength of the design of emissions trading that ensures that more effort is required in a boom cycle in good economic times with higher emissions and, conversely, that less effort is required in a bust cycle with lower emissions when political will is focused on restoring economic growth.
Concerns about Competitiveness
Policymakers on both sides of the Atlantic have been prepared to give away a high proportion of free emission allowances, in their efforts to cobble together enough political support to put a proposal on the table. The May 15 U.S. proposal to grant most allowances on the basis of historical emissions rather than on a sector benchmark would, if adopted, miss an opportunity to encourage all domestic covered entities to catch up with the cleanest companies in the sector. Fewer allowances to auction and a smaller scarcity of allowances will also likely result in lower auction proceeds for activities identified for funding under the W-M bill.
55 Deutsche Bank. “The ETS Review: Unfinished Business.” Market Update, February 23, 2009; Friends of the Earth, Subprime Carbon? Re-thinking the World’s Largest New Derivatives Market, March 2009, among others.
56 Barclays Capital. Monthly Carbon Standard, April 2009; May 2009; Deutsche Bank. “The ETS Review:
Unfinished Business.” Market Update, February 23, 2009
CYCLE-PROOF REGULATION
Cycle-proof regulation is an illusionary goal and many prominent economists have struggled and continue to struggle with the concept. That said, there are some elements of the design of emissions trading schemes such as the EU ETS, the U.S. RGGI and the “on again-off again” Australian CPRS that may be worth considering:
LENGTH OF COMMITMENT PERIODS
There is no reason why longer commitment periods (e.g., 8 or 10 years) cannot also co-exist with shorter phases (e.g., two or three years), as in RGGI. Indicative allocations, perhaps expressed in a range indicated by the latest requirements of science, can be formalized prior to the start of every phase.
CHOICE OF BASE YEARS
A particular base year may not be representative of the carbon profile of a given country over time. Rather than stipulating a specific year as a base year for action (e.g., 1990 or 2005), it may be worth considering average emissions over a specified three to five years under a future international agreement.
TREATMENT OF UNUSED NEW ENTRANT RESERVES
There has not been much use for New Entrant Reserves (NERs) within the EU ETS and there could be temptation to use NERs in the course of a commitment period for other reasons. At the end of 2012, the Commission is supposed to auction any remaining NERs. It may be worth considering whether it may be possible for the Commission to simply cancel unused NERs at the end of every compliance period.57 AUCTIONING ALLOWANCES
Auctioning allowances, rather than giving them away for free creates less of an incentive for the kind of sell-off witnessed recently in the EU ETS. With greater auctioning, there will always be an intrinsic price associated with a greater proportion of allowances.
MARKET-BASED AUCTION RESERVE PRICE:
An approach different from having a regulator set an arbitrary minimum reserve price for auctions would be to allow the market itself to establish a market-based reserve price based on a rolling average of previous auctions. To illustrate, let us imagine that there are monthly auctions, where the reserve price is determined by the average clearing price of the preceding three auctions. Allowances unsold would be retired every three months (or retained in a Strategic Reserve similar to the proposal in the U.S. Waxman-Markey Draft).
Longer-term Trend of Emissions is Key
At the end of the day, it is not the year-to-year emissions, but rather the overall lower downward trend of emissions that is relevant to prevent dangerous climate change. The value of emissions trading as a policy tool is what it helps to deliver the desired environmental outcome over the commitment period (even if it does not guarantee that explicit environmental efforts helped to achieve that goal). The most important role of policy-makers and regulators in a cap-and-trade system is therefore to determine and proclaim the quantity of emissions deemed desirable to prevent global warming in light of the best available science.
Price versus Quantity Intervention
The European Commission (EC) has consistently resisted including formal price control mechanisms into the design of the scheme,58 and there is a lot of economic literature that counsels against creating
57 The US Waxman-Markey Draft legislation creates the concept of a Strategic Reserve, which is triggered to release allowances when the market price for allowances reaches a pre-determined level over a pre-determined time period. (double prevailing prices over a predeter) It is not clear how many allowances from the Strategic reserve will be released, although a pre-determined ratio of Offset credits from RED would replace the released allowances in the Strategic Reserve.
58 A last minute provision, to deal with market volatility (see above).
any such market distortions. Intervention described in the Commission’s package (or for that matter in the Waxman-Markey Draft’s Strategic Reserve proposal) appears to be geared only toward “high price” volatility. A policy of increasing quantities of allowed emissions because of “high” prices would only tend to discourage the required level of early environmental action to achieve the desired environmental outcome. The EC package relies on Member States to determine whether market prices correspond to market evolution, not the market itself. The W-M draft, on the other hand, described triggering the Strategic Reserve when market prices surge more than twice the prices in a specified prior time period.
It should be noted that neither proposal attempts to address the flip side of volatility, i.e., “low price”
volatility, where a consistent application of market intervention policy might suggest that low market prices could similarly trigger a policy of reducing the quantity of allowed emissions. Arbitrary or casual changes to the quantity of allocations for installations should not be made because of normal business cycles and only should be considered if compelling scientific information requires a reduction of allowances in favor of protecting the environment.59
AVERAGE EMISSION TARGETS AND AVERAGE BASE YEARS
At a time when carbon traders and lobbyists have mushroomed overnight in capital cities and a multitude of overnight climate “experts” are found everywhere (including, we might add, at multilateral institutions), it is helpful to review the historical context for the inclusion of certain policy elements of the UNFCCC and the Kyoto Protocol. Some of these elements were designed to promote both greater flexibility of compliance as well as to promote lower market volatility over time, and were relevant to the design of the EU ETS.
The 1992 UNFCCC incorporated both a single point target and a single point base year (“aim to return 2000 emissions to 1990 levels”). At Kyoto, policymakers recognized (and the economic collapse of the former Soviet Union demonstrated) that emissions in any one year may rise or fall due to economic cycles (e.g., the current decline of emissions in a recession). Other factors influencing emissions in a particular year or two include weather conditions (sufficient or insufficient precipitation impacting generation and dispatch of hydropower) or geopolitics (e.g., access to natural gas).
This recognition gave rise to the concept of “average emissions/targets” and the five year commitment periods that were agreed at Kyoto (although a ten year commitment period with shorter phases was also seriously considered). The longer target time-frames were also considered helpful as a meaningful horizon for investment, as well as long enough to accommodate the turning over of capital stock of varying vintages in more mature economies. Shorter target time-frames are important if policymakers need to make quick adjustments based on the latest science and availability of mitigation technology.
Similarly, a particular base year may not be representative of the carbon profile of a given country but may be selected because of particularly high emissions.60 Rather than stipulating a specific year (e.g., 1990 or 2005) as a base year for action, it may be worth considering average emissions over a specified three to five years under a future international agreement.
59 We are all cognizant of the fact that climate science has been becoming stronger and demands more urgent action.
This suggests that flexibility to adjust and reduce allowed emission quantities within the 2012-2020 timeframe would be a desirable design element. If intervention is necessary at all, it should only be done to reduce the risk of global warming by reducing the quantities available. There are those that would argue that this would also be distortionary to the market. The authors agree, but point out that the only defense of such a distortion could be that at least it is aligned toward reducing emissions to prevent dangerous anthropogenic change, the raison d’être of establishing a market in the first place.
60 A good example is the recent choice of 2005 as a base year for U.S. emission reduction proposals. U.S. GHG emissions in recent years peaked in 2005, and started to decline even before the onset of recession in 2008. Even in the absence of climate policy, U.S. emissions are not projected to reach 2005 emissions again until around 2020.