The effect of over-allocation and price uncertainty on investments under the EU ETS Frank Venmans | Université de Mons | Grantham Institute-LSE Frank Venmans

Introduction and relevance Frank Venmans | Université de Mons | Grantham Institute-LSE  EU ETS= Cap and Trade covering 45% of European GHG emissions  ETS lauded for its cost-effectiveness: equal marginal abatement costs across firms  Only if rational inclusion of ETS-incentives in investment decisions  Over-allocation vs under-allocation  Until 2012: electricity under-allocated, rest over-allocated  From 2013 for carbon leakage exposed sectors: benchmarked allocation (emissions of 10% most efficient plants).  Price uncertainty  > 25 € in 2008,  5,8 € yesterday  Recent decision to install a reserve

«Standard » and behavioural economics Frank Venmans | Université de Mons | Grantham Institute-LSE  Standard theory  Coase theorem predicts that over-allocation and under-allocation create the same incentive to invest:  When over-allocated an abatement investment yields extra sales opportunities  When under-allocated an abatement investment results in less purchases of permits.  Pro-cyclical gains are risky, pro-cyclical costs are risk-hedging  Option value  Behavioural economics  Add insight from psychology to describe decision heuristics in a more accurate way  Policy more efficient when behavioural insight on reaction on incentives are added  Reference-dependent preferences => Loss aversion => Endowment effect  Narrow framing

Sample & methodology Frank Venmans | Université de Mons | Grantham Institute-LSE  19 semi-directive interviews of 1h15 to 2h  3 past investments, 2 potential future investments  Focus on barriers and triggers to investment  16 (out of 18) Belgian producers of construction materials in EU ETS:  Bricks (9)  Cement (2)  Lime (2)  Other (3)  Sector represents 15% of CO 2 emissions of EU ETS

Results Frank Venmans | Université de Mons | Grantham Institute-LSE 1.Over-allocation vs Under-allocation 2.Effect of price uncertainty

3 ways of expressing lower incentive to invest when over-allocated Frank Venmans | Université de Mons | Grantham Institute-LSE  As a direct question:  Only 2 managers perceived over-allocation to create the same incentive as under-allocation (~Coase)  1 perceived under-allocation to create a lower incentive (~option value)  11 who perceived under-allocation to create a stronger incentive  Under-allocation was the reason why managers perceived the ETS to be a greater motivation for future investments compared to past investments  Under-allocation was their reason why all gas-fuelled companies omitted carbon gains in their payback times  carbon advantage increase profitability by 12%

Rationale behind perceptions Frank Venmans | Université de Mons | Grantham Institute-LSE  Managers explain higher motivation of under-allocations by reference-dependence (cost higher value than gains)  3 reference points:  Situation without ETS  Initial allocation-endowment effect  Competitors

1st Reference: without ETS Frank Venmans | Université de Mons | Grantham Institute-LSE “In a grandfathered ETS system, growth is absolutely sanctioned. Every marginal production unit you produce above your historical capacity, you will not get extra credits. One believes that people think in mean values, but no, we think in marginal values, of course. So you get to the point where you produce until you have produced your freely allocated level. And then every extra ton that you produce is entirely submitted to the carbon cost.”  Classical view: grandfathered emission rights are a lump sum transfer without marginal effect.  When under-allocated the ETS creates a loss, which attracts more attention than a gain.

2 nd reference: initial allocation Frank Venmans | Université de Mons | Grantham Institute-LSE  The endowment effect creates a lower Willingness To Accept to sell allocated permits than the Willingness To Pay for extra permits.  => Extra permits from energy efficiency are not cashed  “Cash is King”  When over-allocated, the ETS is seen as an environmental regulation with which they comply and thus to which no attention is required. “When you save gas, you emit less CO 2 and those rights will remain unused and at a given moment they can be sold?” “I suppose that is the case, but we didn’t consider it at all, because the carbon aspect is dealt with by somebody who is closer to the accounting department. It is disconnected from the one who is dealing with production... I think that for us this is somewhat too abstract.”

3 rd reference: competitors Frank Venmans | Université de Mons | Grantham Institute-LSE  “In plant X the situation is very critical, due to the quarry. Because we are above the benchmark. So at any price, what can we do, because it will cost us money... A fundamental element in this are the production costs. The one that will survive tomorrow, because there is a terrible competition, will be the one that has the lowest costs. We are on a commodity market. We have new competitors that arrive...”

3 rd reference: competitors Frank Venmans | Université de Mons | Grantham Institute-LSE  According to standard economic theory, both over-allocation and under-allocation have the same effect on the NPV of a project. The NPV equals the extra profit or reduced price.  Compared to extra-European competitors  over-allocation = competitive advantage  under-allocation = competitive disadvantage.  Managers are more motivated to reduce a competitive disadvantage than to increase a competitive advantage.  Compared to intra-European competitors even more puzzling because allocation method doesn’t affect competitiveness  When over-allocated, all producers gain (at least in the short run)  A competitive disadvantage (low energy efficiency) is less urgent to absorb

Results Frank Venmans | Université de Mons | Grantham Institute-LSE 1.Over-allocation vs Underallocation 2.Effect of price uncertainty

Standard financial theory Frank Venmans | Université de Mons | Grantham Institute-LSE  Pro-cyclical gains are risky (Counter-cyclical gains are risk- hedging) (CAPM, Fama 1977)  Pro-cyclical costs are risk-hedging (Counter-cyclical costs are risky) (Ariel 1998, Armitage 2005)  Carbon costs are pro-cyclical  By design  Observed: correlation 2 nd period 0.27  => volatility increases the risk-hedging potential of carbon costs  => volatility decreases the incentive to invest because  It increases riskyness of carbon gains when over-allocated  it reduces riskyness of avoided carbon costs when under-allocated

Contradicting perceptions Frank Venmans | Université de Mons | Grantham Institute-LSE  “Avoiding the uncertainty of the ETS” is a higher motivation to invest for future investments compared to past investments  Not in accordance with standard financial theory.  Because all managers perceive volatility of carbon costs as a risk-increasing feature  = first narrow framing  “What would create highest incentive to invest: narrow price channel between 14 and 16€ or volatile carbon price with expected mean of 15€”  9 companies see volatility (riskiness) of carbon costs as a disincentive to invest =second narrow framing  Conclusion is the same as in standard economics  3 companies see volatility (riskiness) of carbon costs as incentive to invest => higher level of ‘consistency’ leads to non-standard conclusion.

Option value Frank Venmans | Université de Mons | Grantham Institute-LSE  When there is an option to postpone the investment=> option value.  Option value increases with price volatility  = reason to see volatility of carbon prices as disincentive to invest.  Was mentioned by 4 companies, especially big and long term investments

Conclusion Frank Venmans | Université de Mons | Grantham Institute-LSE  Under-allocation reduces behavioural barriers to invest.  Reduced price uncertainty creates higher incentive to invest for most companies. In the case of under-allocation (carbon costs), this relationship is flawed by narrow framing.