The European Carbon market: Market fetishism or ultimate solution? Frank Venmans | Service Finance | FWEG Venmans Frank

Outline  Introduction  A multi-criteria review of the EU ETS  Research articles  Policy recommendations

The EU ETS: introduction  Cap and Trade  Electricity, heat >20MW, steel, cement, bricks, glass, refineries  45% of European greenhouse gas emissions  3 periods:  First period  Second period  cap -6.5% compared to 2005  Third period  cap -21% compared to 2005  Free allocation vs auctioning

Carbon Price

Cap and trade vs command and control

A literature-based multi-criteria analysis of the EU ETS For references: Venmans (2012) Renewable & Sustainable Energy Reviews

1. Environmental effectiveness Abatement – 1 st period :between 2,5% and 5% (Ellerman &Buchner 2008, Ellerman et al. 2010, Anderson & Di Maria 2010, Delarue et al. 2008, Ellerman & Feilhauer 2008, McGuiness and Ellerman 2008) – 2 nd period: observed emissions 13,5% below 2005 – 3 rd period: cap doesn’t impose reduction below 2005 Over-allocation – 1 st period: 5 to 6% (Anderson & Di Maria 2010, Ellerman & Buchner 2008, Clo 2010) Predictability of environmental impact – 1 st period: biased emissions before 2005 and biased growth – 2 nd period: economic downturn (actual banked reserve=ETS emissions in 2012) Environmental side-effects : carbon leakage Multi-criteria analysis

2. Economic efficiency Cost efficiency – Marginal social cost of carbon> marginal abatement cost Cost effectiveness – Equal marginal abatement cost across firms – Distortional incentives of free allocation Updating New entrants reserves Closure withdrawals Transaction costs Dynamic cost-effectiveness: innovation – Effect of carbon price uncertainty on low carbon investments – Too much on intermediate technologies, too little on high-end abatement technologies Multi-criteria analysis

3. Distributional effects Transfers between countries and sectors Social distributional effects Windfall profits Multi-criteria analysis

4. Institutional feasibility ETS passed the European legislation unlike carbon tax – Industry: windfall profits – NGO: certainty of environmental goal – Member states: tool to reach Kyoto target+ transfers Technical complexity of trading The ambiguous effect of free allocation on political acceptability Multi-criteria analysis

Overview multicriteria analysis Environmental effectiveness: + | - in future Economic efficiency: – Cost-efficiency: - – Cost-effectiveness: + and - – Transaction costs: 0 to - – Dynamic efficiency: - Distributional effects: - - Institutional feasibility: + Multi-criteria analysis

Factor model-main equation Capital market response to emission pricess

Distribution β carbon CCC model all sectors Capital market response to emission pricess

Capital market response to emission allowance prices Stock prices are significantly affected by carbon prices. Certain firms are negatively affected by carbon prices. Here investors see the EU ETS as a profit diminishing regulation. Most firms are positively affected by carbon prices. This holds for all sectors. For these firms investors see the EU ETS as a profit increasing regulation. So free allocation overcompensated abatement cots for most firms during the second phase. Capital market response to emission pricess

Bounded rationality Barriers to energy efficiency  65% of projects where payback time was calculated had a payback of 3 years or lower.  3 years was recognised as a required profitability of the majority of the projects. (See also DeCanio 1998, Andersson & Newell 2004)  3 years payback time for an installation running 10 years= IRR of 31%.  Hidden costs and risk profile of projects are generally low and cannot easily justify required IRR of 30%.  Managers do not realise that a payback time of 3 years corresponds to an IRR around 30%  Managers do not make a link with a possible investment level below optimum.  Facilitated by the use of payback time

Motivations and barriers to energy efficiency Barriers to energy efficiency  Required IRR, even when hidden costs and risk are taken into account, are much higher than the weighted cost of capital, indicating that organisational barriers are at play.  Most important barriers:  Capital budgeting  lack of information on technical feasibility and profitability  Transaction cost economics and behavioural economics are relevant to understand these barriers.

The effect of over-allocation and carbon price uncertainty on abatement investments  All companies combusting gas omitted carbon gains in profitability calculations of energy efficiency investments  carbon advantage increase profitability by 12%  All 11 gas-fueled companies explain that they omitted carbon gains because they were over-allocated and think that they will include carbon price when they will be under-allocated.  Under-allocation reduces behavioural barriers to invest.  Price uncertainty entails a lower incentive to invest. Effect of over-allocation and price uncertainty

Social comparisons, habituation and satiation Insights from the subjective well-being literature through the lens of welfare economics and ecological economics Social comparisons, habituation and satiation

Subjective well-being in the US Social comparisons, habituation and satiation

Subjective well-being in the EU Social comparisons, habituation and satiation

Easterlin paradox (1974)  Above 20,000$ GDP/capita, SWB is unaffected by an increase of income over time and between countries  SWB is (strongly) affected by income within a country  Explanations:  Relative position: status effect  Adaptation of habituation  Classical externalities of GDP Social comparisons, habituation and satiation

Importance for discount rate Frank Venmans =0 unethic

Marginal cost and benefit Growth Weak satiation Satiation for certain goods MAC Under-satiated good MAC Over-satiated good MAC GDP SCC 0

Conclusion 4 th study Frank Venmans | Service Finance | FWEG  Externalities of relative position are pervasive  Habituation leads to biased individual choices  Both have led to what is coined as weak satiation  Externalities of relative position and habituation provide an argument for much more ambitious climate policy  Biased individual choices decrease the scope for market-based instruments

Policy recommendations Avoid extremely low prices  Change cap to -30% in 2020  Announce a very stringent cap in 2030  Price floor  Carbon central bank  Set aside (permanent or temporary)

Commission’s proposal Frank Venmans | UMons | Grantham Institute  Proposed targets in 2030:  -40% for whole economy (depends on Paris 2015)  ETS-cap -43% compared to 2005  Backloading proposition (900 M allowances postponed)  Market stability reserve:  If surplus >833M => Add 12% of surplus to the reserve (withdrawn from auctions)  If surplus withdraw 100M from reserve (add to auctions)  Why prefer a quantity regulation above a price regulation? (Clo et al. 2013)

Further policy recommendations Frank Venmans | UMons | Grantham Institute  Limit free allocation  Actual benchmarked companies are expected to be 17% long in allocation will be (Lecourt 2013)  Complementary policies  Price signal is insufficient for a Pareto-efficient investment level  Command and control  Public investments

The European Carbon market: Market fetishism or ultimate solution? Frank Venmans | Service Finance | FWEG