Pricing carbon International Consulting Economists’ Association London 11 November 2014 Sam Fankhauser London School of Economics and Vivid Economics

Overview Why price carbon? Ways to price carbon Designing an emissions trading scheme Experience to date

The global mitigation challenge For median warming of 2oC global emissions must peak within 10 years Be cut by 50% by 2050* Continue to fall thereafter * more (eg 80%) in developed countries Note: The green region contains emissions paths that result in median warming of ≤ 1.9oC in 2100. Median warming for the blue region in ≤ 2.0oC, for the orange region it is ≤ 2.1oC and for the red region ≤ 2.2oC. Source: Bowen and Ranger (2009) 1 3

The three elements of climate policy Put a price on carbon Addresses the climate change externality Support low-carbon technolgy Addresses market failures related to innovation Remove barriers to energy efficiency Addresses behavioural / policy / institutional failures Source: Stern 2007

Countries are pricing carbon Some 40 developed countries and emerging markets are pricing carbon through taxes or emissions trading schemes. Source: World Bank, State and Trends of Carbon Pricing, 2014

Types of markets Cap-and-trade (allowance market) EU Emissions Trading System California Emissions Trading Scheme Regional GHG Initiative (RGGI) Baseline-and-trade (offset market) Clean Development Mechanism Joint Implementation Voluntary Carbon Offsets

Overview Why price carbon? Ways to price carbon Designing an emissions trading scheme Experience to date

Three ways to put a price on carbon Carbon markets Carbon taxes Regulation

Market-based instruments vs regulation Flexibility of markets (or taxes) reduces compliance costs US$ billion Source: Stanford Energy Modeling Forum 1 9

Markets vs. taxes Under certainty taxes and permits are equally efficient With uncertainty they differ Taxes: certain cost, uncertain quantity Permits: uncertain cost, certain quantity Optimal choice depends on the slope of marginal benefit (damage cost) curve (Weitzman 1974)

Steep marginal benefits (MB) Markets vs taxes Flat marginal benefits (MB) Steep marginal benefits (MB) MAC MB Costs, benefits Costs, benefits MAC MB SMEs are a corner stone of many transition economies. In Central Europe in particular, they account for the lion share of employment opportunities, comparable to the economic structure in the EU (see chart). In the countries of the CIS the picture is different (see chart). In these countries the restructuring of the formerly (or still) state-owned has not yet sufficiently progressed, and a majority of people are still employed in the large, unreformed conglomerates of the communist area. The role of SMEs in these countries is however likely to grow as transition advances. Throughout the regions, SMEs have been a driver of transition, with most start ups (new businesses) falling into this category. Most of these start ups are at a higher transition level. They are more efficient, have better corporate governance, use better management practices and are better integrated into the market economy. This is why the support of SMEs is important and helps transition. target target 11

Markets vs taxes Choose tax Choose permits MAC MB MAC Costs, benefits target target 12

Markets vs. taxes Economic arguments probably favour a tax For a stock pollutant MB is flat, at least in the short-term Political economy arguments favour trading Internationally, a carbon tax agreement is difficult to achieve Domestically, industry prefers (grandfathered) permits

Overview Why price carbon? Ways to price carbon Designing an emissions trading scheme Experience to date

Market design issues Permit allocation Auctioning, grandfathering, benchmarking Scope Which sectors to include Degree of flexibility When flexibility: banking and borrowing Where flexibility: linking with other schemes Managing price volatility Safety valve against price spikes Interaction with other policies Set cap to reflect e.g. renewable policies

Free permits bring in industry but create rent Value of surplus permits to EU industry 2008/09 Overall asset pool ca €30bn p.a. (now down to half that) Source: Sandbag (2010), The Carbon Fat Cats

Scope of trading: which sectors to cover Start with sectors that Are easy to monitor Are important emitters Have sophisticated firms E.g., EU ETS: Energy and energy-intensive industry Threshold on the minimum size of an installation EU ETS “non-trading sectors” Phase I coverage was roughly 50% of CO2 emissions and 40% of total GHG emissions. Note Members States may voluntarily opt in installations below the prescribed minimum installation size and in non-ETS sectors, although perhaps unsurprisingly this feature of the ETS Directive has been little used.

Degree of flexibility Longer periods (“when flexibility”) and wider scope (“where flexibility”) reduces costs but increases risk Source: Richels et al (1996)

Managing price volatility EU ETS in particular has been characterised by price shocks

EU ETS price drivers Policy context affects long-term outlook Cap (current and expected); rules on offsets, banking Economic context affects medium-term outlook Economic output in regulated firms, business cycle Cost of fuel switching drives short-term fluctuations Cost of gas, coal; relative efficiency of coal and gas EU Allowances fluctuate with gas, coal prices

Reducing price volatility Carbon price underpin, cap-and-collar or safety valve as options price price S = cap S Δp Δp D D D’ D’ q = const quantity Δq quantity Fixed cap Collar

Policy overlaps affect market performance… Subsidy for abatement option D changes the marginal abatement cost curve, lowers price Although support e.g. for renewable energy may be justified for technology policy reasons Source: Fankhauser, Hepburn, Park, Combining Multiple Climate Policy Instruments, Climate Change Economics 2010

… and skew price signals For example, implicit carbon price faced by the UK business sector Note: EII = electro-intensive industries; legend refers to different UK energy pricing policies Source: Bassi et al (2013).

Overview Why price carbon? Ways to price carbon Designing an emissions trading scheme Experience to date

The negatives On trading schemes On offsets Persistent over-allocation Weak long-term price signal Some regulatory capture, fraud On offsets CDM bubble has burst Unclear environmental additionality of offsets Ellerman et al. figure 6.2. The counterfactual emissions level in the absence of the EU ETS was constructed by estimating the pre-ETS relationship between economic growth and CO2 emissions, and extrapolating. EU ETS surplus sufficient for a decade (Committee on Climate Change 2014)

The achievements (EU ETS only) Firms manage carbon as a matter of routine Environmental goal was achieved Some impact on innovation No negative impact on jobs, profits, exit Ellerman et al. figure 6.2. The counterfactual emissions level in the absence of the EU ETS was constructed by estimating the pre-ETS relationship between economic growth and CO2 emissions, and extrapolating. EU ETS sector emissions, EU25, 1990-2007 Source: Ellerman et al (2010)

Hence the growing number of schemes Some 40 developed countries and emerging markets are pricing carbon through taxes or emissions trading schemes. Source: World Bank, State and Trends of Carbon Pricing, 2014

Pricing carbon International Consulting Economists’ Association London 11 November 2014 Sam Fankhauser London School of Economics and Vivid Economics

Annex slides

The benefits of trading High cost emitter Low cost emitter Marg. Abatement Cost Marg. Abatement Cost SMEs are a corner stone of many transition economies. In Central Europe in particular, they account for the lion share of employment opportunities, comparable to the economic structure in the EU (see chart). In the countries of the CIS the picture is different (see chart). In these countries the restructuring of the formerly (or still) state-owned has not yet sufficiently progressed, and a majority of people are still employed in the large, unreformed conglomerates of the communist area. The role of SMEs in these countries is however likely to grow as transition advances. Throughout the regions, SMEs have been a driver of transition, with most start ups (new businesses) falling into this category. Most of these start ups are at a higher transition level. They are more efficient, have better corporate governance, use better management practices and are better integrated into the market economy. This is why the support of SMEs is important and helps transition. reduction target reduction target

The benefits of trading High cost emitter Low cost emitter Marg. Abatement Cost Marg. Abatement Cost SMEs are a corner stone of many transition economies. In Central Europe in particular, they account for the lion share of employment opportunities, comparable to the economic structure in the EU (see chart). In the countries of the CIS the picture is different (see chart). In these countries the restructuring of the formerly (or still) state-owned has not yet sufficiently progressed, and a majority of people are still employed in the large, unreformed conglomerates of the communist area. The role of SMEs in these countries is however likely to grow as transition advances. Throughout the regions, SMEs have been a driver of transition, with most start ups (new businesses) falling into this category. Most of these start ups are at a higher transition level. They are more efficient, have better corporate governance, use better management practices and are better integrated into the market economy. This is why the support of SMEs is important and helps transition. less more reduction target reduction target

The benefits of trading Buyer Seller Marg. Abatement Cost Marg. Abatement Cost SMEs are a corner stone of many transition economies. In Central Europe in particular, they account for the lion share of employment opportunities, comparable to the economic structure in the EU (see chart). In the countries of the CIS the picture is different (see chart). In these countries the restructuring of the formerly (or still) state-owned has not yet sufficiently progressed, and a majority of people are still employed in the large, unreformed conglomerates of the communist area. The role of SMEs in these countries is however likely to grow as transition advances. Throughout the regions, SMEs have been a driver of transition, with most start ups (new businesses) falling into this category. Most of these start ups are at a higher transition level. They are more efficient, have better corporate governance, use better management practices and are better integrated into the market economy. This is why the support of SMEs is important and helps transition. actual target target actual

Upstream vs downstream EU ETS Upstream Downstream Producers and importers of fossil fuels Individual consumers Industrial fuel users A prominent advocate of upstream regulation is Oliver Tickell in his book ‘Kyoto2’. Loosely speaking, allocation upstream should reduce transaction costs overall, but allocation downstream is thought by some to increase the behavioural response to the price signal (note if you assume all agents behave as profit/utility maximisers then this effect is assumed away by definition). In the EU, there was resistance to upstream regulation from finance ministers, who rely quite heavily on excise duties on fossil fuels (specifically petroleum and diesel) to raise public revenue, and who feared that the introduction of an upstream ETS would create the grounds for removal of the duties due to concerns about double taxation.

The issue with multiple policy instruments Multiple market failures require multiple policy instruments But: A tax on top of a trading scheme reduces the market price and may undermine the scheme Marginal Abatement Costs price tax Δp cap emissions

Do green policies affect competitiveness? No evidence so far that existing taxes have been detrimental Vivid Economics in its recent work for the UK DECC performed detailed modelling of the extent of possible carbon leakage scenarios in the EU under different future carbon prices ‘Carbon leakage’ refers to the effect in which carbon prices drive up relative costs and reduce the competitiveness of EU firms such that their output falls Empirical studies of carbon leakage in the EU Emissions Trading System fail to find convincing evidence of substantial leakage Theoretical studies suggest that leakage rates could be fairly substantial, albeit with substantial differences in predictions between general equilibrium and partial equilibrium models

Global action reduces competitiveness concerns Survey found ca. 500 climate-related laws in 66 jurisdictions Source: Nachmany, Fankhauser et al. (2014)