Emission Trading In Practice Lecture Energy Economics EUR Dr. Sander de Bruyn (CE Delft)

2Sander de Bruyn, 2 december 2010 Content 1.Principles of emission trading 2.History of the EU ETS 3.Design of EU ETS, phase 1 and 2 4.Impacts of EU ETS, phase 1 5.Impacts of EU ETS, phase 2 6.Design of Phase 3 7.Evaluation: does Phase 3 solves the observed problems in Phase 1 and 2? 8.Conclusions

3Sander de Bruyn, 2 december 2010 CE Delft Independent, not-for profit consultancy, founded in 1978 Based in Delft, the Netherlands Transport, Energy, Economy 15+ years of experience with design of market based instruments for environmental policies Main consultant for European Commission on inclusion of aviation in EU ETS Important consultant for Dutch government, EU parliament and European NGOs on EU ETS Clients include European Commission, national governments, international organisations, trade associations, companies, environmental NGOs

4Sander de Bruyn, 2 december Principles of emission trading Coase 1960: property rights define the right to pollute Crocker & Dales late 1960s: efficiency is obtained if rights are being traded Baumol & Oates 1970s: ETS as efficient as Pigovian taxes Tietenberg (1984; 2006) Establishing a property right to pollute Allow to trade these property rights Limit the rights to be issued implies an instrument for emission reduction Because of scarcity, rights get a value. If transaction costs are low and participants are well informed, ETS assures allocative efficiency >> reduction of pollution at the lowest costs possible for society. Experiments with emission trading systems started in the 1970s in the US (Tietenberg, 2006) resulting in 1990 in the SO2 emission trading scheme At present over 20 emission trading systems worldwide. EU ETS is the largest.

5Sander de Bruyn, 2 december Principles: emission trading as ec.instrument Economic problem of dividing a common reduction target (e.g. at the level of a nation) among the different sources of pollution with different cost structure and possibilities to abate emission reduction In economics: least-cost solution is achieved if marginal costs of pollution reduction are equalized among the sources of pollution Economic instruments (subsidies, taxes and emission trading) can assure that marginal costs are equalized among sources Emission trading fixes the total reduction target and assures that by trading the marginal costs are equalized among sources Emission taxes fixes the marginal costs for sources >> the target is however flexible Subsidies fix the marginal costs for sources >> the target is flexible and more out of reach due to negative dynamic impacts (indirectly subsidizing pollution).

6Sander de Bruyn, 2 december Principles of emission trading: efficiency 2-industry example:

7Sander de Bruyn, 2 december Principle of emission trading: allocation Issuing of emission allowances (= emission credits = emission rights) Give the right to pollute 1 unit in a given time frame (e.g. a year) by an entity (e.g. an installation or a factory). Emission allowances need to be distributed by the government Possibilities: Auctioning: everybody must pay for all emission allowances every year Grandfathering: at the start of the system the allowances are given at no charge for every year in the future according to a fixed principle (e.g. industry emissions in 1990). Free allocation: every year allowances are given at no charge according to flexible mechanisms (e.g. industry emissions in last year). Problems with grandfathering/free allocation: -What is a good benchmark for allocation (allocation rule)? -What do we have to do with new entrants?

8Sander de Bruyn, 2 december Principles of emission trading: trading Outcome is only efficient if the ETS market functions well Banking/lending can be part of an efficient market Futures and option trading can be part of an efficient market Markets are efficient if sufficient information is expressed in market transations that determine the price If not enough market transactions are taking place or if information of market transactions does not reflect underlying scarcity suboptimal outcomes may emerge.

9Sander de Bruyn, 2 december History of EU ETS: climate policies GHG are important voor life on earth Warming impact of CO2 (radiative forcing) known since end of 19th century Arrhenius e.a.) Since 1960s known that CO2 concentration in atmosphere is increasing Political attention since 1980s. UN based negotions started at the 1990s. 1992: UN Framework Convention on Climate Change (UNFCCC): ‘stabilization of greenhouse gas concentrations in the atmosphere at a level that would prevent dangerous anthropogenic interference with the climate system’

10Sander de Bruyn, 2 december History of the EU ETS: carbon tax? 1997: Kyoto Protocol to the UNFCCC – developed countries obtain a cap on their emissions One cap for EU15: 8% reduction in GHG in 2010 compared to In 1990s growing recognition that EU needs climate based policy instrument : studies on ‘carbon tax’ Resistance of enterprises against new EU-wide tax that would undermine competitive position EU tax requires unanimity in the European Council 1994: European Council rejects carbon tax.

11Sander de Bruyn, 2 december History of the EU ETS: Final formation At the end of the 1990s: first proposals for carbon emission trading 2000: ‘Green paper’ Emission trading 2001: proposal of the Commission 2003: EU Directive on Emission Trading accepted. Free allocation embraced as allocation mechanism that would minimize harm for companies involved in the scheme. Companies agree with this : first period: trial and error : second period: creating a non-zero price 2013 – 2020: third period: greater emphasis on harmonized allocation rules, auctioning and inclusion of aviation; (2016): mid-term review

12Sander de Bruyn, 2 december History of EU ETS: role of carbon leakage Carbon leakage is due to unilateral climate policies and not specifically ETS In economic language: Higher CO2 costs for companies under a “cap” make capital move to areas where carbon has no cost In normal language: loss of competitiveness Carbon leakage undermines effectiveness of CO2 policies and brings an additional welfare cost for countries that implement climate policies Model studies show small impacts. Biggest impact is fossil fuel price

13Sander de Bruyn, 2 december Design of EU ETS, phase 1 and 2 All big installations (capacity >25MWh) are under EU ETS (electricity, industry, buildings/hospitals). Are subject to yearly monitoring and reporting of CO2 emissions Get emission credits for free – credits issued by national governments Must hand in emission credits at the end of the year covering their CO2 emissions Sheer size of the system is unprecedented EU 2000 Mt CO2; NL 100 Mt CO2; This implies that if CO2 costs €30/ton: EU € 60 mld; NL € 3 mld annually. All emission from small installations are not covered by EU ETS but responsibility of member states (e.g. transport, small buildings, agriculture).

14Sander de Bruyn, 2 december Design of EU ETS, phase 1 and 2 Cap EU divides EU-cap into a cap for member states member states divide their cap in an ETS and non-ETS part Initial allocation High degree of freedom of countries to choose allocation mechanism Mostly done on basis of free allocation Historical emissions used as benchmark Free allocation was done to minimize impacts for international industries and minimizing loss of competitive power of national industries.

15Sander de Bruyn, 2 december Impacts of design: allocation in Phase 1 Strong lobby from especially industrial companies for generous allocation and free allocation EC aware of problem and revised allocations of especially the new-MS Nevertheless, overallocation for industry, underallocation for e-sector

16Sander de Bruyn, 2 december Impacts of design: CO2 price in Phase 1 Overallocation became apparent when emission data for 2005 were published Bron: ECX

17Sander de Bruyn, 2 december Impacts of design: market efficiency Why emerged a positive price in 2005/2006? Limited information Banks and analists were not familiair with ETS Impacts of JI/CDM resulting in CERs were unknown Only at the end of 2005 market analysists reports became available: market was long but not for all firms Banking/lending principle obscured real market information Buyers: electricity companies Sellers: industry Most industrial companies banked emission allowances in 2005 for use in later years. Some new-MS with surplusses became only in 2006 on the market

18Sander de Bruyn, 2 december Impacts of design: Windfall profits Windfall profits in electricity sector Freely obtained allowances were passed through in prices, especially in peak prices; Pass through was just as micro-economic theory would predict Sijm et al. (2006) shows for electricity producers Explanation of EC: electricity is sheltered sector and has therefore passed through the costs… This resulted in adjustments in Phase 3.

19Sander de Bruyn, 2 december Impacts of design: fairness Phase 1 Free allocation based on historical emissions Reward of inefficient carbon intensive companies Get more emission allowances per unit of product Have more and cheaper opportunities to reduce emissions; Free allocation based on production output (e.g. steel) would be more fair. Auctioning would be more efficient and more fair.

20Sander de Bruyn, 2 december Phase 2 ( ): correction of failures? European Commission applied stronger criteria for national allocation plans Almost all NAPs were revised downwards. EU cap in 2nd phase 13% onder cap from 1st phase 6% below 2005 emissions Less chances on overalloaction and zero prices Credits can be banked for use in phase 3 as well (no zero prices) Auctioning remains low >> still windfall profits: 1 st phase: 0,13% of total emission allowances auctioned 2 nd phase: 3% of total emission allowances auctioned Benchmark for free allocation still largely historical (updated) emissions Still largely unfair to cleaner companies

21Sander de Bruyn, 2 december Phase 2 Prices remain positive and stable Since 2008 an indication that the market is long due to recession Still a positive price due to banking for use in Phase 3 Inclusion of installations in Norway, Liechtenstein and Iceland in the scheme Bron: ECX

22Sander de Bruyn, 2 december Phase 3 ( ): novel features EU harmonized allocation rules (no member states anymore) Target: -21% divided among MS: cap decreases annually by 1.74% Aviation included Full auctioning for electricity sectors Partial auctioning for industry that has no risk of carbon leakage Free allocation for industry with risk of carbon leakage and for aviation Free allocation up to a benchmark to reward clean companies Additional reserves made for subsidy of CCS demonstration projects

23Sander de Bruyn, 2 december Phase 3 ( ): allocation rules Definition of risk of carbon leakage became major discussion point in prenegotiations in 2008; Sectors that had risk of carbon leakage would be exempt from auctioning Final outcome (December 2008): A sector (NACE 4-digit) has no risk of carbon leakage if any of these 3 conditions are being met: (1)The trade intensity with non-ETS countries <30%; (2)EU-ETS costs in addition to value added <30% at price of €30/tCO2; (3)The sector has not a trade intensity >10% and cost price increase>5% Numerous exemptions were being created for sectors that would fall under an auctioning regime The result is that only small and carbon extensive sectors (that constitute together 2% of industrial emisions) will be under auctioning in 2020.

24Sander de Bruyn, 2 december Analysis: are problems corrected in Phase 3? Overallocation and price formation (not solved) Benchmarks and stimulus for innovation (solved) Windfall profits and carbon leakage (not solved)

25Sander de Bruyn, 2 december Reduction achieved through EU ETS before crisis

26Sander de Bruyn, 2 december Problems: impact of crisis

27Sander de Bruyn, 2 december Problems: innovation and benchmarks Output based benchmarks are introduced for EU installations E.g. Cement: proposed benchmark at 10%: 780kgCO2/t clinker Free allocation only up to 780kgCO2/t clinker produced provides stimulus for the more polluting firms. However, no revision of benchmarks is foreseen in EU directive until 2020

28Sander de Bruyn, 2 december Problems: windfall profits Industry still obtains allowances largely for free up to the benchmark. But will they obtain windfall profits from these? With EU ETS an individual firm faces this abatement cost curve: E_ETS

29Sander de Bruyn, 2 december Problems: windfall profits This implies that the marginal cost curve shifts outwards >> output will be reduced from q0 to q1.

30Sander de Bruyn, 2 december Problems: windfall profits At product markets a reduced output implies a higher price >> additional (windfall) profits are automatically being made The magnitude of this effect depends on the elasticities of demand and supply and the possibilities of foreign competitors to invade the EU market. Transportation costs, market niches and regulation act as natural barriers here (see e.g. discussion on Armington elasticities).

31Sander de Bruyn, 2 december Windfall profits: empirical estimation  Technique: cointegration.  Cointegration more strict framework than correlation, it reduces risk of omitted variables and prevents spurious results (e.g. pigs and cars: correlation can be found between pigs and cars, but is rejected in cointegration analysis)  Model used investigates market equilibrium and market integration between EU (with ETS and carbon policies) and US market (without ETS and carbon policies): Price change EU market 1. Price change US market 2. Long term equilibrium relation + adjustments 3. Price change CO2 market 4. Control variables: Stock index, exch.rates  Model selection using Johanssen Trace and Granger Causality tests – especially on element (2).

32Sander de Bruyn, 2 december Windfall profits: empirical results  Impact of CO2 prices significant in all cases  CO2 prices tend to be passed through with a lag on the EU markets  Cost-pass-through rates above 100% except for PS. However, exact rates more uncertain.

33Sander de Bruyn, 2 december Windfall profits: results for NL In total about 60% of the marginal opportunity costs will be passed through. Because the marginal costs are higher than the average costs windfall profits occur. Income effectMln/yr Refineries320 Iron and Steel200 Petrochemicals140 Aluminium-80 Inorganic chemicals -25 Paper-17

34Sander de Bruyn, 2 december : Windfall profits: NL in 2020 at €30/ tCO2 IncomeExpendituresNet benefit Government Industry Consumers, Services Total GovernmentEU ETS companiesTechnics Electricity companies 1000 Consumers In billion Euros EU ETS market

35Sander de Bruyn, 2 december Windfall profits & carbon leakage  Higher prices on EU markets due to ETS and windfall profits imply that foreign competitors have most likely increased their market shares on EU markets  The benefit of free allocation (no carbon leakage) is not supported by the empirical data  Other mechanisms to address carbon leakage should be investigated

36Sander de Bruyn, 2 december Conclusions  EU ETS can achieve emission reductions at lowest possible costs  EU ETS is the largest ETS in the world (€60 billion annually)  EU ETS is a political market: politics define the target and allocate emissions  Strong pressure on politicians to accomodate vested interests  This resulted in various adaptations that resulted in a a less effective and efficient economic instrument than in textbook economics is suggested.

37Sander de Bruyn, 2 december Conclusions  Specific problems relate to effectiveness (prices and target), stimulus for innovaton and windfall profits.  EU ETS in Phase 1 ( ) did not result in emission reductions  EU ETS in Phase 2 and 3 combined ( ) will only have limited additional impact for emission reductions in the EU only 25% of the proposed 620Mt reduction in 2020 about 10% of cumulative emission reductions ( )  CO2 prices will stay low unless EU steps up to -30% and/or limit role of CDM  Stimulus for innovation is from included for polluting firms with the introduction of benchmarks  Windfall profits remain a problem and consumers are overcompensating companies for their costs. Carbon leakage is another negative side-effect.

38Sander de Bruyn, 2 december 2010 Merci! Sander de Bruyn

39Sander de Bruyn, 2 december 2010 Literature Ellerman, A. Denny, and Paul L. Joskow, 2008, The European Union’s Emissions Trading System in perspective, PEW Center on Global Climate Change. Report.pdfhttp:// Report.pdf Tietenberg, T.H., ”Emissions Trading. Principles and Practice.”, Resources for the Future, Washington D.C., 2006 de Bruyn, S.M., A. Markowska, D. Nelissen, “Will the energy-intensive industry profit from EU ETS under Phase 3?: Impacts of EU ETS on profits, comptetitiveness and innovation”. CE Delft. De Bruyn, S.M., A. Markowska, F. de Jong, M. Bles. “Does the energy intensive industry obtain windfall profits through the EU ETS? An econometric analysis for products from the refineries, iron and steel and chemical sectors”. CE Delft. Sijm, J., K. Neuhoff and Y. Chen, 2006, ‘CO2 cost pass through andwindfall profits in the power sector’, Climate Policy, Vol. 6, pp