ECBI 2008 THE MICROECONOMICS OF POST 2012 CDM 5 September 2008 Dr Cameron Hepburn Deputy Director, Smith School of Enterprise and the Environment 5 September 20081Dr Cameron Hepburn

5 September 2008 SMITH SCHOOL Demand from business Critical 21st century environmental challenges Smith School of Enterprise and the environment Interest and input from academics and students Demand from policy makers 2Dr Cameron Hepburn

5 September 2008 OTHER RELEVANT INTERESTS 3Dr Cameron Hepburn

5 September What are the CDM’s objectives? 2.The two key challenges 3.Some microeconomics 4.Evaluating the options for reform AGENDA Dr Cameron Hepburn

5 September CDM OBJECTIVES 5Dr Cameron Hepburn Economics: Keep costs down of reducing emissions Deliver subsidy to developing countries Philosophy: “Common but differentiated responsibility” (equity) Politics: Reality is that developing countries will not pay otherwise Enhance “sustainable development” Encourage buy-in to the UNFCCC process

5 September 2008 CATEGORISING THE CDM 6Dr Cameron Hepburn The CDM is both: A market and A subsidy The subsidy paid is a function of a market clearing price Unlike feed-in tariffs, or instruments such as ROCs and RECs, the subsidy is not simply paid upon generation of the desirable thing Rather, the CDM imposes the extra test of additionality, namely that emission reductions must not have otherwise happened without the subsidy. This was considered important to provide an intellectual basis for a fungible market. There are problems with both its functions: As a market, additionality concerns undermine integrity As a subsidy, paying the market-clearing price is non-optimal

5 September What are the CDM’s objectives? 2.The two key challenges 3.Some microeconomics 4.Evaluating the options for reform AGENDA Dr Cameron Hepburn

5 September 2008 TWO KEY CHALLENGES 8Dr Cameron Hepburn Additionality Asymmetric information generates adverse selection and moral hazard Ultimate solution is a global cap and trade scheme Scaling up the mechanism Project-by-project mechanism is very micro A “wholesale” approach is needed to increase scale of support for developing countries and also to reduce emissions more rapidly

5 September 2008 ADDITIONALITY CONCERNS 9Dr Cameron Hepburn –Blue: New Chinese CapacityRed: Applying for CERs

5 September 2008 ADDITIONALITY CONCERNS 10Dr Cameron Hepburn Price EUR/t Quantity of CERs Demand for CERs Supply of CERs Subsidy payment if scheme works P* Q*

5 September 2008 ADDITIONALITY CONCERNS 11Dr Cameron Hepburn Price EUR/t Quantity of CERs Demand for CERs Supply of CERs Payment for additional projects Payment for non- additional projects P* Q* PnPn QnQn

5 September What are the CDM’s objectives? 2.The two key challenges 3.Some microeconomics 4.Evaluating the options for post 2012 AGENDA Dr Cameron Hepburn

5 September 2008 SOME MICROECONOMICS 13Dr Cameron Hepburn Optimal subsidy design How can given quantity of funds be used to do the most good? Additionality results for different sector benchmarks Minimise Type 1 errors (false positives) Minimise Type 2 errors (false negatives) Scaling up the mechanism Project-by-project mechanism is very micro A “wholesale” approach is needed to increase scale of support for developing countries and also to reduce emissions more rapidly

5 September 2008 OPTIMAL SUBSIDY DESIGN 14Dr Cameron Hepburn Price EUR/t Quantity of CERs Demand for CERs Supply of CERs Subsidy payment

5 September 2008 OPTIMAL SUBSIDY DESIGN 15Dr Cameron Hepburn Price EUR/t Quantity of CERs Demand for CERs Supply of CERs Profit to project participants MAC

5 September 2008 OPTIMAL SUBSIDY DESIGN 16Dr Cameron Hepburn Price EUR/t Quantity of CERs Demand for CERs Supply of CERs Purchase more emission reductions

5 September 2008 MODEL ASSUMPTIONS 17Dr Cameron Hepburn

5 September 2008 UNCERTAIN ABATEMENT COSTS 18Dr Cameron Hepburn

5 September 2008 RESULTS: TYPE I AND TYPE II ERRORS 19Dr Cameron Hepburn

5 September 2008 SCALING UP: HOW 20Dr Cameron Hepburn

5 September 2008 SCALING UP: INTERMEDIARIES 21Dr Cameron Hepburn

5 September 2008 SCALING UP: TRADE OFFS 22Dr Cameron Hepburn

5 September What are the CDM’s objectives? 2.The two key challenges 3.Some microeconomics 4.Evaluating the options for post 2012 AGENDA Dr Cameron Hepburn

5 September 2008 EVALUATING THE OPTIONS 24Dr Cameron Hepburn CER discounting − Reducing the CER price signal faced by project developers − Disadvantages: perverse selection effects − Advantages: aggregate environmental additionality, provision of an incentive to transition to cap and trade. − Shift from the commodity to the currency conceptualisation of CERs. Programmatic CDM − Continue to be supported and streamlined; Government deals − Reduce emissions through infrastructure development − Welcomed if rich countries will provide the finance!

5 September 2008 EVALUATING THE OPTIONS 25Dr Cameron Hepburn Sectoral CDM − Provides incentives directly to firms in a manner that is consistent with overall environmental objectives. − In contrast, Policy CDM and Sectoral no-lose targets face the major challenge of leaving implementation to national governments; − Benchmarks trade-off between Type I and Type II errors; − Optimal benchmark will be different for different sectors, and individual country and technology characteristics (e.g. new or old build) will probably need to be taken into account; CER procurement auctions − Likely to play an increasing role as national governments seek value for money from projects earlier on in the development stages, − Potential role for reverse auctions in paying for emission reductions currently outside the Kyoto framework (Montreal gases, forestry).

5 September 2008 THANK YOU Thank you Comments and questions welcome! 26Dr Cameron Hepburn