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

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

3. 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 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

4. 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

5. 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

6. 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

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

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

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

10. 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)

11. 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

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

13. 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

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

15. 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

16. 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

17. 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.

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

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

20. 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

21. 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

22. 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

23. … 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).

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

25. 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)

26. 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,
Source: Ellerman et al (2010)

27. 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

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

29. Annex slides

30. 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

31. 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

32. 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

33. 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.

34. 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

35. 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

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