Allocation of CO2 Emission Allowances

Karsten NeuhoffUniversity of Cambridge

The Cambridge-MITInstitute

Carnegie Mellon UniversityOctober 2004

In collaboration with Kim Keats, ICF Consulting, London.

See also CMI working paper 49 @ econ.cam.ac.uk/electricity

2

Outline

• CO2 emission reduction strategy

– Failure of voluntary commitments– Effectiveness of price mechanism– Separate environmental externalities from

technology policy (learning externalities)• The European Emission Trading Scheme• Impact of updating (conditional allowance allocation)• Impact of free allowance allocation to new entrants• Border tax adjustment to allow auction of allowances

and higher CO2 prices

3

European strategy to reduce CO2 emissions

• European Climate Change Program 2000• Bonn/Marrakech/EU required delivery of

Kyoto targets• After criticising US, policymakers had to show

action• Failure of voluntary commitments in 1990

4

Instrument I: Industry self regulation Example Germany• CO2: 2000 industry promised 20 Mtones

reductions by 2005 –so far only increase• Industry option to avoid renewables

legislation by achieving quota (1990)• Education quotas at firm level • Price stability with Euro introduction• Self-regulation of energy sector• Cigarette advertising/ product labelling

Source: Kontraste.de, Axel Friedrich Umweltbundesamt

failed

• Lacks sanctions: free riding in sector

• BUT good to delay state intervention

5

Development of Energy intensity from 1971 to 2000

0

0,1

0,2

0,3

0,4

0,5

1970 1980 1990 2000

Mto

e/m

ld U

SD

AustriaBelgiumFranceGermanyJPNUKUSA

Source: Miroslav Honzík, GDP is translated using PPP, Prices of 95

Oil price spike in 1970’s increased energy efficiency far more than climate debate of 1990’s.

6

The economy can change energy intensity

0

200

400

600

800

1000

1200

1400

0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00

average energy intensity (kg oil equivalent/$95 GDP)

ave

rag

e en

erg

y p

rice

$/t

oe

Best fit constant price elaticity of -1.0 (S.E. 0.14), R2 = 0.69 (Excl CEE)

SVKCZE

POL

HUN

KOR

CAN

DEN

NORJPN

ITA

SUI

AUT

LUX

UK NZ

USATUR

FIN

SWE

BEL

MEX

Cross-section relation between average energy intensity and average energy price 1993-99

Source: Nebwery 2003

Inertia?

Instrument 2 … prices

7

Instruments CO2 price … increasing energy costs

t

$/tCO2

Allowance price

Energy efficiencymeasures

8

Implied CO2 price varies widely between sectors and countriesExample: Diesel

Source: EU Commission (Stand 2002/Deutschland 2003); American Petroleum Institute 2004, Energy Information Administration, 2004

UK

49 82119 120 126

134 136

157 169

94 97 9891 1108567

020406080

100120140160180

US

Sw

eden

Gre

ece

Luxe

mbo

urg

Pol

and

Aus

tria

Bel

gium

Spa

in

Fin

land

Irel

and

Net

herla

nds

Fra

nce

Ital

y

Den

mar

k

Ger

man

y

taxa

tion

rate

(ce

nts/

gallo

n)

2010 Min.2003 Min.1993 Min.

18 c/gln = CO2 Price E20/tonne

9

And inertia / transaction costs need to be addressed

• EU Commission Green Paper 2000: technical potential for improved energy efficiency of 40%

• EU Commission Green Paper:

>18% potential for cost

effective improvements

“CCLA’s were far more

likely to have taken action

to improve energy

efficiency …87% of CCLA

firms had taken action or

were planning to do so

compared with 42% of non-

CCLA firms”

Source: CBI/EEF review of CCL, October 2002

10

Instrument CO2 price … changing relative costs

t

$/tCO2

Allowance price

Renewables

CO2 pricing is unlikely to unlock new renewable technologies.But reduces costs of strategic deployment programs.

Renewables without technology support for initial deployment

11

Technology cost reductions with deployment

12

Technology Policy – separate from CO2 trading• Renewable contribution

– Quotas EU commitment: 13.9% (97’) to 22% (10’)

– Implemented using national policy – So far only feed in delivered (DK, D, ES)

• Some renewable RDD programs• Transport of energy / transport fuel

– H2, 2 bil.Euro in 6th framework/ in US $1.7 bil.

• Carbon Sequestration/nuclear perceived as marginal– Public concerns about leakage

Source: Directive 2001/77/EC , http://www.europa.eu.int/comm/energy/res/legislation/electricity_member_states_en.htm

13

Emission Trading Scheme and Kyoto

• ETS independent of Kyoto entering into force• ETS set up to comply with Kyoto targets• Russian signature (seems quite secure)

– Would start Kyoto– Will Russia/Ukraine oversupply?

– CO2 allowance trade only at state level

– Review if member state import more than 6% of allowances.

– Limit imports to keep carbon price up• US participation would increase carbon price

14

The ETS System: A Four Level Approach

EU MS 1... …DE... ...EU MS n

Install. 1... …Install. X... …Install. n

Residential ET Sector Transport

Sector 1 Sector X Sector n Reserve

Cap defined by EU Burden Sharing

Different cap options (modeling, voluntary agreements, distance to target)

Different cap options (Flat rate, sector specific caps)

Different Allocation options. Most likely: common formula + extra allocation

Ref: Matthes, Oeko Institute

15

Average cap and BAU emissions compared to Kyoto commitment for 2006

Source: ECOFYS,The BAU numbers are in most cases indicated in the National Allocation Plan. If BAU was not available in NAP, but needed to be derived from other sources, this is indicated by using an open circle, instead of a closed circle. If it was not possible to derive a BAU, no circle is given for that specific country.

16

Issues about the NAPs

• Incentive for countries to allocate more rights– Value of rights for national industry/auction– Impact on EU emission price -> cost of

inappropriate adjustment• Objective of Commission to implement

mechanism on time (January 2005)

17

Allocation plans

• Political economy – buy in of companies

• SO2/NOx: In US – lump sum to incumbents.

• CO2: higher value + politicians equity concern

– Explicit updating• NAPs defined till 2007, Kyoto till 2012

– Implicit updating regarding future allocation• New Entrant provisions

– Regional competition or Coal support?

18

System MCMerit Order

Plant MC

CoalGas

Average Price£/MWh

h/year

AG AC

B

CGCC

B

System MCMerit Order

Plant MC

CoalGas

Average Price£/MWh

h/year

AG AC

B

CGCC

B

Empirical - Impact of CO2 allowances

19

Comparing marginal costs of coal and gas-fired plant

Pulverised coal plant Gas-fired CCGT plant Thermal efficiency (net HHV) 35% 50% Fuel price (£/MMBTu) 1.20 2.30 Fuel cost (£/MWh) 11.70 15.70 VOM (£/MWh) 4.00 2.00 SRMC with out CO2 (£/MWh) 15.70 17.70 CO2 emissions (tCO2/MWh) 930 366 Allowance price (£/tCO2) 6.70 6.70 Allowance cost (£/MWh) 6.20 2.44 SRMC with CO2 (£/MWh) 21.90 20.13

20

Net cashflow impact with auctioned emission rights

Pulverised coal plant Gas-fired CCGT plant All figures in £/kWyr BAU €10/tCO2 Change BAU €10/tCO2 Change

(1) Energy sales revenue 117.8 134.9 17.1 131.1 164.5 33.4 (2) Fuel expense 70.8 69.9 -0.9 95.9 106.8 11.0 (3) O&M expense 33.1 33.1 0.0 21.7 21.7 0.0 (4=1-2-3) Energy sales margin

13.8 31.9 18.1 13.5 35.9 22.4

(5) Net purchases of CO2 allowances

0.0 33.1 33.1 0.0 17.5 17.5

(6=4-5) Operating margin 13.8 -1.2 -15.1 13.5 18.4 4.9 (7) Scarcity rent 13.7 13.7 0.0 13.7 13.7 0.0 (8=7+6) Total margin 27.5 12.4 -15.1 27.2 32.0 4.9

21

UK - change of CO2 emission with regulation

150170190210230250270290

BA

U

CO

2

SO

2/N

Ox

CO

2/S

O2/

NO

x

BA

U

CO

2

SO

2/N

Ox

CO

2/S

O2/

NO

x

2010 Static 2020 Dynamic

CO

2 e

mis

sio

ns

(Mil

lion

to

nn

es) 10 €/tCO2

20 €/tCO2

22

UK - change of SO2 emission with regulation

0

400

800

1,200

1,600

2,000B

AU

CO

2

SO

2/N

Ox

CO

2/S

O2/

NO

x

BA

U

CO

2

SO

2/N

Ox

CO

2/S

O2/

NO

x

2010 Static 2020 Dynamic

SO

2 em

issi

on

s (k

ton

nes

)

10 €/tCO2

20 €/tCO2

23

UK - cost of implementing Carbon Constraint - Static

0

2,000

4,000

6,000

8,000

10,000

12,000

No

cons

trai

nt

Auc

tione

dC

ertif

icat

es

Gra

ndfa

ther

ing

No

cons

trai

nt

Auc

tione

dC

ertif

icat

es

Gra

ndfa

ther

ing

No

cons

trai

nt

Auc

tione

dC

ertif

icat

es

Gra

ndfa

ther

ing

Consumers Generators CO2 Emissions

200

210

220

230

240

250

Scarcity

Tax

Energy

0

2,000

4,000

6,000

8,000

10,000

12,000

No

cons

trai

nt

Auc

tione

dC

ertif

icat

es

Gra

ndfa

ther

ing

No

cons

trai

nt

Auc

tione

dC

ertif

icat

es

Gra

ndfa

ther

ing

No

cons

trai

nt

Auc

tione

dC

ertif

icat

es

Gra

ndfa

ther

ing

Consumers Generators CO2 Emissions

200

210

220

230

240

250

£ m

illio

n

tCO

2

Fixed O&M

CO2 allowances

Fuel & Variable O&M

1840 1385

24

Impact of updating I

25

One time updating

Assume one time updating - pt+1 const

A’ = 0 … only price increaseA’->inf … only emission increaseA’ positive … both price and emission increase

26

Continuous updating

Future allowance price also increases, enhancing the effect of updating on today’s allowance price.

27

Quantification of CO2 constraint

Assume A’->inf … government fixes allowance price

Calculate E’ as function of fuel switching etc.

28

Cost of implementing Carbon Constraint - Static

0

2,000

4,000

6,000

8,000

10,000

12,000

No

cons

trai

nt

Auc

tione

dC

ertif

icat

es

Gra

ndfa

ther

ing

No

cons

trai

nt

Auc

tione

dC

ertif

icat

es

Gra

ndfa

ther

ing

No

cons

trai

nt

Auc

tione

dC

ertif

icat

es

Gra

ndfa

ther

ing

Consumers Generators CO2 Emissions

200

210

220

230

240

250

Scarcity

Tax

Energy

0

2,000

4,000

6,000

8,000

10,000

12,000

No

cons

trai

nt

Auc

tione

dC

ertif

icat

es

Gra

ndfa

ther

ing

No

cons

trai

nt

Auc

tione

dC

ertif

icat

es

Gra

ndfa

ther

ing

No

cons

trai

nt

Auc

tione

dC

ertif

icat

es

Gra

ndfa

ther

ing

Consumers Generators CO2 Emissions

200

210

220

230

240

250

£ m

illio

n

tCO

2

Fixed O&M

CO2 allowances

Fuel & Variable O&M

1840 1385

29

Allocation of Allowances to new entrants

K1 K2

Dmin Dmax

pmax

cm,2

Fixed costs: cf,1 cf,2

(assume Dmax-Dmin=1)

30

Impact of the amount of free allocation

pt=ct

31

Government strict on quota

dK2 /dμ>0 -> dK1/dμ >0 if

Scarcity value of capacity decreasing.

To ensure profitability of technology 1, dct/dμ > 0

• Investment in both technologies is increased (while scarcity value positive)

• Allowance price and for dA/dct>0 emissions increase.

32

Government stabilises price

dK2 /dμ>0 -> dK1/dμ <0 if

Scarcity value of capacity decreasing.

dK2/dμ>0 dK1 /dμ <0 and d(K1 +K2)/dμ K’1+K’2>0 emissions increase dct/du > 0

• Low emission technology is displaces by high emission technology and total capacity increases.

• Allowance price and emissions are increased.

33

Impact of Allocation Rules on UK Wholesale Prices

10

15

20

25

30

35

40

2004 2005-2007 2008-2012 2013-2017

All

-in

Pri

ce

(€

/MW

h)

No closure test/No NER

Closure test/No NER

Closure test/NER

BAU

Price reflects energy-weighted average wholesale power price across UK assuming a CO2 price of 10€/tonne. Source: ICF Consulting, March 2004.

34

Impact of competing countries not participating

• Concerns for competitiveness of EU industry• Could particularly affect location decisions• Hence provisions for allocation of allowances to

new entrants in NAPs (for 2005-2007)– Distortions of technology choice (Germany)– Distortions of location choice (between

countries)– Long-term commitment reduces policy options– How many reserves to retain for entrants?

• Updating provisions – reduce effectiveness

35

Requirement to implement stringent policy

• Emission trading only works if– No updating: allowance price=opportunity cost– Minimise allocation to new entrants

• EU Energy intensive industry will lobby against high CO2 prices if they are unilateral

• US Energy intensive industry will increase lobby against CO2 constraints if they can free ride

• We need border tax adjustment

36

Border Tax Adjustment for CO2 allowance costs

• Reimburse exporter for allowance costs• Add import tax for avoided CO2 allowance costs• Allows for internalisation of externalities• Treatment similar to value added tax

– Other regions can apply it (e.g. Canada)– But product not process based

• Focus on energy intensive component– Small transaction costs– Based on best available technology– Simple monitoring / tariff setting

• WTO compatible

37

Conclusion

• ETS in place and starting January 2005• Covers emissions from large installations• Technology policy separate (and needs to be)• To get industry buy in: Free allocation

– Politicians then required Updating– New entrant allocation

• Result are likely– Allowance prices look higher -> don’t be fooled!– Distortions in investment decisions.

• Border tax adjustment could allow for higher CO2 price levels.