Implementing Emission trading the EU experience

Climate Change Summit, March 2009Johannesburg

Karsten NeuhoffFaculty of EconomicsCambridge University

www.electricitypolicy.org.uk/tsec/2

Karsten Neuhoff

ww

w.e

lectr

icit

ypoli

cy.

org

.uk\t

sec\2

Outline

• The benefit of an economic instrument

• EU experience with implementing ETS– First cap setting, then allocation– Dealing with uncertainty of emission projections– Repeated free allowance allocation creates

perverse incentives– Carbon leakage – can be addressed

• Emission trading is part of the policy mix

Karsten Neuhoff

ww

w.e

lectr

icit

ypoli

cy.

org

.uk\t

sec\2

Companies do respond to EU ETS quotes from the submission of large EU utility

• Establishment and operation of EU ETS have successfully created a truly European market for CO2 allowances.

• concerted emission reduction policies are required.• shift to a low-carbon economy is possible. • supports the further development and wider use of

market-based mechanisms to achieve this change. • A well-functioning EU ETS is the most efficient

method to effectively incentivise companies to invest in the required cleaner technologies.

Source: E.ON submission to EU ETS review

Karsten Neuhoff

ww

w.e

lectr

icit

ypoli

cy.

org

.uk\t

sec\2

Price signal + institutional framework can deliver change:Dash for gas in UK power generation

Source: 1960-1997 DTI Energy statistics, Fuel consumption for power generation, transformed to output using 1998 average efficiencies, 1998-2005 DTI Energy statistics, Power generated, Projections based on Survey among participants on Futuer generation technologies workshop (asking for demand evolution and generation shares), Cambridge 2003

GWh

0

50

100

150

200

1960 1980 2000

Coal

Oil Nuclear

Gas

Karsten Neuhoff

ww

w.e

lectr

icit

ypoli

cy.

org

.uk\t

sec\2

After 2 bad experiences with joint cap setting & allocation -> Europe now first sets cap, then allocates

Karsten Neuhoff

ww

w.e

lectr

icit

ypoli

cy.

org

.uk\t

sec\2

0

500

1000

1500

2000

2500

2005 2008 2009 2010 2011 2012

MtCO2/year

Verified Emissions

NAP II + (JI/CDM range)

Avg. 2008-12

Final NAP II***

Max projection

Min Projection

20% projections60%projections

Adjustments for opt-in in Phase II

88125

Other Adjustments*

Proposed NAP II**

Emission projections are intrinsically uncertain

Source: Emissions Projections 2008-2012 versus NAP2 (2006) by Karsten Neuhoff, Federico Ferrario and Michael Grubb. Published in Climate Policy 6(5), pp 395-410.

Karsten Neuhoff

ww

w.e

lectr

icit

ypoli

cy.

org

.uk\t

sec\2

Several options could be explored to retain strong carbon price in a world with uncertainty

• Banking– Was excluded between phase I and phase II

– Difficult in current financial situation (in Europe)

• Reserve price in auctions– Requires significant auction volume

• Linking with other scheme– Bigger market – smaller uncertainty

– Requires scarcity in joint market

– Requires trust of all market participants in implementation

Karsten Neuhoff

ww

w.e

lectr

icit

ypoli

cy.

org

.uk\t

sec\2

oldcoal

gas • Energy efficiency • Low-carbon technology

Co

st

newcoal

Production

cost

The effect of carbon pricing – example power sector

CO2 Cost

efficient production

choice of the best input

appropriate use of output

Karsten Neuhoff

ww

w.e

lectr

icit

ypoli

cy.

org

.uk\t

sec\2

Does allocation matter for efficiency … the history

• Initially based on US experience SO2/NOx

– One off allocation to existing installations

– Based on historic reported data

– In many ways close to economic text book model

• But differences for EU scheme emerged soon– Scientific/political/economic constraints on setting targets

for more than 10-15 years

– CO2 allowances value order of magnitude bigger

-> repeated shorter-term allocation

-> (opportunity) cost pass through - free allocation?

Karsten Neuhoff

ww

w.e

lectr

icit

ypoli

cy.

org

.uk\t

sec\2

Au

ctio

n /

Gra

nd

fath

erin

g

Uniform updating

Un

iform

up

datin

gF

uel

sp

eci

fic u

pd

atin

g

Fuel specific updating

Em

issi

on

bas

ed

allo

catio

n

Emission based allocation

oldcoal

gas energyefficiency

Co

st

newcoal

Production

cost

Distortions from repeated free allocation … the experience

CO2 Cost

efficient production

choice of the best input

appropriate use of output

+ reduced incentives for low carbon innovation

Karsten Neuhoff

ww

w.e

lectr

icit

ypoli

cy.

org

.uk\t

sec\2

EU phase I, II: High level of free allocation & distortionEU post 2012 -> full auctioning in power sector

0,0

0,2

0,4

0,6

0,8

1,0

1,2

AT*

BE - WBE -

F

BE - B CY DE

ES* FIFR

HU* IE IT*

LV MT NL PL SE SK UK EE LU SI

CZ**DK** GR LT PT

mil. EUA

Hard Coal Plant

Natural Gas Plant

No detailed provisions

Analysis to be done or

No Translation available

NAP II not

available yet

Model Coal power station, 6000h,33% efficiency

Model CCGT (gas), 6000h,45% efficiency

Comparison of National Allocation Plans for the Period 2008-2012, Karsten Neuhoff, Markus Åhman, Regina Betz, Johanna Cludius, Federico Ferrario, Kristina Holmgren, Gabriella Pal, Michael Grubb, Felix Matthes, Karoline Rogge, Misato Sato, Joachim Schleich, Jos Sijm, Andreas Tuerk, Claudia Kettner, Neil Walker

Karsten Neuhoff

ww

w.e

lectr

icit

ypoli

cy.

org

.uk\t

sec\2

Pyramid of distortions – summary of experience from phase I of EU ETS

Excess carbon-intensive capacity

Inefficient fuel choice

Less energy-efficiency investment

Distortions

AuctionCapacity X

Capacity and technology X XHistoric output X X

Historic output and technology X X XHistoric emissions X X X X

Discourage cl

osure of p

lants

Discourage cl

osure of in

efficient p

lant

Increase

operation of in

efficient p

lants

Reduce in

centiv

es for

Efficiency

-improvin

g inve

stment

Allocation method

Distortions increase emissions and/or price impacts

Karsten Neuhoff

ww

w.e

lectr

icit

ypoli

cy.

org

.uk\t

sec\2

C

ost

incr

eas

e r

ela

tive

to v

alu

e a

dde

d

Ce

me

nt

Ba

sic

iron

& s

tee

l

Lime

Fertilisers & Nitrogen

Alu

min

ium

Other inorganicbasic chemicals

Pulp &Paper

Malt

Coke oven

Industrial gases

Non-wovens

Refined petroleum

Household paper

Hollow glass

Finishing of textiles

Rubber tyres & tubes manufact.

Copper

Casting of ironImpact from direct emissions

Impact from indirect emissions (electricity)

Flat glass

Veneer sheets

0%

10%

20%

30%

40%

0.0% 0.2% 0.4% 0.6% 0.8%1.0%

4%2%

Starches& starch products

Preparation of yarn

Other textile weaving

Retreading/rebuilding tyres

Identify activities with risk of leakage

Share of GDP of UK

Karsten Neuhoff

ww

w.e

lectr

icit

ypoli

cy.

org

.uk\t

sec\2

Basic options to address leakage for exposed sectors

Price level

CO2

costs

Price levelPrice level

CO2

costsCO2

costs

Cos

t

Cos

tC

ost

Government ledsectoral agreement

Export taxes Border adjustment

Cos

t

Export taxes Border adjustmentExport taxes Border adjustment

Conditionalfree allocationState aid

•Little substitution to low carbon products/services

•Distorts investment•Bureaucratic constraints for innovation

•Risk of lock-in

•Has to be aligned with international climate engagement

•Requires at least informal international cooperation

•Requires strong policies of developing countries

•Risk of low common denominator

Initial evaluation

Karsten Neuhoff

ww

w.e

lectr

icit

ypoli

cy.

org

.uk\t

sec\2

A carbon price works through the value chain. This can be supported by policies that address leakage.

Clinker Cement Concrete Building

Other building materials

LeanerstructuresLower clinker

content

Sub

stitu

tion

Clinkerimports

Cement imports

Leak

age

Efficiency

Some leakage • Without measures • With unconditional allocation

Forgone substitution/innovation• Without measures• With free allocation

Karsten Neuhoff

ww

w.e

lectr

icit

ypoli

cy.

org

.uk\t

sec\2

Summary

• The benefit of an economic instrument

• EU experience with implementing ETS– First cap setting, then allocation– Dealing with uncertainty of emission projections– Repeated free allowance allocation creates

perverse incentives– Carbon leakage – can be addressed

• Emission trading is part of the policy mix

Karsten Neuhoff

ww

w.e

lectr

icit

ypoli

cy.

org

.uk\t

sec\2

Carbon pricing is one of the 3 pillars of climate policy. It internalises environmental costs and allows substitution away from Carbon intensive products towards more energy efficient and lower Carbon technologies.

1. Price CO2

2. Make credible commitments to targets

3. (Raise funds for international mechanisms)

Inte

rnal

ise

CO

2 co

sts

in

dec

isio

ns

Climate policy

Tec

hn

olog

y In

nov

atio

n

1990th : Industry self-regulation Harmonised CO2 Tax

2003 Emissions Trading

Approaches

Market pull• Future potential for renewables• Central for complex sectors

Rem

ove

non-

mar

ket

bar

rier

s

How?

Karsten Neuhoff

ww

w.e

lectr

icit

ypoli

cy.

org

.uk\t

sec\2

Aspects to consider

• Flexibility with off-sets

• Linking of schemes

• The role of expectations

Karsten Neuhoff

ww

w.e

lectr

icit

ypoli

cy.

org

.uk\t

sec\2

Stern 2006 on uncertainty

The next 10 to 20 years … transition ... to [world] where carbon pricing is universal and is automatically factored into decision making. … avoid the risks of locking into a high-carbon infrastructure … additional measures may be justified to reduce the risks."

Karsten Neuhoff

ww

w.e

lectr

icit

ypoli

cy.

org

.uk\t

sec\2

Outline

• The benefit of an economic instrument

• Issues to consider– Repeated free allowance allocation– Carbon leakage– Emission projection

• Emission trading as part of the policy mix

Karsten Neuhoff

ww

w.e

lectr

icit

ypoli

cy.

org

.uk\t

sec\2

Tax versus tradeTax Trade

Investment security for efficiency improvements

Policy process ?

Incentives for innovation Vision that something can happen Cap creates visibility of market shares for some low carbon options (does it suffice to have this in some regions)

Linkages of price Used as reference price Linking of trading scheme

Address inequality Revenue recycling towards groups that face higher product prices

Revenue from auction recycling

Creates leakage concerns Not if some global similar levels of carbon prices

Not if linkages with trading schemes of most regions

Options to address

leakage concerns

Revenue recycling to support low-carbon investment

Free allocation / or revenue recycling from auctions

Market power Information to set carbon tax Price manipulation creates investment risk

Required institutional capacity Existing tax structure + MRV New administrative and trading institutions + MRV

Time frame for implementation Relatively short Establishing base line for initial allocation, trading, test period?