Archive for the Climate policy Category

Carbon trading game – understanding the difference between the three basic types of environmental policy

Posted in Climate policy with tags , , , , , , , on September 29, 2009 by Dan

I’ve developed a game that explains the differences between three key policy options for reducing emissions: command and control, tax and cap-and-trade. There are other games like it, but I think this one works really well and we like to use it with clients to explain the rationale behind the current preference that many governments have for cap-and-trade policies.

‘Command and control’ is when the government simply tells industry to reduce emissions by a set amount. ‘Tax’ involves levying a charge on each tonne of pollution. ‘Cap-and-trade’ is a policy type that allows companies to buy and sell emission credits, and therefore choose who makes the necessary reductions. Here’s how the game works:

Up to six participants (or six teams of two or three) are cast as the CEOs of large, carbon-intensive companies. They have asked their business analysts to prepare reports on how they can reduce their carbon emissions. These reports are shown at the top of each worksheet (you can download the worksheets here). Each company can implement two projects. You don’t have to implement an entire project – you can do half of it for the half the cost.

The facilitator (who is cast as the government), then asks each company to work out how much it will cost them to meet emission reductions under a command and control regime (i.e. you must meet the reduction target, and you can only implement your own projects). The facilitator asks each company to report how much money they spent and the emission reductions they achieved, and writes totals up on a flipchart.

Next, a tax regime is used. Each company will be charged £40 for every tonne of carbon that they miss their target by. Again, they report the results.

Finally a cap-and-trade scheme is used. Each company decides how many credits they would buy or sell at four price points (using auction ‘order books’, which you can download here). The data is fed into a spreadsheet that works out the optimal clearing price and shows who buys and who sells (the spreadsheet is available here). It’s called a French auction and it’s just like real carbon markets.

The exercise shows that:

  • Command and control achieves the desired emission reductions, but at a high price;
  • Tax is cost efficient, but unpredictable in terms of emission reductions; and
  • Cap-and-trade is cost efficient and achieves the desired reductions.

The game involves huge simplifications, of course, but does outline some basic economics behind these policy choices.


Cap and trade in the context of shrinking production

Posted in Climate policy with tags , , , , , , , , , on December 28, 2008 by Dan

Questions are being asked of the two working installation-level cap and trade schemes in light of economic recession. The EU ETS – the world’s largest carbon market – is trading at about 16 Euros per tonne and is volatile because no-one is quite sure of the impact of shrinking production. Analysts believe that all reductions could now be met through purchase of CERs. Essentially this means that industry within the EU ETS has lowered its output and can comply with the cap by offsetting rather than making additional internal reductions.

The other scheme, RGGI, a scheme covering power plants in north-east US, held its second pre-compliance auction on 18 December and sold 31.5m allowances at a price of $3.38 per short ton (up 31c from the first auction, which is surprising given the commentary that follows). An article on BusinessGreen says:

… the auction came amid fears that the economic downturn meant the US scheme could repeat the mistakes evident in the first phase of the EU’s emissions trading scheme by setting the cap too high – a scenario that led to a glut of available emission permits and a collapse in the price of carbon.

Non-profit policy thinktank Environment Northeast released RGGI Emissions Trends & the Second Allowance Auction, a report which said emissions were currently 16 per cent below the cap. It pointed to skyrocketing fossil fuel prices earlier in the year as the primary reason for a lower than expected emissions rate.

“RGGI was negotiated back in early 2003 through 2005, and at that time everybody thought the trend would be up,” said Derek K Murrow, director of policy analysis at Environment Northeast. “Since it was negotiated we’ve seen a signfiicant decline, which is really a good thing. Now the question is whether that trend will continue as the programme starts up in 2009, in which case the cap might need to be bought down more quickly after the first compliance period. Or will emissions return to their historic levels, in which case the cap would be constraining?”

Comments like this suggest that cap-and-trade must deliver a carbon price that is neither zero nor unbearably high, and also force emission reductions beyond anything that happens ‘naturally’ (as a result of lower consumption or developments in eco-efficiency, for example). These characteristics sound more like tax than cap and trade. Cap and trade provides an absolute limit for emissions and a price crash indicates that the limit can be met with no unusual investment. Equally, if emissions rise unexpectedly, a cap and trade market will force decisions about where additional reductions will be made.

That’s the strength of cap-and-trade: unforeseeable events that effect emission levels are reflected in the permit price. If the price crashes due to unforeseen cuts in emissions, the cap and trade scheme is not a failed policy.

Lack of CDM progress at Poznan will be the major sticking point for negotiations over the next year

Posted in Climate policy with tags , , , , , , , on December 15, 2008 by Dan

CDM reform didn’t get anywhere at Poznan. To me, this is the most worrying outcome of the conference. Although technical discussions and low-level negotiation planning were all anyone expected, there is now very little time to do something about the CDM before the Kyoto Protocol runs out.

There was a lot of discussion about Forestry and CCS. Forestry is unsuitable for the CDM – partly because there are issues with calculating the volume of carbon dioxide a forest absorbs, and mainly because forests would produce far more CERs than Annex I countries could buy (essentially we wouldn’t be able to buy enough carbon credits to protect the forests).

The situation with coal is similar in that the CDM couldn’t support the volumes required (I haven’t done the maths on this but the IEA forecasts that to stabilise at even 550ppm we will require 10 new CCS plants every year), except that CCS will be neither operational nor affordable before 2020. Most estimates show that a carbon price of EUR 40 – 75 will be required to make CCS commercially viable, and CERs are unlikely to enter that range.

There was also discussion on making the CDM more transparent and efficient. These discussions didn’t progress either, but we really need a new approach to technology transfer and funding rather than tweaks to a process that can’t demonstrate additionality.

Despite encouraging statements from China, Brazil and Mexico, the developing world will not sign up to quantified emission reductions without a clear understanding of how rich countries will support them. The ethos behind the CDM needs to switch from reducing the cost of compliance endured by Annex I to structural funding for the developing world to pay for abatement.

EU should insure long term carbon prices to push the climate and energy package through

Posted in Climate policy with tags , , , , , on December 1, 2008 by Dan

Some industries are claiming that carbon costs could lead them to move outside the EU, which would harm the internal economy and prevent emission reductions. Eurogypsum – the trade body of gypsum manufacturers – is claiming this, but it’s not clear whether the issue is the absolute cost of carbon or the uncertainty over price.

In an interview with Euractive the president of Eurogypsum said:

I cannot challenge the fact that we have to decrease the energy content in our product. But I can also say that in the thirty years that I have been in the industry, we divided the cost of energy in our products by two. And there is still room for progress. So, it is our job in managing the business. Having an incentive to push us to accelerate is okay.

What I am afraid of is the free market for the CO2 tickets because it is out of control. We do not know. When we make a simulation at a certain level, we have no vision of the carbon price. So that is one of the main issues is that the system that they are going to adopt is a system that will give us no vision of what could happen. Maybe it will cost nothing. Maybe it will cost a big amount. So we may take decisions on something that will never happen? They should be conscious about that…

When you have to choose in between certainty or uncertainty, you avoid the uncertainty.

EUAs trade out to 2012 on derivative markets, but not ten years out like Eurogypsum is thinking, and there are no readily available financial products that can transfer that sort of risk.

Over the next few months, as traders speculate on the extent of the recession and talks in Poznan and Brussels hopefully provide some clarity on Phase III, the EUA price is going to be volatile and those pushing back against the climate and energy package are likely to use this as a lever.

France (as EU Council president) is putting together a big package of concessions for industries in central and eastern Europe in an attempt to push the package through. One that I would throw into the mix is a publicly backed long-term carbon hedge. This would hopefully knock on the head the argument “we’re all environmentalists and we don’t mind paying for carbon, it’s the uncertainty that messes with our business models”.

Don’t worry Connie Hedegaard, I have an answer for your CDM problem

Posted in Climate policy on October 2, 2008 by Dan

I went to a talk about the UNFCCC’s Copenhagen 2009 conference by Connie Hedegaard and Hilary Benn at the LSE last night (transcript). Connie is Hilary Benn’s Danish counterpart and has responsibility for organising the conference.

She was reassuringly dedicated to an ambitious global agreement. But there were points she raised that made it look like the negotiators have a tall order.

  • She did not seem entirely convinced that the EU climate and energy package could be completed in time for Europe to lead the negotiations. The UK is attempting to water down the package and Hilary Benn did not offer much reassurance on this.
  • While she felt cap and trade markets in Annex I countries were developing and offer the best available way to arrange carbon finance, she recognised that the CDM is not a good method of technology transfer and needs to be reformed. She did not seem to have any ideas, however, and 14 months seems like a very short length of time to get something in place.

I am fond of having random stabs at reformed CDM designs. Here’s my current scheme:

Cap and trade auction revenues are channelled into several privately managed technology transfer funds. Companies and non-profit entities in developing countries can apply to the funds for grants or cheap finance for projects that reduce emissions. The funds would be evaluated on their ratio of emission reductions to funds allocated, and they would be awarded more or less funds in the following year as a result.

Every country would have an emissions cap (i.e. would be allocated AAUs), with the global cap representing a safe limit. Linking between carbon markets in Annex I and Annex II countries would be limited or banned (to force internal reductions in the developed world), and the fund mechanism would reduce the burden of the reductions for the developing world.

This system makes the problem of additionality internal to the fund mechanism rather than a question of effectiveness in climate mitigation terms. It is also likely to allocate funds much more efficiently in the developing world. The CDM has squandered billions on cheap or ineffectual projects.

UK should ringfence EUA auction proceeds

Posted in Climate policy with tags , , on September 18, 2008 by Dan

HM Treasury just announced that Defra is going to hold the UK’s first EUA auction on 19 November. I’m not sure how many will be auctioned on that day, but over phase 2 the government will auction 85 million (7% of the UK’s total allocation). Assuming an average price of EUR 25, that’s over EUR 2 billion of revenue.

The UK government is consistently opposed to any type of hypothecation (ringfencing of revenue for particular purposes) and will not promise to use this money for any climate-related purpose. The EUR 2 billion is ultimately passed down to consumers. Given that the government has no obvious ownership of the climate, EUAs do not seem like an appropriate source of general public funds.

In an economist’s perfect world, the money would be recycled to consumers who pay the EUR 2 billion through embedded carbon costs. This is difficult to do, of course, and the next best thing is to use the money for environmental projects.

Two good options for the money would be

  • a fund for retrofitting domestic property with insulation and energy efficient heating systems. This would be a reasonable way to compensate for the incremental increase in energy bills resulting from emission trading. It would not create net emission reductions (energy generation is within the EU ETS, so lower domestic energy use means that other sectors can use the EUAs no longer required), however.
  • investments in public transport. This would be my favourite option. While it has less symmetry with the costs imposed by the trading scheme, it does encourage reductions outside the EU ETS.

Europe: irrationally inefficient

Posted in Climate policy with tags , , on September 11, 2008 by Dan

McKinsey published a report today (pdf) today that shows how all our energy and carbon targets can be met through productivity improvements alone (i.e. our energy supply does not need altering). And even better – unlike most GHG abatement technologies, all energy productivity improvements are reported to have a positive NPV.

Improving energy productivity involves things like energy efficient buildings and recovering heat from industrial processes.

The chart below from McKinsey’s report shows just how important energy productivity is. When we compare with CCS, which has the potential to deliver 3% of Germany’s GHG abatement potential and according to most industry estimates requires a carbon price of EUR 40 – 75 to be commercially viable, it seems obvious that our obsession with clean coal being necessary to deliver safe levels of emissions is misplaced.

So why isn’t the market delivering these improvements? Even with no carbon price, energy productivity makes economic sense. According to McKinsey, most productivity gains are dispersed among consumers who have insufficient capital and information to make the right investments. Product standards are the only way to address these barriers.

It feels like there’s something missing to me – it just seems like too big a market failure. I’m afraid I don’t have an answer right now but will mull it over.