Archive for cap and trade

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.

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The proviso on a carbon tax – determining the price of carbon – is a show stopper

Posted in Climate policy with tags , , , , on February 16, 2008 by Dan

We Europeans have settled on cap-and-trade and are about to get serious with it. In the States, it looks fairly certain federal carbon pricing law will be put in place, but whether that is a tax or cap-and-trade is still up in the air. The Congressional Budget Office came out in favour of tax earlier this week, and the American economics blogosphere has been chewing the debate over.

The key argument in favour of a tax is that reductions over a period of several decades can be made more cheaply. This is because the cost of reducing emissions is volatile and depends on a range of unpredictable factors, such the weather, credit markets and technological developments. If the carbon price is fixed, companies can make reductions in years when it is cheap to do so, and pay the tax when reductions are expensive. Because cap-and-trade schemes use fixed, time-bound limits, the emissions price could be prone to short term spikes that make reductions pricey.

The problem, of course, with a tax, is that while you do know the cost of emissions, you don’t know what level of reduction that cost will achieve. This is critical – it is not possible to accurately determine the cost of carbon necessary to achieve the targets that climate science gives us. The CBO report says that:

Provided that the tax was set equal to the expected benefit of reducing a ton of CO2, a tax could thus result in substantially greater net benefits (benefits minus costs) than a comparable cap-and-trade program.

Agreed. But the proviso is understated. We have only very rudimentary ideas about what carbon price will deliver the reductions we believe are necessary.

During some years, cap-and-trade will pinch an economy, even with flexibilities such as the facility to bank credits for use in future phases. To deliver a certain volume of emissions reductions, these costs must be accepted.

Will dogs survive in cap and trade?

Posted in Climate policy with tags , , , , on February 13, 2008 by Dan

Most people argue that European and American politicians prefer cap-and-trade over tax because taxes are unpopular with the electorate. There is another benefit to cap-and-trade: by using an cap, the problem of demand elasticity is avoided. A post on Free Exchange today mused whether dogs or SUVs have bigger carbon footprints, and then said that if you tax their emissions then it doesn’t matter, because the market will decide which is worse.

Dogs and SUVs (dogs particularly) are quite elastic. When the price is increased, consumption does not reduce to the extent that would be expected. You are left with a pile of tax revenue, but there are still lots of SUVs and (allegedly) carbon intensive dogs out there. With cap-and-trade, on the other hand, the market is not given the option of simply paying for emissions (by cutting back on some other, potentially low-intensity goods). Refusing to reduce emissions under a cap-and-trade scheme drives the price of allowances so high that something has to give.

A suggestion for a cap and trade scheme that maximises clean development

Posted in Carbon markets with tags , , , , on November 16, 2007 by Dan

Cap and trade systems that allow participants to submit offsets are designed to allocate resources to the cheapest projects that reduce emissions, across the whole world. Take a look at McKinsey’s marginal costs of reducing greenhouse gas emissions by different methods. If a coal power station’s only option to achieve its cap is retrofitting the plant with clean technology, at a cost per ton of CO2-eqivalent abated of around $30, the plant can instead pay for wind farms to be built at around $15 per ton and pocket the difference.

This sounds like an economically sensible outcome, but it does have some flaws. The following is an idea for a cap-and-trade system that maximises the environmental benefit rather than minimising the cost, and also forces more competitiveness into the offset generation industry (without getting into the debate of whether offsets work or not).

(If you are familiar with the EU ETS, for credit read EUA and for offset read CER.)

  1. A cap is set and credits are distributed to participants accordingly.
  2. The fine per ton of emissions that a participant is responsible for but cannot cover with credits is set higher than you would reasonably expect the price of carbon to go in the trading round. The fine is the ceiling for the price of emissions. So far, so good – just like the European scheme. But:
  3. Participants may only present credits at the end of the round – they are not allowed to present any offsets.
  4. Certified offsets may be converted into credits at any time in the trading round according to the ratio (credit price / offset price) * a multiplier, where the multiplier is close to 100%. For example, if credits cost EUR20, offsets cost EUR10 and the multiplier is 80%, participants can convert 1.6 offsets into 1 credit.
  5. Converted credits are tradable but are marked. Participants may only present a certain proportion of marked credits among their overall portfolio at the end of the round.

This system still pushes capital to most efficient place, but has two further benefits. Firstly, it means that where the collective participants do not view it as economical to reduce emissions directly, they must purchase a larger volume of offsets than they do under a scheme where offsets and credits have equal weighting, and therefore finance more clean development. Secondly, it decouples the cost of credits and offsets in the system, allowing the cost of offsets to fall to a more competitive level. In Balance suspects that CER generation can be unreasonably profitable because the CER price is largely driven by the higher EUA price.