Emissions trading cap and trade
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Emissions Trading (Cap and Trade). Kate Macauley. Economics of emissions trading Overview of the EU Emissions Trading Scheme (ETS). Cap and Trade. Quantity regulation: Total allowable emissions capped. Price determined by the market. Total number of allowances created to match cap

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Emissions Trading (Cap and Trade)

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Emissions trading cap and trade

Emissions Trading(Cap and Trade)

Kate Macauley


Emissions trading cap and trade

  • Economics of emissions trading

  • Overview of the EU Emissions Trading Scheme (ETS)


Cap and trade

Cap and Trade

  • Quantity regulation: Total allowable emissions capped. Price determined by the market.

  • Total number of allowances created to match cap

  • Allowances may be traded on a market

  • Individual firms abate until MCA = Ppermit

  • The way you allocate the allowances does not impact the market price


Emissions trading economics

Emissions Trading: Economics

  • Assumptions

    • Global pollutants: concerned with aggregate pollution, not with discharge location (SO2, NOx, CO2)

    • Competitive market

    • Cap set by regulatory body

      • (cap < emissions in base year)

    • Marginal cost of abatement (MCA) is positive and increasing


Emissions trading graphically

∆ABD+ ∆ACD > ∆AEF

Therefore, it is more efficient to allow permits to be traded than to specify a uniform level of abatement across firms.

Emissions Trading Graphically


Emissions trading

Emissions Trading

  • cost of abatement

  • marginal cost of abatement is positive

  • marginal cost of abatement is increasing

  • uncontrolled emissions for firm i in the base year

  • abatement by firm i

  • Individual firms

*Sankar, U. (2001). Environmental Economics. New Delhi: Oxford University Press.


Aggregate level of pollution in base year pollution cap

Therefore, we have the following cost minimization problem subject to the pollution cap restraint:

aggregate level of pollution in base year

Pollution cap

and

Subject to:

*Sankar, U. (2001). Environmental Economics. New Delhi: Oxford University Press.


Emissions trading cap and trade

Solution:

Firms abate until MCA = ppermit

If the market is competitive, the firms are price takers and p is determined by the market.

Then for the individual firm:

Minimize (xi): ci(xi) + p(ei-xi)

Solution: ci’ = p for all i

*Sankar, U. (2001). Environmental Economics. New Delhi: Oxford University Press.


Emissions trading graphically1

Emissions Trading Graphically

Auction versus free allocation


Eu ets emissions trading scheme

EU ETS: Emissions Trading Scheme

  • Proposed in 2001. First carbon dioxide cap-and-trade program

  • Trial period: 2005-2007. Second trading period: 2008-2012

  • Aim to meet obligations outlined by the Kyoto Protocol during the 2008-2012 trading period, not during the trial period. Plan to continue after 2012 (post-Kyoto)

  • Set an absolute cap on CO2 emissions on 12,000 facilities in the EU.

  • Tradable allowances distributed equal to cap quantity. Most allowances freely allocated.

  • Facilities measure and report CO2 emissions. One allowance per ton of CO2 emitted.

  • Initially only included 40% of total GHG emissions. Limited to certain sectors (power, combustion facilities, certain industries -- not transportation or buildings). Plan to expand over time.

Ellerman, D.A. & Joskow, P.L. (2008). The European Union’s Emissions Trading System in perspective.” Pew Center on Global Climate Change.


Ets cont

ETS cont.

Cap-setting process:

Initial cap = Sum of 25 separate decisions across member states. Each individual cap approved by European Commission.

Unknown long-term trajectory for cap. Caps determined again each trading period.

First period: 2005-2007

Second period: 2008-2012

Third Period: 2013-2020

annual cap declines annually by 1.74 percent across EU ETS

20% below 1990 levels by 2020

Ellerman, D.A. & Joskow, P.L. (2008). The European Union’s Emissions Trading System in perspective.” Pew Center on Global Climate Change.


Linking directive

Linking Directive

  • For a specified amount of abatement, firms can comply through carbon offsets (amount set by individual member states)

    • CDM Clean Development Mechanism (established by Kyoto)

  • Limited to prevent over-supply

  • Not significant during trial period, but more important for future periods

  • Concern: Would the offsets have occurred regardless of the CDM?

Ellerman, D.A. & Joskow, P.L. (2008). The European Union’s Emissions Trading System in perspective.” Pew Center on Global Climate Change.


Ets trial period concerns

ETS Trial Period Concerns

Price Volatility

Windfall Profits

Overallocation of permits

Ellerman, D.A. & Joskow, P.L. (2008). The European Union’s Emissions Trading System in perspective.” Pew Center on Global Climate Change.


Emissions trading cap and trade

1. Price Volatility

Ellerman, D.A. & Joskow, P.L. (2008). The European Union’s Emissions Trading System in perspective.” Pew Center on Global Climate Change.


Price volatility cont

Price volatility cont.

Graph explanation

  • Market provides one price signal for MCA

  • Dec. 2007 line shows futures contracts scheduled for delivery in Dec. ‘07

  • Dec. 2008 line represents contracts for delivery in Dec. ‘08 for second trading period

  • Sharp price decline after September ‘06 because of restriction on trading between 1st and 2nd periods (*banking and borrowing)

  • Sharp decline in April ‘06 after release of 2005 emissions reporting. Several member states reported lower emissions than expected.

    • Expected aggregate emissions determines actual demand for allowances. When the data was first released, the market adjusted expected price with the actual demand. Because emissions were lower than expected, the price of allowances fell. This effect is strongest after the first release of information.

Ellerman, D.A. & Joskow, P.L. (2008). The European Union’s Emissions Trading System in perspective.” Pew Center on Global Climate Change.


Emissions trading cap and trade

Ellerman, D.A. & Joskow, P.L. (2008). The European Union’s Emissions Trading System in perspective.” Pew Center on Global Climate Change.


Windfall profits

Windfall profits

  • Higher electricity prices and higher corporate profits from free allocation of allowances.

    • The market price reflects the opportunity cost of the allowances

  • Solution: auction allowances

    • This would not impact electricity prices

    • Raises government revenue

Ellerman, D.A. & Joskow, P.L. (2008). The European Union’s Emissions Trading System in perspective.” Pew Center on Global Climate Change.


Overallocation

Overallocation

  • Member states allocated too many permits during the trial period to create a non-binding EU cap

  • Second period EU cap will be about 13 percent lower than the first period cap and 6 percent lower than comparable 2005 emissions

  • Still some abatement during trial period - because short-term incentive to abate from high prices

    • Estimate: between 2 percent and 5 percent of covered emissions abated annually during trial period

Ellerman, D.A. & Joskow, P.L. (2008). The European Union’s Emissions Trading System in perspective.” Pew Center on Global Climate Change.


Emissions trading cap and trade

Ellerman, D.A. & Joskow, P.L. (2008). The European Union’s Emissions Trading System in perspective.” Pew Center on Global Climate Change.


Changes looking forward

Changes Looking Forward

Banking and Borrowing: inter-period banking of permits allowed.

Majority of permits auctioned, instead of freely allocated

Decentralized nature of the system will become more centralized (ie. Monitoring, controlling)

Lower cap

Ellerman, D.A. & Joskow, P.L. (2008). The European Union’s Emissions Trading System in perspective.” Pew Center on Global Climate Change.


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