Allocation of CO2 Emission Allowances

1. The Cambridge-MIT Institute Allocation of CO2 Emission Allowances Carnegie Mellon University October 2004 Karsten Neuhoff University of Cambridge 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. 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 failed • Lacks sanctions: free riding in sector • BUT good to delay state intervention Instrument I: Industry self regulation Example Germany Source: Kontraste.de, Axel Friedrich Umweltbundesamt

5. Development of Energy intensity from 1971 to 2000 Austria Belgium 0,5 France Germany 0,4 JPN UK USA 0,3 Mtoe/mld USD 0,2 0,1 0 1970 1980 1990 2000 Oil price spike in 1970’s increased energy efficiency far more than climate debate of 1990’s. Source: Miroslav Honzík, GDP is translated using PPP, Prices of 95

6. Instrument 2 … prices The economy can change energy intensity Inertia? Cross-section relation between average energy intensity and average energy price 1993-99 1400 DEN 1200 JPN NOR 1000 AUT ITA 800 average energy price $/toe LUX SUI SWE 600 FIN UK NZ HUN BEL USA TUR 400 KOR MEX SVK CZE CAN POL 200 Best fit constant price elaticity of -1.0 (S.E. 0.14), R2 = 0.69 (Excl CEE) 0 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) Source: Nebwery 2003

7. Instruments CO2 price … increasing energy costs $/tCO2 Energy efficiency measures Allowance price t

8. 169 157 180 160 134 136 140 119 126 120 49 67 82 85 91 94 97 98 110 120 100 taxation rate (cents/gallon) 80 60 40 20 0 US UK Italy Spain Ireland Poland Austria France Greece Finland Sweden Belgium Denmark Germany Netherlands Luxembourg Implied CO2 price varies widely between sectors and countries Example: Diesel 2010 Min. 2003 Min. 1993 Min. 18 c/gln = CO2 Price E20/tonne Source: EU Commission (Stand 2002/Deutschland 2003); American Petroleum Institute 2004, Energy Information Administration, 2004

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. Renewables without technology support for initial deployment Instrument CO2 price … changing relative costs $/tCO2 Allowance price Renewables t CO2 pricing is unlikely to unlock new renewable technologies. But reduces costs of strategic deployment programs.

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. EU MS 1... …DE... ...EU MS n Residential ET Sector Transport Sector 1 Sector X Sector n Reserve Install. 1... …Install. X... …Install. n The ETS System: A Four Level Approach 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. Empirical - Impact of CO2 allowances

19. Comparing marginal costs of coal and gas-fired plant

20. Net cashflow impact with auctioned emission rights All figures in £/kWyr Pulverised coal plant Gas - fired CCGT plant 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 13.8 31.9 18.1 13.5 35.9 22.4 margin (5) Net purchases of CO2 0.0 33.1 33.1 0.0 17.5 17.5 allowances (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

22. UK - change of SO2 emission with regulation

23. UK - cost of implementing Carbon Constraint - Static 1385 1840

24. Impact of updating I

25. One time updating Assume one time updating - pt+1 const A’ = 0 … only price increase A’->inf … only emission increase A’ positive … both price and emission increase

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

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 1385 1840

29. Dmin Dmax (assume Dmax-Dmin=1) Allocation of Allowances to new entrants pmax cm,2 K1 K2 cf,1 cf,2 Fixed costs:

30. pt=ct Impact of the amount of free allocation

31. dK2 /dμ>0 -> dK1/dμ>0 if Government strict on quota 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 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.