Thomas-Olivier Léautier ([email protected])[email protected] with Claude Crampes...

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Thomas-Olivier Léautier ( [email protected] ) with Claude Crampes ( [email protected] ) Limiting Green House Gas emissions: an economist’s perspective Les Houches, February 2014

Transcript of Thomas-Olivier Léautier ([email protected])[email protected] with Claude Crampes...

Thomas-Olivier Léautier ([email protected])with Claude Crampes ([email protected])

Limiting Green House Gas emissions: an economist’s

perspective

Les Houches, February 2014

2

Outline

1. Clean Energy Policy for Europe

2. Basic microeconomics for externalities

3. The European Emission Trading System

4. Microeconomics for cap-and-trade

EU Green-House Gas emissions towards an 80% domestic reduction (100% =1990)

Source: European Commission, “A Roadmap for moving to a competitive low carbon economyin 2050”, March 2011

0%

20%

40%

60%

80%

100%

1990 2000 2010 2020 2030 2040 2050

0%

20%

40%

60%

80%

100%

Current policy

Power Sector

Residential & Tertiary

Non CO2 Other Sectors

Industry

Transport

Non CO2 Agriculture

3

quantity

0

price

q market

Demand

Supply

Equilibrium

2. Basic microeconomics for externalities

p market

4

GHG emissions as a negative externality

Negative externality associated with GHG emissions: ● emitters do not face the full social costs of emissions,

including their impact on the environment (global warming).

Without intervention, the market would emit excessive pollutantsSource: IPCC (2007) 5

qmarketquantity0

price

demand

supply=

private marginal cost

social marginal cost

qoptimum

cost of the negative externality

equilibrium

optimum

Negative externality and market failure

6

A series of complex issues

● Physics (climate science): ● What is the impact of temperature increase?

● Engineering● What technical progress can be expected?

● Economics: ● What is the cost of temperature increase?● What is the cost of decarbonization?

● What weight for future generations versus current ones?● How to split the burden between developed and developing countries? between industries?

● How to limit opportunistic behavior?

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Controlling GHG emissions: what is the right method?

• Overall objective: minimizing the cost of reducing carbon emissions o Set of policies that directly address the market failures

associated with climate change, and only intervene where market failures are present

o Technology- and sector-neutral approach to carbon abatement: carbon reduction in sectors which have the lowest cost of reducing emissions

• Potential policies

o Direct regulation: Command & Control, prohibition, quotas, standards…

o Incentive regulation: carbon pricing (cap-and-trade, carbon taxes), subsidies and R&D incentives

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qmarketquantity0

price

demand

supply=

private marginal cost

social marginal cost

qoptimum

equilibrium

optimum

How to create a carbon price? i) tax

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carbon tax

modified private marginal cost

How to create a carbon price? ii) tradable permits

quantity0

price

demand

qconstrained

volume cap

Optimum

price of the good

price of the permit

supply=

private marginal cost

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social marginal cost

Market vs. tax

• Principle of responsibility: the polluter must pay (article 174-2 of the Treaty); Is the producer or the consumer the true polluter? Is cost pass-through acceptable?

• Carbon tax : Who is in charge? How is it calculated? Who receives the cash? What to do with revenues?

• Tradable permits : Who decides? How many allowances? If given for free, to whom? If sold, who benefits from sale?

• Theory (Weitzman, 1974): quantity control is more efficient than price control when supply is more inelastic than demand

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Price vs. quantity regulation

quantity0

price

Average demand

q*12

social marginal cost

Net Surplus

p*

Welfare loss under quantity regulation

quantity0

price

Average demand

q*13

social marginal cost

p*

Realized demand

Surplus loss under quantity regulation

q**

Welfare loss under price regulation

quantity0

price

Average demand

q*14

social marginal cost

p*

Realized demand

Welfare loss under price regulation

q**

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• Political economy: potential for regulatory capture produces first-order effects

• Concerning CO2 emissions, Directive 2003/87/CE has set the framework: the EU-ETS, a cap-and-trade system

Price vs. quantity regulation 2

3. The European Emission Trading System

• Directive EU ETS (European Emission Trading Scheme) in 2003 before the commitment from the Kyoto protocol.

• Three compliance phases• Now 28+3 heterogeneous States participate

2008 2012

1 Jan. :ETS Phase I

1 Jan. : ETS Phase II

2005 2007

1 Jan. : beginning of first Kyoto protocol period

Feb. : Kyoto protocol comes into force

2020

1 Jan. : ETS Phase III

Dec. : end of first Kyoto protocol period.

3x20 European Objectives

2013

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Cap-and-trade principles

● Binding cap is set on emissions during a given period● Emission permits are allocated to polluters:

o auction or free allocation based on grandfathering or benchmarkingwww.eex.com/en/Market%20Data/Trading%20Data/Emission%20Rights/EU%20Emission%20Allowances%20%7C%20Spot

● Emission permits can be traded (wholesale or, mainly, OTC):

o Regardless of the initial allocation (if no transaction costs), trading allows for an optimal distribution of abatement efforts across sectors and countries (Coase principle)

o The initial allocation of permits only has a wealth effecto If the allocation is auctioned, second hand market is just for efficient adjustment

● Polluters not allowed to emit more than initial allocation + permits bought on the market; otherwise, they pay a penalty.

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European Environmental Policy: 2013-2020

The ETS Directive (2009/29/EC): ● From 2013 onwards (Phase III), emission allowances in

the ETS will be reduced by 21% below their 2005 levels by 2020

● Full auctioning for the power sector, and a gradual phasing out of free allowances for other sectors

● The ETS is also set to be expanded from 2013, to also include the aviation sector. But …

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Allocations by sector

1919

Allocations by country

2020

Total allowances

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BankingEmissions permits can be used in periods subsequent to the one in which they were allocated. Inter or intra-phase?

– in Phase I, only intra-phase– now also interphase (Phase II => Phase III)

BorrowingAllows regulated emitters to use part of their future allocations to cover their present emissions– de facto allowed intra-phase (February 28 => April 30)

Credits offset:- Clean Development Mechanism- Joint Implementation

Flexibility

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Low carbon price

23

juin-05

oct.-05

févr.-06

juin-06

oct.-06

févr.-07

juin-07

oct.-07

févr.-08

juin-08

oct.-08

févr.-09

juin-09

oct.-09

févr.-10

juin-10

oct.-10

févr.-11

juin-11

oct.-11

févr.-12

juin-12

oct.-12

févr.-13

juin-13

oct.-13

0

4

8

12

16

20

24

28

Prix spot 2005-2007 Prix spot (depuis 2008)

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4. Microeconomics for cap-and-trade

,max ( ) ( )

: input = gross emissions, unit price

(.) : output ' 0, '' 0, unit price

: abatement effort

(.) : abatement cost , ' 0 , " 0

: residual polluting emissions

x ypQ x wx g y

x w

Q Q Q p

y

g g g

e x y

' 1FOC: '( ) demand for input ( , ) ( ) and 0def w

pQ x w X w p Q yp

Assume the emissions without constraint ( , ) ,

where is the social optimum level.

oe X w p e

e

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Permits

• The authority limits to the emissions allowed (cap)

and open a permits exchange (trade)

e

0 demand ( 0 supply) of allowances

unit price of allowancesa a

a

q q

p

• , ,

max ( ) ( ) . . ( )a

a a ax y q

pQ x wx g y q p s c x y e q

• FOC: '( ) 0x pQ x w

: '( ) 0 ( 0 if 0)y g y y

: 0a aq p

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Trading

When 0, we have 0. Then 0a ap q x y e is the demand for rights derived from the firm’s optimal production.

2

Assume first that '(0) ; then 0. From the two other FOC,

we obtain the gross demand for emitting COag p y

( , , ) ( , , ) 0a a aq w p p X w p p e

The firm is a net demander of allowances if is small,

a net supplier otherwise.ap

' 1'( ) 0 ( , , ) ( ).def

aa a

w ppQ x w p X w p p Q

p

abatement effort and market of allowances

Assume now '(0) ; the firm fixes so that '( ) .a ag p y g y p ' 1Let ( ) ( ); it is increasing in since '' 0.

def

a a aY p g p p g

We then have

ap

traded permits

effort quota

e ,e x

( , , )a aq w p p

( , , )aX w p p

where ( ) 0 for 0,a a aY p p p

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( ,0, )aq w p

Equilibrium

*The market equilibrium is reached at such thatap

( , , ) ( ) i a i a ii i i

X w p p Y p e

For two « price-takers »

ap

*ap

1 2,a aq q

At equilibrium, 2 is a seller and 1 is a buyer.

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comparative statics

1

- the initial total endowment ,

not the allocation ( ,..., ) : R. Coasen

e

e e

- the shape of the functions of abatment cost (.)g

- input(s) price(s) : coal, natural gas, fuel, etc.w

The market equilibrium varies with

- product(s) price(s) : electricity, aluminium, steel, etc.p

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Paying for allowances

* The marginal conditions remain the same as et are exogeneous.s e

* Risk of foreclosure if the global "tax" is too high.s e

*Assume that firms have to pay for each ton initially alloweds

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Auctionning allowances

• Under the first Directive, only four countries have used the possibility to sell (at most 5 %) allowances : Denmark (5 %), Hungary (2.5 %), Lithuania (1.5 %) and Ireland (0.75 %).

• Under the 2009 Directive, it is 100% mandatory for the electricity producers from 2013 on. Partial obligation in the other industries.

• Then, to produce output q, a firm can now obtain permits from

free allowances, (cost 0)eauctionned permits, (unit cost )a s

abatement effort, (total cost ( ))y g y

traded permits, (unit cost )a aq p31

Conclusions

• For the EU authorities, it takes (at least) three tools to reach objective:

― one for cleaning (Directive 2009/29/EC: mandatory ETS),― one for greening (Directive 2009/28/EC: optional green

certificates, or FIT, or green potfolio, or …),― one for saving (Directive 2012/27/EU: optional white

certificates, or energy efficiency, or load-shedding, or demand response, or …).

• Actually:― as the objective is to cut GHG emissions, one tool is

sufficient― combining several tools produces negative side-effects.

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An economist perspective

Cap and trade for CO2 is a right answer becauseo it fixes a negative externality;o it sends a scarcity signal;o it allows firms to adjust volumes;o it (now) generates public revenues.

Independent quantitative targets for energy saving and renewables are wrong answers becauseo they are viewed as genuine objectives instead of mere means;o they increase the cost of reaching the CO2 target;o they require large amounts of red tape and (distortive) State

aids.

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Appendix

EU-ETS timeline

30 March 30 April

beginning of year N

Installations submit their verified emissions for year N-1 to the national authority.

28 Feb.

Year N allocation on installations accounts in their national registry.

31 déc.

end of year N

Installations surrender the allowances covering their N-1 emissions in the national authority.

1st Jan. 15 May

double allocation period

Publication of year N-1 emissions by the EC

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• •

w

w

,x e ,x e

'( )pQ x '( )pQ xw

w

'( ) apQ x p '( ) apQ x p

• • • •

( , , )aX w p p oee

oe( , , )aX w p p

eap

( , , ) 0a aq w p p ( , , ) 0a aq w p p net supply net demand

,aq x

net demand

net supply

( ,0, )aq w p ( ,0, )X w p

ˆap

( , , )a aq w p p ( , , )aX w p p

e

( , , ) ( , , )a a a

a a

q w p p X w p p

p p

ˆ( , , )aX w p p e

ˆ : switching thresholdap

ap

ap

Timeline

Firms will be active on both the initial sale and on the permits exchange only if there is some randomness (on p and/or w)

,,

max max ( ) . .a

p w a a aa x q

E u sa pQ x wx p q s c x e a q

e

auction a

p and w certain trading (choice of )

time

quota checking

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* Ex post, knowing p and w we have that

'' ( )

and ( ) 0ai i i i

i ai i i ai i a

q x e apQ q e a w p

pQ x w p

' 1* Individual net demands , aai i i i

w pq Q e a

p

, , and the net demands , , . a i i ai i ii i

p e a w p q e a w p

* Remark : If most firms are net suppliers ( ) [for example because is larger than expected] there is no 0 suc the equilibrium prih ce that is 0 : nil.

i i i

a

aii

x e aw p

q

are agregated for all to give the price on the permit exchangei

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,

* We still have to determine how much to buy in the initial auction

max (.) (.) (.) (.)i

p w i i i ai i i ai i i a aia

E u sa pQ q e a w q e a p q

,max (.) (.) (.)i

p w i i ai i i i a ai ia

E u pQ q e a s w a p w q we

* The FOC is

' ', (.) (.) 1 ( ) ( (.) ) 0ai ai

w p i i ai i

q qE u pQ s w p w

a a

(with 0)a

i

p

a

39

or

40

* Equilibrium is given by ( ) supply.ii

a s

',* Since 1, we get (.) (.) 0ai

w p i ai

qE u p s

a

to determine the initial demand for permits ( ).ia s

• Remark 1:

Then• if risk neutral, i buys on the initial auction only if

• if risk averse, we have

meaning that i is ready to pay a risk premium.

',

',

(.) (.)

(.)w p i a

w p i

E u ps

E u

, (.)w p as E p'

,,'

,

(.) (.)(.)

(.)w p i a

w p aw p i

E u ps E p

E u

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* Remark 2:• If the initial auction of permits is not followed by trading possibilities, it

is a private value auction : each firm bids a price only based on its own characteristics.

• Opening an ex post exchange for permits transforms the auction into a common value auction : the total number of allowances and the technical characteristics of all obliged firms.

' depends on that depends oni aiQ q

Dynamic opportunism

• During the first round (2005-2007), the EC has announced that future quotas would not be based on the observed performances of the current round, to reduce opportunism.

• Actually, “it is useful to learn from the most recent data”,

• Finally, the expected individual emissions for 2008-2012 have been based on declared emissions of 2005 multiplied by an expected growth rate until 2010.

• What is the risk?42

Grandfathering: internalizing the review rules

( , )

0

max ( )a

T

a ax q

p Q x w x p q

s.t. 0,..., .ax e q T

gives FOC1 21 2 1 1

1 1

0 ( ' ( ) ) ...a

de de d x depQ x w p

dx dx de dx

With just a one-period effect' 1( ) a a

depQ x w p w p

dx

''1As 0 and ( ) 0, the firm chooses a larger

de

Q x xdx

1which means larger emissions than if is fully exogeneous. e

Not the case when allowances are auctioned.

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