Archive for June, 2012

Next week the carbon pricing mechanism gets going in Australia, starting at a fixed price of AU$23 per tonne of CO2 in the first year, but later on shifting to a full cap-and-trade (probably around 2015). Early on the system will behave more like a carbon tax, in that the government will make available as many allowances as are required at the fixed price, but the infrastructure for the market based system will begin to appear, i.e. allowances, registries, compliance by surrender of allowances etc. A full description of how the Australian Carbon Unit works (the allowance) can be found here.

Apart from the side issue (although not so for some) as to whether Australia should be acting to reduce emissions, the debate has now shifted to whether or not the selected price of $23 is the right one. Many argue that as the “prevailing global price” of carbon is much lower, then Australia is out of step and therefore undermining its own competitiveness. The call seems to be for a price closer to $10, rather than $23.

The problem with this argument is that there is no prevailing global carbon price. Rather there are pockets of carbon pricing in many different jurisdictions. The largest of course is the EU, where the price is currently €8, low by historical standards. But this is a market responsive mechanism and has traded as high as €30 back in 2008 to €6 very recently. In Australian dollar terms, the high coincided with an exchange rate of $2 per €, so the price briefly touched AU$60. The average cost of compliance for Phase II of the ETS (i.e. 2008-2012), assuming purchasing throughout, has been very close to €17. The average exchange rate over the same period has been about 1.5 $/€, so that cost in Australian dollar terms is $25.50. As little as a year ago the ETS price was €15 at an exchange rate of 1.35, or just over AU$20, but the move down started shortly after that. There is something of an upward trend underway at the moment, perhaps in response to moves by the European Commission to support the market through backloading or a set aside of allowances. A look at the forward prices for EU allowances shows a 2020 contract at about €11-12 per tonne of CO2.

Other jurisdictions show variability as well, but in a different way. Canada does not have a Federal carbon pricing scheme, but provinces are beginning to act. Resource heavy Alberta has had a baseline and credit system up and running for a few years now which imposes a carbon price of CAN$15 per tonne on industrial emitters. British Columbia has had a carbon tax in place for some time, which is currently at CAN$25 per tonne, but rising this year to $30. This is about the same in Australian dollars.

The USA currently has two carbon pricing systems, the cap-and-trade system due to start in California in 2013 and the existing RGGI system in the North East States. California allowances currently trade at around US$16-17 (so about the same in Australian Dollars), but the RGGI price has always been relatively low, trading between $2-$4 since 2008. What is not apparent in the USA is the underlying implied CO2 price that will result from the regulatory approach through the Clean Air Act.

A variety of other carbon prices also exist around the world. The UK is introducing a domestic carbon price floor in the electricity sector, initially at £15.70 per tonne of CO2, or about AU$23.55 (at an exchange rate of 1.5 AU$/£). Norway has had a carbon tax in operation since 1991, with the price varying by sector. The average price is about AU$22 per tonne of CO2. In Sweden it is even higher, with the price around $AU100 per tonne of CO2. Switzerland has had a carbon tax in operation from 2008. The current price is up to CHF 36 per tonne, or about AU$37 per tonne.

Finally, there is the one price that could be argued to be global, which is the price of CERs in the Kyoto Protocol’s Clean Development Mechanism. This is currently very low (€4) due to lack of demand from its one main market, the EU ETS.

The price being imposed in Australia is the decision of the government and has been reached on the basis of some objective that it wants to meet. Whether or not this is “right” in terms of emission reductions remains to be seen, but the argument that Australia is “out of line” with the rest of the world is questionable at best. The rest of the world is all over the place, with carbon prices ranging from just a few dollars to over one hundred Australian dollars. On that basis, the Australian price is probably about “right” in terms of starting the system, giving it some grit and getting everybody going. Full cap-and-trade isn’t far off with allowance auctions due to begin as early as 2014, after which a floating price will prevail.

Very recently I participated in the launch of a new report on the state of the EU Emissions Trading System. The event took place in the House of Commons and featured Secretary of State for Energy and Climate Change, Ed Davey. The report was compiled by UK NGO Sandbag, an organization which focuses on carbon pricing and the role of market based systems in delivering such a price.

 

 The report highlights in stark terms the problems facing the ETS today and calls for even more drastic measures than those currently under consideration by the European Commission.

Sandbag argue:

There remains a serious disconnect between the crisis facing the ETS and the solutions tabled to rescue it. The scheme was intended to deliver a significant shortage of allowances against business-as-usual emissions and thereby oblige ETS installations to pollute less. But the debate has focussed on the surplus allowances sitting above the revised emissions projections rather than restoring the levels of scarcity originally envisaged.

Even those stakeholders who have argued for a return to the intended levels of scarcity have been handicapped by a dearth of analysis and consistently invoked inadequate quantities to achieve their stated aim.

The business-as-usual emissions baseline against which both the EU climate target and the ETS caps were set are totally obsolete. Expectations of Europe’s GDP growth out to 2020 are down by a third since the climate package was agreed. This has left the ETS caps with 2.2 billion tonnes less demand than was anticipated.

We recommend this 2.2Gt in European Union Allowances be removed to restore the original scarcity envisaged for the ETS cap. This will also help restore domestic effort proportional with the level of expected offshore abatement in the offsetting provisions.

We identify a further 900 million excess allowances in the scheme against the original emissions forecasts, resulting from industrial overallocation. A full correction to the cap would require withdrawing 3.1Gt of allowances from the scheme.

 They use the chart below to illustrate the issue.

 

This report is a worthwhile contribution to the current debate over the ETS, but it doesn’t really pinpoint the other lurking issue in the EU. Much of the surplus that has built up in the system can be attributed to the Renewable Energy Directive, which forces a certain renewable energy build rate to meet a 2020 goal. Climate Strategies recently published a report which argued that up to 0.9 billion tonnes of emissions will be removed from the power sector by 2020 as a result. They point out that although the recession has further fueled the issue, the surplus problem would likely have appeared anyway, albeit somewhat later. A further contributing factor would be the impact of the proposed Energy Efficiency Directive (up to another 0.9 billion tonnes). While it may be laudable that these reductions have taken (or will take) place, what is not clear is the cost of doing so. It almost certainly isn’t the lowest cost pathway for the economy.

Carbon price driven reductions are entirely cost transparent and we can know simply by looking at the carbon price over time what it has cost society to reach a certain emissions reduction goal. But today the CO2 market is effectively at zero (in my view the €7 price does not reflect any current abatement opportunity, rather it is simply the price that the market is putting on allowances on the understanding that some emitters are buying them and sitting on them for much longer term), which means we have no idea about the cost of reaching the 2020 reduction target. That cost is now hidden in the capital investment required to develop renewable energy, but of course reappears buried in the overall cost of our electricity in the years to come.  

 

The plight of CCS in the EU

This week I attended the quarterly review meeting of the European Technology Platform for Zero Emission Fossil Fuel Power Plants (ZEP), a coalition of stakeholders united in their support for CO2 Capture and Storage (CCS) as a key technology for combating climate change. ZEP serves as advisor to the European Commission on the research, demonstration and deployment of CCS. Many topics related to CCS and the underpinning technology set are discussed at the quarterly meetings, as well as various overview presentations to look at the current status of deployment. It is this latter aspect that is in trouble.

Over the last five years the EU has put great effort into promoting CCS. The Commission has led this, creating a legislative framework for the technology to exist in the field, agreeing on the need for a 10-12 project demonstration programme, supporting that programme with funding mechanisms and of course institutionalizing a carbon price within the industrial economy to act as the principal driver for implementation and longer term deployment.

With such an effort and so much political capital spent, one would expect to see a burgeoning CCS industry, or at least the beginnings of it, appearing across the EU. Unfortunately this is not the case. With the possible exception of the UK, it could be that by 2020 there will not be a single large scale CCS project operating across the 27 member states. This was certainly not the plan.

Looking forward, CCS is clearly going to be required in the EU. The region continues to burn it’s considerable coal and gas resources for power generation and more recently, with the exception of France and the UK, there has been some trepidation with regards further deployment of nuclear for power generation. Renewable energy use may be growing and there have been some remarkable, albeit brief, instances of near 100% power generation from renewables in some parts of the EU, but overall renewable energy growth remains modest (see below).

The first barrier to CCS implementation is a simple political one. Progress on member state transposition of the EU CCS Directive remains stubbornly slow with some member states seemingly less enthusiastic than they first appeared. In particular and despite a wealth of R&D activity and small pilot projects, German interest with regards CCS implementation now appears very low, despite its significant coal capacity. Rather, the focus is on renewable energy. Of the 27 countries required to transpose the directive, only 9 countries are acting. However, these do at least make up the key locations for potential demonstration projects.

The next barrier is a tough one. Public acceptance of on-shore storage has weakened considerably. This has always been a concern, but more recently this concern has resulted in the termination of projects. A Shell project in the Netherlands is one example. The alternative is off-shore storage such as the Sleipner project in Norway, but the cost of this for on-shore produced CO2 is higher.

But the real problem rests with the economics of CCS. In the middle of 2008 the picture looked relatively robust.

  • The ETS CO2 price was in the high €20’s and even broke through the €30 barrier.
  • The Energy and Climate package making its way through the EU Parliament included a provision to set aside allowances as a funding mechanism for the demonstration programme (now called NER300 – short for 300 million allowances from the ETS New Entrant Reserve). The Directive describes the support mechanism as follows and the Commission has established a website to allow bidders and other interested parties to follow the process:

Up to 300 million allowances in the new entrants’ reserve shall be available until 31 December 2015 to help stimulate the construction and operation of up to 12 commercial demonstration projects that aim at the environmentally safe capture and geological storage (CCS) of CO2 as well as demonstration projects of innovative renewable energy technologies, in the territory of the Union.
The allowances shall be made available for support for demonstration projects that provide for the development, in geographically balanced locations, of a wide range of CCS and innovative renewable energy technologies that are not yet commercially viable. Their award shall be dependent upon the verified avoidance of CO2 emissions.
Projects shall be selected on the basis of objective and transparent criteria that include requirements for knowledge-sharing. Those criteria and the measures shall be adopted in accordance with the regulatory procedure with scrutiny referred to in Article 23(3), and shall be made available to the public.
Allowances shall be set aside for the projects that meet the criteria referred to in the third subparagraph. Support for these projects shall be given via Member States and shall be complementary to substantial co-financing by the operator of the installation. They could also be co-financed by the Member State concerned, as well as by other instruments. No project shall receive support via the mechanism under this paragraph that exceeds 15 % of the total number of allowances available for this purpose. These allowances shall be taken into account under paragraph 7.

The mechanism, in combination with a robust underlying carbon price, meant that a viable demonstration programme could emerge. The 300 million allowances could conceivably generate €9 billion in funds, which meant up to €1.35 billion for some projects (i.e. the 15% limit). With potential Member State co-funding adding additional support, a 500 MW end-to-end CCS power station was even feasible and some of the projects originally submitted to the Commission for consideration were on this scale.

But the collapse of the CO2 price in the EU throws a huge question mark over the viability of the programme. So far the European Investment Bank (charged with monetizing the 300 million allowances) have sold over a 100 million allowances at a price of around €8.10 each. That’s a good effort in the current market, but it substantially changes the economics of a project. Now the maximum grant that any given project can collect is €360 million and it will be operating in a €6 CO2 market. Even with matching funds from the relevant member state, now much more challenging due to EU financial circumstances, a large scale project looks very unlikely. Large scale early CCS projects require a CO2 price in the range €60-100, not €20-25 (assuming €6 ETS price, maximum NER 300 financing and some member state co-financing).

The selection process for projects will proceed over the balance of this year with an announcement expected in December, but at least for the CCS part of the NER300 (innovative renewable energy projects are also supported) one wonders how this will pan out.

An exception to all this is the UK, which has taken matters into its own hands and which I have written quite a bit about in the past. A new UK CCS competition has been announced with £1 billion in funding and the UK is implementing a CO2 floor price for facilities operating under the EU ETS. In addition a clean energy CfD (Contract for Differences) construction will provide further support. A single viable CCS project (at least) should emerge from this approach.

Back in the rest of the EU, organizations like ZEP are stepping up their advocacy for a revised package of EU measures to ensure that at least some part of the demonstration programme is delivered. Without it, there will be real problems commercializing and gaining experience with CCS in the limited time available before much wider deployment is actually needed. The ZEP proposals should be available for a posting in the next week or so.

There has been considerable discussion over recent months as to what action needs to be taken both in the short and long term to ensure that the EU ETS continues to provide the necessary investment signal for major investments such as carbon capture and storage. The current price of €6.50 isn’t going to drive any change at all. I have discussed short term action in recent postings and the Commission now seems to be coming around to the idea of at least re-phasing upcoming auctions so as to “backload” the available allowances to the later part of this decade.

But the longer term also needs some thought. The UK has already acted in this regard and introduced its own floor price, although such unilateral local action in an EU wide system is problematic. But the idea here may be right. A floor price, even if not pitched particularly high, shifts the carbon pricing risk on a project at least to some extent. This is what lies behind the UK approach with the proposed £17 carbon price CFD (contract for difference).

Not all economists see this the same way though. In an opinion piece in the UK Daily Telegraph today, Tim Worstall, a Senior Fellow at the Adam Smith Institute in London, argues against the need for such a mechanism.

We’ve also an inspired misunderstanding about carbon prices. The EU has a cap and trade system: if you want to emit a tonne of CO2, you’ll need a permit to do so. Many of these are given to industry but some have to be bought. Our Ed Davey – you know, the man in charge of this whole climate change thing – has recently announced that there must be a minimum price for such permits. Showing, sadly, that he doesn’t understand the first thing about such a permit system. In the carbon tax that I recommend, yes, it is the tax which limits the emissions. In a permit system it is the number of permits: the price of the permits shows how expensive or cheap it is to meet the target. Thus we should all want to have very low permit prices, for that shows us that it is very cheap to meet that target. At which point the minister in charge says no, my goodness no, we can’t have it being cheap to save Gaia – we’ll have to artificially raise the price! I’m sure you’ll agree that this is just drivelling absurdity.

On the other hand, there is a body of literature that suggests there are good reasons to combine certain features of both price-based and quantity-based instruments, to create so-called hybrid policies (Fankhauser and Hepburn 2010, Fankhauser et al., 2010, Roberts and Spence 1976, Pizer 2002, Jacoby and Ellerman 2004, Hepburn et. al 2006, Grubb and Newbery 2008, Grubb 2009).  Hybrid instruments offer the potential for providing greater certainty regarding prices and investment signals, while maintaining the advantages of a trading scheme (Grubb 2012).

One approach is to introduce an auction reserve price which ensures that no allowances are released onto the market if the reserve auction price is not met.  This requires a sufficient proportion of allowances to be auctioned, instead of being allocated free of charge and auctions to be held periodically throughout the commitment period. It is too late to do this for Phase III of the EU ETS (2013-2020) but it could be introduced as part of the expected legislative process to set the parameters for Phase IV (2021 and beyond, probably extending to 2030). Such a reserve would also impact Phase III as buying allowances now and banking them to 2021 would offer an alternative to paying the reserve price at that time.

Summarizing the various pieces of literature on the subject of price floors (or an auction reserve price);

  • A price floor gives investors in low-emission assets greater certainty about the minimum return to their investments—it effectively provides insurance against low carbon prices, analogous to the insurance function of a price ceiling against cost blow-outs to owners of existing high-emissions assets (Wood and Jozto, 2011).
  • A very low carbon price could seriously undermine the credibility of emissions trading and undermine the EU’s attempts to forge a platform of leadership in the post-Durban negotiations. Moreover, the historical pattern of ‘boom and bust’ points to the inherently volatile characteristic of emissions trading systems to date, and the potential benefits of building in a more robust design. There are various options that could be considered. Amongst these, reserve price auctions merit particular attention (Grubb 2009).
  • An auction reserve price would imply that there is no strict price floor, because although there would be a minimum price that firms would pay at auctions, the market price could fall below the reserve price. An advantage of having a reserve price is that independent of its function as a price floor, it is an auction design feature that can protect sellers and in some cases buyers from unexpected outcomes in the auction (Hepburn et al., 2006).
  • Project investment and finance is hindered by the risk of low carbon prices. A reserve price in auctions addresses this risk (Neuhoff 2008). 
  • There are interesting hybrid schemes, such as auction releases with a commitment to a floor and ceiling price that could evolve in response to success in reducing GHG emissions or otherwise in limiting the cumulative emissions available through the scheme (Grubb and Newbery 2008).
  • Under a pure cap-and-trade approach, innovation will only increase abatement if the regulator adjusts emissions targets in response to a lower, or lower than expected, carbon price. A price floor by contrast provides a mechanism for additional emission reductions to be achieved automatically (Wood and Jotzo).
  • Irrespective of the initial level set, establishing a rising floor price through a European Reserve Price for Auctions would give confidence for investors regarding a minimum allowance price in the EU ETS. It would remove large perceived downside risks, support low-carbon investment decisions, and reduce the cost of capital, which could result in substantial economic savings (Grubb, 2012).
  • Investment certainty would be improved by price floors. Investments such as power plants, buildings, and infrastructure involve long-term time horizons. Uncertainty about the future carbon price increases costs for both investors in mitigation and investors in polluting technology. Policy design that reduces cost uncertainty can therefore limit the overall effective cost of achieving a mitigation outcome and is more likely to attract political support from business constituencies (Wood and Jozto 2010).
  • A recent blog posting by Prof. Robert Stavins states that if complementary policies exist alongside an ETS then there will be interaction and if the objective of the ETS is to provide a signal for low emission investment then the concept of a price floor may be required.

Price floors (through an auction reserve price) in an emissions trading system can reduce excessive price volatility and provide better management of cost uncertainty in the event of lower than expected abatement costs, which in turn improves predictability of returns and increases expected returns for low-emissions investments.  All in all, price floors could fulfill an important supporting role in ensuring effective and efficient climate change mitigation. They can be implemented without compromising vital aspects of emissions trading and their budgetary properties might be attractive to governments (Wood and Jozto 2011). The core benefit of hybrid systems is that they provide policy makers with greater control over the supply curve of emissions allowances. Like all markets, the market for emission reductions has a demand curve, determined by the marginal abatement costs of regulated entities and a supply curve, which is determined by policy (Fankhauser and Hepburn, 2010).

For those interested, the complete reference list is as follows:

Fankhauser, S. and Hepburn, C. (2010). Designing carbon markets. Part I: Carbon markets in time.  Energy Policy 38 (2010) 4363–4370

Fankhauser S., Hepburn, C., and Park, J. (2010). Combining multiple climate policy instruments: how not to do it. Climate Change Economics 1 (33), pp. 209-225. ISSN 2010-0078

Grubb, M. (2009). Reinforcing carbon markets under uncertainty: the role of reserve price auctions and other options. Climate Strategies Briefing Paper (www.climatestrategies.org).

Grubb, M. (2012). Strengthening the EU ETS. Creating a stable platform for EU energy sector investment. Climate Strategies Full Report (www.climatestrategies.org).

Grubb M. and D. Newbery (2008), ‘Pricing carbon for electricity generation’, in Grubb, Jamasb and Pollitt(eds), Delivering a low-carbon electricity system: technology, economics and policy, CUP, 2008.

Helm, D., Hepburn, C. and Mash, R. 2003. Credible carbon policy. Oxford Review of Economic Policy, 19:3, 438‐50.

Hepburn, C. 2006. Regulation by prices, quantities or both: a review of instrument choice. Oxford Review of Economic Policy, 22:2, forthcoming.

Hepburn, Cameron, Grubb, Michael, Neuhoff, Karsten, Matthes, Felix and Tse, Maximilien (2006) Auctioning of EU ETS Phase II Allowances: How and Why? Climate Policy, 6, 137-160.

Jacoby, H. D. and Ellerman, A. D. (2004). The safety valve and climate policy. Energy Policy, 32(4):481-491.

Neuhoff, K. (2011). Carbon Pricing for Low-Carbon Investment.  CPI and Climate Strategies

Neuhoff, K. (2008). Tackling Carbon: How to Price Carbon for Climate Policy. Climate Strategies Report.

Pizer, William A. 2002. Combining Price and Quantity Controls to Mitigate Global Climate Change. Journal of Public Economics 85(3): 409–434.

Roberts, M. and Spence, M. (1976). Effluent charges and licenses under uncertainty.

Journal of Public Economic, 5(3):193-208.

Stavins, R.(2012) Low Prices a Problem? Making Sense of Misleading Talk about Cap-and-Trade in Europe and the USA.  (http://www.robertstavinsblog.org/2012/)

Weitzman, M. L. (1974). Prices vs. quantities. Review of Economic Studies, 41(4):683-691.

Wood, P.J. and Jozto, F. (2011). Price floors for emissions trading, Energy Policy 39 (2011) 1746–1753

UK Government, Department of Trade and Industry (2006).  The Energy Challenge, Energy Review Report 2006. Page 157.

Thanks to my colleague Helen Bray for the research work behind this.