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.