Category: Carbon price

A link up between Australia and the EU

September 3, 2012

As Australia struggled through the ill fated CPRS legislation and finally landed with its carbon pricing mechanism, I often thought that it would be much simpler if they just joined the EU ETS. Governments don’t tend to do simple practical things like that, perhaps it makes them feel they are giving away some portion of national sovereignty or that they aren’t doing the job they were elected for (i.e. “we must invent it here” syndrome). But despite all this and having gone the very long way around to get there, Australia has, in effect now joined the EU ETS (or perhaps the ETS has joined the Australian trading system).

Last week the Australian Government and the European Commission announced that their respective emission trading systems would link up progressively over Phase III of the EU system, but for Australian entities from the start of full carbon allowance trading in 2015. This is a bold move by both parties and quite possibly one that will make others with nascent trading systems sit up and think about where they want to go. For Australia, provided the changes can be implemented by a parliament that isn’t exactly friendly towards carbon pricing (but a wafer thin majority currently is), the move cements the system into place even further, in that undoing it would likely cause some embarrassment on the international stage. For the EU, it puts the ETS back in the frame and maybe introduces some additional demand at a time of allowance oversupply, depressed prices and a consequent lack of confidence in the system. Let’s hope this move helps both sides to deliver confidence and stability in their respective systems.

A full two-way link between the two cap and trade systems will start no later than 1 July 2018. Under this arrangement businesses will be able to use carbon units from the Australian emissions trading scheme or the EU Emissions Trading System (EU ETS) for compliance under either system. To facilitate linking, the Australian government will make two changes to the design of the Australian carbon price:

  • The price floor will not be implemented;
  • A new sub-limit will apply to the use of eligible Kyoto units. While liable entities in Australia will still be able to meet up to 50% of their liabilities through purchasing eligible international units, only 12.5% of their liabilities will be able to be met by Kyoto units.

In recognition of these changes and while formal negotiations proceed towards a full two-way link, an interim link will be established enabling Australian businesses to use EU allowances to help meet liabilities under the Australian emissions trading scheme from 1 July 2015 until the full link is established.

Various Australian, EU and other websites cover all the details, so I won’t repeat them here. Rather, let me spend some time on a key issue that this move raises, namely the future design of any international framework via the UNFCCC (or other process). Both Australia and the EU have stressed that this is a bilateral linkage, to the extent that the allowance transactions will not be processed through the International Transaction Log (ITL), but CER transactions will be. However, there will still be a Kyoto AAU balancing at various times to ensure compliance in that system (although there remains considerable uncertainty with regards the issuance of Kyoto Second Period AAUs as there has been no firm agreement on the full nature of that period).

Despite this apparent distancing from the Kyoto based ITL, it must still be the case that the overarching Kyoto framework has helped this linkage – I might even go a step further here and say “allowed this linkage to happen”. Thanks to the UNFCCC architecture, these two systems grew up with enough harmony to make a linkage possible.  They “count” the same way, “track” the same way and “comply” the same way.  Both the systems have common offset arrangements through CERs under the Kyoto Clean Development Mechanism and the units created under the Australian Carbon Farming Initiative are also Kyoto compliant. This means we have the makings of a linked system with global reach.

This could be the primary goal of a new international framework, i.e. to provide sufficient tools, rules and mechanisms which countries can use in developing their carbon trading systems, thus facilitating linkage at a convenient time for those interested in doing so. Such a linkage framework could deliver the global market that we need, as shown in my illustration below (which by the way has been around for about 5-6 years now, so for me it is great to see that one of my linkage lines has finally been filled in!!).

The opportunity to devise such a framework now exists under the Durban Platform for Enhanced Action, which aims to see a new international agreement in place by 2015, for commencement not later than 2020. The agreement between Australia and the EU should be seen as a catalyst for the thinking behind what is to come.

Finally, as something of an aside, one of the major complaints by Australian companies has been that the current $23 fixed price and the future market floor price put the Australian price of carbon “out of line with the international price”. I challenged this notion in a recent post, but irrespective those who called for such alignment have pretty much got what they wanted, although obviously not in the very short term. There may be eventual irony in this, should the EU system go through something of a recovery in its fortunes. While every indicator today points to a continued depressed price through to Phase IV, stranger things have happened in commodity markets.

P.S. I still think that the simplest approach for Canada, which has been putting off economy wide carbon pricing legislation for years, would be to join the EU ETS.

Encouraging CCS in Europe

August 3, 2012

In a recent post I discussed the problems that the EU flagship programme to demonstrate CCS (carbon capture and storage) is having. With an allowance surplus building up in the ETS and a resulting low carbon price, the urgent need for commercial deployment of CCS has diminished. Furthermore, with natural gas availability growing and renewable energy becoming a sizable factor in the EU electricity mix, it may be well into the 2020s before large scale deployment of CCS is actually needed.

These developments might instill a false sense of security, in that we imagine there is no need to do anything now with regards large scale CCS commercialization. While it is clear that there is no immediate need for rapid rollout, every low carbon energy scenario still shows CCS as an essential component of energy delivery. In a posting late last year, I argued that global emissions are unlikely to be reduced at all without CCS.

Even with widespread deployment starting as late as 2030, action in this decade is still important. Early demonstration and commercialization of new technologies can be a long process. Take for example Shell’s own experience with Gas to Liquids technology. A very large scale plant is now operating successfully in Qatar, but the advanced catalysts used in the process started development in the 1980s and the small commercial scale demonstration plant in Malaysia was an early 1990s development. A final investment decision for the first full commercial deployment was made in 2006 and even then construction and startup took five years. A 10-20 year timeline for first commercial deployment is not unusual, which is one of the reasons why it takes 25+ years for new energy technologies to become globally material (>1% of the energy mix). I discussed this in a post back in late 2009.

All this still points to the need for some CCS activity in Europe this decade and for project development to proceed next decade for startup around 2030 (at the very latest). It may also be the case that a need for deeper cuts in emissions brings CCS forward.

The question of how to promote CCS activity today, in the midst of difficult economic times and carbon markets that are clearly not calling for it, is discussed in a new report issued today by the European Technology Platform for Zero Emission Fossil Fuel Power Plants (ZEP).The ZEP report, Creating a Secure Environment for Investment in Europe, looks comprehensively at short (through to 2020), medium (the 2020s) and long term (post 2030) measures. In the short term the focus must be on recalibrating the ETS, but the report also calls for a number of the measures similar (but not necessarily identical) to those being implemented in the UK as part of the Electricity Market Reform. CCS Feed-In Tariffs, CCS Purchase Contracts and CCS Capacity Payments are all discussed. These measures could also continue in some form into the 2020s, but securing early clarity on 2030 and 2040 EU carbon targets is seen as the key priority for the medium term. For the longer term, the 2050 emissions target is the key driver, but the introduction of an auction reserve price for ETS allowances post 2030 would provide investment certainty for large scale project decisions made in the 2020s. Such investments would be exposed to the prevailing carbon price in the 2030s and beyond.

The EU has put considerable effort into stimulating CCS, but the goal of early demonstration has proved to be intractable. The ZEP report provides some further thinking on the issue and because of the ZEP constituency, is backed by industry, academia and NGOs.

The bureaucracy in Europe blinks

July 26, 2012

A year ago as the EU ETS price showed clear signs of a second step change downwards (in 2008/9 from €25 to €15 then in 2011 from €15 to €7), the EU Commission was resolute in its view that the mechanism was working, that it was responding to changes in the market and that all was well in the house of emissions trading. Rightly or wrongly, that view was backed by most of the major industry and business groups as well, to the extent that even if the Commission had thought that action was necessary it had absolutely no mandate for action. 

But a year is a very long time in business and politics and this week, with the backing and support of many business groups, the EU Commission released its first concrete thinking on the state of the emissions market and began the political process necessary to attempt to address the problems.

The initial report (with the somewhat long title “Information provided on the functioning of the EU Emissions Trading System, the volumes of greenhouse gas emission allowances auctioned and freely allocated and the impact on the surplus of allowances in the period up to 2020”) spells out in pretty stark terms the scale of the allowance surplus that now weighs down the price. It also highlights the fact that it won’t be until well into the 2020s that this shows any real sign of going away through the natural development of the system and its declining cap. The report then lays out a course of action, with three proposed levels of severity examined. 

That course of action involves skewing the allowance distribution in Phase III, such that less allowances are auctioned in the early years (2013 to 2016) and more are auctioned in the later years (2017-2020) – but the total number of allowances to be released remains unchanged, which means that there is no overall change in the surplus position that is forecast for 2020. The proposal is called “backloading”. The Commission has limited power in this area and even this step has required them to propose a very minor change in the Emissions Trading Directive to clarify the role that they have in the carbon market.

 

The largest backloading proposed is (quoting the Commission working paper):

 “a reduction by 1.2 billion in the first three years of phase 3. This would result in a large reduction in the surplus in 2013. Nevertheless the reduction in the surplus remains significantly below the increase experienced in 2011 and expected over 2012. By 2015 the surplus would be below 1 billion unused allowances compared to a case where no changes in the auction time profile were implemented. After 2015 the auctioned amounts would actually increase significantly, resulting in an issuance of allowances well above future emission levels. This would drive a re-emergence of the surplus. Total annual issuance in the period 2016 to 2019 would be higher than in any year in phase 2 bar 2012. The decrease in auctioned volumes early in phase 3 would require drawing on the existing surpluses to make available the necessary allowances to the market to comply with emissions. This type of change of the auction time profile is thus likely to give strong temporary support to prices in 2013 to 2015, but would put downward pressure on prices in the second half of phase 3.”

At best, the move buys time and gives the Commission some breathing room to gain agreement on the necessary Phase IV parameters (rate of cap decline, possible use of auction reserve pricing, sectoral coverage, free allocation levels etc.), but doesn’t inflame the whole ETS target debate by proposing a full set aside and cancellation of allowances. This latter step is what is really needed, but may be politically too big a bite to chew on given the recent animosity over the Low Carbon Roadmap to 2030 and beyond. As such the Commission has opted for something that it thinks can be done today, rather than fighting the bigger fight over targets which it will have to do anyway in the context of Phase IV. Better leave it for that discussion!!

It is important to reflect on the role of the business community in all this. None of this would have happened were it not for a shift in position from opposition to market intervention to support. This isn’t to say that all business groups support such a move, but today many do. The catalyst for support was the gradual realisation that if the ETS failed to trigger a change in the (power sector) investment profile going forward, governments would inevitably make the decisions for business by applying mandates.

Some business groups remain opposed to intervention, but these now appear to be the ones that have always opposed action to reduce CO2 emissions. While they claim to support the ETS, they strongly argue the case that the market should be left to its own devices. The real agenda is often very different. With the high levels of free allocation that have existed during Phases I and II, the businesses involved are more than happy with the status quo which requires little more than administrative compliance (it certainly doesn’t require emissions reduction through projects and investment).

The battle isn’t over yet and much remains to be done, but this week saw an important step forward and one that hopefully leads to the restoration of the ETS as the primary driver for emission reduction investments across Europe.

The limits of energy efficiency

July 13, 2012

With the recent passage of the Energy Efficiency Directive through the key EU parliamentary committee on Industry, Research and Energy (ITRE), it is clear that the idea of managing emissions, improving energy security and increasing the competitiveness of the economy through managing energy efficiency remains a key policy objective. The Directive has only one more stage to pass: a vote in the whole plenary in September. The Directive obliges Member States to prepare a long-term strategy to increase the energy efficiency of their entire building sector by 2050 and to set up an energy efficiency obligation scheme that ensures that utilities reach 1.1 – 1.5% energy saving of their end-users. In addition, the Directive aims to stimulate technologies such as Combined Heat and Power in the utilities sector.

In fact many commentators and policymakers continue to believe that energy efficiency alone can address much of the CO2 problem – and that it can do so at very low cost (or even negative cost), at least compared to a ‘do nothing case’.  But  any successful policy toward mitigation of CO2 emissions must centre on CO2 pricing. Energy efficiency can only be a contributory factor and, in some circumstances, can even have a negative long-term impact if the centrality of CO2 pricing is not recognised.

The impact of energy efficiency policy on CO2 emissions is explored in a paper by a Shell colleague, Jonathan Sample and was recently published in The European Energy Review, but also attached here [The Limits of Energy Efficiency]. The paper looks at the issue of energy efficiency and examines some of the established beliefs about its benefits and impacts. It highlights some important missing nuances in the logic linking efficiency improvements with reductions in CO2 emissions and argues that in the absence of a credible price on CO2 emissions, the effectiveness of energy efficiency measures is greatly reduced. In fact, in some cases they may even make the problem of CO2 emissions worse in the long term.

The key to understanding the impact of energy efficiency on CO2 emissions lies in the long-term competition between the costs of using fossil fuels on the one hand, and of using non-fossil fuels (the latter of which, in this paper, includes fossil-based fuels using CCS technology) on the other. Specifically, innovations that improve the efficiency with which fossil fuel is converted into energy service, but which don’t do the same for non-fossil fuels,  make fossil fuels fundamentally more affordable compared to non-fossil fuels, even though they reduce the rate of consumption in the short term. An example of this is a policy which encourages improvements in (internal combustion) vehicle efficiency. In the paper, this is referred to as a “carbon-augmenting” policy (versus a carbon-neutral policy).

Consider the example of a driver who initially uses a 30 mpg (miles per gallon) car to drive 300 miles per week when gasoline costs $4/gallon. If at some point in the future, that same driver acquires a car that achieves 60 mpg, he can carry on driving the same distance per week even if the price of gasoline were to rise to $8/gallon (all other things being equal).

At first sight, the improvement in efficiency seems a good thing: after all, there has been an immediate improvement in the driver’s living standards, as driving is now cheaper than it was before. So how might there be a problem? The greater affordability of fossil fuels caused by such improvements in energy efficiency serves to increase the future supply of fossil fuels – again a matter that Jevons brought up. The increased efficiency of the car effectively has made it profitable to produce oil with higher extraction costs without causing the driver to drive fewer miles. In the short term, the increase in productivity, net income and wealth, which is brought about by higher efficiency, contributes an additional boost to energy affordability (this ‘income effect’ will not be considered further in this paper, however).

In the long run, then, the initial halving in the rate of consumption from replacing a 30mpg car with a 60mpg car does not represent a reduction in CO2 emissions: instead of avoided emissions, it may represent only a postponement, plus a long-term addition to the stock of economically extractable resources.

CO2 pricing (through measures such as cap-and-trade or taxation) is the key to unlocking the full potential of energy efficiency to reduce CO2 emissions. In the absence of an offsetting price on CO2 emissions, measures to encourage (specifically carbon-augmenting) energy efficiency can lead to higher ultimate/potential emissions. However, where an offsetting CO2 price is applied, this can be avoided. Importantly, where there is an increase in carbon-augmenting efficiency, it is the price placed on CO2 emissions that leads to the offsetting reduction in economically extractable fossil fuels. In other words, it is the CO2 price, which does most of the work to avoid emissions, and not the efficiency increase. Unless such a price on CO2 emissions is established, carbon-augmenting energy efficiency increases should not be viewed as an “alternative” or equivalent means of reducing CO2 emissions.

In the short term, more effective and less risky options than energy efficiency measures are available in the form of transitions such as coal-to-gas switching. The effectiveness of energy efficiency measures (particularly in their carbon-augmenting form) will be greatly constrained until a CO2 pricing system is in place. Before this comes about, it is necessary to pursue more realistic, yet cost-effective alternatives.

Is $23 per tonne the right price for Australia?

June 29, 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.

The plight of CCS in the EU

June 15, 2012

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.

The case for an auction reserve price

June 7, 2012

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.

A new market mechanism from the UNFCCC

May 30, 2012

While much of the focus in the recent UNFCCC meeting in Bonn was on the protracted discussion around agenda and chair for the ADP (Ad-Hoc Working Group on the Durban Platform for Enhanced Action), some progress was made in other meeting rooms. On the middle Saturday a workshop was held for initial discussions around the call for a “New market Mechanism” (NMM). A report out from the workshop can be found here.

So far, the discussion on a NMM has tended to focus on the crediting of mitigation activities in developing countries, such as the role performed by the CDM. The talk is often about up-scaling rather than having an initial discussion about the market conditions necessary for crediting to be effective or alternatively to ask what a market mechanism actually is. For some, the CDM can be represented as shown below. 

This is a very supply biased conversation, when in fact the full description of the mechanism must include both the creation of supply and the likely demand. The mechanism is much broader than the CDM and involves the core design of the Kyoto Protocol and the various elements within it. 

There are many definitions of “market mechanism”, but all talk about the process of the whole market rather than just a sub-part within it. Here are three;

  1. Means by which the forces of demand and supply determine prices and quantities of goods and services offered for sale in a free market.
  2. The use of money exchanged by buyers and sellers with an open and understood system of value and time tradeoffs to produce the best distribution of goods and services.
  3. The process by which a market solves a problem of allocating resources, especially that of deciding how much of a good or service should be produced, but other such problems as well. The market mechanism is an alternative, for example, to having such decisions made by government.

As the NMM discussion matures and eventually becomes part of the ADP, a much broader discussion on the need for a viable carbon market will be necessary. This cannot be limited to a discussion on crediting mechanisms because these, if standing alone, are not market mechanisms. A working mechanism requires some means of establishing price and particularly demand, a feature not inherent to the CDM.

The assumption that demand for credits will somehow be created is arguably a flawed one. The Kyoto Protocol addressed this by assigning AAUs to certain countries and making the CER (from the CDM) a fungible instrument, thereby allowing interchange for compliance. The AAU approach created demand in countries that had compliance obligations which in turn completed the market mechanism. Nations that held AAUs tended to cascade the instrument directly into their economies or if not, a proxy (e.g. the EUA under the EU ETS). Either way, the compliance obligation remained and allowed private investors to participate in the market.

There was a certain elegance in the market mechanism design of the Kyoto Protocol, one that shouldn’t be lost in the transition to a new international agreement. While it may not be smart politics in some quarters to highlight the benefits within the KP, the NMM discussion will do well to learn from what was developed in years gone by and not throw the baby out with the bathwater.

Oil sands and atmospheric CO2

May 21, 2012

In a recent New York Times opinion piece, NASA climate scientist James Hansen again puts forward his very compelling argument for strong action on limiting global CO2 emissions. Some observers have challenged his thinking, but the warnings he has given over the last thirty years have proven to be pretty much on the mark as observations show that the world is warming.

In the most recent piece, Hansen links the production of synthetic crude from oil sands bitumen in Alberta as a game changer for the climate. He states;

That is why I was so troubled to read a recent interview with President Obama in Rolling Stone in which he said that Canada would exploit the oil in its vast tar sands reserves “regardless of what we do.” If Canada proceeds, and we do nothing, it will be game over for the climate. . . . . . . The concentration of carbon dioxide in the atmosphere has risen from 280 parts per million to 393 p.p.m. over the last 150 years. The tar sands contain enough carbon — 240 gigatons — to add 120 p.p.m.

There is no doubt that the oil sands bitumen reserves in Canada are very significant. In a recent report the Alberta Energy Resources Conservation Board (ERCB) estimates that provable reserves stand at some 170 billion bbls, with a potential total reserve of some 1.7 trillion bbls. The first figure represents the current estimate of recoverable oil on the basis of existing technology, whereas the latter is indicative of the total amount of oil in the region, recoverable or not. The second figure is the one that equates to 240 gigatons of carbon quoted by James Hansen.

But actual production of oil from the region gives rise to a completely different set of figures. Production of oil sands bitumen started in the late 1960s and by 2010 had reached some 1.6 million bbls per day (ERCB figures). ERCB estimates production at about 3.6 mbbl/day by 2020. Assuming an increasing trajectory which sees production doubling again by 2050 (to 7 million bbbls/day), total cumulative production over 80 years would be 74 billion bbls, which equates to some 35 billion tonnes of CO2 emitted through the production and use of the oil. This equates to an increase in atmospheric CO2 of about 2 ppm (by contrast, Saudi production over the same period could contribute about 6 ppm). If production continued through to 2100 and reached 10 million bbls/day, cumulative production would exceed current proven reserves (so assuming technology improvements) and would equate to an increase in atmospheric CO2 of about 7 ppm over 130 years of production. The resource may be vast, but production is limited by the rate at which new projects come on stream. Given a scenario of complete inaction on climate change over the very long term, it may well be that oil sands might eventually contribute some 100 ppm to atmospheric CO2 levels, but that could take 1000 years. Current trends would likely have us hitting a climate induced “brick wall” long before that.

The point here is not to argue that this is all OK or that James Hansen is wrong, but to illustrate that the issue of CO2 emissions and the resulting climate impact cannot be linked to any individual fossil fuel extraction. Each and every major reserve on the planet can clearly only contribute a few ppm at most over the coming 50 to 100 years, but so goes the tragedy of the commons. This of course highlights the critical need for collective action.

The point that Hansen is really making is that oil sands is illustrative of an ongoing global trend to extract or mine increasingly challenging reserves of oil, gas and coal and bring them to market. Global energy markets are driving this behaviour and will probably continue to do so as population increases and economies develop. Put simply, energy is in demand and the market will respond.

Given the recent change in estimates for global natural gas supply, there is now evidence that the availability of fossil fuels may not be self limiting, at least for a century or so (and possibly much longer as extraction technology improves). This argues strongly for the introduction of carbon pricing, which Hansen also calls for in his opinion piece.

Carbon pricing is the essential precursor to technologies such as carbon capture and storage (CCS), which may be the only available route forward to allow both energy demand to be met and CO2 emissions reduced. Alberta has at least started down this route, with a C$15 price driving behaviour in oil sands operations. That price, in combination with a technology incentive package, should see CCS activity emerge as part of future oil sands development.

Getting the message right – public perception and climate change

May 11, 2012

This week in Australia the carbon pricing mechanism (no, it isn’t a tax, despite some similarities) is back in the news as the government releases it’s budget for the coming fiscal period. The fixed price period of $23 per tonne (and rising) represents a significant new source of income for the government, although when the mechanism was announced so too were a number of cost offset measures for the consumer and trade exposed industries. As such, the system is largely revenue neutral, but this has done little to quell the noisy opposition to the policy package. On Wednesday, the day after the Budget was released, many newspapers again raised the issue of increasing prices related to the carbon pricing scheme and therefore falling living standards, despite statements by the government over recent months that the system recycles its revenue back through the economy. Unfortunately, public perception appears to be on the side of those who argue that this is a new and unnecessary cost burden.

This isn’t the only negative view that the public have of climate change policy. The other is that energy austerity is the mechanism we must adopt to reduce emissions. The source of this is many and various, including the government itself, some NGOs and even a few business organisations. “Turn out the lights to save the planet” has become a common rallying cry and is amplified by campaigns such as Earth Hour which calls for cities to be blacked out for one hour a year to highlight the issue of energy use and climate change.

So the public are left with the view that energy austerity and extra cost are the two routes to follow if climate change is to be robustly addressed. Little wonder it is an uphill battle gaining political traction on this issue. Perhaps some new and more accurate messaging should be formulated to help sell the need for policy action.

The energy austerity issue is one that can and should be tackled. Reducing energy use and improving energy efficiency are both good things to do, but should be advocated for on the basis of managing energy costs, not attempting to address climate change. For reasons discussed in an earlier posting, local energy austerity may not even be an effective emissions reduction strategy at all. At issue with energy is the emissions from our current sources, not necessarily how much we use. After all, energy availability is almost unlimited, it’s just harnessing it economically that is the challenge.

The austerity message has its roots in various social agendas, but has kept into the environmental agenda as well. It is easy to see why this has happened, given the clear link between ecosystem welfare and overuse (e.g. logging in tropical rain forests), but for the climate change debate this particular approach may not be helping the issue at all.

The climate change issue needs to return to its roots, which is managing, reducing and ultimately eliminating anthropogenic CO2 emissions. This is done by changing the primary energy mix, implementing upstream CCS and shifting final energy use in homes and transport (where emissions are very to capture) to carriers such as electricity, hydrogen and bio.

Such a change won’t come at no cost, but elements of it can be conveyed to the public more easily. For example, running a home entirely on electricity is very doable today, both in hot and cold climates. The option of electric, hydrogen fuel cell or bio mobility is also becoming a reality – and potentially an attractive one as oil prices remain in the realms of $100 per barrel. These are very different value propositions to the austerity message.

The emphasis then shifts to the upstream and the use of renewable energy in the electricity sector together with technologies such as CCS in combination with natural gas. Here costs can be managed and change implemented over time as the grid is renewed and expanded. This can be achieved through carbon pricing, either directly in a cap and trade system or indirectly through emission performance standards. Although the scale of change is less, over the last thirty years many countries have managed to almost eliminate sulphur emissions from both the electricity and transport sectors and have done so without great public rancour. Costs have dropped and the job has just been done.

Getting the message right is essential if we want to make progress on this issue. Pedalling austerity and high cost is neither helpful or even correct.