1. BIT’s 1 st Annual World Congress of Greentech EU Emissions Trading Scheme: Much Progress, But Not Yet A Blueprint For The World Guangzhou Baiyun International Convention Center, 19-21 October 2012, Guangzhou, China Vianney Schyns, Utility Support Group www.ifieceurope.org & www.usgbv.com for publications www.ifieceurope.orgwww.usgbv.com 1

2. 1.Chinese ETS – introductory remarks 2.Theory allocation: auctioning or free allocation (historical grandfathering, or benchmark based) 3.EU ETS progress / achievement: industry benchmarks 4.Theory activity factor: absolute or relative or “hybrid” 5.The EU ETS for phase 3 (2013-2020) –Regulatory framework –What were the aims of free allocation? –Needed changes in Europe (in our opinion) 6.Thoughts about Chinese ETS 7.Some references 2 Contents

3. A successful Chinese ETS is of high importance: global level playing field, sustainability ETS long-term globally –China is the biggest emitter, with high growth –No BRIC ETS was the argument for no ETS in USA & Canada –Chinese ETS may be the key for a successful COP-21 result Important issues Chinese ETS –MRV (monitoring, reporting, verification) –Market liberalisation, esp. electricity –Theoretical framework Difficulty: not all experts agree totally Thus, China will decide based on careful analysis 3 1. Chinese ETS – introductory remarks

4. 1.Auctioning 2.Free allocation, historical grandfathering (basis historical emissions), like EU ETS phase 1 (2005-2007), phase 2 (2008-2012) 3.Free allocation, benchmark based –Static benchmarking: allocation = benchmark x historical production –Dynamic benchmarking: allocation = benchmark x actual production 4.Hybrids, like EU ETS phase 3 (2013-2020): –Auctioning for electricity production, static benchmarking for direct emissions of industry, possible financial compensation for the indirect (electricity) emissions (restricted, inherently unstable) 4 2. Theory: method of allocation (1)

5. Auctioning: only if applied globally (otherwise carbon leakage) –Generally regarded as ideal system: most effective & efficient –Production & product carbon price signal Production: incentive to reduce emissions for manufacturing installations Product: carbon cost fully in variable costs of each product –Higher product price  lower market demand (price elasticity of demand) –Inter-product competition  lower carbon products win market share –Note, dynamic benchmarking: same production carbon price signal Carbon costs also variable costs, carbon cost difference between 2 manufacturing plants: same as for auctioning (unlike static systems) Auctioning & dynamic BM: same in following of market dynamics: win/lose market share, growth and shrinkage on firm level (unlike static systems) 5 2. Theory: method of allocation (2)

6. Free allocation, historical grandfathering –EU ETS, phase 1 (2005-2007) and phase 2 (2008-2012) –Considered in the 7 Chinese ETS pilots EU ETS experience: historical grandfathering was a failure  Baseline years include crisis years, shut downs, expansions  High polluters are rewarded (high allocation), disadvantage for modern efficient plants (no reward of early action) as scarcity increases  Uncertainty for expansions, complex rules, barriers & risks for growth  Huge windfall profits for electricity producers (opportunity costs)  “Update” problem: investment to reduce emission  lower allocation later, so operators delay abatement (discount of carbon price signal) 6 2. Theory: method of allocation (3)

7. Free allocation, static benchmarking –For industry, EU ETS, phase 3 (2013-2020) EU ETS experience: progress, but still huge problems  Baseline years for historical production include crisis years, shut downs, expansions: historical production tells nothing about the future  Uncertainty for expansions, complex rules, barriers & risks for growth (see reference 4) The important “update” problem: disappeared, problem solved 7 2. Theory: method of allocation (4)

8. The European Union achieved benchmarks for phase 3 –Leading support role by Ecofys/Fraunhofer and industry federations –52 benchmarks: chemicals (15), Paper & pulp (11), ceramics incl. plaster/gypsum/plasterboard (7), steel industry (6), cement industry incl. lime/dolime (5), glass (4) aluminium (2), refineries & aromatics (2) EU ETS lessons –A correct technical definition is feasible in a reasonable time –Stringency of the benchmark is an important framework choice EU ETS: “top 10%” benchmarks (average of 10% best installations) Australian ETS: weighted average benchmarks, better for competitiveness –More stringent benchmarks: not better for the environment, to the contrary: higher incentive carbon leakage  lower overall efficiency 8 3. EU ETS achievement: industry benchmarks

9. Introduction names & concepts: absolute, relative, hybrid –Absolute schemes, cap & trade in narrow sense Permit trading (environmental economists’ literature), ex-ante fixed caps per firm or auctioning; includes static benchmarking (see reference 5) Aims: certainty environmental outcome, claimed as most efficient system because of (product) carbon price signal – price elasticity of demand –Relative schemes Credit trading (environmental economists’ literature), ex-post to actual production; other names: baseline-and-credit, performance standard rate (PSR), rate-, intensity-, output-based; includes dynamic benchmarking Claim: auctioning = “relative” (benchmark x actual production, BM = 0) Aims: avoid carbon leakage, avoid competitive distortions (winning/losing market share), avoid barriers & risks for growth (see references 2 & 3) –A hybrid: relative for firms, absolute cap for total (see references 2 & 3) 9 4. Theory: absolute or relative or “hybrid” (1)

10. What is best? Difficult subject, analyse via “elimination” Level 1: absolute caps give certainty of environmental outcome, relative caps do not; often expressed –E.g. by Koutstaal et al (CATEP, 2002), EU Commission e.g. in Decision (2003) on Dutch NOx ETS, EU ETS Directive demands “absolute” for linking trading schemes (but: position is softening) –However “absolute” is no guarantee, some targets “can’t be done”: Who could have foreseen the immense Chinese growth 10 years ago? If absolute would be guaranteed: why not set -85% for 2020, or for 2025? –Canada (2007): “World Resources Institute noted in a 2006 report, ‘for environmental performance, what matters overall is that targets are set at reasonably stringent levels and subsequently are met. This may be achieved with absolute or intensity targets.’” 10 4. Theory: absolute or relative or “hybrid” (2)

11. Level 1: issues about ex-ante absolute caps –Illusion: supply-demand balance predictable for e.g. 10 years ahead? –Will Europe recover from the crisis? Or remain depressed for 10 years? Or something in between? –Or: what will happen if Europe recovers from the crisis and economic growth becomes much higher than expectation? (explosion to very high carbon price) 11 4. Theory: absolute or relative or “hybrid” (3)

12. Level 2: carbon price signal – carbon leakage – windfalls –Climate Strategies / Carbon Trust, Öko-Institut and many other environmental economists: actual production is solution to avoid carbon leakage, but not acceptable because of loss of carbon price signal (meant: product carbon price signal), “with relative caps product prices are inefficient” (Koutstaal) – price elasticity of demand –However: avoidance of carbon leakage and avoidance of possibility of windfall profits (ref. CE Delft) and maintenance of product carbon price signal are conflicting objectives, mutually exclusive Carbon leakage >> elasticity profit (Carbon Trust) Carbon leakage is inefficient, total loss for the environment (see reference 3) 12 4. Theory: absolute or relative or “hybrid” (4)

13. Level 3, hybrid, combining absolute with relative: ex-ante absolute cap for total, relative (actual production, ex-post correction 1 or 2 years later) for individual operator *) –Examples: (1) Australian ETS (average benchmark incl. indirect (electricity) allocation, ‘true-up’ to actual production), (2) Waxman-Markey bill (with strategic reserve for growth/shrinkage and with price collar) –“Ex-post” with guarantee of total cap is easy in present EU ETS: New entrants’ reserve (NER): allowances for growth, allowances flow back if production is lower than assumed (certainty for growth) NER to be refilled from action volume, if NER is depleted  However, EU ETS cap > 2020 is problem in case of no global ETS by 2020 *) Fischer (Resources of the Future), Quirion (CIRED a.o.), Loske / Schyns (see reference 2 & 3) 13 4. Theory: absolute or relative or “hybrid” (5)

14. Summary problems EU ETS ex-ante allocation 1.Under-allocation: major barriers and risks for growth, likelihood of investment carbon leakage, neglected by advocates of permit trading 2.Incentive for production carbon leakage (49%, partial cessation rules), neglected by advocates of permit trading 3.Possibility of windfall profits (but permit trading advocates state: there must be windfall profits (carbon price signal), efficiency of the scheme) 4.The big debate for 3 years in Europe: over-supply during crisis (EU ETS only commodity market without supply response) – backloading / set- aside is conceptually questionable, no structural solution 14 4. Theory: absolute or relative or “hybrid” (7)

15. Wide agreement on ideal system long-term –Auctioning, but then also global rules: what (not) to do with revenues (otherwise allocation problems are reintroduced via backdoor) –Probably also: some supply response – e.g. with carbon banks –Global cap, one single carbon price –Same & clever ETS coverage, avoid incentive lack by “ETS borders” Example: full bio-based manufacturing plant should not be ‘non-ETS’ (such as now in the EU ETS), this removes the incentive 15 4. Theory: absolute or relative or “hybrid” (8)

16. 1.EU ETS Directive of 2003 –Revised, 23 April 2009 (published OJ 5 June 2009), legally binding 2.Commission Decision on Benchmarks and Allocation Rules –Adopted 27 April 2011 (OJ 17 May 2011), legally binding (the “CIMs” *) 3.Guidance Documents on Benchmarks and Allocation Rules –Adopted 14 April 2011 and later, not legally binding –(1) General guidance, (2) allocation methodologies, (3) data collection, (4) verification NIMs baseline data reports, (5) carbon leakage, (6) cross boundary heat flows, (7) new entrants / closure rules, (8) waste gases, (9) sector specific guidance, PLUS guidance methodology report + Q&As (together 500+ pages) *) CIMs: Community-wide and fully-harmonised Implementation Measures 16 5. EU ETS: regulatory framework 2013-2020

17. Globally –Avoid carbon leakage (e.g. recital 24, statements Barroso, EP, Council) Production leakage (lower production, import product & unemployment) Investment leakage –Protect competitiveness as good as possible (recital 25, Tajani) Within Europe: avoid distortions, improve effectiveness –“Harmonised ETS is imperative to avoid distortions in the internal market” (recital 8) through “Community-wide and fully-harmonised implementing measures” (Art. 10a(1)) –Environmental effectiveness (recital 20 old, Art. 1, Art. 10a, etc.): move away from historical grandfathering 17 5. EU ETS: The aims of free allocation?

18. Avoid carbon leakage, protect competitiveness better, support Europe 2020 Strategy for growth and jobs Ex-ante incentive to 49% lower production; should move to ex-post, eliminates barriers & risks for growth, creates recession-proof system NER limited (sufficient for 1.2% annual growth), should move to refill from auction volume if depleted and be defined also for after 2020 Unstable, unpredictable financial compensation, should move to indirect allocation, complementary to direct allocation Stringent “top 10%” immediately in 2013, should move to top 10% for 2025 or 2030 (‘sliding path’ allocation, stringent targets need time & resources) Carbon Leakage List: assessments each 5 years, should move to: industry “exposed” by default (comparison EU ETS with ETSs outside EU) Abandon correction factors on allocation (“LRF”, “CSF”, “CLEF”) Abandon Guidance Docs, move to legally binding rules, simplify rules 18 5. What about these aims – needed changes

19. The 7 pilot schemes: avoid historical grandfathering Company “individual” benchmarks {(direct + indirect emission)/production}, average 2009-2011, little extra complexity Create strategic reserve Annual true-up to actual production (higher production than previous year from reserve, lower production to reserve) – OK for new entrants / growth The future nation-wide ETS Nation-wide average benchmarks {(direct + indirect emission)/production}, also average 2009-2011, to promote reductions in pilots until national ETS) Create strategic reserve Annual true-up to actual production (higher production than previous year from reserve, lower production to reserve) – OK for new entrants / growth 19 6. Thoughts about Chinese ETS

20. 1.“Climate change challenges and the search for a sustainable policy”, Schyns (2005), a.o. about absolute or relative targets 2.“The IFIEC method for the allocation of CO 2 allowances in the EU Emissions Trading Scheme”, by Ecofys (2008), a.o. electricity benchmark as alternative for auctioning 3.Trilogy Study: “The benefits and feasibility of an ETS based on benchmarks and actual production”, Loske, Schyns (2008), about ensuring the total cap in an intensity based scheme & carbon leakage, possible windfall profits and the product- and the production carbon price signal 4.“A reality check of the EU Emissions Trading Scheme; Does it allow growth – the major objective of the EU industry policy?”, Brouwers, Stalmans, Schyns (2012), detailed study of CIMs & Guidance Documents: major barriers & risks for growth 5.“Tradable Permits versus Tradable Credits: A Survey and Analysis”, Nentjes, Woerdman (2012), a comprehensive ETS history & a comparison of ex-ante (absolute) fixed emission caps per firm with (relative) ex-post systems 20 7. Some References