An Experimental Economic Analysis of Carbon Trading Options for Australia John Tisdell and Corinne Grainger Atmospheric Environment Research Centre Griffith University Brisbane Australia

Outline Background Research questions Experimental design and procedures Experimental results Conclusions and recommendations

Background Government reports: PM Task Force, Garnaut Review, Carbon Pollution Reduction Scheme emissions trajectory, coverage, permit allocation, inter-temporality, governance and compliance. Two main issues.. – Inter-temporal flexibility Futures and spot markets – Emissions trajectory Low or high permit reductions

Inter-temporal flexibility In markets for pollution such as greenhouse gases, inter- temporal flexibility plays a large role in ensuring market success (Stavins 1998; Stern 2007).

Emissions trajectory The trajectory chosen to achieve the final level of stabilisation is of as much importance in determining the costs of mitigation, as the actual level of final stabilisation (Goulder and Mathai 2000; Grübler and Messner 1998; Jaffe et al. 1999, 2002; Manne and Richels 1997, 2004; Richels and Edmonds 1995; Schneider and Goulder 1997; Wigley et al. 1996)

6 Emissions Trajectory PM Task Force Report 2007 p.101

Research questions 1.Emissions trajectory Does the rate of decline in carbon permits impact on compliance? 2.Inter-temporal flexibility Do futures markets produce better results than simple spot markets in terms of compliance and market activity?

Experimental design and procedures High Reduction (HR) Low Reduction (LR) Spot Market (SM) 4 sessions 10 periods 4 sessions 10 periods Futures Market (FM) 4 sessions 10 periods 4 sessions 10 periods

Experimental Environment Players were informed that they were the producer of a fictitious good and that they could produce this good up to a maximum production level. They were provided with a simple production function and marginal value for the good. They were also provided with a stock of carbon permits which declined over time. For each unit they produced they were required to hold a permit. Players faced random auditing and if found to have less permits than their production they would face a fine. The aim was to maximise their earnings taking into account their earnings from production, trade and any fines they may receive. Instructions and Quiz:

Computer Screens

Income Table

Future Trading Table

Experimental Parameters Pd Low High Player Marginal Value

Modeled equilibrium prices and associated fines Period Low Equilibrium Price Penalty High Equilibrium Price Penalty

Experimental results Level of Compliance – Differential between production and carbon permit holdings Convergence – Market prices and quantities to CE

Convergence of market prices through rounds

Convergence of market quantities through rounds

Spot and Future Quantities Mean Quantity Futures Market, Low Reduction Futures Market, High Reduction Round Spot Qty Forward Qty p-value

Interaction of emission reductions and market form

Future volumes traded

Conclusions and recommendations The policy implications of these results.. Based on the experimental data: If the authority is concerned with achieving an emission target quickly, high rates of permit reduction with spot markets should be considered. Higher rates of reduction did not result in greater non-compliance. There should be high rates of compliance and limited need for futures markets during the initial phase. If a low emissions trajectory is adopted then it could be implemented with a futures market option.

The findings of this work are based on experimentation. Experimental economic techniques are the glass houses of policy… Field trials are required before the new variety is released… Further research is required to explore operational and field specific implications.

Key elements: – Reduce carbon pollution by 60 per cent of 2000 levels by – Unconditional 5 per cent reduction in carbon pollution below 2000 levels by Up to 15% depending on global agreement. – Use of market-based instruments – Assistance for households and business – Price cap The intention is to commence the scheme on 1 July Carbon Pollution Reduction Scheme

Coverage  Entities with direct emissions (stationary and transport) of t co 2 -e per year or more.  Setting the cap  5 year caps with gateways (projections) to 10 years depending on international agreements  Differences between the scheme cap and the national target will be reconciled through the allocation of notional credits to firms and industries not covered by the scheme.  Definition and allocation of permits  Vintage permits defined in tones of carbon emission  Administrative Allocations Emissions-intensive trade exposed industries (EITE) Strongly affected industries – Government auctions – Unlimited banking (exception: those issued under the price cap) – Short-term borrowing from following year (max 5%) Framework

Reporting and compliance  Compliance requires surrender of one permit for each tonne of carbon dioxide equivalent emitted  Annual independent audit  National Greenhouse and Energy Reporting Act  National greenhouse and Energy Reporting System -

– EITE scheme Emissions-intensive, trade exposed industries 90% for activities that has at least 2000 t co 2 -e per million dollars of revenue. 60% for activities that have at least 1000 t co 2 -e per million dollars of revenue. 4 year evaluation – 1 July 04 to 31 December 08. – strongly affected industries Also includes strongly affected industries –coal fired electricity generation 1 July 04 to 30 June 07 >0.86 t co 2 -e/MWh. Due for review in Assistance will be in the form of funding for carbon capture, storage technology and sustainable coal. It will be delivered through existing schemes. (National Low Emissions Coal Initiative) Direct assistance in the form of administratively allocated permits (approx. $3.9 billion) – Objective – avoid ‘carbon leakage’ – companies moving overseas as a result of carbon reduction requirements. Administrative allocation

Auction will be held 12 times through the financial year Future vintage auctions – four years of vintages will be advanced auctioned (current vintage plus advance auctions of three future vintages). Simultaneous ascending clock auctions Price cap in – price cap of $40 - unlimited store of additional permits at the fixed price. Effectively capping prices and imposing a static Pigovian tax on any firm who can earn more than $40/Ct from production. All permits are tradeable except those issued under the price cap scheme Government Auction