Limiting Green House Gas emissions: an economist’s perspective Thomas-Olivier Léautier (thomas.leautier@tse-fr.eu) with Claude Crampes (claude.crampes@tse-fre.eu) Les Houches, February 2014

Outline Clean Energy Policy for Europe Basic microeconomics for externalities The European Emission Trading System Microeconomics for cap-and-trade

EU Green-House Gas emissions towards an 80% domestic reduction (100% =1990) Source: European Commission, “A Roadmap for moving to a competitive low carbon economy in 2050”, March 2011

2. Basic microeconomics for externalities price Supply p market Equilibrium q market Demand quantity

GHG emissions as a negative externality Negative externality associated with GHG emissions: emitters do not face the full social costs of emissions, including their impact on the environment (global warming). Without intervention, the market would emit excessive pollutants Source: IPCC (2007)

Negative externality and market failure price cost of the negative externality social marginal cost supply = private marginal cost optimum equilibrium demand qoptimum qmarket quantity

A series of complex issues Physics (climate science): What is the impact of temperature increase? Engineering What technical progress can be expected? Economics: What is the cost of temperature increase? What is the cost of decarbonization? What weight for future generations versus current ones? How to split the burden between developed and developing countries? between industries? How to limit opportunistic behavior?

Controlling GHG emissions: what is the right method? Overall objective: minimizing the cost of reducing carbon emissions Set of policies that directly address the market failures associated with climate change, and only intervene where market failures are present Technology- and sector-neutral approach to carbon abatement: carbon reduction in sectors which have the lowest cost of reducing emissions Potential policies Direct regulation: Command & Control, prohibition, quotas, standards… Incentive regulation: carbon pricing (cap-and-trade, carbon taxes), subsidies and R&D incentives objectif global de minimiser le coût de réduction des émissions de carbone. Demandes pour minimiser les coûts pour l’adoption d’un ensemble de politiques qui résolvent directement les défaillances du marché associées au changement climatique, et de n’intervenir qu’en cas de défaillances. Cela suggère également le besoin de concevoir une approche basée sur la technologie et le secteur en vue d’une baisse du carbone, ce qui signifie que la réduction du carbone devra se produire dans les secteurs qui ont le plus bas coût de réduction d’émission et qui utilisent des technologies qui réduisent également les coûts d’abattement (sur le temps).

How to create a carbon price? i) tax modified private marginal cost social marginal cost price supply = private marginal cost optimum equilibrium carbon tax demand qoptimum qmarket quantity

How to create a carbon price? ii) tradable permits social marginal cost price volume cap supply = private marginal cost Optimum price of the permit Le système d’échange de quotas d’émission est un système de plafonnement et d’échange : Les pollueurs reçoivent (ou paient) des quotas. Les quotas sont échangeables. Les pollueurs ne sont pas autorisés à émettre plus que leur nombre alloué initialement + la quantité achetée sur le marché. Basé sur le principes de Coase : Si les droits de propriété sont bien définis, les externalités permettront d’allouer efficacement, quel que soit le point de départ. La distribution initiale des quotas n’a qu’un effet de richesse. Si l’allocation initiale est gratuite (« grandfathering », étalonnage), l’échange est essentiel pour optimiser l’efficacité. Si l’allocation initiale est effectuée à l’aide d’enchères concurrentielles, l’allocation est déjà efficace : l’échange n’est qu’une histoire d’ajustement. price of the good demand qconstrained quantity

Market vs. tax Principle of responsibility: the polluter must pay (article 174-2 of the Treaty); Is the producer or the consumer the true polluter? Is cost pass-through acceptable? Carbon tax : Who is in charge? How is it calculated? Who receives the cash? What to do with revenues? Tradable permits : Who decides? How many allowances? If given for free, to whom? If sold, who benefits from sale? Theory (Weitzman, 1974): quantity control is more efficient than price control when supply is more inelastic than demand 11

Price vs. quantity regulation social marginal cost Net Surplus p* Le système d’échange de quotas d’émission est un système de plafonnement et d’échange : Les pollueurs reçoivent (ou paient) des quotas. Les quotas sont échangeables. Les pollueurs ne sont pas autorisés à émettre plus que leur nombre alloué initialement + la quantité achetée sur le marché. Basé sur le principes de Coase : Si les droits de propriété sont bien définis, les externalités permettront d’allouer efficacement, quel que soit le point de départ. La distribution initiale des quotas n’a qu’un effet de richesse. Si l’allocation initiale est gratuite (« grandfathering », étalonnage), l’échange est essentiel pour optimiser l’efficacité. Si l’allocation initiale est effectuée à l’aide d’enchères concurrentielles, l’allocation est déjà efficace : l’échange n’est qu’une histoire d’ajustement. Average demand quantity q*

Welfare loss under quantity regulation price social marginal cost Surplus loss under quantity regulation p* Le système d’échange de quotas d’émission est un système de plafonnement et d’échange : Les pollueurs reçoivent (ou paient) des quotas. Les quotas sont échangeables. Les pollueurs ne sont pas autorisés à émettre plus que leur nombre alloué initialement + la quantité achetée sur le marché. Basé sur le principes de Coase : Si les droits de propriété sont bien définis, les externalités permettront d’allouer efficacement, quel que soit le point de départ. La distribution initiale des quotas n’a qu’un effet de richesse. Si l’allocation initiale est gratuite (« grandfathering », étalonnage), l’échange est essentiel pour optimiser l’efficacité. Si l’allocation initiale est effectuée à l’aide d’enchères concurrentielles, l’allocation est déjà efficace : l’échange n’est qu’une histoire d’ajustement. Realized demand Average demand quantity q* q**

Welfare loss under price regulation social marginal cost Welfare loss under price regulation p* Le système d’échange de quotas d’émission est un système de plafonnement et d’échange : Les pollueurs reçoivent (ou paient) des quotas. Les quotas sont échangeables. Les pollueurs ne sont pas autorisés à émettre plus que leur nombre alloué initialement + la quantité achetée sur le marché. Basé sur le principes de Coase : Si les droits de propriété sont bien définis, les externalités permettront d’allouer efficacement, quel que soit le point de départ. La distribution initiale des quotas n’a qu’un effet de richesse. Si l’allocation initiale est gratuite (« grandfathering », étalonnage), l’échange est essentiel pour optimiser l’efficacité. Si l’allocation initiale est effectuée à l’aide d’enchères concurrentielles, l’allocation est déjà efficace : l’échange n’est qu’une histoire d’ajustement. Realized demand Average demand quantity q* q**

Price vs. quantity regulation 2 Political economy: potential for regulatory capture produces first-order effects Concerning CO2 emissions, Directive 2003/87/CE has set the framework: the EU-ETS, a cap-and-trade system

3. The European Emission Trading System Directive EU ETS (European Emission Trading Scheme) in 2003 before the commitment from the Kyoto protocol. Three compliance phases Now 28+3 heterogeneous States participate 3x20 European Objectives 1 Jan. : ETS Phase I 1 Jan. : ETS Phase II 1 Jan. : ETS Phase III 2005 2007 2008 2012 2013 2020 Feb. : Kyoto protocol comes into force 1 Jan. : beginning of first Kyoto protocol period Dec. : end of first Kyoto protocol period. 16 16

Cap-and-trade principles Binding cap is set on emissions during a given period Emission permits are allocated to polluters: auction or free allocation based on grandfathering or benchmarking www.eex.com/en/Market%20Data/Trading%20Data/Emission%20Rights/EU%20Emission%20Allowances%20%7C%20Spot Emission permits can be traded (wholesale or, mainly, OTC): Regardless of the initial allocation (if no transaction costs), trading allows for an optimal distribution of abatement efforts across sectors and countries (Coase principle) The initial allocation of permits only has a wealth effect If the allocation is auctioned, second hand market is just for efficient adjustment Polluters not allowed to emit more than initial allocation + permits bought on the market; otherwise, they pay a penalty. The Emissions Trading Scheme is a cap- and-trade system: Polluters receive (or pay for) permits; Permits are tradable Polluters are not allowed to emit more than their initial endowment + the quantity bought on the market. Based on Coase principles: If property rights are well defined, externalities will lead to the efficient allocation, whatever the starting point. The initial distribution of permits has only a wealth effect. If the initial endowment is for free (grandfathering, benchmarking), trade is essential to reach efficiency. If the initial endowment is auctioned competitively, the allocation is already efficient; trade is just a matter of adjustment.

European Environmental Policy: 2013-2020 The ETS Directive (2009/29/EC): From 2013 onwards (Phase III), emission allowances in the ETS will be reduced by 21% below their 2005 levels by 2020 Full auctioning for the power sector, and a gradual phasing out of free allowances for other sectors The ETS is also set to be expanded from 2013, to also include the aviation sector. But …

Allocations by sector 19

Allocations by country 20

Total allowances

Flexibility Banking Emissions permits can be used in periods subsequent to the one in which they were allocated. Inter or intra-phase? in Phase I, only intra-phase now also interphase (Phase II => Phase III) Borrowing Allows regulated emitters to use part of their future allocations to cover their present emissions de facto allowed intra-phase (February 28 => April 30) Credits offset: - Clean Development Mechanism - Joint Implementation

Low carbon price

4. Microeconomics for cap-and-trade 24

Permits FOC

Trading is the demand for rights derived from the firm’s optimal production.

abatement effort and market of allowances • We then have effort quota traded permits

Equilibrium For two « price-takers » At equilibrium, 2 is a seller and 1 is a buyer.

comparative statics

Paying for allowances

Auctionning allowances Under the first Directive, only four countries have used the possibility to sell (at most 5 %) allowances : Denmark (5 %), Hungary (2.5 %), Lithuania (1.5 %) and Ireland (0.75 %). Under the 2009 Directive, it is 100% mandatory for the electricity producers from 2013 on. Partial obligation in the other industries. Then, to produce output q, a firm can now obtain permits from

Conclusions For the EU authorities, it takes (at least) three tools to reach objective: one for cleaning (Directive 2009/29/EC: mandatory ETS), one for greening (Directive 2009/28/EC: optional green certificates, or FIT, or green potfolio, or …), one for saving (Directive 2012/27/EU: optional white certificates, or energy efficiency, or load-shedding, or demand response, or …). Actually: as the objective is to cut GHG emissions, one tool is sufficient combining several tools produces negative side-effects.

An economist perspective Cap and trade for CO2 is a right answer because it fixes a negative externality; it sends a scarcity signal; it allows firms to adjust volumes; it (now) generates public revenues. Independent quantitative targets for energy saving and renewables are wrong answers because they are viewed as genuine objectives instead of mere means; they increase the cost of reaching the CO2 target; they require large amounts of red tape and (distortive) State aids.

Appendix

EU-ETS timeline beginning of year N end of year N 1st Jan. 28 Feb. Publication of year N-1 emissions by the EC double allocation period 1st Jan. 28 Feb. 30 March 30 April 15 May 31 déc. Year N allocation on installations accounts in their national registry. Installations submit their verified emissions for year N-1 to the national authority. Installations surrender the allowances covering their N-1 emissions in the national authority. 35 35

net supply net demand net supply net demand

Timeline Firms will be active on both the initial sale and on the permits exchange only if there is some randomness (on p and/or w) auction a quota checking time p and w certain trading (choice of 𝑞 𝑎 )

* Ex post, knowing p and w we have that

or * The FOC is

Remark 1: Then if risk neutral, i buys on the initial auction only if if risk averse, we have meaning that i is ready to pay a risk premium.

* Remark 2: If the initial auction of permits is not followed by trading possibilities, it is a private value auction : each firm bids a price only based on its own characteristics. Opening an ex post exchange for permits transforms the auction into a common value auction : the total number of allowances and the technical characteristics of all obliged firms.

Dynamic opportunism During the first round (2005-2007), the EC has announced that future quotas would not be based on the observed performances of the current round, to reduce opportunism. Actually, “it is useful to learn from the most recent data”, Finally, the expected individual emissions for 2008-2012 have been based on declared emissions of 2005 multiplied by an expected growth rate until 2010. What is the risk?

Grandfathering: internalizing the review rules gives FOC With just a one-period effect Not the case when allowances are auctioned.