1. Limiting Green House Gas emissions: an economist’s perspective
Thomas-Olivier Léautier
with Claude Crampes
Les Houches, February 2014

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

3. 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

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

5. 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)

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

7. 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?

8. 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).

9. 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

10. 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

11. Market vs. tax
Principle of responsibility: the polluter must pay (article 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

12. 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*

13. 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**

14. 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**

15. 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

16. 3. The European Emission Trading System
Directive EU ETS (European Emission Trading Scheme) in 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

17. 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
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.

18. 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 …

19. Allocations by sector 19

20. Allocations by country20

21. Total allowances

22. 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

23. Low carbon price

24. 4. Microeconomics for cap-and-trade24

25. Permits
FOC

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

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

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

29. comparative statics

30. Paying for allowances

31. 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

32. 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.

33. 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.

34. Appendix

35. 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

36. net supply
net demand
net supply
net demand

37. 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 )

38. * Ex post, knowing p and w we have that

39. or
* The FOC is

40. 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.

41. * 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.

42. Dynamic opportunism
During the first round ( ), 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 have been based on declared emissions of 2005 multiplied by an expected growth rate until 2010.
What is the risk?

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