The EUETS and the Need for Price Floors (and Maybe Soft Ceilings)
23 September 2016 | Trading
With the price of allowances in the EUETS currently down at around €4/tCO2 the question of whether direct price containment (price floors and ceilings) should be introduced has naturally been the subject of renewed debate, especially in the light of the French proposal earlier this year to introduce a price corridor.
The debate tends always to feature a standard set of objections to price containment. Most of these lack validity when applied to well-designed mechanisms. Here I take a look at why this is so, in the hope that the debate can become more realistic and constructive, focusing on the benefits and design challenges around price containment.
The broad themes underpinning the rationale for price containment are as follows:
- All emissions of GHGs are damaging, not just those above the cap. Reducing emissions below the cap and further tightening the cap thus have benefits.
- The financial cost of damages emissions (the social cost of carbon – SCC), although uncertain, is well above current prices. This implies that further emissions reductions with a cost between the current price and the cost of damages have a net benefit. However these are not currently being incentivised by the carbon price. This is one reason why a floor prices is beneficial.
- The market structure and parameters are set by regulatory decisions. These decisions are inevitably taken under uncertainty, and market design is about optimising outcomes under uncertainty. Design is more robust to uncertainty with both price and quantity targets than with either alone.
- Supply adjusting in response to price makes the EUETS more like a normal market.
- It is essential for reasons of international obligations and environmental integrity that the cap is maintained, so moving to a pure carbon tax is not a good idea.
Based on these premises the following responses to standard objections to price management can be made.
“Price management is interfering in the market”
The form of the market is a politically determined construct. Modifications to this construct are appropriate to correct shortcomings in the current design, where supply is too rigid to accommodate uncertainties. The cap does succeed in limiting the total emissions but fails to produce adequate signals for additional abatement. Modification is required to reduce supply of allowances if prices become too low, in order to retain efficient price signals.
Allowing the supply of allowances to respond to price is not interfering with the day-to-day operation of the market. On the contrary, it is designing it to function more like a normal market. In most markets supply varies with price (elasticity of supply is not zero in most markets).
“There is no environmental benefit to a floor price because the cap does not change” or “it does nothing to reduce supply or increase ambition towards targets in the Paris Agreement”
The critical question here is what happens to unsold allowances. There are many possibilities for dealing with unsold allowances, including cancelling them at the end of a phase, cancelling a proportion at the end of a phase, or cancelling them on a rolling basis.
Provided that there are appropriate provisions for cancelling unsold allowances, total emissions over time can be reduced, and so there is a clear environmental benefit. Even if this is not the case, allowances may simply stay in the reserve, or caps may be tighter in future due to emissions reductions achieved, also creating an environmental benefit.
“If the EU is meeting its target at low cost the price should be correspondingly low”
No it should not. The low price signals that the target is not stringent enough to adequately reflect damages. All emissions are damaging, even those within the cap, and if more abatement can be achieved at lower cost than the damage caused this is what should happen.
Measures which further decrease emissions in response to lower cost of abatement also help reinforce the EU’s international leadership position on climate change.
“It goes against the quantity based nature of the EUETS” or “it’s introducing a carbon tax”
Prices can managed by automatically adjusting supply in response to price, for example by putting a reserve price in auctions. This is entirely consistent with the quantity based nature of the EUETS, in that it works by adjusting quantity. Indeed, as noted, it makes the EUETS more like almost all other markets where the quantity of supply varies in response to market prices.
It is possible to use tax-based measures to impose a floor, as the UK does and France will do from January 2017, but it is not necessary to do so.
Characterising price floors as a tax appears often to be used as a way of creating political momentum against the idea. An EU tax requires unanimity among Members States and attempts to introduce a carbon and energy tax in the 1990s were notably unsuccessful, and similar efforts would doubtless prove challenging. Characterising floors as a tax may also help develop political opposition to a floor. Branding the Australian ETS as a tax (which it was not) was successful in helping build opposition there, with eventual repeal of the scheme. Price management through adjusting quantities should not be misrepresented in this way to artificially discredit it.
“It reduces market efficiency”
This confuses efficiency of trading with efficiency of the price signal. If you were never to change the number of allowances, trading alone might indeed remain the most efficient way of meeting the cap. However this has created prices which failed to adequately signal efficient abatement (in effect the market is telling you that the current cap is too loose). There is thus a misallocation of resources towards to many emissions and too little abatement.
“The price may be set at the wrong level”
Having both price and quantity limits increases robustness to the unexpected. If the cap has been set at appropriate levels then prices will anyway lie within the range of any price containment, and price limits will not bind. However the existing EUETS cap has been set at a sub-optimal level –too many allowances have been issued and the price is too low.
Limiting the price simply recognises that future demand for allowances may be mis-estimated, or the level of the cap may be subject to biases, for example due to asymmetries of political risk from setting the cap too high or too low.
“It will never be possible to agree a price”
Price will doubtless be contentious but there are several reference points, notably the following:
- estimates of the SCC, which represents the financial cost of damages, although calcualtions typically exclude important costs of damage. The SCC is highly uncertain, but well above the €4/tonne currently prevailing in the EUETS under almost any reasonable set of assumptions.
- prices under other schemes, especially those with price management;
- prices consistent with those needed to signal abatement sufficient to reach climate targets.
This gives a framework of negotiation. The level of the cap, which is always set with a view to abatement costs and prices, is anyway contentious.
There are many difficult issues to resolve in designing appropriate price containment mechanisms for the EUETS and setting price boundaries at appropriate levels. Spurious objections such as the ones discussed here should not be allowed to form an obstacle to much-needed debate about the best way forward.
Note: The advantages of hybrid price quantity instruments have been extensively reviewed in the environmental economics literature, going back to the original paper on the subject by Roberts and Spence Effluent Charges and Licenses Under Uncertainty (1976). Understanding the need for prices to fully reflect the cost of environmental damages goes back further, to Pigou “The economics of welfare” (1920). See standard texts on environmental economics for a fuller treatment. These conclusions are not uncontentious, in particular because some observers continuing to favour a carbon tax. My own view remains that including a cap on emissions is preferable, and that many of the advantages of a carbon tax can be realised by a well-designed floor price.
Furthermore there are other non-priced damages which imply the benefit of abatement is greater than implied by the SCC.
Also, any ceiling should be soft to allow prices to rise above the ceiling rather than allowing emission to go above the cap, for example with allowances in price containment reserve taken from within the cap.
Almost the only markets with completely fixed supply are the markets for tickets to major sporting events and for authentic works by dead artists. For example the number of tickets to the men’s final at the Wimbledon tennis championships is limited by the number of seats, and the number of authentic Picasso’s cannot now increase with price (although the number of fakes can).
Source: The Energy Collective