Decarbonization and EU ETS Reform : Introducing a price floor to drive low-carbon investments - PowerPoint Presentation

Decarbonization and EU ETS Reform:Introducing a price floor to drive low-carbon investments AHEAD Workshop Berkeley, 2 October 2017Prof. Dr. Ottmar Edenhofer

EUA price below economic benchmark levelObserved EUA priceCarbon price with efficientinvestment and technology R&D in 12 energy-economy modelsICE 2017Knopf et al. 2013

Reason for concernPersistently low EUA price might lead to „hockey stick“ price curve Escalating price will induce future downward adjustment of the capConcern over self-fulfilling prophecy (Salant 2016, Koch et al. 2016, Acworth et al. 2017, Fuss et al. 2017)€/tCO2 time efficient inefficient

Low EUA price: External demand shocks? Are external demand shocks the reason for low EUA price? → according to empirical evidence, they explain only 10% of price slide→ indicates relevance of regulatory and market failures(Koch et al. 2014)

Mechanisms distorting EUA price formation Market myopia (short-sightedness): time horizon of market participants lower than socially optimalLiquid EUA futures market only until 2021 Limited hedging time horizons of utilitiesAnecdotal evidence for thin long term EUA market, little capacity for speculating on rising priceRegulatory uncertainty (lack of political credibility): low credibility of political commitment to long-term targets affects expectations over future capEconomic theory and empirical evidence indicate downward pressure of policy events on EUA price ( Salant 2016, Koch et al. 2016, Fuss et al. 2017 ) Waterbed effect (heterogeneous preferences): unilateral emission reductions lower EUA price , shift emissions in space and time, no additional emission reductions Well- established in economic literature ( Goulder and Stavins 2011, IPCC 2014, Edenhofer et al. 2017) Empirical evidence for only very limited effect in EU ETS so far (Koch et al. 2014)

Empirical evidence: Regulatory uncertaintyKoch et al. 2016Event study: Policy announcements related to cap-setting have systematically contributed to EUA price decline9 of 14 backloading-announcements have led to EUA price declines Proposal EC: -23%Refutation EP: -31%Adoption EP: -9%

Mechanisms distorting EUA price formation Market myopia (short-sightedness): time horizon of market participants lower than socially optimalLiquid EUA futures market only until 2021 Limited hedging time horizons of utilitiesAnecdotal evidence for thin long term EUA market, little capacity for speculating on rising priceRegulatory uncertainty (lack of political credibility): low credibility of political commitment to long -term targets affects expectations over future cap Economic theory and empirical evidence indicate downward pressure of policy events on EUA price ( Salant 2016, Koch et al. 2016, Fuss et al. 2017 ) Waterbed effect (heterogeneous preferences): unilateral emission reductions lower EUA price , shift emissions in space and time, no additional emission reductions Well- established in economic literature ( Goulder and Stavins 2011, IPCC 2014, Edenhofer et al. 2017) Empirical evidence for only very limited effect in EU ETS so far (Koch et al. 2014)

Heterogeneous Member State preferences are essential! Based on Chichilnisky and Heal (1994) and Edenhofer et al. (2017)Emissions trading equalizes marg. abatement costs for all Member States i=1,…,N. Thus:If the income level in Member State i is lower than in Member State j, then:Requirement for 1st best allocative efficiency with ETSEqualization of marg. social valuations of private consumption,Via optimal transfers from rich to poor countries, such that:E.g. by initial allocation of allowances or redistribution of auction revenues.

Current response in EU ETS: Market Stability Reserve (MSR)MSR already adopted: aims at limiting allowances in circulationCurrently discussed MSR reforms: Change removal rate, delete allowances Starts in 2019

Will the ongoing reform remedy the 3 challenges?MSR reform proposals apparantly rely on unspecified theory of surplus-price relationshipUnclear how they would address 3 underlying EU ETS challengesScientific study finds limited effect on price (Perino & Willner 2017)Models by market analysts lack transparency and peer-review (Jones 2017)

Proposal: EUA floor price €/tCO2timeSignificant and rising carbon price floor Potentially complemented by price ceilingLevel of price floorAvailable EU modeling indicates 20-40€/t in 2020, rising over time (Knopf et al. 2013) Stern- Stiglitz Commission global 40-80$/t by 2020 50-100$/t by 2030 Set up expert commission to propose EU ETS price floor levels , governance mechanism

Price floor implementation options€/tCO2tCO2supply demanda) Current EU ETS p p P uni P EUA support rate p ECR allowances withheld allowances withheld c) Price support (UK) b) Auction reserve price (California) d ) Emissions Containment Reserve (RGGI) p r es p CCR

UK experience: Effects of Carbon Price Support MechanismIEA 2016

One Europe – or multiple speeds ?EU-wide implementation of significant auction reserve price or ECR clearly preferableContain waterbed effectCommon decarbonization effort – no one left behindRole-model for global approachIf not feasible – a coalition of the willingGermany is essential, but has so far not displayed required political willCoalition with France, possibly Scandinavian countries, and Benelux to minimize power market leakage (WWF 2014)Move towards EU-wide approach over time

Carbon pricing and companion policiesRegulatory policies including technology subsidies and standards can be important complements – but not substitutes!Substituting carbon price floor …Is ineffective due to waterbed effectSignals lack of political commitmentIs costly – no incentive for some mitigation options (e.g. demand reduction)Increases wedge between leaders (Germany) and laggards (Poland) Complementing carbon price floor …Signals political commitmentReduces reliance on politically uncertain future carbon price and related uncertainty in expected profitability of investments Sequencing: Politically feasible regulation in early decarbonization stage can prepare acceptance of more significant carbon pricing at later stage (Pahle et al. 2017)  Other policies with equivalent level of ambition face equivalent political challenges !

Conclusion - the way forwardIntroduce EU ETS carbon price floor + transfers to adress three core challenges:Heterogeneous preferencesRegulatory uncertaintyMyopiaProposal: Set up expert commission on EU ETS price floor implementationPrice levelsImplementation optionsGovernance framework balancing flexibility and commitmentNext German government needs to make carbon price floor a reform priorityJoint EU-initiative with Macron, and othersEmbed carbon price floor discussion in broader energy and environmental fiscal reform (Agora 2017)

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