Allocation of CO2 Emission Allowances

1
Allocation of CO2 Emission Allowances
Carnegie Mellon University October 2004
Karsten Neuhoff
University of Cambridge
In collaboration with Kim Keats, ICF Consulting,
London. See also CMI working paper 49 _at_
econ.cam.ac.uk/electricity
2
Outline

• CO2 emission reduction strategy
• Failure of voluntary commitments
• Effectiveness of price mechanism
• Separate environmental externalities from
  technology policy (learning externalities)
• The European Emission Trading Scheme
• Impact of updating (conditional allowance
  allocation)
• Impact of free allowance allocation to new
  entrants
• Border tax adjustment to allow auction of
  allowances and higher CO2 prices

3
European strategy to reduce CO2 emissions

• European Climate Change Program 2000
• Bonn/Marrakech/EU required delivery of Kyoto
  targets
• After criticising US, policymakers had to show
  action
• Failure of voluntary commitments in 1990

4
Instrument I Industry self regulation Example
Germany

• CO2 2000 industry promised 20 Mtones reductions
  by 2005 so far only increase
• Industry option to avoid renewables legislation
  by achieving quota (1990)
• Education quotas at firm level
• Price stability with Euro introduction
• Self-regulation of energy sector
• Cigarette advertising/ product labelling

Source Kontraste.de, Axel Friedrich
Umweltbundesamt
5
Development of Energy intensity from 1971 to 2000
Austria
Belgium
0,5
France
Germany
0,4
JPN
UK
USA
0,3
Mtoe/mld USD
0,2
0,1
0
1970
1980
1990
2000
Oil price spike in 1970s increased energy
efficiency far more than climate debate of 1990s.

Source Miroslav Honzík, GDP is translated using
PPP, Prices of 95
6
The economy can change energy intensity
Instrument 2 prices
Cross-section relation between average energy
intensity and average energy price 1993-99
1400
DEN
1200
JPN
NOR
1000
AUT
ITA
800
average energy price /toe
LUX
SUI
SWE
600
FIN
UK
NZ
HUN
USA
BEL
TUR
400
KOR
MEX
SVK
CZE
POL
CAN
200
Best fit constant price elaticity of -1.0
(S.E. 0.14), R2 0.69 (Excl CEE)
0
0.00
0.10
0.20
0.30
0.40
0.50
0.60
0.70
0.80
0.90
1.00
average energy intensity (kg oil equivalent/95
GDP)
Source Nebwery 2003
7
Instruments CO2 price increasing energy costs
/tCO2
Energy efficiency measures
Allowance price
t
8
Implied CO2 price varies widely between sectors
and countries
Example Diesel
2010 Min.
2003 Min.
1993 Min.
18 c/gln CO2 Price E20/tonne
Source EU Commission (Stand 2002/Deutschland
2003) American Petroleum Institute 2004,
Energy Information Administration, 2004
9
And inertia / transaction costs need to be
addressed

• EU Commission Green Paper 2000 technical
  potential for improved energy efficiency of 40
• EU Commission Green Paper
• gt18 potential for cost
• effective improvements

CCLAs were far more likely to have taken action
to improve energy efficiency 87 of CCLA firms
had taken action or were planning to do so
compared with 42 of non-CCLA firms Source
CBI/EEF review of CCL, October 2002
10
Instrument CO2 price changing relative costs
/tCO2
Allowance price
Renewables
t
CO2 pricing is unlikely to unlock new renewable
technologies. But reduces costs of strategic
deployment programs.
11
Technology cost reductions with deployment
12
Technology Policy separate from CO2 trading

• Renewable contribution
• Quotas EU commitment 13.9 (97) to 22 (10)
• Implemented using national policy
• So far only feed in delivered (DK, D, ES)
• Some renewable RDD programs
• Transport of energy / transport fuel
• H2, 2 bil.Euro in 6th framework/ in US 1.7 bil.
• Carbon Sequestration/nuclear perceived as
  marginal
• Public concerns about leakage

Source Directive 2001/77/EC , http//www.europa.e
u.int/comm/energy/res/legislation/electricity_memb
er_states_en.htm
13
Emission Trading Scheme and Kyoto

• ETS independent of Kyoto entering into force
• ETS set up to comply with Kyoto targets
• Russian signature (seems quite secure)
• Would start Kyoto
• Will Russia/Ukraine oversupply?
• CO2 allowance trade only at state level
• Review if member state import more than 6 of
  allowances.
• Limit imports to keep carbon price up
• US participation would increase carbon price

14
The ETS System A Four Level Approach
Cap defined by EU Burden Sharing
Different cap options (modeling, voluntary
agreements, distance to target)
Different cap options (Flat rate, sector specific
caps)
Different Allocation options. Most likely
common formula extra allocation
Ref Matthes, Oeko Institute
15
Average cap and BAU emissions compared to Kyoto
commitment for 2006
Source ECOFYS, The BAU numbers are in most cases
indicated in the National Allocation Plan. If BAU
was not available in NAP, but needed to be
derived from other sources, this is indicated by
using an open circle, instead of a closed circle.
If it was not possible to derive a BAU, no circle
is given for that specific country.
16
Issues about the NAPs

• Incentive for countries to allocate more rights
• Value of rights for national industry/auction
• Impact on EU emission price -gt cost of
  inappropriate adjustment
• Objective of Commission to implement mechanism on
  time (January 2005)

17
Allocation plans

• Political economy buy in of companies
• SO2/NOx In US lump sum to incumbents.
• CO2 higher value politicians equity concern
• Explicit updating
• NAPs defined till 2007, Kyoto till 2012
• Implicit updating regarding future allocation
• New Entrant provisions
• Regional competition or Coal support?

18
Empirical - Impact of CO2 allowances
19
Comparing marginal costs of coal and gas-fired
plant
20
Net cashflow impact with auctioned emission rights
Pulverised coal plant

Gas
-
fired CCGT plant

All figures in /kWyr

BAU

10/tCO2

Change

BAU

10/tCO2

Change

(1) Energy sales revenue

117.8

134.9

17.1

131.1

164.5

33.4

(2) Fuel expense

70.8

69.9

-
0.9

95.9

106.8

11.0

(3) OM expense

33.1

33.1

0.0

21.7

21.7

0.0

(41
-
2
-
3) Energy sales
13.8

31.9

18.1

13.5

35.9

22.4

margin

(5)
Net purchases of CO2
0.0

33.1

33.1

0.0

17.5

17.5

allowances

(64
-
5) Operating margin

13.8

-
1.2

-
15.1

13.5

18.4

4.9

(7) Scarcity rent

13.7

13.7

0.0

13.7

13.7

0.0

(876) Total margin

27.5

12.4

-
15.1

27.2

32.0

4.9


21
UK - change of CO2 emission with regulation
22
UK - change of SO2 emission with regulation
23
UK - cost of implementing Carbon Constraint -
Static
1385
1840
24
Impact of updating I
25
One time updating
Assume one time updating - pt1 const A 0
only price increase A-gtinf
only emission increase A positive both
price and emission increase
26
Continuous updating
27
Quantification of CO2 constraint
Assume A-gtinf government fixes allowance
price Calculate E as function of fuel switching
etc.
28
Cost of implementing Carbon Constraint - Static
1385
1840
29
Allocation of Allowances to new entrants
pmax
cm,2
K1
K2
cf,1
cf,2
Fixed costs
30
Impact of the amount of free allocation
31
Government strict on quota
Scarcity value of capacity decreasing. To ensure
profitability of technology 1, dct/dµ gt 0

• Investment in both technologies is increased
  (while scarcity value positive)
• Allowance price and for dA/dctgt0 emissions
  increase.

32
Government stabilises price
dK2 /dµgt0 -gt dK1/dµ lt0 if
Scarcity value of capacity decreasing. dK2/dµgt0
dK1 /dµ lt0 and d(K1 K2)/dµ K1K2gt0 ?
emissions increase ?dct/du gt 0

• Low emission technology is displaces by high
  emission technology and total capacity increases.
• Allowance price and emissions are increased.

33
Impact of Allocation Rules on UK Wholesale Prices
Price reflects energy-weighted average wholesale
power price across UK assuming a CO2 price of
10/tonne. Source ICF Consulting, March 2004.
34
Impact of competing countries not participating

• Concerns for competitiveness of EU industry
• Could particularly affect location decisions
• Hence provisions for allocation of allowances to
  new entrants in NAPs (for 2005-2007)
• Distortions of technology choice (Germany)
• Distortions of location choice (between
  countries)
• Long-term commitment reduces policy options
• How many reserves to retain for entrants?
• Updating provisions reduce effectiveness

35
Requirement to implement stringent policy

• Emission trading only works if
• No updating allowance priceopportunity cost
• Minimise allocation to new entrants
• EU Energy intensive industry will lobby against
  high CO2 prices if they are unilateral
• US Energy intensive industry will increase lobby
  against CO2 constraints if they can free ride
• We need border tax adjustment

36
Border Tax Adjustment for CO2 allowance costs

• Reimburse exporter for allowance costs
• Add import tax for avoided CO2 allowance costs
• Allows for internalisation of externalities
• Treatment similar to value added tax
• Other regions can apply it (e.g. Canada)
• But product not process based
• Focus on energy intensive component
• Small transaction costs
• Based on best available technology
• Simple monitoring / tariff setting
• WTO compatible

37
Conclusion

• ETS in place and starting January 2005
• Covers emissions from large installations
• Technology policy separate (and needs to be)
• To get industry buy in Free allocation
• Politicians then required Updating
• New entrant allocation
• Result are likely
• Allowance prices look higher -gt dont be fooled!
• Distortions in investment decisions.
• Border tax adjustment could allow for higher CO2
  price levels.