Price floors

1
Price floors getting some perspective

• Professor Michael Grubb, Chief Economist, the
  Carbon Trust
• Senior Research Associate, Faculty of
  Economics, Cambridge University
• Tim Laing, Research Assistant, Cambridge Faculty
  of Economics

2
Outline

• Advocating a considered debate
• Why carbon prices are unstable and why it
  matters
• Some characteristics of floor prices
• Why its legitimate to consider solutions
• What makes reserve price auctions an attractive
  approach?

3
Says it all

• Reactions to draft report (for US-German Marshall
  Fund) on ten lessons from the EU ETS, in which
  one lesson was proposed as prices have been
  volatile and generally lower than expected
• Official reviewer from intergovernmental
  organisation
• I dont think the observation on price
  volatility is very fair or relevant its a
  market, and the EU ETS has been no more volatile
  than other commodity markets
• A review from an industry-based (not carbon
  market!) organisation
• The one lesson I thought stuck out was that
  Prices can be volatile . . . . I think this one
  is the biggest barrier to internalising carbon
  advantage (or disadvantage) into investment
  appraisals.

4
Why carbon prices are unstable

• Perceptions usual characteristic of commodity
  markets, amplified by market perceptions of
  political processes (likely to be very volatile)
• Intrinsic uncertainties
• Projected emissions uncertain
• Scale of cutbacks modest relative to uncertainty
• Over-allocation tendencies Projection
  inflation
• Inherent bias towards for optimism in industrial
  projections (strong evidence base)
• Lobbying pressure
• Asymmetric information
• Fixed supply coupled with uncertain and volatile
  demand

5
Cutbacks are modest compared to uncertainties
10 auctions with price floor could readily
underpin prices
Source Emissions Projections 2008-2012 versus
NAP2 (2006) by Neuhoff, Ferrario, Grubb, Gabel,
and Keats and . Published in Climate Policy
6(5), pp 395-410.
6
and why it matters

• Created for public policy purposes
• Not a natural market but instrument for
  collective public goals
• One such goal
• To provide incentives for low carbon investment
  and innovation
• So far boom and bust of current schemes doesnt
  effectively deliver this goal
• Risk aversion, and scepticism in industry over
  future prices amplify effects of volatile prices
• On path to a low carbon economy?
• Price variations reflect short-term factors, do
  not reflect long-term abatement investment costs
• Its not enough to deliver the short term target
  if this demonstrably fails to get us on the
  long-term path
• An inadequate carbon price inevitably feeds the
  case for much more micro-managed interventions to
  support other actions that then in turn undermine
  the carbon price and make it (even) more
  unpredictable

7
Economic characteristics of floor prices

• Market price stays above floor price, reflecting
  market judgement on the upside potential
• Investment downside risk to investments are
  reduced, while upside remains
• In a study of CCS investment incentives,
  cap-with-floor both reduces spread and
  outperforms NPV of cap alone by hundreds of m
  even for a floor well below CCS costs
• But worries about implementation complexities and
  politics

8
Why its legitimate to consider solutions

• As instrument for public policy goals will be
  judged and should be designed against whether
  it delivers those goals
• A lower-than expected carbon price reveals that
  the initial setting of the cap was based upon
  expectations that turned out to be incorrect
• The instrument is more robust and more likely to
  deliver its goals if it carries in-built
  corrective mechanisms, and in particular that
  remove the risk of very low prices
• Within-period options include supply-side
  interventions in offsets (Chinese floor price),
  demand side interventions (eg. re-entry of Canada
  into international market, or governmental
  buy-to-bank or to retire), reserve price
  auctions, or active intervention through a carbon
  bank

9
The features of reserve price auctions

• Mechanism
• Governments announce in advance a path of reserve
  prices on ETS auctions
• If industry does not bid above the price, the
  allowances do not enter the market but are held
  over for the next auction
• Government option to cancel or bank at end of a
  period
• Core rationale
• No ex-post intervention the rules are clear at
  the outside, thus increasing price confidence in
  the market but without gaming potential
• If the cap-setting turns out to be too lenient in
  the light of improved information, a mechanism
  that automatically adjusts supply accordingly has
  inherent logical attractions
• Holding over allowances not bought at one auction
  enables the mechanism to smooth for some of the
  cycles of perception without changing
  fundamentals until the full period performance is
  clear
• Possibilities in EU ETS Phase II
• Reserve prices for UK and Germany auctions and
  for unused New Entrant Reserves
• Although auction volumes are small (7 and 9 of
  allocations respectively), small adjustments
  could do a lot to stave off price collapse
• and set the stage for decisions about the
  larger volume of New Entrant Reserves that may be
  brought to auction

10
Price floors getting some perspective

• Annex modelling instrument performance the
  Phase II balance
• Professor Michael Grubb, Chief Economist, the
  Carbon Trust
• Senior Research Associate, Faculty of
  Economics, Cambridge University
• Tim Laing, Research Assistant, Cambridge Faculty
  of Economics

11
Annex More on modelling results

• Model focuses on firm level incentives for a
  programme of investment in a new technology from
  taxes, cap-and-trade schemes and hybrid
  instruments
• Uses CCS as an example technology
• Cap-and-trade produces higher average returns
  than taxes, but with a greater distribution
• Price floors increase average returns and reduce
  distribution
• Price ceilings reduce average returns and
  distribution effect depends on risk-aversion of
  the firm

12
Impact of floors and ceilings
13
Returns weighted by frequency against average
carbon prices
14
The Phase II supply, demand and market outlook
an intrinsic governmental surplus, likely private
market surplus balanced only through large EU ETS
buy to bank