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Price floors

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Price floors getting some perspective Professor Michael Grubb, Chief Economist, the Carbon Trust & Senior Research Associate, Faculty of Economics, Cambridge ... – PowerPoint PPT presentation

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Title: 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
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