Title: Price floors
1Price 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
2Outline
- 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?
3Says 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.
4Why 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
5Cutbacks 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
7Economic 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
8Why 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
9The 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
10Price 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
11Annex 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
12Impact of floors and ceilings
13Returns weighted by frequency against average
carbon prices
14The Phase II supply, demand and market outlook
an intrinsic governmental surplus, likely private
market surplus balanced only through large EU ETS
buy to bank