Experience and lessons learned: domestic emissions trading schemes

Experience and lessons learned: domestic emissions trading schemes

World Bank Workshop

“Mitigation action and the Role of Market Instruments: Bridging Readiness Gaps”

Dr. Felix Chr. Matthes

Seoul, March 9, 2010

• The views and opinions presented in this paper are partly based on results from research commissioned by the German Federal Ministry for the Environment, Nature Protection and Reactor Safety, the German Federal Environment Agency and the European Commission.

• However, the contents of this paper does not necessarily reflect any official position.

• For some more details on the EU ETS see backup #1

Disclaimer

1. ETS in the Policy Mix of Climate Policy

2. Basic Features and Design Issues

• Issues

• Lessons learnt

3. Institutions, procedures & data flows

• Issues

• Lessons learnt

4. Cap-setting

• Lessons learnt

5. Allocation of allowances

• Lessons learnt

Structure of the presentation

Climate policy = ETS & more T · (I2+C) · I · m (F,L, P) + s(B,P,T) + (Ii+Mi)

Innovation Internalization Capacities

Fair & liquid market with manifold players

specific

specific

specific

Strengthen

Support

Remove barriers*

players*

technologies*

International initiatives & markets

Tar

get

s

Tar

get

s

Infrastructures

* Evaluate, modify & eliminate specific policies, if necessary

Cap

Scarcity

Revenues

• The ETS should

– put a price on emissions (based on scarcity and trading)

– maintain cost-efficient emissions mitigation (via a non-distorted price signal) in the whole system

• technical improvements (incentives)

• optimal level of production & consumption (product prices)

– maintain overall efficiency (low transactional costs)

– reward early action

• The ETS will

– create rents – and different cost burdens

– … and this is the purpose of the scheme

Emissions Trading SchemesIntroduction (2)

• The regulator defines …

– the basic approach of the scheme

• cap-and-trade vs. baseline-and-credit

– the scope of the scheme (sectors, installations and gases), e.g. based on the following criteria

• practicalities and transactional costs (large vs. small, point vs. diffuse sources)

• real-world data availability and real-world data uncertainties

• governance structures

• market structures (cost-pass-through etc.)

• availability and suitability of complementary policies

• infra-marginal rents and related distributional effects

Emissions Trading SchemesMain features (1)

An inclusive policy mix will be key- especially under uncertainties

Abatement potential [mln t]

Ab

atem

ent

cost

s [€

/t C

O2e

]

Competitive potentials:Carbon pricing (ETS for largelarge point sources, taxes fordiffuse sources(Exceptions: large uncertainties on quantities)

Locked potentialsRegulation, incentives- complementary tocarbon pricing (ETS, etc)

Innovation- and infrastructure-intensivepotentials:Regulations, incentives,infrastructure roll-out- complementary to carbon pricing (ETS, etc)


– the point of regulation

• upstream vs. downstream (in the real world all emerging ETS tend towards downstream by good practical reasons)

• installations vs. firms (installations are more suitable from the practical point of view)

– mandatory monitoring, reporting and verification provisions and calendars

• precision is important, time series consistency is decisive

– commitment period and vintage provisions

• short-term banking and borrowing

• longer term banking (and borrowing?)

– the cap



– the allocation scheme

• free allocation vs. auctioning

• in case of free allocation

– free allocation to regulated entities and/or free allocation to other entities

– free allocation based on grandfathering and/or benchmarking

– free allocation without or with updating provisions (updating of base periods, new entrant allocation, etc)

– the fungibility of credits/allowances from offsets or other ETS

• type of credits and/or allowances

• limitations on the use of credits and/or allowances



– the penalties for non-compliance

• with or without buy-out provisions

– the legal nature of allowances and allocations

• commodities vs. financial tools

• assets in terms of balance sheets

– the market oversight regime

• to avoid frauds and abuse of market power

• in line with other (commodity and/or financial) market oversight regimes


• The regulated entities …

– receive a permit which allows them to operate if an allowance is surrendered for each unit of emissions

– collect, calculate and report data (emissions, activities, etc) and commission third-party verification

– could receive free allowances

– trade allowances (sell surplus allowances, buy necessary allowances, hedge activities)

– assess their mitigation potentials and implement mitigation measures (if cheaper than the market price for emission allowances)

– surrender allowances in line with their emissions


• The administrator …

– organizes data collection and processing

– accredits verifiers

– operates registries and accounts

– issues operation permits

– allocates and issues allowances

– assesses compliance status

– holds or commissions auctions

– issues sanctions


• Third party entities …

– provide verification services

– provide trading services and platforms

– provide hedging services

– provide system services (registries, auctions, etc)


Emissions Trading SchemesInstitutions, procedures & data flows

Legislator / Regulator: Basic Architecture and Provisions, Set up and Oversight on the overall Process, Sanctions (if applicable)

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tyAllocationRegistry:

Zertifikats-ausgabe

Third Party Registry*:Tracking

etc

Compliance Registry:

Compliance Assessment

Operators Operators

Administration (Competent Authority): Allocation , Data Management, Compliance Assessment

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Data* Data*

Standardised Interface to Trading*

OwnershipTransfer

OwnershipTransfer

Exchanges(Spot)

OTC-Trades(Spot)

Trading

Common Monitoring, Reporting and Verification System

Per

mit

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Allo

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Exchanges(Derivates)

OTC-Trades(Derivates)



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Dat

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Data* Data*

Standardised Interface to Trading*

OwnershipTransfer

OwnershipTransfer

Exchanges(Spot)

OTC-Trades(Spot)

Trading

Common Monitoring, Reporting and Verification System

Per

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Allo

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**

Dat

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Exchanges(Derivates)

OTC-Trades(Derivates)

• Climate policy is (much) more than ETS

• Downstream ETS is an appropriate approach (regulation at the point of emission)

• The reality ends with multi-period schemes

• CO2 emissions from large point sources and N2O emissions from some industrial processes meet the uncertainty criteria

• An early and broad debate on the general design of the scheme is crucial and limits surprises (for all participants and the regulator)

• Learning by doing is important

• Technicalities are political and policy ends with many technical implementation issues

ETS & basic design issuesLessons learnt

• Key decisions on the design must be made early

• Effective institutions are crucial and transparent provisions are key

– state institutions

– intermediate entities

• Dealing with new institutions and provisions takes time – for the state authorities, the regulated and intermediate entities

• Data management is demanding (for all parties) and requires lead-times

• Strong links exist to other regulatory arenas (taxation, trading, financial industry)

• However, it’s worth to go through this learning process– perhaps in a pilot phase

ETS & it’s institutional needsLessons learnt

• Ambitious caps are key

• Strict separation of the cap-setting process and other issues (institutions, allocation, etc) is key

• Clear basic principles should be defined for the cap-setting process to minimize the bargaining process

• Ensuring consistency is important

– with the aggregate (national) target

– with other policies and measures

– with the approach on sectoral credits

• Reliable and consistent data are an essential basis for the cap-setting process

ETS & Cap-settingLessons learnt (see also backup #2)

• Allocation of allowances is much more than distribution

• Maintaining a non-distorted price signal is a key issue

• Free allocation vs. auctioning is the main battleground

• The level of free allocation should be based on clear priorities with regard to

– compensation

– rewarding early action

– combating carbon leakage

The design of allocation approaches and provisions strongly depend on these priorities (grandfathering vs. benchmarking)

• Developing allocation regimes over time is appropriate

• Revenue recycling from auctioning must be addressed well in advance

ETS & AllocationLessons learnt (see also backup #3)

• Emissions trading can be done in an efficient manner (and in a rather short period of time)

• Significant emission reductions can be proved and some innovation triggered by the EU ETS can be observed

• The institutional and administrative efforts as well as the transactional costs are managable

• ETS rises awareness substantially

– at the level of firms (climate issues emerge as an issue at CEO and CFO level – and for the controllers)

– at the level of financial institutions

– at the level of third-party service providers

– at the level of policy-makers (fixing a cap and allocating allowances improves transparency of climate and distributional policies)

The EU ETSLessons learnt from 5 years ETS in practice

Thank you very much

Dr. Felix Chr. Matthes Energy & Climate DivisionBerlin OfficeNovalisstrasse 10D-10115 [email protected] www.oeko.de

Backup #1: Background on the EU ETS

• The EU ETS is a multi-national ETS– 27 EU Member States, 2.2 (2005) 2.4 bn t CO2e (2013)– Linking: CDM & JI, Norway, Iceland, Liechtenstein, etc

• The EU ETS is a downstream ETS– Power generation– Combustion installations > 20 MW– Other installations in energy-intensive industries (cement, iron

and steel, glass, ceramics, refineries, etc)– From 2013: N2O emissions from large industrial point sources– From 2011: aviation included

• The EU ETS is a multi-period scheme– Pilot phase 2005-2007– Second phase 2008-2012– Third phase 2013-2020

The EU Emissions Trading SchemeSome background information (1)

• The real world EU ETS is different from textbook-style ETS– Multi-period– Allocation more complex than pure auctioning and simple

ex-ante (lump-sum) allocation– Thus allocation is not only relevant for distribution but also for

the efficiency of the scheme

• The EU ETS includes a series of updating components– Updating of base periods between the phases

• for production• for emissions

– Free new entrant allocation from the New Entrant Reserve (NER)

– Plant closure provisions


• Free allocation under the EU ETS is strictly based on ex-ante allocation

• Only participants of the EU ETS can receive free allocation

• The allocation approach within the EU ETS changed significantly– 2005-2007: >95% free allocation

• mostly based on historic emissions– 2008-2012: >90% free allocation

• increasing share of benchmarking– 2013-2020: <40% free allocation

• No free allocation for power generation• Free allocation (based on benchmarks) for sectors which

face significant problems from carbon leakage• Continuous phase-out of free allocation for other industrial

sectors by 2027 (based on benchmarks)



Pricing Carbon: The European Union EmissionsTrading Scheme

Cambridge University Press, 2010

A. Denny EllermanFrank J. ConveryChristian de PerthuisEmilie AlberolaRichard BaronBarbara K. BuchnerAnaïs DelboscCate HightJan Keppler Felix Chr. Matthes

Backup #2: Some more background on cap-setting

• Setting the cap– creates a scarcity and the price on emissions and is a key

feature of the scheme– is crucial for the integrity of the scheme– is strongly depending on high-quality and consistent data

(consistency is in real-world ETS more crucial than precision)

– should strictly be separated from all distributional issues and procedures

• Cap setting partial ETS (scope: energy-intensive industries)– should be consistent to aggregate (national) targets – could be based on different approaches

• economic efficiency• cost burdens• gateways to non-ETS could create opportunities

– Should reflect other policies (efficiency renewables)

Emissions Trading SchemesSetting the cap

Cap-setting in partial ETSThe economist’s dream: cost-efficiency

Mitigation

Sp

ecif

ic M

itig

atio

n C

ost

s

Topt

Copt

M

MACC A1

MACC A2

B1 B2

Total costs: least cost Burden sharing: different burdens

Cap-setting in partial ETSThe politician’s dream: burden sharing

Mitigation

Sp

ecif

ic M

itig

atio

n C

ost

s

ToptTEB

C2

C1

Copt

M

MACC A1

MACC A2

B1

B2

Total costs: higher than least cost Burden sharing: equal burden

Cap-setting in partial ETSA way out: Integrate project-based credits

Mitigation

Sp

ecif

ic M

itig

atio

n C

ost

s

ToptTEBTEB-ET

C2

C1

Copt

M

MACC 1

MACC 2

B1 B2B1'

B2'

C1'

Total costs: least cost (but transfers between Party 1 and 2)) Burden sharing: equal burden

• Project credits could– create additional flexibility– maintain overall efficiency– create additional revenue streams for non-ETS sectors

• Requirements for integration of project credits – integrity of projects– low data uncertainties– appropriate baselines (safeguarding additionality)

Emissions Trading SchemesIntegration of project credits

The effects of policy integrationCareful assessment is needed

0.0

0.5

1.0

1.5

2.0

2.5

2005emissions

2020emissions

1/3 1/2 2/3 multilateraltarget

unilateraltarget

ETS Baseline Electricity in add'l renewables in 2020from other support schemes

2020EU ETS cap

bn

t C

O2

Complementary P&Mfor renewables will deliverabatement

CO2 price triggersmore abatement

Cap safeguards the total

Backup #3: Some more background on allocation

ETS & Allowance allocationIntroduction (1)

1. Definition of allocation within an emissions trading scheme

Initial distribution of emission allowances(whoever will receive the allowances for what costs …)

2. A starting point: the (surprising and) outstanding role of allocation in newer emissions trading schemes

First experiences with emissions trading schemes (in the US)

• Cap and trade

• Cap-setting and trading as key issues

New experience from the EU ETS

• Cap, allocate and trade

• Cap-setting and allocation as key issues

ETS & Allowance allocation Introduction (2)

• The textbook perspective

– Cap defines scarcity, scarcity defines the price, the price ensures cost-efficiency

– Allocation is solely a distributional issue

• The real-world perspective (in real-world emissions trading schemes)

– Allocation is an important distributional issue (rewarding early action, ensuring competitiveness, avoiding leakage, etc.)

– Allocation is also important for cost-efficiency

ETS & Allowance allocation Introduction (3)

• Allocation has an impact on cost-efficiency? Indeed, if the ETS has updating components!

– Intended updating: output-based allocation (1 year delay, 4 year delay, 10 year delay)

– Indirect updating

• Updating of base periods in multi-period ETS

• New entrant allocation

• Plant closure provisions

• Allocation has an impact on cost-efficiency? Indeed, if allocation avoids country- or sector-leakage!

• Allocation has an impact on cost-efficiency? Indeed, if double-dividend effects are taken into account!

Allocation in ETSRole of different criteria

• Allocation to reward early action

– Important for the phase-in

– Decreasing importance (legitimation) over time

• Allocation as approach to deal with carbon leakage

– For a few sectors

– Not the only approach to deal with carbon leakage

• Allocation as approach for (direct and indirect) compensation

– Compensation for hardships within the scheme

– Compensation for hardships for indirect effects of the ETS

• Allocation to raise revenues

• Allocation to ensure cost-efficiency of the ETS

Allocation in ETSBasic approaches

• Free Allocation

– Free allocation to ETS-regulated entities

• Grandfathering based on historic/planned emissions (with or without updating elements)

• Benchmarking based on historic/planned activities and benchmarks

• Distributional and efficiency effects are critical

– Free allocation to other entities

• Benchmarking based on historic/planned activities and benchmarks

• Distributional effects are critical

• Auctioning

– Distributional effects are critical

Allocation approachesGrandfathering (historic emissions)

• Allocation formula

A E AF

withA (Free) allocationE Emissions (base period/planned)AF Adjustment factor

• Assessment

– Simple

– Significant distributional problems

– Market transparency is a problem

– Major distortions of the carbon price signal

Allocation approachesBenchmarking


A AR BM AF

withA (Free) allocationAR Activity rate (historic/standardized/planned)BM BenchmarkAF Adjustment factor

• Assessment

– More complex

– Distributional problems depend on benchmark design

– Market transparency is a problem

– Distortions of the carbon price signal depend on benchmark design

Allocation approachesAuctioning


A 0

withA (Free) allocation

• Assessment

– Easy, but not trivial

– Least distortions of the carbon price signal

– Perfect market transparency

– Revenue spending as key challenge

Allocation – The pyramid of distortionsand the efficiency of the scheme

demand/ product

innovationproduction

CO2

(energy, fuel, other inputs)

Energy

Comprehen-sive price

signal. Least

distortion

Price signal for optimal production

at given demand

Price signal for optimal

specific CO2 emissions at

plant level

Price signal for optimal

energy efficiency at plant level

X* X X X

(X) X X X

All parameters (products, technology, inputs and/or fuels)

(X) X X X

Capacity only (X) (X) X X

Product-specific only O (X) X X

Product- and technology-specific O O (X) X

Product-, technology- and input-/fuel- specific

O O O X

O O O O

Optimal level of Optimal intensity for

CO2 price signal creates incentives for

System-wide Plant-specific

O - not ensured. X - ensured. (X) - ensured in general, but depends also from other factors. X* - ensured in general, if no carbon leakage can be assumed

Historic emissions

Fre

e A

lloca

tion

Distortion of CO2 price signal = loss of economic efficiency = higher allowance prices in future

Auctioning

Be

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Up

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No

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Historic emissions

Incentivized optimization is

Ranking of potential distortions (efficiency losses) from allocation (1)

1. Interactions between updating, allocation and efficiency

– new entrant allocation creates the most critical efficiency losses – especially if this allocation is not based on uniform benchmarks

– efficiency losses from operational decisions are less significant

• if trading periods are long ~10 years

• if free allocation is based on uniform (capacity) benchmarks (to the extent possible)

– real-world assessment of plant closure provisions is complicated

• plant closure provisions and new entrant allocation are often (politically seen as ‘twins’)

• plant closure provisions have a strong leakage dimension

– Benchmarking & benchmark designs are important

– Pass-through of CO2 costs to product prices is crucial for allocational efficiency

Energy and emissions markets Price signal are important

0

10

20

30

40

50

60

70

80

90

100

01.01.2003 01.01.2004 01.01.2005 01.01.2006 01.01.2007 01.01.2008 01.01.2009

€ /

MW

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0

10

20

30

40

50

60

70

80

90

100

€ /

EU

A

Future contract hard coal (year+1, cif ARA)

Future contract for CO2 allowances (year+1, until 09/2005 Spot)

Future contract for power (year+1, base)

Short-term marginal costs hard coal power plant

New entrant allocation matters for distribution & efficiency (power 2005/07)

-2,0 -1,0 0,0 1,0 2,0 3,0 4,0 5,0 6,0

Emission

Allocation

Emission

Allocation

Emission

Allocation

Emission

Allocation

DE

UK

Gas CC

Hard coalG

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mln EUA

Hard coal plant 1,000 MW 7,000 hrs/yrGas CC plant 1,000 MW 7,000 hrs/yr

Ranking of potential distortions (efficiency losses) from allocation (2)

2. Economy-wide efficiency gains from redistribution of auctioning revenues

– if revenues are used to remove distorting taxes (labour, etc)

– if revenues are used to boost innovation – for future backstop technologies

3. Summary: Key aspects for the impact of allocation on efficiency

– direct and indirect updating provisions are critical for (dynamic) efficiency

• in combination with the design of methods used for free allocation

• depending on the ‘updating levers’ (e.g. length of trading periods)

• new entrant allocation has the most significant potential for efficiency losses

– auctioning and targeted revenue redistribution is important

Documents

Experience and lessons learned: domestic emissions trading schemes