Experience and lessons learned: domestic emissions trading schemes

1. 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

2. Disclaimer • 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

3. Structure of the presentation • ETS in the Policy Mix of Climate Policy • Basic Features and Design Issues • Issues • Lessons learnt • Institutions, procedures & data flows • Issues • Lessons learnt • Cap-setting • Lessons learnt • Allocation of allowances • Lessons learnt

4. Climate policy = ETS & moreT · (I2+C) · I · m (F,L, P) + s(B,P,T) + (Ii+Mi) Revenues International initiatives & markets Remove specific barriers* Cap Strengthen specific players* specific technologies* Support Targets Targets Fair & liquid market with manifold players Infrastructures Innovation Internalization Capacities Scarcity * Evaluate, modify & eliminate specific policies, if necessary

5. Emissions Trading SchemesIntroduction (2) • 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

6. Emissions Trading SchemesMain features (1) • 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

7. An inclusive policy mix will be key- especially under uncertainties

8. Emissions Trading SchemesMain features (2) • The regulator defines … • 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

9. Emissions Trading SchemesMain features (3) • The regulator defines … • 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

10. Emissions Trading SchemesMain features (4) • The regulator defines … • 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

11. Emissions Trading SchemesMain features (5) • 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

12. Emissions Trading SchemesMain features (6) • 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

13. Emissions Trading SchemesMain features (7) • Third party entities … • provide verification services • provide trading services and platforms • provide hedging services • provide system services (registries, auctions, etc)

14. Emissions Trading SchemesInstitutions, procedures & data flows

15. ETS & basic design issuesLessons learnt • 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

16. ETS & it’s institutional needsLessons 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

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

18. ETS & AllocationLessons learnt (see also backup #3) • 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

19. The EU ETSLessons learnt from 5 years ETS in practice • 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)

20. Thank you very much Dr. Felix Chr. Matthes Energy & Climate Division Berlin Office Novalisstrasse 10 D-10115 Berlin f.matthes@oeko.de www.oeko.de

21. Backup #1: Background on the EU ETS

22. The EU Emissions Trading SchemeSome background information (1) • 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

23. The EU Emissions Trading SchemeSome background information (2) • 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

24. The EU Emissions Trading SchemeSome background information (3) • 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)

25. The EU Emissions Trading SchemeSome background information (4) Pricing Carbon: The European Union Emissions Trading Scheme Cambridge University Press, 2010 A. Denny Ellerman Frank J. Convery Christian de Perthuis Emilie Alberola Richard Baron Barbara K. Buchner Anaïs Delbosc Cate Hight Jan Keppler Felix Chr. Matthes

26. Backup #2: Some more background on cap-setting

27. Emissions Trading SchemesSetting the cap • 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)

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

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

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

31. Emissions Trading SchemesIntegration of project credits • 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)

32. The effects of policy integrationCareful assessment is needed

33. Backup #3: Some more background on allocation

34. Definition of allocation within an emissions trading scheme Initial distribution of emission allowances (whoever will receive the allowances for what costs …) 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 allocationIntroduction (1)

35. 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 (2)

36. 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! ETS & Allowance allocation Introduction (3)

37. 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 ETSRole of different criteria

38. 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 in ETSBasic approaches

39. Allocation formula Allocation approachesGrandfathering (historic emissions) • Assessment • Simple • Significant distributional problems • Market transparency is a problem • Major distortions of the carbon price signal

40. Allocation formula Allocation approachesBenchmarking • Assessment • More complex • Distributional problems depend on benchmark design • Market transparency is a problem • Distortions of the carbon price signal depend on benchmark design

41. Allocation formula Allocation approachesAuctioning • Assessment • Easy, but not trivial • Least distortions of the carbon price signal • Perfect market transparency • Revenue spending as key challenge

42. Allocation – The pyramid of distortionsand the efficiency of the scheme

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

44. Energy and emissions markets Price signal are important

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

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