Price floors – getting some perspective

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 don’t think the observation on price volatility is very fair or relevant – it’s 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. Price set by price floor Free allocation Free allocation Coordinated auction with price floor can reduce risk of low prices 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 Policy6(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 doesn’t 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’