Barbara Buchner, PhD Climate Policy Initiative Graz, 25 November 2010

1. Workshop on Institutional options for the Carbon market: Can financial markets and institutions be a model? Is there a need for more market oversight and regulation in the EU ETS? Barbara Buchner, PhD Climate Policy Initiative Graz, 25 November 2010

2. The EU ETS • Mandatory system in place since January 2005 • Legislation agreed by Member State Ministers (Council) and European Parliament in ‘co-decision’ • Extensive stakeholder dialogue • Covers currently 40% of EU GHG emissions • Cap on emissions from ~11,500 energy-intensive installations across EU • Direct: regulated at source of pollution • Single largest market for GHG emissions • True multi-national scheme (25/27 MSs) • Link to Norway, Iceland, Liechtenstein • A “Linking Directive” governs the relationships between EU ETS & Kyoto Protocol • EU ETS stimulates overall carbon market EU energy & climate policy objectives Jan 1: Start of phase III Jan 1: Start of phase I Jan 1: Start of phase II 2013 2012 2007 2020 2005 2008 Feb 15: Entry into force of Kyoto Pr. Dec: end of 1st CP Jan 1: Start of 1st CP of KP

3. A phased approach • A “broad then deep” strategy • All inclusive, non-demanding beginning • Increasing differentiation with greater stringency • Participation of the less committed in decisions • Highly decentralized implementation • MRV and enforcement by Member States • But: highly uniform infrastructure for registries • And: importance of central coordination (EC) • Towards harmonization and centralization • From country ‘caps’ to EU-wide cap • From national allocation plans towards EU-wide auctioning and harmonized benchmarks • Differentiate through auction rights • Towards common definitions, scope and criteria for inclusion learning the lessons from the pilot phase

4. The carbon market – who, what, where? • Who? • Industrial companies • Energy companies • Banks/intermediaries • What? • Spot - a commodity • Derivatives – financial instruments • Standardized and non-standardized contracts • Where? • Exchanges – regulated markets, MTFs • OTC – brokered/non-brokered, unregulated exchanges Art. 12(1a) of Dir 2009/29/EC: “Commission shall by 31 Dec 2010, examine whether the market for emission allowances is sufficiently protected from insider dealing or market manipulation….”

5. A single, accountable long-term cap and a longer time horizon Source: Öko-Institut 2010 • Note… • Linear factor to be reviewed by 2025 • Aviation to be included; will change figures correspondingly but cap not reduced • Uncertainty re move to 30% GHG reduction target

6. Some conclusions from Phase I • A pilot phase is useful. • Trading infrastructure and experience • Data issues • Everything doesn’t have to be ready on Day 1 Learning by Doing: A phased approach- allows learning and revision • Carbon now has a real price. • Phase 2 tightened overall cap (-6% wrt 2005) • Agreed amendments add to scarcity (-1.74%/year) • A new commodity and liquid market emerged. • Price behavior has been rational • Steady growth in volume and products • Volatility not extraordinary (less than in other commodity markets) • Widespread participation in the trading

7. May 15, 2006: verified emissions A price signal • Data and design matter ! • Reliable information - MRV • Market infrastructure • Flexibility/certainty/predictability

8. Some more conclusions from Phase I • Allocation is controversial. • Free allocation was price of acceptance • Also, many choices impractical due to data constraints • But subsequently very controversial • Abatement occurred. • A significant positive price • Emissions are lower than historical levels (even after allowing for plausible bias), despite robust economic growth and adverse energy price developments • Probably 120-300 MtCO2/year (2-5%) in 2005-2007: modest, but in line with modest ambition • Too early to observe investment effects • Carbon price has had limited impact on industrial competitiveness. • No empirical evidence of market share loss due to carbon pricing: only one price among many • But: may change in the longer term

9. Learning the lessons for carbon markets governance • The principles • Simplicity & Transparency • The conditions • Suitable club benefits: broader benefits than GHG • Actors with varying marginal abatement costs • Low transaction costs • Good data availability • Good decision process (a ‘center’, coordinating mechanisms) • The choices • A robust, binding cap • Predictability/certainty • Flexibility: scope, linking, international offsets (with limits to ensure sustained effort) • Effective monitoring, reporting, verification long term carbon price stability & integrity of system Secure

10. What if…more oversight through price floors/caps/collars? • Combination solution • Permits & “ safety valve” • Implementation • Along with emission targets, government sets a “trigger price” • If price of permits > trigger, government guarantees the “safety” price • Theory… • On economic grounds, they can be helpful to lower cost of achieving ambitious targets • Quantitative analysis: price floor much higher than price levels experienced in EU ETS • EUR 35/tCO2 in 2011, to EUR 120 in 2050 to reach 50% from 2005 levels by 2050 • also higher than some suggested caps in other legislations (US price collar in Senate bill: US$ 28)

11. More oversight through price floors/caps/collars? • …and practice: what if we had adopted some? • Implications for compliance costs: the market has worked well, lowering cost of compliance when entities had economic difficulties • Practical implications: floor/cap levels determined by national circumstances, not science • Linking of trading systems proves challenging (environmental ambition, GHGs, activities, etc.) • Collars, here but not there, make linking unwieldy/meaningless • Coordinating floor/cap levels unlikely to facilitate matters • The issue of the rents: a reserve price in auctioning has a value … especially for sellers into the system (CDM, AAUs?)

12. How to optimize market regulation? • Do not address the wrong issues • Low prices criticized for lack of sufficient signal: blame the target, not the mechanism • Maximize confidence in system • Learn from mistakes, allow adjustments • Consider that regulatory interference with the carbon price undermines the market and investment decisions, and thus confidence from the beginning • Important to set proper instruments to hedge against future risk • What hedging instruments in presence of gov’t guaranteed prices? • Experience tells us that markets can deal with price uncertainty, while policy uncertainty is much more difficult to handle

13. Bottom line • CO2-emissions are no longer free in the European Union • Importance not so much in price per se, but in institutions & thinking • From rather dubious initiative to accepted fact and cornerstone of EU policy • Achieved despite significant obstacles and problems • Pre-existing institutions, powerful club benefits facilitated EU ETS • But significant obstacles: time schedule, inexperience with trading • Importance of pilot phase • Provided infrastructure and lessons: balance flexibility & regulation • Illustrates incentives: carbon price has induced some abatement • Importance of continuous learning by doing • Market oversight – based on stocktaking exercise • EU ETS shows that multi-national systems can be successfully implemented more than least-cost abatement

14. Thank you! barbara.buchner@CPIVenice.org www.climatepolicyinitiative.org