Submission to the inquiry by the House of Commons Select Committee on Energy and Climate Change on ‘Linking Emissions Trading Systems’

Headline issue: There are now a number of different emissions trading systems in operation around the world and more planned. Linking these systems together would make economic sense, since larger markets mean more buyers with access to more low-cost abatement opportunities in different geographical locations. It would also be good news for companies threatened by the high compliance costs of multiple emissions trading schemes. However, linking systems faces a number of practical challenges, including whether it is possible to successfully link systems with differing levels of ambition or a significantly different permit prices, differences in sector coverage and differences in the eligibility of offsets. Key points: Linking emissions trading systems is a good idea with a number of potential economic and non-economic benefits. However, successful linkage is likely to be difficult to achieve in practice. Linking is only likely to be successful if schemes under undergo a ‘linking partner match selection process’ to assess in detail whether schemes are compatible in a number of key aspects, including their ambition/cap, the price of permits, sector coverage, and the eligibility of offsets. To facilitate future linkages the United Kingdom government should work with partners in Europe to reform the European Union Emissions Trading System (EU ETS) as quickly as possible and actively engage with countries and regions that are developing emissions trading systems to ensure that the option to link with the EU ETS is not closed. The design of the future Chinese emissions trading system, though not public, is likely to be well advanced. It is unlikely that it has been designed to harmonise with the EU ETS to any great extent. The long-term challenges of linking Chinese emissions trading system and the EU ETS make an ongoing dialogue between the UK and China particularly important

New reforms to the EU’s emissions trading system are welcome, but the devil will be in the details

The EU’s emissions trading system employs a ‘cap and trade’ framework under which a ‘cap’ on the level of greenhouse gas emissions is set, with allowances for emissions becoming tradable between business and other actors. Since the financial crisis, however, a surplus of emission allowances has built up, undermining the effectiveness of the system. Luca Taschini writes on a recent proposal, approved in the European Parliament on 8 July, to tackle this problem by creating a so called ‘Market Stability Reserve’. He argues that while this should be seen as a positive development, its impact will depend heavily on the details of the reform that are eventually agreed between national governments

Pollution permits, Strategic Trading and Dynamic Technology Adoption

This paper analyzes the dynamic incentives for technology adoption under a transferable permits system, which allows for strategic trading on the permit market. Initially, firms can both invest in low- emitting production technologies and trade permits. In the model, technology adoption and allowance prices are generated endogenously and are inter-dependent. It is shown that the non-cooperative permit trading game possesses a pure-strategy Nash equilibrium, where the allowance value reflects the level of uncovered pollution (demand), the level of unused allowances (supply), and the technological status. These conditions are also satisfied when a price support instrument (dubbed European-cash- for{permits), which is contingent on the adoption of the new technology, is introduced. Numerical investigation confirms that this policy generates a floating price floor for the allowances, and it restores the dynamic incentives to invest. Given that this policy comes at a cost, a criterion for the selection of a self-financing policy (based on convex risk measures) is proposed and implemented.Dynamic regulation, emission permits, environment, self-financing policy, technology adoption

An Empirical and Theoretical Study on Emission Permits

Market-based measures are currently very popular among policy makers. In a system for marketable permits, relevant companies exchange permits on the theory that trading creates economic incentives that encourage firms to minimize the costs to society of pollution control. The chief appeal of economic incentives as the regulatory device for achieving environmental standards is the potentially large cost-saving that they promise. The source of these cost savings is the capacity of economic instruments to take advantage of the large differentials abatement costs across polluters, as formally proved by [74]. In chapter 2, we review fundamental concepts in environmental economics and survey the main theoretical results regarding the use of emission permits. In an effort to bridge the gap between theory and observed market-price behavior, in chapter 3 we investigate the historical time series of the SO2 and CO2 emission permits price in the U.S. market and in the EU ETS, respectively. More precisely, we advocate the use of a new GARCH-type structure for the analysis of the returns of the permit price and demonstrate its effectiveness in terms of model fit and out-of-sample value-at-risk forecasting. Taking into account the most important features of the EU ETS, in chapter 4 we provide a simple conceptual framework and develop an equilibrium model for the price of the emission permits. This chapter is similar in spirit to [44] and [91] - two papers developed in parallel to our work. Unlike these two, this chapter gives insights into the dynamics of the CO2 permit price for a finite time horizon in presence of asymmetric information. In particular, the obtained equilibrium price for emission reflects the scarcity or excess of permits in the market. Finally, we introduce a CO2-option pricing model comparison. The comparison is carried out between the conventional Black, Merton and Scholes model and our equilibrium model. In the final chapter of the thesis, chapter 5, we evaluate when it is optimal to undertake a reversible investment to reduce noxious emissions or trading permits. In other words, we evaluate the price-level at which trading permits is a cheaper solution. In particular, I derive in analytic form the premium for the flexibility embedded in emission permits, extending the works of [22] and [5]. This preliminary result explains the different behavior of the premium for the flexibility of emission permits under both reversible and irreversible investment. Such a result has also extremely interesting and practical relevance for policy makers, as discussed in the chapter

Pollution Permits, Strategic Trading and Dynamic Technology Adoption

This paper analyzes the dynamic incentives for technology adoption under a transferable permits system, which allows for strategic trading on the permit market. Initially, firms can invest both in low-emitting production technologies and trade permits. In the model, technology adoption and allowance price are generated endogenously and are inter-dependent. It is shown that the non-cooperative permit trading game possesses a pure-strategy Nash equilibrium, where the allowance value reflects the level of uncovered pollution (demand), the level of unused allowances (supply), and the technological status. These conditions are also satisfied when a price support instrument, which is contingent on the adoption of the new technology, is introduced. Numerical investigation confirms that this policy generates a floating price floor for the allowances, and it restores the dynamic incentives to invest. Given that this policy comes at a cost, a criterion for the selection of a self-financing policy (based on convex risk measures) is proposed and implemented.dynamic regulation, emission permits, environment, self-financing policy, technology adoption

Emissions trading systems with cap adjustments

Emissions Trading Systems (ETSs) with fixed caps lack provisions to address systematic imbalances in the supply and demand of permits due to changes in the state of the regulated economy. We propose a mechanism which adjusts the allocation of permits based on the current bank of permits. The mechanism spans the spectrum between a pure quantity instrument and a pure price instrument. We solve the firms' emissions control problem and obtain an explicit dependency between the key policy stringency parameter – the adjustment rate – and the firms' abatement and trading strategies. We present an analytical tool for selecting the optimal adjustment rate under both risk-neutrality and risk-aversion, which provides an analytical basis for the regulator's choice of a responsive ETS policy

Cap-and-Trade Properties under Different Scheme Designs

This paper examines the key design mechanisms of existing and proposed cap-and-trade markets. First, it is shown that the hybrid systems under investigation (safety-valve with offsets, price floor using a subsidy, price collar, allowance reserve, and options offered by the regulator) can be decomposed into a combination of an ordinary cap-and-trade scheme with European- or American-style call and put options. Then, we quantify and discuss the advantages and disadvantages of the proposed hybrid schemes by investigating whether pre-set objectives (enforcement of permit price bounds and reduction of potential costs for relevant companies) can be accomplished while maintaining the original environmental targets.Massachusetts Institute of Technology. Center for Energy and Environmental Policy Research

Submission to the inquiry by the Energy and Climate Change Committee inquiry on ‘leaving the EU: implications for UK climate policy’

This submission outlines the latest research evidence from the ESRC Centre for Climate Change Economics and Policy and Grantham Research Institute on Climate Change and the Environment focusing on the question: ‘What should be the Government’s priorities on the EU Emissions Trading System when negotiating the UK’s exit from the EU? What would a successful negotiation outcome look like?

Stocks & Shocks: A Clarification in the Debate Over Price vs. Quantity Controls for Greenhouse Gases

We construct two simple examples that help to clarify the role of a key assumption in the analysis of price or quantity controls of greenhouse gases in the presence of uncertain costs. Traditionally much has been made of the fact that greenhouse gases are a stock pollutant, and that therefore the marginal benefit curve must be relatively flat. This fact is said to establish the preference of a price control over a quantity control. The stock pollutant argument is considered dispositive, so that the preference for price controls is categorical. We show that this argument can only be true if the uncertainty about cost is a special form: all shocks are transitory. We show that in the case of permanent shocks, the traditional comparison of marginal benefits vs. marginal costs is mis-measured. The choice between quantity and price controls becomes ambiguous again and depends upon a more difficult measurement of marginal costs and benefits. The simplicity of the examples and the solutions is a major element of the contribution here. The examples are readily accessible and the comparison of results under the alternative assumptions of transitory and permanent shocks is stark.Massachusetts Institute of Technology. Center for Energy and Environmental Policy Researc

System responsiveness and the European Union Emissions Trading System

This paper argues in favour of a reform of the European Union Emissions Trading System (EU ETS) that makes the system more responsive to unexpected price shocks. The paper proposed rules based mechanism for withdrawing and injecting allowances from the market based on price trends. Key points: Following the 2008 economic recession, the price of European Union Allowances (EUAs) unsurprisingly dropped, following a fall in demand. However the low price has persisted despite mild economic growth within Europe since the beginning of the crisis. Policy regulators are currently unable to respond to unforeseen changes in economic circumstances, technology advancement and complementary policies that generate downward price pressure. The decision by the European Commission to temporarily withdraw 900 million EUAs from the market will have little impact on the long term market price expectation. Other one-off measures would also leave the system vulnerable, addressing the symptoms but not the cause of structural weakness in the system. What is needed is a responsiveness mechanism that enables the European Commission to respond to unanticipated shocks. This ‘rules-based reserve management mechanism’ would have a double trigger system in place. A price trend ‘trigger’ to determine when intervention would be needed, and a volume ‘trigger’, that would determine the amount of EUAs to inject or withdraw. This would encourage self-adjusting behaviour from market participants, anticipating an intervention by looking at the price trend over the specified period, thus acting in their own interest to buy, sell or banking their EUAs in advance of an intervention. This behaviour would help regulate the supply-demand balance of the market which would effectively limit the need for an intervention to exceptional circumstances