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June 2017 Emissions Trading and the Role of a Long-run Carbon Price Signal Achieving Cost-effective Emission Reductions under an Emissions Trading System June 2017, Berlin, Germany International Carbon Action Partnership Secretariat William Acworth, Johannes Ackva, Constanze Haug, and Mariza Montes de Oca Mercator Research Institute on Global Commons and Climate Change Sabine Fuss , Christian Flachslanda, Nicolas Koch, Ulrike Kornek, Brigitte Knopf, and Ottmar Edenhoferb,c. Resources for the Future Dallas Burtraw a Hertie School of Governance b Potsdam Institute for Climate Impact Research c Technische Universität Berlin June 2017 Acknowledgements This paper benefited greatly from a technical workshop with ICAP members, held in Burlington, Vermont, United States on 12 October 2016 as well as specific comments from Angelika Smuda of the German Federal Ministry for the Environment, Nature Conservation and Nuclear Safety; Mark Wenzel of the Californian Environment Protection Agency; Jason Gray of the Californian Air Resources Board; Sophie Wenger of the Swiss Federal Ministry of Environment, William Space of the Massachusetts Department of Environmental Protection, and Stephane Legros of the Québec Ministry of Sustainable Development, Environment and the Fight against Climate Change. The authors are also most grateful to Lisa Murken who provided support while completing an internship with the ICAP Secretariat. All mistakes or errors are the sole responsibility of the authors. Cite as Acworth, W., Ackva, J., Burtraw, D., Edenhofer, O., Fuss, S., Flachsland, C., Haug, C., Koch, N., Kornek, U., Knopf, B. and Montes de Oca, M. 2017. Emissions Trading and the Role of a Long Run Carbon Price Signal Achieving cost effective emission reductions under an Emissions Trading System. Berlin ICAP. Disclaimer The ideas expressed in this report do not necessarily represent the views of ICAP or its members, or their endorsement of any approach described herein. Resources for the Future RFF is an independent, nonpartisan organization that conducts rigorous economic research and analysis to help leaders make better decisions and craft smarter policies about natural resources and the environment. Unless otherwise stated, interpretations and conclusions in RFF publications are those of the authors. RFF does not take institutional positions. Emissions Trading and the Role of a Long-run Carbon Price Signal i International Carbon Action Partnership Table of Contents Summary for Policymakers. 1 1. Introduction 8 2. Objectives of an ETS and the role of the allowance price 11 3. What might preclude an ETS from achieving dynamic cost-effectiveness . 14 Conceptual framework . 14 Complementary policies and exogenous shocks 15 Myopia . 16 Excessive discounting . 18 Regulatory uncertainty and political commitment . 19 4. Addressing market and regulatory imperfections tools to adjust the allowance market 22 No or limited controls . 23 Price-based controls . 24 Quantity-based controls . 28 Delegation . 29 Commitments through financial options 30 5. Enhancing political commitment embed the ETS within a long-term policy framework 32 Time periods for cap setting. 32 Alignment with long-term targets 38 The institutional context for changing the cap . 39 6. Building constituencies in support of ETS . 40 Engagement with key stakeholders . 40 Distributing climate rents . 41 Make co-benefits explicit, visible and politically salient . 44 7. Conclusions . 45 8. References . 47 Emissions Trading and the Role of a Long-run Carbon Price Signal ii International Carbon Action Partnership Emissions Trading and the Role of a Long-run Carbon Price Signal 1 International Carbon Action Partnership Summary for Policymakers Emissions trading is now a well-established tool for reducing greenhouse gas GHG emissions in an effort to mitigate the impacts of global climate change. By the end of 2017, Emissions Trading Systems ETSs will regulate more than seven billion tons of CO2e, with 19 systems operating worldwide. This paper is concerned with market or regulatory imperfections that could disrupt the dynamic cost effectiveness, i.e. achieving reductions at least cost over time, of an ETS and examines options for how these imperfections may be addressed. Objectives of an ETS and the role of the allowance price The economic rationale for applying an ETS to achieve emission reduction targets is well established. By allowing flexibility over where emission reductions take place, least cost options are taken up broadly across the economy. By providing flexibility as to when emission reductions take place, firms can make choices about the timing of investments -- whether to abate now, or to compensate another firm to abate now while delaying abatement at their own facilities to a later point in time. Importantly, an ETS allows market participants to expectations about future carbon prices, connecting today’s investment decisions with expected future carbon prices and abatement costs. In theory, an ETS achieves cost effectiveness for any chosen reduction target. Crucially, this depends on classical economic assumptions -- that decision-makers are rational and operate with perfect foresight, that ination about prices and costs is complete, and that the program has unlimited banking and borrowing. The economic mechanism behind this is that marginal abatement costs, the costs for an additional unit of emissions avoided, converge across the covered entities as the market discovers the cheapest possible options for the respective reduction target. The same mechanism works across time as discounted marginal abatement costs converge for future time-points. Under such conditions, a clear allowance price emerges. It represents the intertemporal marginal cost of abatement. The resulting price over time which increases at the social discount rate is referred to as the dynamic cost-effective abatement pathway. What might preclude an ETS from achieving cost dynamic effectiveness Shocks such as economic crises, technological developments, or complementary policies, for instance promoting energy efficiency or renewable energies, can decrease demand for allowances, resulting in lower allowance prices. Low prices, below levels anticipated in the initial program design, have been common in some emissions markets, leading newer ETSs to directly protect themselves against price drops with a reserve price at auction or other minimum price controls See Figure E.S. 1. Emissions Trading and the Role of a Long-run Carbon Price Signal 2 International Carbon Action Partnership Figure E.S.1 Allowance price development in three longest established ETSs Low prices resulting from exogenous shocks would not be a concern under a static perspective, which considers an ETS effective as long as the annual caps are met. However, low prices are problematic when they are the result of market or regulatory imperfections that depress the allowance price. Moreover, when depressed allowance prices are the result of ancillary policies promoting specific technologies under the sources covered by the cap, they erode the additionality of those policies, undermining cost-effectiveness even further. When today’s allowance price signal is out of line with long-term objectives, investment decisions are made with disregard for long-term carbon budgets. As a consequence, economies might lock into carbon-intensive infrastructure whose emissions have to be abated at higher costs in the future. Furthermore, lower prices today may slow down innovation and technological learning, making future emission reductions more costly. However, it is difficult to ascertain whether low prices are associated with external demand shocks, or with inherent market and regulatory imperfections. Making such a distinction is important, as the associated policy response may differ depending on the cause of the low price. More empirical research is needed across different allowance markets to assess the presence and magnitude of market and regulatory imperfections. The paper starts out by introducing a conceptual framework to assess the dynamic cost-effectiveness of an ETS. This framework is then applied to assess three potential market and regulatory distortions that might hamper intertemporal perance, providing evidence where available. These effects are not mutually exclusive and may interact when multiple market and regulatory imperfections are present. 1 Myopia Myopia is present when participants display a limited time horizon. Kollenberg and Taschini 2015 argue that if participants have insufficient regard for long-term strategies then the allowance price will not be determined by the overall carbon budget, Emissions Trading and the Role of a Long-run Carbon Price Signal 3 International Carbon Action Partnership but rather by short-term conditions. In other words, the unwillingness or inability of market participants to consider the long term leads to allowance prices that disregard expected future costs of compliance. When allowances are relatively abundant in the present compared to the future depending on the cap trajectory myopia will induce prices that are too low to be dynamically cost-effective. The extent to which market participants are myopic is difficult to assess, due to a lack of conclusive empirical evidence. 2 Excessive discounting An ETS achieves dynamic cost-effectiveness when the market values future allowances with a discount rate which would be considered socially optimal. Excessive discounting denotes behavior where market participants value future allowances far less than a social planner would. This might be the case because participants are institutionally limited to hold emission allowances beyond those needed for immediate hedging or because risk averse market participants factor in future potential regulatory interventions which may depress allowance price trajectories. 3 Regulatory uncertainty and political commitment A high extent of regulatory uncertainty surrounding an ETS is likely to encourage participants to focus on the short-term or alternatively increase the risk premium, the expected additional benefit for carrying risk, required to bank surplus allowances. Lessons from real options theory Dixit and Pindyck, 1994 suggest that investors may be better off waiting for additional ination on the stringency and design of future climate policy than making costly irreversible investments into low carbon technologies Blyth et al., 2007; Fuss et al., 2007. Related, there is evidence that doubts surrounding a system’s long-term viability or stringency can dampen prices or invoke speculative behavior. In a market that is dominated by such dynamics, assuming increasing marginal abatement costs,1 delayed abatement would result in steeply rising future prices if original stringent allowance caps are to be met. Such drastic price increases would put significant pressure on policymakers to intervene either to relax the cap or implement alternative res in order to avoid the related societal costs. Such dynamics feed already existing regulatory uncertainty surrounding future targets and might intensify market participants’ focus on the short term. Addressing market imperfections tools to adjust the allowance market At least partially in response to these market and regulatory imperfections, of the 18 ETSs operating today, most systems include some mechanism to adjust the allowance market. The theoretical set of options can be mapped in a two-dimensional ETS governance space. The horizontal dimension represents the extent to which the chosen tool to adjust the market targets allowance quantities or prices. At one end of the spectrum is a pure ETS where prices have no limits and the quantity of allowances is fixed. At the other end is a carbon tax. In between are many different hybrid options – for example, ETSs containing 1 Marginal abatement costs are generally expected to increase over time as low cost options are exhausted first, leaving more expensive abatement options for later. This however might not be the case if technological progress reduces future abatement costs below current costs. Emissions Trading and the Role of a Long-run Carbon Price Signal 4 International Carbon Action Partnership price floors, corridors, or cost containment reserves. The vertical dimension refers to the institutional arrangements for adjusting the market and the extent to which governance for the ETS has been delegated away from the government. In a textbook ETS, there is no delegation of governance the government legislative or cutive, depending on the jurisdiction and the nature of the change implements changes directly. However, the market could also be adjusted in part automatically via a rule-based mechanism or by an independent body. Note a box with a solid line denotes a governance model that has been implemented. A box with a dashed line represents one that has been proposed. As the government is not required to maintain the price floor, this is not a strict hard price floor. The regional ETS in China are pilots with the main aim of testing options for the national system. As a result, they operate with more flexibility and less al procedures. Details regarding the operation of delegated authorities are sparse. Figure E.S.2 ETS Governance Space – an empirical mapping of tools to adjust the allowance market, based on Grosjean et al 2014. Price instruments explicitly maintain allowances prices within a pre-determined range. Prices are supported either via a reserve price at auction RGGI, California, Québec, Ontario or through a hard price floor where the regulator intervenes in the secondary market to support prices Beijing. High prices are restricted either via a cost containment reserve RGGI, California, Québec, and Ontario, which releases a limited number of additional allowances from a reserve to the market when certain trigger prices are reached or through a hard price cap where the government guarantees to defend the upper price level by releasing an unlimited number of allowances or charging a fixed fee for emissions at a set price New Zealand NZ ETS. Emissions Trading and the Role of a Long-run Carbon Price Signal 5 International Carbon Action Partnership If credible, price control measures can guide price expectations of market participants and to some extent prevent the distortions resulting from myopia and excessive discounting. Experience with different systems indicates that a price floor may also be set at a level below what is required to induce abatement. However, this still results in a guaranteed abatement “fee” that raises revenues and, at the same time, reinforces government commitment to the longevity of the system until prices rise or further adjustment are made. Somewhat less directly, quantity control measures automatically add or