DESIGNING AND IMPLEMENTING EFFECTIVE, EFFICIENT AND EQUITABLE TRADING SCHEMESPrinciples, Experience to date and Current Australian Proposals

Presented by Dr. Regina Betz © CEEM, 2007E + CO2, Melbourne

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ContentEvaluation criteria and relevant design parameters – Environmental Effectiveness – Efficiency– Equity

Lessons from the European Emissions Trading Scheme (EU ETS)Current Australian proposals (State based and Federal proposals)

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Evaluation criteriaEnvironmental Effectiveness: the extent to which the environmental objective is achieved. – how well the scheme is actually mitigating the dangers of climate

change by delivering long-term reductions in greenhouse gases (GHG).

Efficiency: the extent to which the required objective is met at least cost. – This includes dynamic efficiency (innovation incentives)

Equity aspects: the extent to which any group is unfairly disadvantaged or favoured.

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Relevant design elementsEnvironmental Effectiveness– Target– Coverage– Leakage

Efficiency– Target– Coverage– Allocation method

Equity aspects– Target (Burden sharing between generations)– Allocation method– Burden Sharing between sectors

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How effective is the EU ETS?Target:

– First phase: EUAs allocation exceeded 2005 emissions by around 100 Mio. t CO2– Reasons: Uncertainties in base data were significant compared to small cutbacks

Technical and time constraints when determining the reductions: E.g. data was not verified by independent auditors (lack of time and accredited institutions) -> potential exaggeration of emissionsOver-optimistic economic growth in the baseline since government and business sector like to believe in strong economic growthDifficulties with new entrants: dividing between growth of existing installations and new installations -> double counting possible

– Second Phase: Substantially improved by EC decision, higher prices for EUAs; signal to other MS and carbon markets

Coverage:– First Phase: Only CO2 from proces and combustion emissions.– Second Phase: Some MS cover N2O emissions

Leakage: – Free and generous allocation to most sectors, little leakage expected

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Decision by European Commission (Phase 2)

Aggregate reduction of ET-budgets for 24 MS 200 million EUA or -9%.

Source: EU Commission

-2.1

-4.8 -2

.0

-6.4

-1.5

-13.

2

-1.3

-4.6 -2

.4

-15.

1

-1.6

-11.

7

-4.6

-7.8

-76.

1

-10.

3

0.0

0.0

0.0

0.0

-0.4 -0.8

-4.5

-28.

9

-6.4

%

-7.6

%

-5.1

%

-8.5

%

-6.6

%

-6.3

%

-31.

9%

-5.1

%

-9.5

%

-14.

8%

-23.

0%

-47.

8%

-12.

4%

-57.

7%

-46.

9%

-26.

7%

-25.

1%

0.0%

0.0%

0.0%0.0%

-0.3

%

-27.

5%

-6.0

%

-80

-70

-60

-50

-40

-30

-20

-10

0

Austria

Belgium

Denmark

Finnlan

dFran

ceGerm

any

Greece

Irelan

dIta

lyLu

xembo

urg

Netherl

ands

Spain

Sweden

UK Czech

Rep

ublic

Cyprus

Estonia

Hunga

ryLa

tvia

Lithu

ania

Malta

Poland

Slovak

iaSlov

enia

2

-70%

-60%

-50%

-40%

-30%

-20%

-10%

0%

Cut by EU Commission (Mt CO2e/a) Cut by EU Commission (%)

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How effective are the Australian proposals?

Target setting: long-term aspirational goal, with gateways defining short-term windows (see next slide)– Difficult to assess since no targets have been published yet– Danger of backsliding at each review point– Price cap / safety valve may reduce GHG reductions, since more permits

will be issued over the price cap.Coverage: Broad coverage based on a mixture of upstream (small emitters) and downstream (big emitters).– Only effective if double counting is avoided and GHG can be accounted

for with high accuracyLeakage: Free allocation to TEEII to avoid industrial relocation of production to countries with no climate policy– Additional permits for significant new Trade-exposed emissions-intensive

industries (TEEII) will reduce GHG reductions

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The Emissions Trajectory

Source: TG report

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How efficient is the EU ETS?Target– Introduction of ETS is questionable if only little reductions compared to

Business as usual are achieved, since scheme bears transaction costsCoverage:– Too many small companies included in scheme: Costs outweigh benefits

Allocation:– Little auctioning (3.4 %) mostly allocation for free (96.6%)– Up-dating dilemma (see next slide): If future allocation is a function of

today’s emissions it provides a perverse incentive for less abatement today in order to receive more permits in the future

– Perverse incentives for new entrants and closures: Free allocation to new entrants coupled with withdrawal of allocation from ceasing installations gives an incentive to keep inefficient plants in operationAllocation to new entrants based on benchmarks on capacity installed gives perverse incentive to build oversized boilers (Denmark has reduced allocation BAT/benchmark)

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Coverage: Emissions – Installation relation

-0.10

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00

0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00

Share of number of installations

Shar

e of

acc

umul

ated

allo

wan

ced

Austria Belgium CyprusTchek Republic Finland FranceGermany Greece IrelandLatvia Lithuania LuxembourgMalta Poland PortugalSlovenia Sweden UKDenmark Netherlands SlovakiaItaly Hungary SpainEstonia EU

Share of allowance allocation compared to share of number of installations (Lorenzcurve): around 50% of the covered installations emitted around 2% of total CO2 emissions

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Base periods – Up-dating

Country 1995 1996 1997 1998 1999 2000 2001 2002 2003ATBE - WBE - FBE - BCYCZDEDKEEESFIFRGRHUIEITLTLULVMTNLPLPTSESISKUK

No use of historic emissionsNo use of historic emissions

NAP II not available

No use of historic emissions, but 2005 output

Not analysed yet

No use of historic emissions

No use of historic emissions

NAP II not available

2004 2005

InstallationAggregate

Country 1995 1996 1997 1998 1999 2000 2001 2002 2003ATBE - WBE - FBE - BCYCZDEDKEEESFIFRGRHUIEITLTLULVMTNLPLPTSESISKUK

No use of historic emissionsNo use of historic emissions

NAP II not available

No use of historic emissions, but 2005 output

Not analysed yet

No use of historic emissions

No use of historic emissions

NAP II not available

2004 2005

InstallationAggregate

Source: Neuhoff et al. Climate Policy 2006

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How efficient are the Australian proposals? Target:

– Difficult to assess since no targets published yet Coverage:

– Mixture of upstream and downstream should avoid having small companies directly liable - they will be incorporated via upstream trading

– Inclusion of wide range of offset projects can reduce costs further. However, additionality and measurement needs to be ensured.

– International linking will improve efficiency but some of current design elements likely to not be compatible (e.g. safety valve, non-Kyoto offsets, forestry offsets)

Allocation:– Compensation approach will require many untestable assumptions under large

information asymmetry, might not be feasible and potential for legal challenges– Perverse incentives before ‘announcement date’– TEEII compensation through free allocation will eliminate internal price signal and

increase costs to rest of economy. Output (benchmark * output) on which free allocation to TEEII is based will function as a subsidy of output.

– Auctioning might have positive impacts on efficiency of market. Proposal does not set a minimum share and might therefore be subject to lobbying.

– Safety Value and banking trigger might have negative impacts on price stability

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Is the EU ETS fair regarding equity? Target– Equity with regard to future generations is questionable

Allocation– Companies pass through the carbon opportunity costs to their customers– Free allocation leads to high windfall profits for emitters– Rough estimate (Sijm) of windfall profits for phase II (reduced to phase I,

since free allocation to electricity generators was reduced):non-fossil producers EUR 8-11 bnfossil generators approximately: EUR 8-12 bn

Sectoral Burden Sharing– Cut in emissions for ETS covered sectors relatively low. However, cut in

total allocation by EU commission has improved this burden sharing.– Empirical evidence from bottom-up and top-down models: mitigation

costs in ET-sector are smaller than in other sectors (households, services, transport)

– To meet Kyoto target non-covered sector and Government treasuries will bear costs e.g. by buying Kyoto credits

14Source: Jack Pezzey Presentation, ANU

Distributional effects of emissions trading

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Allocation between ET and Non-ET sector€/t CO2 for ET-sector €/t CO2 for non ET-sector

Marginal abatement costsfor ET-sector

Marginal abatement costsfor non ET-sector

Emissionreductionshare for ET-sector in %

Emissionreduction sharefor non ET-sector in % 0/100 100/0

ideal share for ET sector ideal share fornon-ET-sector

Source: Schleich, Fraunhofer ISI

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Sectoral Burden Sharing EU ETS12

.5%

7.3%

23.6

%

11.2

%

3.7% 4.8%

2.3% 5.

7%

4.6%

-5.1

%

7.3%

-16.

2%

-0.9

%

4.7%

-24.

2%

18.4

%

7.2%

5.3%

13.5

%

2.5%

-3.6

%

-2.5

%

-4.0

%

-2.8

%

-5.3

%

0.6%

-5.4

%

-2.5

%

-16.

2%

-74.

6%

-15.

4%

2.5%

28.3

%

NA

NA

6.8%

6.8%

-0.3

%

-92.

9%

-100%

-80%

-60%

-40%

-20%

0%

20%

40%

Austria

Belgium

Denmark

Finlan

dFran

ceGerm

any

Greece

Irelan

dIta

lyLu

xembo

urgNeth

erlan

dsPort

ugal

Spain

Sweden UK

Cyprus

Czech

Rep

ublic

Estonia

Hunga

ryLa

tvia

Lithu

ania

Malta

Poland

Slovak

iaSlov

enia

4- Hypothetical allocation scenario (with KM) / ET-budget phase 2

4- Hypothetical allocation scenario (with KM) / ET-budget phase 2 (COM decision)

Source: Betz et al. Climate Policy 2006

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Are the Australian proposals equitable?Target:

Difficult to assess since no targets published yet

Allocation– “provides an up-front, once-and-for-all, free allocation of permits as compensation

to existing businesses identified as likely to suffer a disproportionate loss of value due to the introduction of a carbon price”

– “free allocation [to ameliorate] the carbon-related exposures of existing and new investments in trade-exposed, emissions-intensive industries”

– “Govt. will move early to establish the information base on which free permits will be allocated...Treasury will model...impact on different sectors of the economy”

Depends on share of auctioning which depends on compensation to industry (modeling approach) e.g. if “net” figures are taken or only “losses” (individual generators vs. generator portfolios; losses and winning years)Depends on recycling of auction revenue if this is used to compensate consumers, support technology development or lower taxes

Sectoral Burden SharingWide coverage should reduce unfair burden sharing

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Conclusions on Australian proposalsSome innovative design features, ambitious coverageTargets not published yet which are key elements to evaluate the proposalsSome implementation issues unclearBalance of auctioning vs. free allocation questionableInternational linking will be challenging under current offset, price-cap arrangementsCould end up with a well-designed but (initially) toothless scheme since the devil is in the details!– Perverse incentives are easily created– BUT auctioning could cure most of the problems

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