This is a rare moment for climate policy making in the EU, writes Emil Dimantchev, senior carbon market analyst at Thomson Reuters. Lawmakers in Europe have begun a process to redesign the EU carbon market with new rules that will take effect after 2020. According to Dimantchev, they should follow the example of California and introduce a dynamic allocation system of CO2 permits. It is the most practical and politically feasible way to end windfall profits.
In the current process to reform the carbon market, one important goal for lawmakers, unanimously embraced by EU member states, is to ensure the system does not grant polluting industries windfall profits. Lawmaker concern stems from an inconvenient fact. The current design of EU’s Emissions Trading System (EU ETS) gives companies CO2 permits for free in a way that allows them to reap bountiful profits at the expense of consumers. The question is: how could the EU fix this?
The best solution is likely to be a free allocation system similar to what has already been implemented in California – a dynamic output-based allocation of permits. In Europe, a related, but very complicated, proposal failed to gain traction in 2014. But the idea of aligning free allocation to industrial output has endured in both the Council and the Parliament. This post takes a look at a dynamic allocation system for the EU that could both end windfall profits and garner broad political support.
Redesigning CO2 permit allocation in the EU
A dynamic allocation system gives away CO2 permits to companies based on their most recent production levels. To understand exactly how it would work in the EU context, we need to briefly consider how the EU ETS currently operates.
Today, the EU calculates how many free permits each installation would receive based on how many tons of industrial product the facility is expected to make per year. Crucially, EU regulators calculate an installationâs annual production based on output data observed over some fixed historical period. For example, the Commission mainly used data up to 2010 to determine free allocation for the whole period 2013-2020. Now, it proposes to base free allocation in 2021-2025 mainly on data up to 2017.
Dynamic allocation would work differently. The assumed annual production would be equal to the most recent industrial output data. Thus, the allocation in 2021 could be based on data in 2019, the allocation in 2022 on 2020 data, and so on. In this fashion, the basis for the production level would keep rolling and free allocation would keep changing based on the latest economic developments.
Hence, dynamic allocation. For such a system to work, there should be an additional design feature: an ex-post correction. This provision would adjust future allocation to compensate for any over- or under-allocation (up to a point) in the past.
Some industries have already expressed support for dynamic allocation. It may be the most pragmatic way forward
The following example illustrates, broadly, the mechanics of dynamic allocation. Say a cement maker reduces its production level by 5% in year Y. The allocation in year Y remains unchanged. In year Y+1, member states collect verified production data for the previous year, which then forms the basis for allocation in the following year. In year Y+2, free allocation is cut by 5% of what would have been allocated (to account for the latest known production level) and by an additional 5% of the allocation in year Y (to account for the fact that the cement producer was over-allocated CO2 allowances). And vice versa in the case of higher production.
Importantly, such a system would only work well if there is a hard cap on industrial free allocation. This cap could be the same as the one proposed by the Commission, which suggested that 43% of the total EU ETS cap be available for free allocation. This cap would leave plenty of allowances available for industries that grow their production.
Our analysis at Thomson Reuters suggests current draft proposals in the Industry and Environment committees in the European Parliament would result in a significant amount of allowances from the industry cap that will be left unallocated. These can accommodate any production increases.
How dynamic allocation minimizes windfall profits
To see how dynamic allocation can serve as a solution to windfall profits, letâs recap briefly the cause behind the problem.
The reason industry can gain windfall profits from the carbon market is because the current system of free allocation incentivizes producers to raise the prices of their products, even though they get CO2 allowances for free. Revenues go up, while costs stay the same. This happens because manufacturers are driven by opportunity costs. A company that receives free permits can always choose to cut production and sell its allowances. So, to keep producing implies giving up this opportunity, which amounts to an economic cost.
As I explained earlier, a profit maximizing company will raise its product price to reflect this framework of incentives. Comprehensive empirical research shows that industrial companies have indeed engaged in such CO2 cost pass through in the past.
A dynamic allocation system would largely wipe out the incentive for companies to pass through opportunity costs. To see how, consider what would happen when a company reduces its production. It will now know that its future allocation will be cut. The company will still have surplus allowances because the allocation adjustment will occur in two yearsâ time. However, it will lack the option of selling these allowances because it will need them in the future. The continuous ex-post correction described above ensures that the opportunity cost will, for the most part, no longer exist. As a result, the current pernicious system of incentives that causes windfall profits will collapse.
Once the current reform process is over, the next chance to change the free allocation rules will probably fall around the mid 2020s
One downside is that the price of steel and other products will no longer reflect the CO2 price. Companies using such materials, like carmakers, will lose the incentive to use them more efficiently or switch to less carbon intensive products. This effect will be limited to industrial sectors that receive 100% of their allowances for free, which will likely be the case for steel, given the current state of the discussion in the Parliament. Other sectors, which may need to buy some of their allowances, will continue to reflect part of the CO2 price in their products.
To ensure that industrial consumers are incentivized to reduce emissions, the EU could implement a consumption charge in combination with dynamic allocation, in line with a recent proposal by Climate Strategies. Researchers have long understood how dynamic allocation curbs windfall profits, but the insights have only rarely escaped academia’s bubble. Though regulators in California recognized it, the policyâs potential has been largely absent from EU policy talks. It is time for that to change.
A politically feasible solution
Dynamic allocation would be a practical way to end windfall profits. It would be very challenging to do so without it.
The ideal solution, full auctioning combined with border levies on imports, is likely out of reach. Lawmakers and stakeholders have to accept the idea that the EU will continue to give away CO2 permits. Another proposal, put forward by Carbon Market Watch, is for lawmakers to try to adjust the future amount of free allocation by the percent of CO2 costs that they think industries can pass through to consumers without losing market share. But it is a challenge to calculate, let alone agree on, such percentages.
This difficulty is not an excuse for inaction. Yet it does complicate matters for those who would like to prevent windfall profits. Whatâs more, some industries have already expressed support for dynamic allocation. It may be the most pragmatic way forward. The last time the EU ETS directive was opened up for full overhaul was eight years ago. Once the current process is over, the next chance to change the free allocation rules will probably fall around the mid 2020s. Lawmakers may wish to make the most of this rare opportunity.
Editor’s Note
Emil Dimantchev is a senior carbon market analyst at Thomson Reuters, previously known as Point Carbon, an independent provider of analysis on global carbon markets, where he develops quantitative models and writes extensively on market developments and policy issues. The views expressed in this article do not necessarily represent those of Thomson Reuters.
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Hans says
With the dynamic allocation system would some companies get all of their C02 certificates for free? If so, where is the incentive to reduce CO2 emissions? Would it not be more useful to put a limit on that, like 60% of last years emissions?
More general: the article nicely shows how complicated and bureaucratic the certificate trading scheme is, with plenty of room for governments to protect their favourite vested interests from paying for the damage they do to the climate (and therefore to us all). Let’s also not forget how fraude sensitve the system has shown to be, with Russia selling fraudulent certificates, and refridgerator factories that were built to leak fluorcarbohydrates, just so that the CO2-equivalent emission reduction from repairing it could be sold under the clean development mechanism.
Overall, it seems that a simple CO2 tax must be simpler, cheaper and more effective.
Emil Dimantchev says
Hi Hans, yes some probably will but only under certain conditions. Without getting into the details, some companies will keep receiving allowances for free but only up to a certain free allocation cap. If they need more allowances than the cap, then they will face a shortage and have to buy them on the market. The incentive to reduce emissions comes from the fact that if a company becomes more CO2 efficient, it will have extra allowances it can sell. It also comes from the fact that only the companies that are among the top 10% most CO2 efficient ones in their sector will receive what they need for free (this is because of the so called CO2 benchmark). The rest will receive fewer permits and will thus be incentivized to become more efficient (just like they are now – the benchmarking is part of the current system and can be part of a dynamic allocation system too).
I agree, it is complex. But remember that the EU tried to pass a CO2 tax in the 1990s, twice, and failed. A tax is simply out of the question. It requires unanimous consent among member states. Even a price floor for the ETS is a very controversial idea that is currently being shelved. The EU ETS is the best carbon pricing system the EU’s got. So if those interested in improving carbon pricing in the EU, will have to work on it by improving the ETS in my opinion.
Tilleul says
At one point when there is so many things to do for this thing to start working : stop calling it a market, call it a overly complex state regulation.
At the same time we had a full support for a renewable directive and an energy efficiency directive (with a binding target on renewable) and that worked particularly well. Creating a market for a problem don’t create solutions, taxing it neither.
Companies don’t become more CO2 efficient by magic, they are reducing their CO2 emissions because they use their ressource more efficiently by investing into more efficient means of production (which is simply good business). If you want to invest, you need money ; if you need money, you need to go to the bank. So the simple question is that : are banks taking into account the price of CO2 when they assess the bankability of SMIs who want to invest in a new industrial boiler ? No they don’t, and they can’t because of the variable price of CO2. Do they take into account a carbon tax, no more… To reduce CO2 you need loan guarantee and grants or removal of environmental harmful subsidies to provide a level playing field with fossil fuels anything else don’t work.
A lot of countries in Europe had introduced a levy on energy consumption to fund these clean technology as part of the polluter pays principle and not a carbon market for a simple reason : if SMIs are paying an energy levy, they can recover their costs by investing into clean technologies funded by the levy. If they have to pay a carbon market, they will give money to large corporation who have the bankability to do energy efficiency investments (and usually receiving free allowances) and they won’t receive anything in return.
The system based on “state aid for environmental protection” which allowed members states to bring the cost to clean production of clean technologies to the level of carbon intensive one is working. We only have to continue and start removing environmental armful subsidies in the same time and everything will be fine.
This discussion about carbon market in the EU is really insane… This is a policy which has never work, that no one want and which even its proponents are not sure on how it should work. Yet we keep hear talking about removing everything that works because it goes against the carbon market…
Emil Dimantchev says
Tilleul, you raise good points about low carbon investments. The unpredictability of the EU carbon price makes it a poor basis for investment decisions. This is why I think a price floor would vastly improve the carbon market. A system of Contracts for Difference can also work well in conjunction with the carbon market.
But you are wrong the EU ETS has never worked. It does a good job (when the price is sufficiently high) of curbing coal use in the power sector. A number of studies have shown that the ETS has reduced 200-500 million tons of CO2 through by encouraging more gas use. (eg see: https://books.google.com/books?id=QxhgAwAAQBAJ&pg). The carbon market has had other, indirect effects too. For instance, it’s raised board room awareness of emission reduction measures. Yes, many such investments already make sense, but part of why they are not undertaken is because they are unknown or ignored by management.
I couldn’t agree more with your last point. I think both extremes are misguided. Let’s design complementary climate policies so they can effectively coexist.
onesecond says
This should really be a no-brainer.
Commenter says
The purpose of a carbon market is to make sure the carbon cost of production is considered when deciding how much to produce. Dynamic allocation undermines this mechanism, and as such prevents efficient emissions reduction. You can make a case for it on the basis that in the absence of a level playing field internationally it could help prevent investment leakage, but I donât see any environmental case in the longer term.
Cost pass-through is a good thing, and not something we should seek to fix. It happens whether allowances are given for free or auctioned, and is the consequence of producers deciding to produce less in response to carbon price signals. It also results in consumers facing carbon price signals, which is necessary to deliver efficient emissions reduction (and arguably also morally right).
Firms are more profitable when allowances are given for free, sure, but they still face the same carbon price signals and make the same production decisions (because they include opportunity costs in their marginal cost curve): the environmental outcome is the same, so I see no environmental grounds for objecting.
We shouldnât make the mistake of thinking âwindfall profitsâ mean polluters are being rewarded for polluting, or that the incentive to reduce emissions is being undermined. Free allocation is not at odds with the polluter pays principle or carbon pricing.
The distinction between free allocation and auctioning is economic not environmental: itâs about whether industry is more profitable or governments get the revenue. There are arguments are on both sides and consumers pay the same in both scenarios.
Itâs regrettable that environmental NGOs focus on arguing for phasing out free allocation but support dynamic allocation: it seems to me this is precisely the wrong way around.
There is nothing particularly environmental ambitious about a larger auction shareâwhat matters is the number of allowances in the system (and penalty price), not how they are issued. In fact a larger free share could result in fewer allowances being issued, if it exceeded what was needed to meet commitments to the carbon leakage list installations. This would reduce the market surplus and push up prices, improving environmental outcomes.
Dynamic allocation is seen as a means of reducing surplus allocation to individual installations, but this is a red herringâthis kind of surplus is an economic issue not an environmental one. As long as the overall number of allowances is ambitious (and not in surplus), the environmental outcome will be right. Adjusting individual allocations according to changes in output just prevents efficient emissions reduction by undermining the fundamental mechanism of the carbon market.
Emil Dimantchev says
Thank you for the thoughtful comments. You are right to point out that curbing cost pass through would lessen the incentive for consumers to take use CO2-intensive products more efficiently or to switch to less CO2-intensive ones, as I wrote in the piece. Yet it’s unclear how significant this problem is. Can you quantify how much abatement is currently being driven by industrial cost-pass through that would then disappear? Even if this is deemed a problem, as I suggested, a consumption charge, implemented together with dynamic allocation, will alleviate this problem.
However, saying that the choice of free allocation or auctioning has no environmental effects is incorrect. It ignores the fact that 87% of revenues from auctioned allowances are currently funding climate mitigation and low-carbon innovation The same cannot be said for the windfall profits accruing to businesses. Increase the latter at the expense of the former and you decrease environmental effectiveness by reducing low carbon finance in the EU.
Moreover, your argument that companies participating in a carbon market face the same incentive whether they buy permits or get them for free is based on a neoclassical economic view that assumes perfect rationality, which has been proven false by behavioral economics. Though it is hard to know how the bounded rationality of companies affects their carbon market decisions, we should at least stop treating the neoclassical view as a forgone conclusion.
Finally, windfall profits may have environmental repercussions through their economic effects. By effectively subsidizing businesses, they may be propping up polluting companies that might otherwise have gone out of business. In this way, windfall profits can have complex and potentially significant environmental effects.
And to your point about how a larger free allocation share might reduce the overall supply of permits – our modeling at Thomson Reuters does suggest this may happen, but only if you make a number of assumptions, chief among which is that the extra “unused” allowances would not be funneled to other uses and be given out to the market one way or another, which lobbyists and lawmakers from various factions would be interested to do.
Emil
Commenter says
Hi Emil–thanks very much for responding.
I’m not just arguing that cost-pass through is good because it exposes consumers to carbon price signals. My main point is that itâs good because it reflects the fact that producers are responding to carbon price signals when deciding how much to produce (thatâs how the cost is passed through): itâs a sign that things are working.
In other words Iâm arguing that if you want to stop cost pass-through, you want to stop the situation where firms consider carbon costs in their production decisions, which is a really fundamental aspect of the carbon market that we should keep.
I donât have any data on the consumer carbon price signal issue, Iâm afraid, but this Harvard study has some interesting comments on dynamic allocation subsidising production and preventing efficient emissions reduction (it’s a bit old but probably makes the case better than I’m doing):
https://www.hks.harvard.edu/m-rcbg/rpp/Working%20papers/Hahn%20%20Stavins%20RPP%202010.02.pdf
Iâm not deaf to the hypothecation argument, but Iâm sceptical about additionality (would the governments not have spent these sums anyway?). And if a lot of it goes towards reducing emissions of participants in the ETS it would presumably just distort the efficiency of emissions reduction without increasing reductions overall.
And on the other side, in favour of free allocation, you could argue that if industry is more profitable they are more likely to respond to carbon price signals by investing rather than reducing production, which could be good to develop breakthrough technology (and has economic benefits).
I totally agree that my post was putting forward the neoclassical view, which is based on the assumption that firms are profit maximisers and base production decisions on marginal costs. But I would point out that the cost pass-through you seek to address also assumes this. I donât think these assumptions perfectly reflect how people behave, but at the same time theyâre not terrible approximations either, and your position assumes them too.
In saying that thereâs no environmental difference between free allocation and auctioning Iâm simplifying. In practice there are some transaction costs and endowment effect etc, but I donât think these are massive issues, and studies like the one linked above provide some empirical support for the view that how you issue allowances is independent from the environmental outcomes.
I think there are arguments for auctioning and free allocation, but primarily itâs an economic issue rather than environmentalâdouble dividend hypothesis, versus jobs etc. (And Iâm not saying there shouldnât be any auctioning.)
At the end of the day, though, you could still have a very ambitious scheme within which all allowances had been issued for free. And as you note, a large free share (again making certain assumptions) could lead to stronger carbon price signals within the benchmarking system.
In this sense I would still maintain that it makes more sense to argue against dynamic allocation (at least as a level playing field emerges), rather than attacking free allocation. And I think the concern about individual surpluses is misplacedâthe real issue is the overall number of allowances. Interfering to correct individual surpluses (or allow for growth) just subsidises production, undermining the whole point of carbon pricing, doing more harm than good. Indeed, simplifying again, you could give all the allowances to one installation (who would make a killing economically), and still basically bring about the same environmental outcome–what matters is the overall situation from an environmetnal perspective.
Interested in your thoughts, and sorry for the length of the post!
Emil Dimantchev says
Is the point of the ETS really to influence the how much is being produced? I think the first and foremost goal, which is stipulated in the EU ETS directive, is for the carbon price to drive cost effective emission reductions. Emissions are most effectively reduced by changing how we produce things (i.e. lowering CO2 intensity), not how much we produce (less production in Europe only means more production elsewhere, all else being equal, aka carbon leakage).
Regarding production incentives, the current system has some pernicious effects – a Sandbag study found production in the cement sector was higher than it would have been because ailing producers made sure to stay above the 50% activity threshold that enables them to get their full dose of free allocation. https://sandbag.org.uk/reports/final-carbon-fatcat/ This reveals an environmental benefit of output-based allocation I havenât yet mentioned – less allocation and higher carbon prices during economic downturns.
The study you linked is very interesting. Thanks for pointing me to it! Yes, output-based allocation subsidizes production. But by allowing windfall profits, we are already subsidizing industry, wouldnât you agree? I donât currently see how one is worse than the other, do you? Moreover, I suggested that dynamic allocation should be allowed only up to a point – there should still be a cap on free allocation, and this cap would limit such subsidization.
You are totally right to question the additionality of low carbon finance from auctioning revenues. It would be a much needed improvement of the ETS if lawmakers approved rules to ensure additionality. But I would be surprised if none of the current funding was additional. Most likely, the revenues are having at least some small impact. I would be less trusting of industryâs foresight and willingness to invest its windfall profits in low-carbon R&D. The private sector is generally a follower rather than a leader in high-capital, risky innovation. Mariana Mazzucato provides some empirical and illustrative evidence of this in âthe Entrepreneurial Stateâ.
On the point about the independence property, the study you linked does offer some thoughts in its defense but remains far from providing sufficient proof, even for the EU ETS where it cites another study that uses very limited data and only looks at production decisions, neglecting abatement decisions that reduce CO2 intensity and how they may be impacted by bounded rationality. To its credit, the Harvard paper makes references to several reasons why firms may not be profit maximizers, but it doesnât test all of them, at least not for the EU ETS. So I remain skeptical of the hypothesis that free allocation and auctioning are equivalent or even approximately equivalent.
A final environmental benefit – if dynamic allocation alleviates carbon leakage worries, this may clear a political path towards a stronger EU ETS, via a tighter cap, or an enhanced Market Stability Reserve. I am curious what you think.
-Emil
Commenter says
Thanks again Emil.
The traditional understanding of a carbon market is that we price carbon, thereby internalising negative externalities and ensuring carbon costs are considered in our economic activity. This means only producing units where the benefit outweighs the cost (including carbon cost). And efficient emissions reduction here means that the least valuable production drops out first. In this sense, reducing production is one thing a carbon market is typically expected to do.
But as you note, you can reduce emissions by improving the emissions intensity of production as well. In the absence of a level playing field this should perhaps be the focus of the EU ETS, and we can use policy to focus it in this way. I agree, then, that there is an investment/carbon leakage case for dynamic allocation in the short term, but Iâm arguing that there isnât a long-term environmental case for it if weâre serious about pricing carbon (which I noted in my first comment). I also take your point about there still being a cap on free allocation in your proposal, so itâs not infinitely dynamic, which is an important restraint for sure.
On the cement situation I would see that as an example of how activity level thresholds (which are a clumsy kind of dynamic allocation) subsidise production. If there hadnât been any thresholds, the overallocation due to the recession would still have resulted in windfall profits but would not have encouraged the cement sector to produce more (and thereby emit more). This assumes theyâre rational profit maximisers (but based on their savvy gaming of the system thatâs probably a safe assumption!).
As counterintuitive as it may seem, then, itâs the attempt to address individual over-allocations, not the overallocation itself, that is causing the over-production problem here. More responsive activity level thresholds are better (and 10% seems to have a majority in ITRE at the moment), but none at all would be better yet.
Having said that, I take your point that if we werenât over-allocating free allowances, more might remain unissued and hence put upward pressure on the carbon price. My first instinct is that you could probably solve this using your dynamic model, but take out the ex post correction bit to avoid subsidising production. Does that make sense? So youâd stop the overallocation (pretty much at least), but it wouldnât detach production decisions from carbon price signals.
On windfall profits being a subsidy, I would stress that thereâs no subsidy for producing/polluting here. Itâs still rational for installations to only produce those units where the benefit exceeds the costs (including carbon costs), and sell the remaining allowances (and thatâs where the profit comes from). In the case of the cost pass-through you describe in your article, for instance, windfall profits arise precisely because participants respond to carbon price signals and decide to produce/pollute less. The profits are evidence of carbon pricing in action not something at odds with carbon pricing.
Now whether you see the profits as a subsidy in a wider sense (to which you may have an economic/philosophical objection) is another matter. But on this I would note that thereâs no transfer of taxpayersâ money to industry, thereâs no anti-competitive behaviour from industry, and consumers are not paying any more than they would do in the auctioning counterfactual. If we call this a âsubsidyâ, couldnât we call the auctioning scenario a âtaxâ (consumers paying money that ultimately goes to governments)? It seems a bit emotive and Iâm not sure if these labels help the debate.
Iâd like to know more about rules to ensure additionalityâIâve not looked into this area. If you have any info that would be great! Do you take the point that government spending can also overlap with the ETS and thereby reduce the efficiency of emissions reduction without bringing about more reduction?
I agree that there isnât a huge amount of empirical work out there on the independence thesis, and the assumptions are unlikely to hold perfectly, but the basic idea that how you distribute allowances originally doesnât change the carbon price signals or the (rough) outcome seems likely to be right to me. (And the cost pass-through youâre seeking to address seems basically to assume the independence thesis, i.e. carbon price signals are the same and firms behave the same whether they get allowances through auction or for free.)
Allowances have value insofar as they are scarce and allow an installation to avoid a penalty. They have this value regardless of how they are issued. Given that these valuable items have to be surrendered as production/emissions intensity increases, it would be surprising if firms were not considering this in their production/investment decisions. If someone gave me some gold for free, for instance, but said I had to return it if I produced a unit of stuff, I would be stupid to produce that unit unless the benefit outweighed the cost of losing the gold.
Now, market power, endowment effect, transaction costs, imperfect knowledge and so on, may mean there isnât perfect independence, but these seem unlikely to be major issues to me (no one has much market power, transaction costs are low, the seemingly autarkic behaviour with free allowances probably just reflects low carbon prices etc). I think we risk overcomplicating things by worrying too much about whether the reduction is exactly equally efficient.
Perhaps itâs more useful just to reflect on the fact that even the most ambitious ETS (with a really high carbon price and steep LRF) could use free allocation as its exclusive means of allocation. And you could give all the allowances in the system to one installation and theyâd still have the same value and be sold and distributed to bring about the same outcome (roughly).
On your final point, Iâm arguing a larger free share would keep industry happy (and avoid the need for a nightmare conversation about tiering). This wouldnât subsidise production and could even be better for the carbon price if it turned out to be an over-estimate. I think there is an investment leakage case for dynamic allocation, though, and youâre right that it would keep industry happy so could be used as political leverage (but we should just be wary of dynamic allocation in the longer run).
(That was quite a long one again!)
BVB says
Insightful post and discussion.
One practical – detrimental – aspect in the transition to dynamic allocation:
If industry is certain to receive the necessary amount of allocation – what would prevent them to sell the estimated 800m EUA long position they are currently holding?
I would argue that industry is holding on to banked length with a view to tighter allocation rules post 2020. No decision maker wants to be seen selling EUA at 5 EUR and eventually having to purchase additional EUA in 2021 at a higher cost. Implicitly this is akin to backloading, supporting short term prices and decreasing increases in the future (when industry uses reserves instead of buying).
Dynamic allocation would “burst the bubble” of risk managing prices via banking, thus converting EUAs from a compliance instrument into a cash reserve, potentially depressing prices until banked length is eroded.
In the best case prudent long companies will wait for the MSR to impact prices and to sell at a higher price. But holding large volume of EUAs when there is no need might be seen as “speculation” and as such not even been allowed.
On the topic of “passing through costs”: I would propose that any subsidized investment in Renewables or Energy Efficiency via FIT, tax exemptions, direct funding etc) must buy and retire EUAs equivalent to the expected CO2 reduction it would induce. We know from the CDM experience how baseline emissions can be calculated.
Otherwise reduction in EUA “demand” (via renewables) without a reduction in supply is akin to raising the cap, ie increasing amount in the system.
Arguably, only when you reduce equivalent volume of EUA does investment in RE and EE have a reduction effect in the EUETS, otherwise it just leads to lower CO2 prices without real reductions.
Emil Dimantchev says
Thanks for your comment!
I agree that the carbon price is being supported by industriesâ holding onto large reserves of allowances on the back of expectations for future shortages. However, the dynamic allocation system I have laid out would still probably lead to significant shortages because of the benchmark improvements proposed by the Commission. But, yes, these shortages will probably be smaller. I am not sure this is something to worry about. The extent to which the current price level depends on industry banking is uncertain. Most industries look out about three years ahead so I do not think phase 4 shortages are the main factor holding up the carbon price right now, no?
Your proposal for nullifying the impacts of complementary policies on the EU ETS is sensible. It may be difficult for the EU to come to a mutually agreed system of calculating RE and EE emission reductions. Do you think there is a feasible way member states can reach consensus on a workable way to calculate the necessary reductions in the cap? Perhaps a more realistic pathway to achieving this goal could be to strengthen the MSR so that it effectively cancels out such impacts. Our modeling at Thomson Reuters showed that the current MSR design cancels out about half of the impact of such external shocks.
Best,
Emil