Cap-and-trade systems

For cap-and-trade systems, there are more options, starting from current ETS. The domain is expanded long term so as to cover all fossil CO2 emissions as there are no strategic reasons to get stuck halfway, and the IPCC stresses “that that a consistent carbon pricing, covering all sectors of the economy, is a defining feature of the 2 °C scenarios” ((IPCC-AR5-WGIII 2014), Annex III, paragraphs 183, 184 and 187), quoted approvingly by the expert group preparing for COP21 (UNFCCC-Experts 2015). All emission permits are auctioned. The pure volume based cap system sets emission levels and leaves prices as they come through market mechanisms. It has the advantage of a predetermined maximum emission level, if administered properly and if politically feasible if prices explode. It will include a national administration directly linked to national proceeds, to create the incentives for proper public administrative implementation, and from there the privately adequate administration. It has the disadvantage of unknown long term price

11 McDermott’s “Managed Carbon Price Act’ introduced in the US House of Representatives in 2014, starts at

$12.50 per metric ton of CO², increasing yearly with that same amount. In 35 years’ time this amounts comes close to 450$/tonne.

levels. From a long term perspective, the predictability of the price level is an important issue for long term investment decisions, and for helping to direct research and R&D in climate relevant directions. Heat pumps with seasonal storage require high capital investments, returned only if there is an operating cost differential with low-capital natural gas based heating systems. The emission price is one key factor then, of course operant only if that price signal is translated into decentral market prices. Also for medium term investments emission pricing may be decisive, see the car example based on current technologies, in BOX 4. Such cost considerations are due in any investment decision. The long term trajectory of pure cap based permit prices may be estimated based on past prices and trends therein. These shorter term trends are made less clear because of price volatility, see the survey paper by (Dinan and Stocking 2012) and the assessment by (Schmalensee and Stavins 2013) on the US experience with carbon trading for SOx. With future emission prices uncertain, decisions cannot be based on reasonably expected future prices. There is some certainty however, as long as it is not other instruments taking over from the cap-and-trade system: permit prices will rise substantially. Their overall expected level will be higher than the level deemed relevant for the carbon tax, due to inherent price uncertainty. The expected long term price also carries a subjective uncertainty as there is no carbon tax price given as a reference. Investors will therefor reckon with a lower price than actually would evolve with perfect foresight. This underinvestment in emission reducing measures bites back: it also raises the long term permit prices as will actually evolve.

There are several options to deviate from the fixed volume pure cap system, moving permit prices to an aspired higher level, or lower level as well. Adapting the volume of permits brought on the market is the main option, involving other instruments in the same domain the other. Currently there is an agreement to take non-used permits temporary but substantially out of the market, in the Market Stability Reserve, to be introduced by 2019. Such a fix on-the-go measure may be a perfect solution in the current situation, but is belongs to satisficing, not optimizing and is certainly not part of strategic planning. If too low prices are a problem in not guiding long term private R&D and Investment, the strategic solution is to stabilize the price at relevant levels, rising similar to the emission tax case to avoid unnecessary costs. Two cap options will thus be taken into account in the bottom up instrumentation development for the four sectors, in Chapter 5:

the Pure Cap-and-Trade option and the price stabilized cap version, as Hybrid Cap-and-Trade.

(The term is coined after (Goulder and Schein 2013)¹²). The pros and cons of these cap options will be analyzed in turn.

BOX 2 Rising emission prices in time? Theoretical positions

There are different positions on the most relevant dynamics of emission pricing. A strict economic-Pigovian type of reasoning is that the damage cost of emissions at time t should be reflected in the price level, as is advocated for example by (Tol 2008) who is a strong believer in a single and precise outcome of emission damage specification. With emissions going down to the optimum level, and adaptive measures being implemented, damages go down and the Pigovian tax is to be going down. The price starts high, directly, and then goes down as also advocated by Tol. This is the most clear and simple economic optimality reasoning, assuming markets to function and technologies to be there, the better ones replacing the

12 They mention as an advantage of price stabilization a reduction in the rent income of oil producing countries, a subject left out of discussion here.

existing ones. Start now at the relevant highest pricing level and things will only become easier, as marginal damages will go down. The implementation would be direct in the carbon tax and in the tradable cap system could be realized by moving from a fixed yearly reduction rate to a variable one inducing the required decreasing prices with volumes long term fixed in the Pure Cap system or more regular in the Hybrid Cap system. Politically this seems hardly feasible, certainly not if the EU would take a lead in policy.

The second position in reasoning is close but makes technology variable in time. Several low carbon technologies to be introduced are still to be developed. As the EU Commission states: ´The effort would become greater over time as a wider set of cost-effective technologies becomes available.” (COM 2011).

The emission price should be high enough by the time these cost-effective technologies have become available for investment. A first step in reasoning is to see which emission price level would make a renewable competitive, assuming all costs for all technologies as constant. See (IEA 2015) on the diversity of cost concepts, with levelized cost of electricity (LCOE) then including the cost of emission pricing. Also, a high speed of shifting to the new technologies implies a faster write off of existing capital. Furthermore, the speed of technology change is always restricted by many factors to be adapted, from adjoining technologies to norms and regulations, see (Kramer and Haigh 2009) with empirical data on energy and the more general ’35 years’ rule by (Hirooka 2006), stating that it takes 35 years for substantially new technologies to reach their maximum expansion rate, the fuller penetration rate following. Thirdly, with rising income, the value of damages will increase because of higher physical damage like by extreme weather events, with higher valuation. Finally, emissions are not falling for some time to come, but rising, with damages increasing, also due to delay effects. This is a similar type of optimality reasoning as in position number one, but with more factors made variable and hence more apt for longer term optimization. This version of optimality reasoning leads to a slowly rising emission price to start with, like rising to relevant levels in the next two decades, and later possibly leveling off and decreasing, if policies are successful. Implementation in the Hybrid Cap system and in the Emission tax seems possible.

The third type of reasoning is of the backcasting type, the Baumol type of reasoning. Targets are set, with the required prices to get there following. The target is not a specific path but the time integrated volume of emissions, like here the ‘1 teratonne CO2’ for the aspired level of 2-degrees climate stabilization. Within that target, the timing is somewhat open again, linking reasoning towards the second position. The abstract version of optimality, not technically specified, is guiding the path. One factor is added here: the last 10% of emission reductions may well be more difficult to realize than then first 90%, as low hanging fruits will have been picked in 25 years’ time. This would lead to a steadier rise in emission prices. The option of slowing down the rise in emission price can maybe be evaluated based on performance in 2040, mirrored by the requirement of raising the price faster. The (UNFCCC-Experts 2015) meeting in Bonn advocates fast reductions, for climate risks reasons, as later negative emissions are uncertain in their feasibility.

A fourth type of reasoning leaves the realm of integrated optimality reasoning. Targets are set, as in the Commission Roadmap, and the emission price is following, whatever that price may be. This position is linked to the pure and strict version of tradable emission permits, with a yearly specified immutable cap.

That pure position has been left somewhat by the Commission, reducing permit volumes in the market somewhat to raise their price. This then links to the third type of reasoning. It has been the position in the UNFCCC, with substantial literature on how to set the targets per year to remain within the climate budget, following RCP2.6 modelling. Later emission reductions require larger negative emissions later this century.

Finally, a fully different type of reasoning of a much more tax-practical type may be applied: what would be the proceeds of emission pricing, see Table 5, to help development of a green the tax system? From a tax office point of view, stable proceeds then are to be preferred. Ideally, then the price of emissions would be inversely proportional to the volume of emissions. This again links to a rising emission price, extreme in the end, with steadily decreasing emissions.

For all carbon pricing a consideration of primary producers is to reduce the risk of future very low product prices, bringing their resources on the market at higher volumes, and hence - collectively - lower prices now, see (Sinn 2012) for the reasoning involved in this paradox. (Edenhofer and Kalkuhl 2011) expand outcomes of the paradox to more precise assumptions and (Michaelowa 2012) gives a critical review indicating that the base assumption of equal cost for all production is highly unrealistic. Investment in most expensive new production capacity will be reduced by emission pricing, reducing the incentive to increase production now. (Harstad 2012) sees this leakage as undermining climate coalition efforts and proposes that the coalition buys all fossil resources to keep them in the ground, globally. This seems fully impossible, given the undefined nature of what constitutes resources and the extreme prices and related transfer payments that would be involved. More realistic leakage modelling methods have been developed by (Hoel 2011a, Hoel 2012) with more diverse outcomes. In their review on the subject (Fischer and Salant 2013) conclude that the paradox effect will be limited, if present at all. Other mechanisms induced by lower prices also due to climate policy may play a role however. The OPEC (Saudi) reaction to low oil prices, hardly induced by effective climate policy, has been to increase production to press US fracking production out of the market, accepting even lower prices. Such imperfect market mechanisms will remain.

Overall conclusion is that slowly but predictably rising prices reduce the cost of emission reduction, with a revision of the level after maybe two decades, to avoid underperformance or too substantial overperformance. Starting low and rising predictably has proven politically feasible in the UK price floor tax on CO2 emissions linked to ETS and the Canadian emission tax in British Columbia.

Table 5 Proceeds of emission pricing: emission price starting at 100€/ton in 2020 rising by 10€ per year