Price floors – getting some
perspective
Professor Michael Grubb, Chief Economist, the Carbon Trust
& Senior Research Associate, Faculty of Economics,
Cambridge University
Tim Laing, Research Assistant, Cambridge Faculty of
Economics
Outline
Advocating … a considered debate
Why carbon prices are unstable – and why it
matters
Some characteristics of floor prices
Why its legitimate to consider solutions
What makes reserve price auctions an
attractive approach?
“Says it all …”
Reactions to draft report (for US-German Marshall Fund) on
‘ten lessons from the EU ETS’, in which one lesson was
proposed as ‘prices have been volatile and generally lower
than expected’
Official reviewer from intergovernmental organisation:
I don’t think the observation on price volatility is very fair or relevant – it’s
a market, and the EU ETS has been no more volatile than other
commodity markets
A review from an industry-based (not carbon market!) organisation:
The one lesson I thought stuck out was that “Prices can be volatile . . . .” I
think this one is the biggest barrier to internalising carbon advantage (or
disadvantage) into investment appraisals.
Why carbon prices are
unstable
Perceptions – usual characteristic of commodity markets,
amplified by market perceptions of political processes
(likely to be very volatile)
Intrinsic uncertainties
– Projected emissions uncertain
– Scale of cutbacks modest relative to uncertainty
Over-allocation tendencies – ‘Projection inflation’
– Inherent bias towards for optimism in industrial
projections (strong evidence base)
– Lobbying pressure
– Asymmetric information
Fixed supply coupled with uncertain and volatile demand
Cutbacks are modest compared to uncertainties
10% auctions with price floor could readily underpin prices
MtCO2/year
2500
Proposed
NAP II**
125
88
2000
Adjustments
for opt-in in
Phase II
1500
NAP II
+ (JI/CDM range)
Max projection
1000
60%
projections
500
20% projections
Verified
Emissions
Min Projection
0
2005
2008
2009
2010
2011
2012
Free allocation
Other Adjustments*
Free allocation
Final
NAP II***
Price set
by price floor
Avg.
2008-12
Coordinated auction with price floor can reduce risk of low prices
Source:
Emissions Projections 2008-2012 versus NAP2 (2006) by Neuhoff, Ferrario, Grubb, Gabel,
and Keats and . Published in Climate Policy 6(5), pp 395-410.
… and why it matters
Created for public policy purposes
– Not a ‘natural market’ but instrument for collective public goals
One such goal:
‘To provide incentives for low carbon investment and
innovation’
So far ‘boom and bust’ of current schemes doesn’t
effectively deliver this goal
Risk aversion, and scepticism in industry over future prices
amplify effects of volatile prices
On path to a low carbon economy?
– Price variations reflect short-term factors, do not reflect longterm abatement investment costs
– Its not enough to ‘deliver the short term target’ if this
demonstrably fails to get us on the long-term path
– An inadequate carbon price inevitably feeds the case for much
more micro-managed interventions to support other actions
that then in turn undermine the carbon price and make it
(even) more unpredictable
Economic characteristics of
floor prices
2000
1800
1600
1400
1200
1000
800
600
400
200
0
Tax over
Investment
2770
2460
2150
1840
1530
1220
910
600
290
-20
-330
-640
Cap over
Investment
-950
Number of observations
Market: price stays above floor price, reflecting market judgement on the
upside potential
Investment: “downside” risk to investments are reduced, while “upside”
remains
In a study of CCS investment incentives, cap-with-floor both reduces
spread and outperforms NPV of cap alone by hundreds of €m even for a
floor well below CCS costs
Cap with
floor over
investment
Surplus (M$)
But worries about implementation complexities and politics
Why its legitimate to consider
solutions
As instrument for public policy goals will be judged –
and should be designed – against whether it delivers
those goals
A lower-than expected carbon price reveals that the initial
setting of the cap was based upon expectations that turned
out to be incorrect
The instrument is more robust and more likely to deliver its
goals if it carries in-built corrective mechanisms, and in
particular that remove the risk of very low prices
Within-period options include supply-side interventions in
offsets (Chinese floor price), demand side interventions
(eg. re-entry of Canada into international market, or
governmental ‘buy-to-bank’ or to retire), reserve price
auctions, or active intervention through a carbon bank
The features of reserve
price auctions
Mechanism:
Governments announce in advance a path of reserve prices on ETS auctions
If industry does not bid above the price, the allowances do not enter the market but are
held over for the next auction
Government option to cancel or bank at end of a period
Core rationale:
No ex-post intervention: the rules are clear at the outside, thus increasing price
confidence in the market but without gaming potential
If the cap-setting turns out to be too lenient in the light of improved information, a
mechanism that automatically adjusts supply accordingly has inherent logical attractions
Holding over allowances not bought at one auction enables the mechanism to smooth for
some of the cycles of perception without changing fundamentals until the full period
performance is clear
Possibilities in EU ETS Phase II
Reserve prices for UK and Germany auctions and for unused New Entrant Reserves
Although auction volumes are small (7% and 9% of allocations respectively), small
adjustments could do a lot to stave off price collapse
… and set the stage for decisions about the larger volume of New Entrant Reserves that
may be brought to auction
Price floors – getting some
perspective
Annex: modelling instrument performance;
the Phase II balance
Professor Michael Grubb, Chief Economist, the Carbon Trust
& Senior Research Associate, Faculty of Economics, Cambridge University
Tim Laing, Research Assistant, Cambridge Faculty of Economics
Annex: More on modelling
& results
Model focuses on firm level incentives for a
programme of investment in a new technology
from taxes, cap-and-trade schemes and hybrid
instruments
Uses CCS as an example technology
Cap-and-trade produces higher average returns
than taxes, but with a greater distribution
Price floors increase average returns and reduce
distribution
Price ceilings reduce average returns and
distribution – effect depends on risk-aversion of
the firm
Impact of floors and ceilings
1200
Cap over
Investment
1000
800
600
Cap with
floor and
ceiling over
Investment
400
200
0
-950
-690
-430
-170
90
350
610
870
1130
1390
1650
1910
2170
2430
2690
2950
Number of observations
1400
Surplus (M$)
Returns weighted by frequency
against average carbon prices
100000
Returns weighted by frequency
0
10
20
30
40
50
60
70
80
90
100
110
120
130
140
150
160
170
180
190
200
210
220
230
240
250
0
-100000
-200000
-300000
-400000
-500000
Average Carbon Price ($/tCO2)
The Phase II supply, demand and market outlook – an
intrinsic governmental surplus, likely private market surplus
balanced only through large EU ETS ‘buy to bank’