Current Issues
Bidding for the better
International topics
November 8, 2010
EU Emissions Trading Scheme moves to auctioning
The European Emission Trading Scheme (ETS) has come of age.
Operating since January 1, 2005, the EU ETS is the world‘s first large-scale
CO2 emissions trading programme. In 2008, over six billion European Union
Allowances (EUAs) worth EUR 89 bn were transacted.
Grandfathering was originally the norm for initial allocation of
emission allowances. Although initial allocation of emission allowances
was predominantly performed by means of grandfathering during the first
two phases of the ETS, EU Member States were already permitted to
auction small numbers of allowances.
In phase 3 of the EU ETS, a paradigm shift will take place. As of
2013, national allocation plans will be abolished and auctioning will become
the default method of allowance allocation.
Auctioning is economically and environmentally more efficient
for allocating emission permits to installations. The reasons are:
— The ―polluter pays‖ principle is implemented.
— Allocative efficiency is improved.
— In contrast to grandfathering, auctions generate public revenue.
— Higher costs incurred by installations in the auctioning process represent
greater innovation incentives.
In July 2010 the European Commission finalised its Auctioning
Regulation draft. The regulation shall ensure that auctioning is conducted
in an open, transparent, harmonised and non-discriminatory way. Overall,
the proposed draft is reasonably designed aiming at implementing a
competitive and efficient auctioning mechanism.
Authors
Michael Chlistalla
+49 69 910-31732
[email protected]
Meta Zähres
+49 69 910-31444
[email protected]
Editor
Bernhard Speyer
Technical Assistant
Sabine Kaiser
Deutsche Bank Research
Frankfurt am Main
Germany
Internet: www.dbresearch.com
E-mail: [email protected]
Fax: +49 69 910-31877
Managing Director
Thomas Mayer
The Commission’s effort to create a single auctioning platform is
to be welcomed. The objective of eliminating inconsistent allocation of
allowances between Member States, however, will be thwarted by the
possibility for Member States to opt out of the central platform which
materialised due to strong political exertion of influence.
Current Issues
Introduction
The global carbon market amounted to EUR 103 bn in 2009, which
represents a 6% increase compared to 2008. The EU‘s Emission
Trading Scheme (EU ETS) was the main driver of the carbon market
with over 6 billion European Union Allowances (EUAs) transacted
worth EUR 89 bn. The overall number of transactions increased
despite the fact that average EUA prices fell by 42% to EUR 14.00
compared to EUR 22.10 in 2008.
The EU ETS is the world‘s first large-scale CO2 emissions trading
programme. Its objective is to reduce CO2 emissions from sectors
included in the ETS in a cost-efficient way. After a first phase of the
EU ETS, which ran from 2005 to 2007 and which was aimed at
gaining experience with this new instrument, the second phase
(2008 to 2012) is ongoing. Currently, European regulators, notably
the European Commission, are focussing on designing the rules for
the third trading phase, which runs from 2013 to 2020.
During the second phase of the EU ETS, initial allocations of CO2
allowances to installations have been organised by means of
―grandfathering‖, that is based on historical data on emissions or
fuel use. While the grandfathering approach is being applied for the
far bigger part of allowances, Member States could individually sell
or auction off small quota of the emission allowances – up to a
maximum of 5% in phase 1 and 10% in phase 2. However, only few
Member States used this option. For phase 3, the European
Commission has announced its intention to increase the relevance
and proportion of allowances being allocated via an auctioning
mechanism. The discussion of this mechanism will be at the heart of
this study.
First, we will shed light on the background and the rationale of the
EU ETS, looking at the Kyoto Protocol as the trigger of emissions
trading and considering the environmental problem of CO2
emissions from an economic point of view. We will then focus on the
EU ETS, in particular highlighting the mechanisms and
organisational issues of auctions held in phases 1 and 2, and look at
how the European Commission intends to modify the allocation
mechanism in phase 3. Before turning in detail to the auction design
of phase 3, which we will base on the analysis of platforms that
performed auctions during the earlier phases, we will focus on the
efficiency of different approaches for auctioning CO2 allowances. An
evaluation of the Commission‘s auctioning regulation proposal will
complement the analysis.
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November 8, 2010
Bidding for the better: EU Emissions Trading Scheme moves to auctioning
UNFCCC Kyoto Protocol
Emissions trading
Annex I countries:
Annex I countries include the industrialised
countries that were members of the OECD in
1992, plus countries with economies in
transition. Since the United Nations Climate
Change Conference in Copenhagen in
December 2009, the list of Annex I countries
includes 41 nations plus the European Union,
which is also a member:
Australia, Austria, Belarus, Belgium, Bulgaria,
Canada, Croatia, Czech Republic, Denmark,
Estonia, European Union, Finland, France,
Germany, Greece, Hungary, Iceland, Ireland,
Italy, Japan, Latvia, Liechtenstein, Lithuania,
Luxembourg, Malta, Monaco, Netherlands,
New Zealand, Norway, Poland, Portugal,
Romania, Russian Federation, Slovakia,
Slovenia, Spain, Sweden, Switzerland,
Turkey, Ukraine, United Kingdom, United
States of America.
Flexible Mechanisms:
Clean Development Mechanism (CDM):
Flexible mechanism under Article 12 of the
Kyoto Protocol through which companies from
Annex I countries may finance greenhouse
gas emission reduction or removal projects in
developing countries and receive so called
Certified Emission Reductions (CERs) for
doing so.
Joint Implementation (JI): Flexible mechanism
under Article 6 of the Kyoto Protocol through
which companies from Annex I countries may
finance greenhouse gas emission reduction or
removal projects in other developed countries
and receive Emissions Reduction Units
(ERUs) for doing so.
Both may be used according to the ―Linking
Directive‖ (Directive 2004/101/EC amending
Directive 2003/87/EC) up to a certain limit for
compliance purposes within the EU ETS, i.e.
they are accepted by the EU as equivalent to
EU Allowances (EUAs – see glossary on page
5) and can be used by operators of
installations covered by the EU ETS in order
to comply with their obligations to surrender
(i.e. retire) EUAs.
Source: UNFCCC
Externalities
In economics, an externality is described as a
situation in which the private costs or benefits
to the producers or purchasers of a good or
service differ from the total social costs or
benefits entailed in its production and
consumption and are part of market prices.
Serious consideration of CO2 emissions trading as an integral part of
climate policy in Europe was launched for the first time in 2000 with
1
the European Commission‘s Green Paper on GHG Emissions
Trading. On January 1, 2005, the EU ETS began operating as a
community-wide, large-scale CO2 emissions trading programme.
While motivated by the Kyoto Protocol, the EU ETS is embedded in
European law in a manner that makes its implementation
independent of the Kyoto Protocol (Ellerman and Buchner, 2007). It
was created to help achieve the European Union‘s emissions
reduction commitments under the Kyoto Protocol (see table 1). So
far, the EU ETS only incorporates CO2 emissions; other greenhouse
gases mentioned in the Kyoto Protocol are not yet included.
The Kyoto Protocol and its flexible mechanisms
The Kyoto Protocol was adopted during the United Nations
2
Framework Convention on Climate Change (UNFCCC) in
December 1997 in Kyoto, Japan, and entered into force in February
2005. It is the world‘s first binding agreement under international law
designed to slow the pace of climate change. Most industrialised
countries (―Annex I countries‖) committed themselves to a reduction
of six major greenhouse gases: carbon dioxide, methane, nitrous
oxide, sulphur hexafluoride, hydrofluorocarbons and perfluorocarbons. To achieve the industrialised nations‘ collective GHG
emissions reduction objectives (-5.2% between 2008 and 2012 in
relation to the 1990 level), the treaty allows for several ―flexible
mechanisms‖, such as international emissions trading (IET), the
clean development mechanism (CDM) and joint implementation (JI).
The Kyoto Protocol required the, at that time, 15 EU members to
3
reduce their collective emissions by 8% compared with 1990 levels .
For the EU to arrive at its reduction targets, a political agreement
was reached in 1998 to share the burden unequally amongst
Member States (burden sharing). This method takes into account
national conditions, including current GHG emissions, the
opportunities for reducing them, and the level of economic
development.
Economic concepts to solve the CO2 emissions problem
Anthropogenic (i.e. man-made) climate change can be described as
a form of negative technological externality. An externality exists
whenever an individual's actions affect the well-being of another
individual – whether for better or worse – in ways that need not be
paid for according to the existing definition of property rights in
society. A benefit in this case is called a positive externality or
external benefit, while a cost is called a negative externality or
external cost. To deal with the phenomenon of negative externalities,
various market-based concepts have been proposed in economic
literature.
1
2
3
November 8, 2010
GHG: Greenhouse gases.
UNFCCC: The United Nations Framework Convention on Climate Change,
negotiated in 1992 in Rio de Janeiro, provides the international structure for
climate change policy and requires signatories to report GHG emissions, among
other things.
In 2007, EU leaders endorsed an integrated approach to climate and energy
policy. They made a unilateral commitment that the EU would cut its emissions by
at least 20% of 1990 levels by 2020.
3
Current Issues
Pigouvian tax, Environmental Pricing and Standards Approach,
Coase theorem
Pigouvian tax
One way to deal with the problem of pollution (e.g. in the form of
carbon emissions) is to introduce a Pigouvian tax. A Pigouvian tax is
levied on a market activity that generates negative externalities. It is
intended to correct the inefficient market outcome by transferring
costs associated with pollution from the public to the polluter. The
difficulty with Pigouvian taxes, however, is to calculate what level of
tax will compensate the negative externality as the theoretical model
assumes facts as given which in reality cannot be assumed as given
(Pigou, 1954). Application examples of Pigouvian taxes include "sin
taxes" on tobacco products and alcohol or ―green taxes‖ on fuel.
Environmental Pricing and Standards
Approach
Baumol and Oates (1971) claim that the adoption of a Pigouvian tax
has rarely proven to be feasible in practice because of the inability
to measure marginal social damage. They therefore propose to
establish a predetermined set of acceptability standards of
4
environmental quality and then impose a set of charges or unit
taxes (resource-use prices) on emissions sufficient to attain these
standards (―Environmental Pricing and Standards Approach‖). The
difference to the Pigouvian tax approach is the assessment basis,
i.e. taxes (or prices) would be selected so as to achieve specific
acceptability standards rather than to base them on the unknown
value of marginal social damage. The most severe shortcoming of
5
this approach is that it does not induce an optimal outcome , which,
however, is a problem by no means unique to the Pricing and
Standard approach but rather a difficulty common to the provision of
nearly all public goods. One working implementation of the
Environmental Pricing and Standards Approach is the control of
6
water quality in the Ruhr River in the 1960s in Germany .
Tradable Emissions Permits
Emissions‘ trading is a market-based
approach to control pollution by providing
economic incentives for achieving reductions
in the emissions of pollutants. A central
authority, usually a governmental body, sets a
limit on the amount of a pollutant that can be
emitted. The limit is allocated or sold to firms
in the form of emissions permits which
represent the right to emit a specific volume of
the specified pollutant. Firms are required to
hold a number of permits equivalent to their
emissions. Those who need to increase their
permits buy them from those who require
fewer permits; the buyer is paying a charge
for polluting, while the seller is rewarded for
having reduced emissions. Thus, those who
can reduce emissions most cheaply will do so,
achieving the pollution reduction at the lowest
cost to society.
Coase Theorem
The theorem states that under certain
assumptions bargaining between economic
agents will lead to an efficient outcome
regardless of the initial allocation of property
rights. In practice, obstacles to bargaining or
poorly defined property rights can prevent
Coasian bargaining: Since in reality
transaction costs cannot be neglected, the
initial allocation of property rights often does
matter – leading to the normative conclusion
that property rights should initially be assigned
to agents for whom they are most useful.
Another weak point of the Coase theorem is
that it does not differentiate between property
rights and rights of disposal, i.e. it ignores
distributional effects.
A third approach to deal with pollution is by way of tradable emission
permits, issued by the state in some predetermined quantity.
7
Emissions trading, originally proposed by J.H. Dales in 1968 , is
based on elements of the so-called Coase theorem (see box), which
describes the economic efficiency of an economic allocation or
outcome in the presence of externalities.
In the past, environmental taxes were usually favoured by policy
makers over tradable permits in pollution control, most likely
because taxes are a well-known instrument to control externalities
and are thus easily accessible. However, we think that emissions
trading is the most important climate protection instrument and will
remain so as it brings many advantages: Tradable permits give
governments direct control over achieving a predetermined level of
emissions. Thus, the total emissions cap for the participants in the
trading system cannot be exceeded, as long as overall control over
emissions works. This is not guaranteed where a tax is levied.
Additionally, with environmental taxes, prices for emission rights are
fixed and the amount is determined by the market, whereas with
4
5
6
7
4
E.g., the dissolved oxygen content of a waterway should not exceed x% at least
99% of the time, or the decibel (noise) level in residential neighbourhoods should
not exceed y% at least 99% of the time.
Presumably there is an optimal level of pollution (e.g., quality of water or air), but in
the absence of a correct pricing mechanism to indicate the true value of a predetermined set of quality standards, it is nearly impossible to accurately determine
the set of taxes necessary to induce the optimal outcome. The result is a somewhat arbitrary character of the standard selected.
Here, water suppliers distribute the costs of the water quality management system
proportionally to the quality and quantity of the individual effluents which cause the
costs to be incurred.
J. H. Dales‘s Pollution, Property and Prices (1968) is today regarded a classic
work of environmental economic literature.
November 8, 2010
Bidding for the better: EU Emissions Trading Scheme moves to auctioning
Glossary of relevant terms:
AAUs
Assigned Amount Units
Annex I Parties are issued AAUs up
to the level of their assigned
amount, corresponding to the
quantity of greenhouse gases they
can release in accordance with the
Kyoto Protocol, during the
commitment period 2008-12.
CERs
Certified Emission Reduction
CER credits can be acquired with
projects in developing countries and
emerging markets, i.e. in line with
the CDM. Here, an industrialised
country invests in a developing
country. CERs may be counted
towards meeting Kyoto targets of
the project-executing country or
company or else traded in the
market.
ERUs
Emission Reduction Units
ERUs are emission certificates
issued for emission reduction or
emission removal projects in other
countries, i.e. upon successful
execution of joint implementation
(JI) projects. Here, an industrialised
country invests in another
industrialised country. ERUs can be
counted towards meeting Kyoto
targets.
EUAs
European Union Allowances
EUAs are emission permits in the
EU ETS. They are currently
allocated at the national/state level
to the emissions sources. EUAs are
tradable between Member States
and enterprises in the Member
States.
EUAAs
European Union Aviation
Allowances
EUAAs are comparable to EUAs.
They are emission permits in the
EU ETS and cover the aviation
industry.
RMUs
Removal Units
RMUs are granted on the basis of
land use, land-use change and
forestry activities such as
reforestation and may be
transferred to CO2 allowances as
well.
VERs
Verified Emission Reductions
A unit of greenhouse gas emission
reductions that has been verified by
an independent auditor. Most often,
this designates emission reductions
units that are traded on the
voluntary market.
Source: UNFCCC and EC
emissions trading, the amount is fixed and prices are determined by
the market. Furthermore, emissions are reduced where this is most
opportune; leaving the decision about how the reduction is to be
made to market forces. As a consequence, emission trading leads to
higher effectiveness and efficiency.
The European Union Greenhouse Gas
Emission Trading Scheme (EU ETS)
In January 2005 the European Union GHG Emission Trading
Scheme (EU ETS) started operation as the largest multi-country,
8
multi-sector GHG trading system worldwide . Until now, it is the
world‘s most advanced emissions trading system (Gupta et al.,
2007). The EU ETS is implemented as a ―cap-and-trade‖ system. An
aggregate limit (cap) on the amount of a pollutant that can be
emitted is established. The cap is represented by emission
allowances which can be transferred (traded) among installations
required to hold a number of allowances equivalent to their
emissions. Installations which emit less than their individual cap
allows are able to sell their surplus emission allowances – and vice
versa. Thus, the buyer is paying a charge for polluting, while the
seller is being rewarded for having reduced emissions. Plus,
emissions are reduced where it costs least. The cap is lowered over
time, aiming towards the national emissions reduction target.
The EU ETS is based on the Emission Trading Directive (Directive
2003/87/EC), which entered into force in October 2003, and is
implemented at an installation level. This means that some 11,500
large emitters of carbon dioxide within the EU must monitor and
report their CO2 emissions annually and are obliged to surrender a
number of emission allowances (EUAs) and CERs/ERUs equal to
the total emissions from their installation during the preceding
9
calendar year by 30 April at the latest . Installations currently
covered by the ETS are collectively responsible for close to half of
the EU's emissions of CO2 and 40% of its total greenhouse gas
emissions. Since January 2008, the EU ETS not only applies to the
27 EU Member States, but also to the other three members of the
European Economic Area (EEA) – Iceland, Liechtenstein and
Norway. In July 2008, the EU ETS Directive was amended to bring
the aviation sector into the system from 2012 onwards (see
Directive 2008/101/EC).
In order to compensate for fluctuations in annual CO2 emission
levels, emission allowances for any plant operator subject to the
ETS are calculated for a sequence of several years at once (―trading
period‖ or ETS phase). These trading periods of the EU ETS run
from 2005 to 2007 (phase 1, trial period), 2008 to 2012 (phase 2),
and 2013 to 2020 (phase 3) respectively. While Member States had
the discretion to allow or restrict banking of EUAs between phase 1
and phase 2, the European Commission introduced unlimited
banking of allowances between phases 2 and 3 (see box on next
page). For phases 1 and 2, initial allocation rules are governed by
the Emission Trading Directive: so-called National Allocation Plans
(NAP) define the total quantity of EUAs to be allocated by each
Member State to ETS operators for the current trading year.
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9
November 8, 2010
Note that the EU ETS only incorporates CO2 emissions thus far.
Sectors covered by the EU ETS: Combustion of fuel (installation with a total rated
thermal input exceeding 20 MW), refinery, coke, iron and steel, metallic ore,
cement and lime, glass, ceramics and bricks, pulp and paper.
5
Current Issues
Banking and Borrowing of EUAs:
GHG emission reduction targets
Banking:
Mt CO2 equivalent,
2008-2012 relative to base-year emissions
Banking refers to the ability to save unused
emission allowances for use in future periods.
Banking is important for a programme of CO2
control because it allows for smoothing
cyclical fluctuations. Further, CO2 is long-lived
in the atmosphere, meaning that it matters
little whether emissions occur in one year or
the next.
Old Member States:
EU-15 -339.6
DE
UK
IT
DK
NL
BE
AT
LU
FI
FR
SE
IE
PT
GR
ES
New Member States:
PL
RO
CZ
BG
SV
HU
LT
EE
LV
SI
CY*
As banking was restricted between phases 1
and 2, allowances lost value at the end of
phase 1 and prices declined sharply. With the
allowance of unlimited banking between
phases 2 and 3 this problem was resolved.
Borrowing:
Borrowing refers to the ability to use future
emission allowances today. However, in the
EU ETS inter-period borrowing is not allowed.
*) no target
-400
-258.7
-96.5
-33.6
-14.5
-12.7
-10.8
-10.2
-3.7
0.0
0.0
2.9
7.1
16.0
25.8
42.8
-27.2
-19.4
-15.6
-9.4
-5.9
-5.8
-4.0
-3.3
-2.1
-1.5
-300
-200
-100
0
100
Source: COM 2002/358/EC, Annex II
1
During phase 1, most EUAs were grandfathered for free to
participating installations based on burden sharing obligations under
the Kyoto Protocol, past emissions, and economic projections for
the trading period. ETS operators could trade their allowances on
10
the spot market of one of the European climate exchanges , over
the counter (OTC) – i.e. privately by moving allowances between
11
themselves – or by using a broker to privately match buyers and
sellers. Even though grandfathering was and is the rule for the initial
allocation of emission allowances, EU Member States were
permitted to auction or sell up to 5% of allowances in phase 1 and
up to 10% in phase 2. However, only few Member States, notably
Hungary, Ireland and Lithuania in phase 1 and Austria, Germany, the
Netherlands and the UK in phase 2, made use of this possibility.
EU ETS phase 1 and 2 – existing carbon auction platforms
Member States individually
determined auction design and
organisation in phases 1 and 2
Auction design and organisation in phase 1 and 2 were not
determined centrally by the European Commission, but individually
by the Member States.
During phase 1 of the EU ETS, the amount of allowances auctioned
by Hungary, Ireland and Lithuania only totalled some 0.2% of the
EU-27 phase 1 allowances. The auction format used was a single10
11
6
Exchanges are e.g.: ECX, EEX, Climex, BlueNext or NordPool ASA.
EUAs may also be transferred across national borders.
November 8, 2010
Bidding for the better: EU Emissions Trading Scheme moves to auctioning
Individual auctions in phase 2
Member State
Ø annual quantity to be
auctioned (% of
national allotment)
Austria
400,000 (1.3%)
Germany
40 million (about 9%)
Netherlands
3.2 million (3.7%)
UK
17 million (7%)
Source: European Commission
Carbon trading platforms –
secondary markets
— The European Climate Exchange (ECX)
offers derivative contracts on EUAs and
CERs. Services started in 2005 with the
launch of futures on EUAs. EUA options
were listed the following year. Options on
CERs were introduced in 2008, with Daily
Futures (spot) contracts on both
underlying products added in 2009.
— In January 2010, BlueNext began to offer
ERU auctions. Auctions are single-round,
uniform-price; the quantity offered
amounts to 400,000 ERUs. BlueNext also
offers EUA /CER spot and futures trading.
— Nord Pool ASA lists EUAs as
standardised exchange contracts. In
2007, CERs trading began. The overall
product range comprises: EUA/CER spot
contracts, EUA/CER futures, EUA/CER
forwards and EUA/CER option contracts.
A clearing service for EUAs and CERs
traded over-the-counter (OTC) is also
available.
— Environmental contracts at the Green
Exchange are currently listed for trading
and clearing at the New York Mercantile
Exchange (NYMEX) – which is part of the
CME Group – and include EUA/CER
futures and options. In July 2010, the U.S.
Commodity Future Trading Commission
approved the Green Exchange as a
designated contract market. Contracts on
emissions allowances and credits in CO2
will soon be transferred to the Green
Exchange. Futures are available on CME
Globex and through CME ClearPort,
options through CME ClearPort and on
the New York trading floor.
round, sealed-bid, uniform price auction. Denmark originally
intended to auction 5% of its total number of allowances, but then
decided to sell the allowances through the brokered market instead
to maximise state revenues. The rationale behind this decision was
that a professional broker would have had the ability to sell the bulk
of the allowances in high-price periods – which was deemed better
than if a number of unprofessional government officials had decided
when to sell (Fazekas, 2008).
During the current phase 2, four countries are using an auctioning
12
mechanism (see box) . The sum of allowances auctioned amounts
to nearly 4% of the total EU-27 allowances (Betz, 2007). All
auctioning governments again decided in favour of a single-round,
sealed-bid, uniform price auction.
Individual auctions in phase 2
In Austria, two auctions per year are foreseen for the 2009-2012
period with a total annual volume of 400,000 allowances (1.3% of
the total Austrian allotment for phase 2). Austria has assigned the
realisation of its primary auctions to the Climex trading platform.
Climex is domiciled in the Netherlands and provides web-based
auction and trading platforms for spot and forward auctions of
CERs, ERUs, EUAs and VERs as well as spot trading of EUAs and
CERs. The first auction of Austrian EUAs took place on March 16,
2009. It was organised in two parts, a non-competitive auction
where 5,050 of 100,000 possible EUAs were sold (the maximum
volume per buyer was 2,500 EUAs), and a competitive part where
13
205,050 EUAs were sold at EUR 11.65 per tonne of CO2 . The
competitive auction had the format of a single-round, sealed-bid,
uniform price auction. The non-competitive auction was specifically
developed for small and medium-sized enterprises (SMEs) not
active on the trading market and permitted small number purchases
of EUAs (the minimum bid size was 50 EUAs). Participants in the
non-competitive auction only bid for volumes, the price was defined
during the competitive auction. The second auction took place on
October 13, 2009, when 200,000 EUAs were auctioned in a
competitive procedure at EUR 14.23 per tonne of CO2. The third
auction took place on March 23, 2010. The competitive auction
closed at EUR 12.78 per tonne of CO2. There was no interest in
non-competitive auctions.
Germany has the highest auction budget in absolute terms; since
January 2010, EUAs auctions are held on a weekly basis at the
European Energy Exchange (EEX), which operates from Leipzig
and Luxembourg and offers primary auctions of EUA as well as
trading of EUA/CER futures, spots and EUA options. Each auction
comprises 300,000 EUAs on the spot market with a contract volume
of 1 EUA and a minimum bid volume of 500 EUAs, and 570,000
futures with both a contract volume and a minimum bid volume of
1,000 EUAs. This amounts to an average annual quantity of 40
12
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November 8, 2010
Originally, eight countries planned to auction fractions of their EUAs: Austria,
Belgium, Germany, Italy, Luxembourg, the Netherlands, Poland and the UK.
However, no information on any phase 2 auctions could be found for Belgium, Italy,
Luxembourg and Poland. Hungary and Lithuania have not performed any auctions
in phase 2, either. Ireland decided to sell the allowances rather than to auction
them. In January 2009 and February 2010 Ireland sold 185,000 allowances each.
The remainder of the 557,065 allowances for period 2 is likely to be sold as well.
The competitive auction‘s minimum price was EUR 7.16 per tonne of CO2,
calculated by multiplying the average spot end-of-day prices for EUA of January
and February 2009 with a factor of 0.9. The competitive auction‘s reference price
was EUR 9.55 per tonne of CO2, calculated by multiplying the average spot endof-day prices for EUA from January and February 2009 with a factor of 1.2.
7
Current Issues
million emission allowances (about 9% of the German allotment).
Auctions are held as sealed-bid auctions with no indicative price
during the outcry phase. Transaction fees range from EUR 0.0018 to
EUR 0.0020 per EUA (exchange fee) plus EUR 0.001 per EUA
(clearing fee).
In the Netherlands, a total of 16 million EUAs will be auctioned in
phase 2, with the average annual quantity amounting to 3.2 million
allowances (3.7%). The first auction was carried out by the Dutch
State Treasury Agency (DSTA) on April 15, 2010. DSTA was the sole
book runner, employing a book building process via its carbon
14
dealers . The allocation process was based on the price
composition of the order book where allocations were assigned at a
single cut-off price. The clearing price amounted to EUR 14.10 per
tonne of CO2. A further 4 million allowances will be auctioned on the
Climex trading platform in two consecutive auctions in October and
November 2010. Auctions will be held as single-round, sealed-bid,
uniform price auctions. Participation in the auction will be free of
charge for all buyers; no transaction fees will be charged to
15
successful buyers .
In the UK, 13 auctions have been held as yet, each of them with a
volume between 4 and 4.4 million EUAs. The average annual
quantity to be auctioned during phase 2 amounts to 17 million EUAs
(7%). Auctions are held on a monthly basis. The clearing price is the
lowest accepted bid at or above a reserve price set by the Treasury
at which all allowances for sale would otherwise be allocated. All
auctions are spot auctions. They are performed through the UK Debt
Management Office (DMO) which acts on behalf of the United
Kingdom‘s Department of Energy and Climate Change (DECC).
Changes to the EU ETS in Phase 3
Majority of allowances will be
allocated via auctions in phase 3
For phase 3, the European Commission announced its intention to
increase the proportion of allowances being allocated via auctions.
According to the Commission, auctioning best ensures the
efficiency, transparency and simplicity of the EU ETS and creates
the greatest incentive for investments in a low-carbon economy.
Auctioning also potentially eliminates windfall profits which can arise
when operators charge the cost of the allowances to their customers
even where they received them free of charge.
Revisions of European directives lay
the foundation for auctioning
On April 23, 2009, Directive 2003/87/EC was amended by Directive
2009/29/EC (the ―revised ETS Directive‖) so as to improve and
extend the EU ETS. Auctioning as the basic principle for allocation
16
was established through Article 10(1) . Article 10(4) requires the
Commission to adopt a regulation on timing, administration and
other aspects of auctioning to ensure that it is conducted in an open,
transparent, harmonised and non-discriminatory way.
On July 14, 2010, Member States in the Climate Change Committee
17
(CCC) unanimously voted in support of the Commission's draft
Auctioning Regulation (see COM, 2010c), which was then submitted
to the European Parliament and the Council for a three-month
14
15
16
17
8
In December 2009, Barclays Capital, Credit-Suisse, JP Morgan and Orbeo were
selected as carbon dealers.
cf. http://www.bloomberg.com/news/2010-07-19/climex-will-hold-european-unioncarbon-dioxide-auctions-for-netherlands.html
The design and implementation aspects for the auctioning of EU aviation
allowances (EUAAs) is regulated by Directive 2008/101/EC of the European
Parliament and of the Council of 19 November 2008 amending Directive
2003/87/EC so as to include aviation activities in the scheme for greenhouse gas
emission allowance trading within the Community.
The CCC is composed of the Member States and chaired by the Commission.
November 8, 2010
Bidding for the better: EU Emissions Trading Scheme moves to auctioning
rd
Annual caps for the 3 EU ETS period
(2013 to 2020):
— 2013: 2,039 million t CO2
— 2014: 2,002 million t CO2
— 2015: 1,964 million t CO2
— 2016: 1,927 million t CO2
— 2017: 1,889 million t CO2
— 2018: 1,852 million t CO2
— 2019: 1,815 million t CO2
— 2020: 1,777 million t CO2
Annual reduction to continue beyond 2020,
subject to revision no later than 2025.
Source: DB Research
Auctions and benchmarking
The starting point for establishing the
benchmarks is the average performance of
the 10% most efficient installations in a sector
or sub-sector in the Community in the years
2007-2008. The benchmarks will be
calculated by product and will take into
account ―the most efficient techniques,
substitutes, alternative production processes,
high efficiency cogeneration, efficient energy
recovery of waste gases, use of biomass and
capture and storage of CO2, where such
facilities are available.‖ In general, no
distinction due to individual aspects will be
made, i.e. benchmarks will be established
according to a ―one product, one benchmark‖
principle.
scrutiny. Provided neither of them opposes the draft within this
period, the Commission will adopt the Auctioning Regulation by the
end of 2010 as proposed.
For phase 3 of the EU ETS, the Commission has determined a
community-wide ex-ante benchmark starting at 2,039,152,882
18
allowances in 2013 with an ex-ante defined, linear reduction path
of 1.74% p.a. and an ex-ante defined, harmonised allocation
methodology (COM, 2010a). This cap will amount to a 21%
reduction in 2020 compared to 2005 verified emissions.
In contrast to previous phases there is a paradigm shift in 2013 with
regard to the initial allocation of allowances to installations: National
allocation plans are abolished and auctioning will become the
19
default method of allowance allocation . In the power sector, 100%
auctioning is proposed from 2013 onwards, whereas for all other
sectors an initial auctioning share of 20% in 2013 to be increased
20
linearly to 70% in 2020 is suggested (Directive 2009/29/EC) .
Accordingly, industrial sectors will receive 80% of benchmarked
allowances for free in 2013, with the percentage decreasing
annually to 30% in 2020. Full auctioning to all installations in all
covered sectors will then occur by 2027.
Non-auctioned allowances, i.e. those to be allocated for free, will
transitionally be distributed on the basis of ambitious benchmarks
for industries up to a fixed industry cap. Corresponding EU-wide
harmonised rules based, to the extent feasible, on these benchmarks (see box), will be defined by the Commission before
December 31, 2010.
Carbon auctions
Source: Directive 2009/29/EC, Article 10a
Unlike other markets, emissions trading systems are designed
markets where demand and supply are dependent on government
decisions (Betz and Sato, 2006). As seen above, emissions trading
is an efficient way to deal with carbon emissions. An integral part is
to decide how allowances should be allocated in the first place. In
principle, two options are available for the allocation to the market
participants: One is grandfathering, where Member States allocate
allowances on the basis of past usage; the other is to sell the
allowances in periodic auctions. From an economic point of view,
what are the differences between the two approaches?
Auctioning vs. grandfathering – why auctioning is better
economically
Grandfathering means that installations receive emission
allowances for future periods based – at least partly – on their
18
19
20
November 8, 2010
The methodology for calculating this figure is explained in the Commission‘s
decision of October 22, 2010 on the Community-wide quantity of allowances to be
issued under the EU ETS for 2013. The figure does not include new sectors and
gases. The cap to be allocated to aircraft operators will be determined by a
separate decision of the Commission, as requested in Directive 2008/101/EC.
Exceptions: 1. Sectors and sub-sectors that are at risk of carbon leakage will still
be eligible for free allocation; they will receive 100% of the benchmarked
allowances for free during Phase 3 (Directive 2009/29/EC). 2. Parts of the
allowances designated for 2013 and 2014 may be early auctioned as of 2011
(COM, 2010c, Art. 10(1)).
The larger reduction burden for the power sector is being justified with: the power
sector is not exposed to international competition (compared to other industrial
sectors), it has the largest potential for emissions reduction (e.g. through switching
from coal-fired to gas-fired generation) and it has the ability to pass-through the
costs of purchasing allowances into the power price (Point Carbon, 2008).
9
Current Issues
historical output and emission levels. This corresponds to output or
emission-based rebating schemes of tax revenues (Böhringer and
Lange, 2005). The advantages of grandfathering are straightforward:
— Grandfathering is conceptually easy to understand. Emission
allowances are allocated based on past usage, if need be subject
to a disagio in order to attain predetermined reduction targets.
— Grandfathering is easy to implement as no specific infrastructure
is required.
— Grandfathering avoids directly increasing costs for firms as it is
often combined with free allocation. It thus lowers political
hurdles barring the introduction of a trading system. The
establishment of the EU ETS would have been highly unlikely
without such complaisance towards the industry.
— Grandfathering provides greater political control over the
distributional effects of regulations. Accordingly, free allocation
rather than auctioning may be justified for a few sectors, e.g.
aluminium and steel, which face international competition and for
which the price of carbon is particularly important. The intention
21
here is to avoid carbon leakage as this would have a
detrimental impact on both the environment and the economy.
Unsurprisingly, generators and emitters favour free-of-charge
allocation of emission allowances in a way related to their historic
output (Cramton and Kerr, 2002).
Still, the grandfathering approach is also subject to a number of
shortcomings:
“Polluter pays” principle
The ―polluter pays‖ principle (PPP) is a
principle according to which the polluter
should bear the cost of measures to reduce
pollution according to the extent of either the
damage done to society or the exceeding of
an acceptable level of pollution.
The Kyoto Protocol is an example of
application of the PPP: parties that have
obligations to reduce their GHG emissions
must bear the costs of reducing such polluting
emissions.
Source: OECD
— Grandfathering is generally accepted to be inconsistent with the
―polluter pays‖ principle.
— Grandfathering emission certificates requires extensive
information about past emissions and political negotiations on a
number of issues including the treatment of new entrants
(Harrison and Radov, 2002). The danger related to the
grandfathering approach therefore lies in the potential overallocation of allowances, which may occur in case of overinflated
estimates of previous emissions or in case of lower production
levels of emissions due to the collapse of parts of the industry.
22
Indeed, several studies using historical industrial emissions
data have discovered that over-allocation and abatement
(emissions reduction) occurred across European countries during
the EU ETS pilot phase. Grandfathering had prompted
participants in the scheme to report that they needed more
allowances. Some installations thus managed to book windfall
profits; they added the price of the allowances they had received
free of charge to the prices of their products.
— Free-of-charge grandfathering emissions allowances may
diminish the industry‘s incentives to supply clean, renewable
energy by means of innovative new competition.
— An emissions trading scheme based entirely on grandfathering
as primary allocation approach gives installations all the scarcity
rents. There is ample evidence (see Burtraw, 2007) that
21
22
10
Carbon leakage describes the risk that installations in sectors subject to strong
international competition might relocate from the EU to third countries with less
stringent constraints on GHG emissions.
Anderson and di Maria (2010), for instance, compared allocated and verified
emissions to a baseline ―business-as-usual‖ emissions scenario and found overallocation of approximately 280 million EUAs and total abatement of 247 Mt CO 2
over the three trading years of the pilot phase.
November 8, 2010
Bidding for the better: EU Emissions Trading Scheme moves to auctioning
grandfathering over-compensates generators and emitters and
leads to rising product prices and hence to an increase in
suppliers‘ profits.
Auctioning is an alternative to the
grandfathering approach
An alternative for the initial allocation of emission allowances to
installations is auctioning, which features the following benefits:
— In auctioning the ―polluter pays‖ principle is implemented.
Thereby, auctioning not only ensures that pollution costs are
internalised, but also that producers buy allowances before they
pass on the costs to consumers.
— Auctioning improves allocative efficiency. It leads to a price that
is fairer as it considers the negative externality and is closer to
the real scarcity of emission allowances.
— In contrast to grandfathering, auctions generate public revenue,
i.e. it is the government (and ultimately, by means of revenue
recycling, the taxpayers) who receive the scarcity rents.
Auctioning revenues could, for instance, be used to ease
distributional inequalities or to fund low-carbon investments.
— Higher costs incurred by installations in the auctioning process
represent greater innovation incentives, i.e. a relatively high
market price for allowances acts as natural incentive to reduce
emissions / which does not hold true for grandfathering where
allowances are given away for free.
Auctioning allocates emission
allowances efficiently
Against this background, auctioning appears to be an economically
and environmentally more efficient means to allocate emission
allowances. Two frequently read counter-arguments against
auctioning are easy to invalidate:
— Allocating emission allowances by means of auctioning increases
energy prices at the expense of consumers since energy
companies allocate the auctioning cost onto the energy price.
Ceteris paribus, only the supply of allowances set by the
governmental cap and not the method of their allocation to
23
emitters, affects the energy price . Apart from that, implementing
the ―polluter pays‖ principle typically implies rising product prices
in the affected sectors. Since ultimately consumers are the
polluters, influencing consumers‘ decisions by means of having
prices reflect true costs is exactly the way to achieve the
environmentally desired outcome.
— Introducing auctioning as allocation mechanism is more complex
as significant investments into the required infrastructure become
necessary. This argument could hold true if the infrastructure
were to be built from scratch. However, there is an abundance of
regulated markets in Europe that could (and seem to be willing
to) provide the auctioning platform, e.g. those that have already
done so in phases 1 or 2. Besides, part of the auction and
infrastructure costs could be financed through auction revenues.
Correct auction design is essential When considering allocating allowances via auctions, considerable
for the auction’s success experience in the sale of assets by governments has led to the
conclusion that careful attention to auction design is critical for an
23
November 8, 2010
According to Cramton and Kerr (2002), the same energy price should be expected
regardless of whether the government auctions allowances or gives them away for
free. In either case the cost of producing energy (i.e. the energy supply curve) will
rise by the price of carbon permits times the carbon per unit of energy. The price of
carbon permits depends only on the marginal cost of abating carbon, i.e. the
demand for permits, and the supply of permits set by the cap. The method of
allocation affects neither demand for nor the supply of permits. The energy price
rise depends only on the carbon permit price, the carbon intensity of the marginal
energy source, and the relative elasticities of energy demand and supply.
11
Current Issues
auction‘s success in achieving the goals specified for the auction
(Holt et al., 2007). We shall therefore evaluate how, in theory, such
an auction should optimally be designed. In our view, auction design
consists of the auctioning mechanism and of the organisation of the
auction. In the subsequent sections, we discuss the prospective EU
ETS auction design and organisation.
Design and organisation of a carbon emissions auctioning
mechanism
When designing an auction, the first task is to clarify what exactly is
being auctioned. With carbon emission allowances the matter is
fairly simple: Each allowance represents the permission for one
metric tonne of carbon usage, i.e. the vested right to emit one tonne
of CO2. If necessary, it must be clarified whether or not to auction
futures in addition to spots.
The next task is to select the auctioning mechanism and to
determine how to organise the auction itself. Holt et al., 2007, have
compiled an overview of a number of relevant criteria. These design
principles relate both to the auction itself and to the performance of
the allowance market and include: efficiency, price discovery,
minimising price volatility, no interference with the secondary
market, safeguard against collusion and/or market manipulation,
fairness and transparency, revenue, minimising administrative and
transaction costs as well as familiarity to the industry.
Auction mechanism
Auction mechanisms can be divided into two basic forms: sealed-bid
auctions and ascending-bid auctions (see table on next page).
Sealed-bid auctions
Sealed-bid auctions are differentiated according to the number of
bids participants are allowed to submit. In a first-price sealed-bid
auction, bidders submit a single bid representing a valuation based
on supposed market value and their own willingness to pay. In this
setting, bidders cannot adjust their own bids as they cannot see the
bids of other participants. Hence, there is no competition with other
bidders through relative prices.
A second-price sealed-bid auction (also referred to as Vickrey
auction) essentially functions the same way, but the price paid is the
second-highest bid. Each winner thus pays the opportunity cost of
its winnings, i.e. the extra value that would be gained if the units
went to the most deserving losers. Vickrey pricing accomplishes
truthful revelation of the bidders‘ valuation for the auctioned item; it
eliminates bidding below true valuation (―bid shading‖) as bidding
the true demand curve is the dominant strategy (Mas-Colell et al.,
1995). The limitation of the Vickrey auction, however, is that without
sequential rounds it does not allow for price discovery in case the
bidders are unsure of their own valuations.
Auctions where participants may submit multiple bids at different
prices differ in terms of their pricing methods: Uniform pricing and
discriminatory (or ―pay-your-bid‖) pricing are the two most common
forms. Bidding behaviour is quite different under the two
approaches. With discriminatory pricing, every bidder tries to guess
where the clearing price will be and then bids slightly above it.
Winning bidders pay their bid; therefore bids in excess of the
clearing price are money left on the table. With uniform pricing,
predicting the clearing price is less important, as every winner pays
the clearing price regardless of their bids.
12
November 8, 2010
Bidding for the better: EU Emissions Trading Scheme moves to auctioning
Auction Format
Description
First-price sealed-bid
auction
Single-round, sealed-bid auction in which
bidders simultaneously submit one bid each
in a concealed manner. The bidder with the
highest bid wins and pays the amount of his
bid to the seller.
Ascending-bid auctions
Sealed-bid auctions
Second-price sealed-bid Second price, single-round, sealed-bid
auction (Vickrey auction) auction in which bidders submit one bid each
in a concealed manner. The highest bidder
wins, but the price paid is the second-highest
bid.
Discriminatory-price
sealed-bid auction
Single-round, sealed-bid auction in which
bidders can submit multiple bids at different
prices in a concealed manner. The highest
bids for the Q allowances to be sold obtain
allowances at their own bid prices.
Uniform-price sealed-bid Single-round, sealed-bid auction in which
auction
bidders can submit multiple bids at different
prices in a concealed manner. The price paid
by all bidders with the highest bids for the Q
available units is equal to the highest
rejected bid.
English auction / Open
ascending-price auction
Multi-round, open-bid auction where
participants bid openly against one another,
with each subsequent bid higher than the
previous bid. If no competing bidder
challenges the standing bid within a given
time frame, the standing bid becomes the
winner, and the item is sold to the highest
bidder at a price equal to his or her bid. Most
common form of auction used today.
English clock auction /
Ascending clock auction
Multi-round auction in which the auctioneer
posts a sequence of increasing (ascending)
prices, usually at regular time intervals; in
response, the bidders state the quantity they
are willing to buy at the specified price. The
auction stops when demand falls below the
amount of allowances offered for sale.
Shot clock auction
Hybrid between English clock and a
discriminatory, sealed-bid auction: Multiround English clock auction where the clock
stops when the total number of units
requested falls to a cut-off level that is a
specified fraction higher than the number of
units being auctioned. When the clock stops,
all bidders may submit a final set of sealed
bids into a discriminatory-price, sealed-bid
auction. Allowances are awarded to those
making the Q highest bids and bidders pay
their own bid prices.
Dutch auction
Multi-round discriminatory-price auction that
starts with a high provisional price, which
falls by predetermined increments. The
auction stops when the number of
allowances locked in is greater than or equal
to Q available units.
Sources: Cramton and Kerr, 2002; Holt et al., 2007
When comparing sealed-bid auctions, Vickrey is best from an
efficiency standpoint. The assessment of uniform pricing and
Vickrey pricing in terms of efficiency depends on the extent of
market power: when no bidder has significant market power, the
outcomes are close. Uniform pricing is nearly as efficient as Vickrey
November 8, 2010
13
Current Issues
pricing and has the additional advantage that everyone pays the
same price. Further, it encourages participation by small bidders,
since it is strategically simple and small bidders benefit from the
demand reduction by large bidders. In contrast, discriminatory
pricing exposes small bidders to strategic risk, since they may be
less able to gauge where the clearing price tends to be.
Ascending-bid auctions
Ascending auctions have many advantages over sealed-bid
auctions, e.g. a reliable process of price discovery. Both price and
allocation are determined through a process of open competition. In
a multi-round setting, each bidder has the opportunity to improve his
bids, i.e. to change losing bids into winning bids or to withdraw if the
price gets too high. Those willing to pay most win the auction.
However, ascending-bid auctions are inefficient as well: Bidders
shade their bids in order to keep the price down. And, multiple-round
auctions might be more conducive to collusion (coordinated
bidding), as they provide participants with opportunities for signalling
and detecting when someone has reneged on a collusive agreement
(Holt et al., 2007).
Auction organisation
Apart from the question as to how to design the auctioning
mechanism, it is relevant to determine the organisation of the
auction. This includes the following aspects:
— Frequency and timing of auctions: Weighing the desirable
24
features of frequent auctions against the administrative and
transaction costs of conducting repeated auctions.
— Supervision: Aims at designing criteria for detecting market
manipulation such as potential collusion. It also improves
investor confidence in the knowledge that the value of investments will not be diminished by illegal activity in the market and
provides information on the performance of the market similar to
an early-warning system (Holt, et al. 2007).
— Transparency: In analogy to equity markets, where transparency
is categorised into pre- and post-trade-transparency, similar
constructs are thinkable in terms of an auction. When e.g. a
sealed-bid auction format is chosen, a priori transparency is per
se foreclosed as individual bidders will only see their own bids.
Ex post, a wide scope of information disclosure is theoretically
possible, ranging from full disclosure of all bids along with the
overall demand for allowances to selective disclosure of
particular key figures only.
— Auctioneer: Must possess technical capabilities to conduct the
auction properly, such as capacity and experience or relevant
professional licences. The auctioneer‘s integrity needs to be
guaranteed, e.g. regarding the confidentiality of the bids or the
ability to manage sensitive information in an appropriate manner.
— Participants: In terms of allowing participation in the auctions, two
options are possible. Either, only entities that have a vested
24
14
Desirable features of frequent auctions include: (i) restricting the number of
allowances auctioned at one time and thereby limiting the likelihood that a buyer
could use the auction to manipulate the market, (ii) contributing to the liquidity of
the allowance market by making allowances available for purchase on a regular
basis and (iii) limiting the potential for the allowance auction to disrupt the spot
market by dumping large quantities of allowances on the market at a particular
time.
November 8, 2010
Bidding for the better: EU Emissions Trading Scheme moves to auctioning
interest in purchasing allowances because of their obligation to
surrender them to their government are admitted for participation,
or participation is open to all interested parties, including, for
instance, financial institutions. In any case, it must be assured
that in order to reduce the risk of market abuse, potential bidders
are subject to a pre-qualification process and a deposit
(collateral). As pre-qualification is vital to the integrity of the
auction, access should be subject to adequate customer due
diligence checks – including financial assurance mechanisms to
25
guarantee that all participants can fulfil their bids . Crucial in
terms of deposit are the quantity and the type of collateral to be
posted; in secondary markets, the level of collateral typically
varies according to the risk profile of the buyer.
— Reserve price: May act as an indicator of any flaw in the auction
process. A divergence of the auction clearing price from recent
secondary market prices would suggest an issue that could
invalidate the auction. Yet, a reserve price always represents
government intervention in the price setting process which is
incompatible with a fully market-driven approach.
— Maximum / minimum bid-size: A maximum bid-size in terms of
bid volume per single entity may limit the actual or potential
perceivable risk of market manipulation, anti-competitive
behaviour or collusion; while it may prevent the domination of a
particular auction by a single bidder, it may also represent a
restriction for participants facing considerable annual allowance
purchase requirements. A minimum bid size would only be
justified in case certain parties are deliberately to be excluded
from participation in the auction. A too small lot size would also
cause inefficiencies due to higher administrative burden.
— Clearing and settlement: The auction platform should ensure
connection to clearing and settlement systems for the handling of
payments, delivery of the auctioned allowances and management of collateral and margins.
Lessons learnt from EU ETS phase 1 and 2 carbon auctions
Analysing practical considerations of auctions held in previous
phases may help to prepare the regulatory framework for phase 3
auctions. Bearing in mind that the purpose of any emissions trading
scheme is not allowance trading in itself, but to achieve a reduction
of GHG emissions, Burtraw (2007) concludes that the best market
design is a simple and transparent one. Also, the first two phases
have proven how much market design matters to its operation.
General experiences and lessons learnt
26
— Inefficiencies due to inconsistent allocation methodologies across
the Member States in conjunction with proposed caps that
27
varied widely in terms of stringency.
— Banking limitations: Allowances are assets that can have
significant value. Phase 1 EU ETS allowances, however, had a
fixed life. Due to that and the over-allocation of allowances in
phase 1, values of allowances went to zero at their terminal
25
26
27
November 8, 2010
Appropriate pre-qualification requirements may include the proof of identity, CITLregistry (Community Independent Transaction Log account details), type of
business, declaration of participation in EU ETS, creditworthiness, etc.
Sources: CENR, 2007; Burtraw, 2007; COM, 2006.
Counterproductive allocation methods may cause intense lobbying, undue
distortion of competition between sectors and installations, and affect the credibility
of the system.
15
Current Issues
points. This raised difficult issues of asset management for those
required to hold allowances. The prohibition of banking from
phase 1 to phase 2 created a significant price disparity between
allowances at the end of the first trading period and the
beginning of the second trading period.
— Long-term uncertainty: For participants in the EU ETS,
predictability for the medium- and long-term objectives was
missing as ground rules, e.g. regarding allocation, were not
determined beyond the second trading period.
— Monitoring / supervision: In phase 1 of the EU ETS, many
Member States lacked accounting and monitoring systems.
Supervision of the auctioning processes was thus missing.
Auction design: Specific lessons learnt
Apart from lessons learnt in terms of the general setup of the EU
ETS, experiences with the strengths and weaknesses of the
respective auction organisation have been gathered during the
auctions in Ireland and Hungary (see Betz, 2007; Macken, 2007). To
ensure smooth functioning of the CO2 auctions, the following auction
setup was chosen:
— Potential bidders were subject to a pre-qualification process
and a deposit. Any winners not honouring their bids forfeited
their deposits.
— A uniform-price sealed-bid auction was chosen, including a
non-disclosed reserve price.
— The initial lot size for the first auction of 250,000 allowances
was set at 500 allowances.
Experiences with this auction setup can be summarised as follows:
— As timelines for electronic funds transfer are generally very
fast, the 5-day settlement period proved too long. In the
second auction, where full settlement within two days was
implemented, all allowances were successfully transferred.
— Considering the vulnerability of an auction in case the market
dipped during the settlement period, the deposit of 3,000 EUR
seemed insufficient to ensure payment and delivery. A deposit
of 15,000 EUR was therefore considered more appropriate.
— The lot size of 500 EUAs emerged as being too low and was
therefore raised to 1,000 EUAs.
— Manual pre-qualification and bidding were replaced by an online process.
— During the first few auctions, disclosure of the reserve price
led to a sharp drop of forward prices by minus EUR 0.90.
Thus, Betz (2007) argues in favour of non-disclosure of the
reserve price.
Our recommendations
Based on our exploratory work on auction design and auction
organisation and taking into consideration the lessons learnt as
illustrated above, this section presents our recommendations of a
reasonable phase 3 auctioning mechanism.
Carbon auction design
Efficient auctions for carbon emission allowances need to achieve
several objectives. First, the auction needs to assign the limited
allowances efficiently. Second, the auction should provide reliable
16
November 8, 2010
Bidding for the better: EU Emissions Trading Scheme moves to auctioning
price signals to help guide firms‘ long-term planning and investment
as well as government policy development. Prices are more likely to
reflect true market values and thus provide better information if they
emerge from transparent and competitive auction mechanisms.
Third, to promote confidence among market participants the auction
process should be fair and non-discriminatory (i.e. full access to
SMEs needs to be guaranteed).
Single-round, sealed-bid, uniform
price auction most suitable carbon
auction design
Considering these objectives and the benefits and shortcomings of
the individual auction formats presented above, we recommend a
single-round, sealed-bid, uniform price format as being best suited
for carbon auctions to be open, transparent, harmonised, simple,
non-discriminatory and to avoid distortion of competition (e.g. by
collusion). Due to its simplicity, the above design also facilitates
participation. Uniform pricing seems to be the fairest pricing
mechanism considering that every winning bidder pays the same
price for an identical, homogeneous good. Additionally, fairness and
the need to mitigate risk of market abuse are best enabled through
this format as single-round auctions are less complex and less
prone to collusion (Holt et al., 2007).
Carbon auction organisation
In the following we present our recommendations for a best suited
carbon auction organisation.
Frequency: The balance between ensuring sufficient participation in
each auction and limiting the scale of the auctions to prevent shocks
to the secondary market is a pivotal issue. A steady flow of
allowances into the secondary market should be maintained whilst
minimising the size of each individual injection to avoid destabilising
the secondary market. Frequent carbon auctions have a smaller
impact on liquidity and prices in the secondary market, reduce the
risk of market manipulation and facilitate cash management for
participants. The potential disadvantages of too frequent auctions
are an increase in administrative costs and the risk of too few
participants in individual auctions. Balancing the costs, risks, and
benefits, a regular programme of at least quarterly auctions seems
to be the most appropriate frequency.
Supervision: Central oversight of the auction process seems most
adequate to ensure non-discriminatory access to the auction.
Existing market structures already covered by regulation (e.g.
MiFID) might be used to supervise auction processes as well. This
seems sensible, as the objectives of market structure regulation
coincide with those intended to be achieved by promoting
auctioning.
Transparency: Winning bidders and the overall demand (quantity)
for allowances together with the minimum/maximum bids should be
revealed. However, we strongly advise against revealing specific
offer prices by individual participants as collusion could occur when
bidders learn about other participants‘ bidding behaviour.
Participants: Participation in the auction should be open as the
involvement of financial institutions as intermediaries enables
access for SMEs. These might wish to assign another party to act
on their behalf, themselves not having the required resources or
knowledge. Larger participation in open auctions ensures a
competitive outcome; artificially restricting participation to national
buyers or specific sectors is likely to abate revenues and the
efficiency of the allocation process (Hepburn, et al. 2006).
November 8, 2010
17
Current Issues
Deposits / collateral: In order to reduce risks of market abuse,
potential bidders should be subject to pre-qualification and a
deposit. Pre-registration requirements for admittance to EU auctions
should be harmonised throughout the EU. Yet, it must be borne in
mind that in case auctions are performed by Regulated Markets
(RMs), the RM would enforce its criteria and no pre-registration for
each individual auction would be necessary. The RM would also be
in charge of calculating and collecting the deposits. As each RM has
proprietary methods for this purpose, the approach of some national
phase 1 and 2 auctions to raise a non-discriminatory fixed amount of
deposit from every participant is not realistic.
Bidding details: No reserve price should be prescribed as any
regulatory influence on the price should be avoided. A maximum bid
size does not seem to be necessary as the availability of price
signals and of the allowances themselves on the secondary market
as well as the use of frequent auctions serve as protection against
market abuse. Limiting the bid size could place large emitters at a
disadvantage by forcing them to buy in the secondary market,
leading to unnecessary additional intermediation. Smaller lot sizes
may be useful for smaller emitters as a large lot size may act as a
barrier to small emitters. However, smaller lot sizes represent a
higher administrative burden for the auction platform. A lot size of
1,000 allowances would correspond to secondary market practice.
Auction design in phase 3 of the EU ETS
When determining the organisation of an auction in a setting where
diverse parties, i.e. the Member States of the EU, are involved, a
question that arises is whether to use one single auction process
28
(―full centralisation‖) or multiple ones (―full decentralisation‖) .
Number of auction processes?
If one single auction process were to be used, one institution at the
EU level would manage the auctions and return the revenue to the
Member States according to their share of supply thereafter.
Proponents to this organisational setting – the Commission itself,
the majority of stakeholders and a large majority of Member States –
argue that such a setting would lead to uniform pricing, high cost
efficiency due to uniformity in processes, an improvement in liquidity
based on better and broader accessibility for market participants
and higher price stability. Additionally, market abuse risks decline as
one single process avoids spreading volume and participation over
several platforms. Against the background of these significant
efficiency gains, the use of one single EU-wide auctioning process
seems to be reasonable.
An alternative to a single process are auctions held independently
and individually by Member States. The use of multiple processes
risks inefficiencies, though, that would also reduce revenues; so it is
difficult to identify any advantages of this option. Additionally, full
decentralisation would only function properly if adequate supervision
of the platforms were guaranteed and proper sanctioning
mechanisms were introduced in case an opt-out platform did not
respect the predefined common rules. As we expect no competitive
28
18
According to the Commission ―auction process‖ encompasses the chain from
setting the date and volume of auctions, registering and pre-qualifying participants
to providing infrastructure, collecting bids, managing collateral, running the auction
and calculating the results, ensuring payment, delivery and monitoring. ―Auctioning
platform‖ refers to the IT system used to run the auction (COM, 2009).
November 8, 2010
Bidding for the better: EU Emissions Trading Scheme moves to auctioning
benefits from peripheral auction processes, we advise against full
decentralisation.
Auction platform(s) and selection procedure
Formation of the compromise
The coordinated approach emerged as four
Member States refused to vote in favour of
one common platform; a blocking minority of
Germany, Poland, Spain and the UK had
insisted on their right to opt out of the
European auction organisation. In particular,
Germany and the UK were keen to maintain
their own national systems, based on the
arguments of the sheer size of the underlying
market (Germany) and the country‘s large
financial services industry (UK) and blocked
the idea of a single centralised auction.
Ironically, considering that Spain and Poland
have no experience in auctioning yet and that
it would not be cost-effective for the two to
create new trading platforms for two or three
years, i.e. before the third trading period
starts, both are likely to opt for the central
platform after all.
Source: www.euractiv.com/en/eu-backs-down-centralisedco2-auctioning-news-422398
Alternative auction provider models:
— Primary participants’ model
Few intermediaries, usually financial
institutions, are exclusively mandated to
directly participate in the auction. Bidding
is possible both on behalf of their clients
and of their own account. Drawback:
majority of bidders bid indirectly through
financial institutions, thereby revealing
their trading strategy to the primary
participant.
— Third-party service provider model
A private company is selected through an
open and competitive selection procedure
and mandated by the State to organise
the auction process. Drawback: need to
set up new infrastructure and establish
new trading relations.
A compromise began to emerge in early 2010, suggesting a
coordinated approach. The draft regulation (COM, 2010c) primarily
foresees one single EU-wide joint platform where the auctioneer(s)
act(s) on behalf of the Member States for auctioning carbon
allowances established during the third phase of the EU ETS
starting in 2013. At the same time, the proposal gives Member
States the possibility to opt out of the joint platform and to provide
an own auctioning system, provided they meet certain criteria which
ensure the proper functioning of the auctions (see COM, 2010c).
The selection of the common auction platform will take place
through a competitive joint procurement procedure by the European
Commission and those Member States choosing to auction their
allowances through this platform. The selected platform will initially
be assigned for a five-year period only – an open and competitive
29
selection procedure shall then be repeated .
Opt-out platforms
Member States intending to opt out of the common auction platform
will need to inform the Commission of their intention within three
months of adopting the Auctioning Regulation. Once a Member
State has determined the details of its intended opt-out platform, it
must notify the Commission of its plans. Each opt-out platform will
be assessed by the Commission to make sure that all eligible
bidders are given equal access to the auctions and that no
preference is given to any party. Approved opt-out platforms are
listed in an annex to the regulation. Member States who decide to
opt out may be given observer status for the common platform.
The Regulation draft provides for open, transparent and nondiscriminatory access to the auctions. As such, it does not restrict
access to auction platforms or geographical locations of the bidders.
Installations are not limited to the Member States they are domiciled
in. As a result, an installation may bid in any auction and on any
platform, whether opt-out or central platform.
Regulated market best suited to perform the auction
The Commission proposes auctions to be conducted by a regulated
market authorised pursuant to EU financial markets legislation. This
could either be an existing regulated carbon exchange operating on
the secondary market, an existing securities exchange or a newly
set-up regulated market. These infrastructures are proposed by the
Commission because they are already regulated at the EU-level, i.e.
the Markets in Financial Instruments Directive (MiFID, Directive
2004/39/EC) and the Market Abuse Directive (Directive 2003/6/EC).
A further advantage of drawing on regulated markets as auction
platforms is that existing secondary market clearing or settlement
infrastructure may be used to which many potential participants in
the auctions are already connected (see COM, 2010c). Employing
existing infrastructure further allows making use of existing trading
relations with clearing houses or settlement facilities.
29
November 8, 2010
Cf. European Commission‗s Presentation at the CCAP Workshop in Warsaw on
January 28, 2010.
19
Current Issues
Formation of auction clearing
price
Price
Auction clearing price
Amount of auctioned
allow ances
A*
B*
C**
D
E
Bid size
* Successful bids A, B and C.
** The amount demanded at the auction clearing price
exceeds the amount of allowances to be auctioned.
Bid C can thus not be fully satisfied.
The auction design chosen by the Commission is a single-round,
sealed-bid, uniform price auction. Any auction platform shall ensure
its auctions can be accessed remotely via an electronic interface
accessible securely and reliably through the internet. An auction
calendar must be maintained, specifying frequency and dates at
which auctions will take place. Each auction‘s bidding window must
be open for at least two hours. Upon closure of the bidding window,
the auction platform will determine the price at which demand for
allowances equals the number of allowances offered for sale, i.e. the
clearing price (see figure). Successful bidders are those having
30
placed bids for allowances at or above the clearing price . All
successful bidders pay the same price, independent of the price
they specified in their bids. An auction is to be cancelled by the
auction platform in case the total volume of bids falls short of the
volume of auctioned allowances or if the auction clearing price is
significantly under the price on the secondary market prevailing
during and immediately before the bidding window.
Auctioned products
The Auctioning Regulation draft specifies that allowances shall be
auctioned either in the form of two-day spot or five-day future
contracts by the common auctioning platform as well as by any optout platform(s). The exact specification will be made during the
process of appointing the auction platform(s).
Resolution of tied bids
Price
Amount of auctioned
allow ances
Auction clearing price
General auction design
As the delivery of allowances for the third trading period requires
modifications to the Registry Regulation and the IT infrastructure,
the draft Auctioning Regulation provides for the possibility to auction
on a transitional basis futures and forwards with delivery no later
than December 31, 2013. In this situation, each Member State
would need to determine whether to auction forwards or futures.
A
B
C*
D*
When auctioning spot products becomes the rule, together with the
possibility of forwards and futures being auctioned on a transitional
basis until the legal and technical infrastructure is ready, two
platforms for auctioning forwards and futures, respectively, may be
procured in addition to the platform that auctions spot. However, it is
also possible that one auction platform offers more than one of
these products (COM, 2010b).
E
Bid size
* The tied bids of bids C and D are being solved with
the help of a random algorithm.
Source: CEP, 2010
2
Bid size, auction participation and frequency
The minimum bid size – representing one lot – is 500 EUAs (and
1,000 EUAAs, respectively) to ensure the access of SMEs and small
emitters to the platform. A maximum bid size, either expressed as a
percentage of the total number of auctioned allowances in any given
auction or as a percentage of the total number of auctioned
allowances in any given year, may be imposed by any auction
platform in order to mitigate actual or potential perceivable risk of
market abuse and anti-competitive behaviour (see COM, 2010c).
Participation in the auctioning process shall be open to all parties
with a valid account in the EU ETS registry system. As a signatory to
the Kyoto Protocol in its own right, the Community is obliged to
maintain a registry – the Community Registry – which is distinct from
the registries of Member States. Allowances issued from January 1,
2013 onwards will be held in the Community registry instead of in
national registries. This is in contrast to phases 1 and 2 where it was
30
20
In case of tied bids, a random selection made in accordance with an algorithm
determined by the auction platform before the auction resolves successful bidders.
November 8, 2010
Bidding for the better: EU Emissions Trading Scheme moves to auctioning
mandatory for each Member State to have a national registry.
Eligibility to apply for admission to the auctions will be given to
easily identifiable, well-defined categories of participants (e.g.
operators of stationary installations and aircraft operators covered
by the ETS), as well as regulated financial entities such as
investment firms and credit institutions. As registration processes
are independent for each phase of the EU ETS, parties will thus
have to register for phase 3 independently of whether they had
already been registered in phase 1 or 2.
Auctions at the common EU-wide auction platform will be held at
least weekly for EUAs and at least once every two months for
EUAAs. The Commission justifies this high frequency with smaller
auction sizes which allow for easy access for SMEs, the limitation of
impact on the secondary market, a reduction of market abuse risk
and an increase in flexibility due to the possibility to make use of
later auctions to adjust trading positions. Volume will be spread
evenly throughout the calendar year with reduced frequency over
holiday periods (see COM, 2010c). Opt-out platforms will need to
determine the frequency of auctions on their own, taking into
account that the regulation determines a minimum amount of
allowances per auction in order to avoid too many auctions.
The auction platform must provide or enable access to at least one
clearing and settlement system for the handling of payments,
delivery of the auctioned allowances and management of collateral
and margins. Auctioned allowances shall be delivered within a
maximum of five working days after the auction.
Evaluation and conclusion
The Regulation draft as proposed by the European Commission can
in general be appraised as sensible. Compared with the previous
phases, it is likely to improve the functioning of the EU ETS.
We appreciate the introduction of auctioning as the principal
allocation method for emissions trading in phase 3 of the EU ETS.
Auctioning is an economically and environmentally more efficient
means to allocate emission allowances to installations and is thus to
be preferred over grandfathering.
Further, the Commission seems to have acknowledged key lessons
from the structure of existing phase 1 and 2 auctions which most
notably becomes apparent in the introduction of a common EU-wide
platform. However, the need for political compromise has left its
marks on the Regulation draft. Abolishing national allocation plans in
favour of a single auctioning platform to eliminate the issue of
inconsistent allocation of allowances between Member States is
clearly to be welcomed. This progress, however, will be thwarted by
the possibility for Member States to opt out of the central platform
which materialised due to strong political influence. This high degree
of flexibility for the member states does at the present stage not
support the objective to reduce the complexity of the EU ETS. The
lack of full harmonisation due to the choice of this coordinated
approach further interferes with the long-term objective of a global
system of CO2 emissions trading. A well-designed EU ETS as the
world‘s first large-scale CO2 emissions trading programme could
have the potential to set standards in this regard. For this, however,
full harmonisation would be essential. The fact that the two biggest
carbon emitters in the EU – Germany and the UK – have declared
November 8, 2010
21
Current Issues
their intention to opt out is very likely to considerably reduce the
liquidity and effectiveness of the central platform.
The proposed auction mechanism and organisation in the
Auctioning Regulation draft is designed reasonably. Still, it reflects
the fact that the European Commission had to compromise between
a wide range of potential participants (small versus large emitters,
financial institutions, NGOs). A major concern of the Commission
was to provide non-discriminatory access to the auctions, especially
with regard to SMEs. It is for that purpose that the Commission
decided to increase the frequency of auctions to a weekly setting
and to decrease the lot size to 500 allowances – which is rather
uncommon compared with standard secondary market lot sizes of
1,000 allowances.
Another point to acknowledge is the preference of a regulated
market as operator of the auctioning platform. This is a good choice
as it means existent infrastructure and expertise can be used.
Regulated markets are subject to consistent rules and regulations
across the EEA with infrastructure and connectivity already familiar
to most market participants.
Apart from these arguments that specifically refer to the auctioning
mechanism, some broader issues in conjunction with the EU ETS at
large shall be pointed out. Issues of long-term uncertainty remain
although the third phase of the EU ETS runs over a significant
timespan: Currently, the EU and its Member States are committed to
an independently quantified economy-wide emissions reduction
target of 20% compared to 1990 levels by 2020. However, as part of
a global and comprehensive agreement for the period beyond 2012,
the EU and its Member States have expressed (in Appendix I of the
Copenhagen accord) a conditional offer to move to a 30% reduction
by 2020 compared to 1990 levels, provided that other developed
countries commit themselves to comparable emission reductions
and that developing countries contribute adequately according to
their responsibilities and respective capabilities. This would boost
demand for project-based credits which in combination with the fact
that the rules governing the use of CERs and ERUs in phase 3 are
still uncertain once more increases long-term uncertainty for
participants in the EU ETS.
Another drawback is that with the auctioning regulation not being
finalised before the end of 2010, the Commission delays the
important decision about the realisation and concrete design of early
auctions, which should start in 2011 at the latest. It is currently not
clear whether this is still possible at all.
A more general issue that may be criticised in terms of the EU ETS
is that it currently only covers CO2, but no other GHGs pursuant to
the Kyoto Protocol. In the long run, emissions trading should be
extended to cover more – if not all – greenhouse gases. A reasonable start is the inclusion of nitrous oxide and perfluorocarbon in the
EU ETS which is foreseen from 2013 onwards. Also, incorporating
more sectors in emissions trading over the next few years is an
issue. There are some new sectors intended to join the scheme in
2013 (e.g. aluminium). Other possibilities comprise e.g. the maritime
sector. It would also be worthwhile to take into account whether and
how larger firms in the agriculture and forestry businesses (that emit
methane rather than CO2 or are responsible for large-scale
deforestation) could be integrated into emissions trading.
Michael Chlistalla (+49 69 910-31732, [email protected])
Meta Zähres (+49 69 910-31444, [email protected])
22
November 8, 2010
Bidding for the better: EU Emissions Trading Scheme moves to auctioning
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© Copyright 2010. Deutsche Bank AG, DB Research, D-60262 Frankfurt am Main, Germany. All rights reserved. When quoting please cite ―Deutsche Bank
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November 8, 2010