Misato Sato

Allocation, incentives and distortions: the impact of EU ETS emissions allowance allocations to the electricity sector

Abstract The allowance allocation under the European emission trading schemes differs fundamentally from earlier cap-and-trade programmes, such as SO2 and NOx in the USA. Because of the sequential nature of negotiations of the overall budget, the allocation also has to follow a sequential process. If power generators anticipate that their current behaviour will affect future allowance allocation, then this can distort todays decisions. Furthermore, the national allocation plans (NAPs) contain multiple provisions dealing with existing installations, what happens to their allocation when they close, and allocations to new entrants. We provide a framework to assess the economic incentives and distortions that provisions in NAPs can have on market prices, operation and investment decisions. To this end, we use both analytic models to illustrate the effects of the incentives, and results from numerical simulation runs that estimate the magnitude of impacts from different allocation rules.

Emissions trading: lessons learnt from the 1st phase of the EU ETS and prospects for the 2nd phase

In January 2005, the European Union launched an EU-wide emissions trading scheme (EU ETS) for CO 2 emissions. It covers approximately 45% of total CO 2 emissions and is thus the largest ‘cap-and-trade’ carbon trading scheme in the world – an ambitious and highly challenging policy experiment. As it emerges from its pilot phase and prepares for phase II, the EU ETS now stands at a crossroad: will it quickly address the problems experienced in phase I and establish strong price signals in Europe, or will the prevailing uncertainty continue into phase II? Phase I has indeed proved how much market design matters to its operation and signalling. Unlike normal markets, emissions trading schemes are designed markets, where the demand and supply are dependent on government decisions. The volume of allowance allocation determines scarcity levels and thus the effectiveness of the scheme. Furthermore, the various provisions in the allocation plans can influence investment and operational choices and thus the efficiency of the scheme. Decisions on auctioning and free allocation, as well as on how to split the allocation pie across sectors and installations, will also have distributional consequences. This special issue presents seven articles that consider the influence of allowance allocation, and inform the debate surrounding ‘National allocation plans in the EU ETS: lessons and implications for phase II’. Five articles focus on recent experience with the design of national allocation plans (NAPs) for the period 2008–2012 and provide qualitative and quantitative assessments. These are complemented by two numerical simulations of trade and distributional effects. We summarize their findings in the context of the debate, which we structure into the three key criteria for ETS assessment: market efficiency; distributional effects, and environmental effectiveness.

Implications of announced phase II national allocation plans for the EU ETS

Abstract We quantified the volume of free allowances that different national allocation plans proposed to allocate to existing and new installations, with specific reference to the power sector. Most countries continue to allocate based on historic emissions, contrary to hopes for improved allocation methods, with allocations to installations frequently based on 2005 emission data; this may strengthen the belief in the private sector that emissions in the coming years will influence their subsequent allowance allocation. Allocations to new installations provide high and frequently fuel-differentiated subsidies, risking significant distortions to investment choices. Thus, in addition to supplying a long market in aggregate, proposed allocation plans reveal continuing diverse problems, including perverse incentives. To ensure the effectiveness of the EU ETS in the future, the private sector will need to be shown credible evidence that free allowance allocation will be drastically reduced post-2012, or that these problems will be addressed in some other way.

Embodied Carbon in Trade: A Survey of the Empirical Literature

This paper critically reviews the literature on embodied carbon in trade and evaluates our present empirical understanding of these flows. A careful comparison of quantitative results from this literature exposes significant inconsistencies. For instance, estimates for emission embodied in world trade in 2004 range between 4.4 Gt and 6.2 Gt CO2, the difference corresponding to around half of Europes annual emissions. A few consistent themes do nevertheless emerge from the literature. Most importantly, emissions in trade constitute a large and growing share of global emissions. Uncertainty about country-level embodied emissions remains large, however, which presents severe limitations for the practical application of embodied carbon principles in climate policy.

The impacts of environmental regulations on competitiveness

This article reviews the empirical literature on the impacts of environmental regulations on firms’ competitiveness as measured by trade, industry location, employment, productivity, and innovation. The evidence shows that environmental regulations can lead to statistically significant adverse effects on trade, employment, plant location, and productivity in the short run, in particular in a well-identified subset of pollution- and energy-intensive sectors, but that these impacts are small relative to general trends in production. At the same time, there is evidence that environmental regulations induce innovation in clean technologies, but the resulting benefits do not appear to be large enough to outweigh the costs of regulations for the regulated entities. As measures to address competitiveness impacts are increasingly incorporated into the design of environmental regulations, future research will be needed to assess the validity and effectiveness of such measures and to ensure they are compatible with the environmental objectives of the policies.

Differentiation and dynamics of competitiveness impacts from the EU ETS

We summarises the main factors that differentiate impacts of the EU ETS on profitability and market share. By examining sampling a range of sectors, we present some simple metrics and indicators to help judge the nature of potential impacts. We also consider briefly the mitigation response to these impacts by sectors, and how they may evolve over time. The broad conclusion confirms the aggregate findings presented in the existing literature - most participating sectors are likely to profit under the current ETS structure out to 2012 at the cost of a modest loss of market share, but this may not hold for individual companies and regions. The period 2008-12 can assist participating sectors to build experience and financial reserves for longer term technology investments and diversification, providing the continuation and basic principles of the EU ETS post-2012 is quickly defined and incentives are in place for sectors to pursue this.

EU ETS, free allocations and activity level thresholds, the devil lies in the details

It is well known that discontinuous jumps or thresholds in tax or subsidies are socially inefficient, because they create incentives to make strategic behavioral changes that lead to substantial increases in private benefits. This paper investigates these distortions in the context of the EU Emissions Trading Scheme, where activity level thresholds (ALTs) were introduced in Phase 3 to reduce the overallocation of free allowances to low-activity installations. Using installation-level data, we find evidence that cement producers indeed respond to such thresholds when confronted with low demand, by strategically adjusting output to obtain more free allocation. We estimate that in 2012, ALTs induced excess cement clinker production of 6.4 Mt (5% of total EU output), and in affected regions this further distorted trade patterns and reversed carbon intensity improvements. As intended, ALTs reduced free allocation by 4%; however, a linear scheme (output-based allocation) would have achieved a 32% reduction.

Solving the Clinker Dilemma with Hybrid Output-Based Allocation

Output-based allocation (OBA) is one of the main options discussed for addressing carbon leakage in emissions trading systems. This paper studies how different OBA designs affect incentives on mitigation and trade in the cement sector. To do so, we develop an analytical model of sector emissions as a function of technical parameters representing abatement levers. We propose a specific design called hybrid OBA, and show that unlike the alternatives, it provides incentives for firms to reduce the carbon intensity of production without offshoring production. We assess the feasibility of hybrid OBA through expert interviews and find that the main barriers identified, including technical and administrative complexities, are manageable. However, hybrid OBA represents a mid-term solution until more robust anti-leakage measures can be introduced, because of two key limitations of OBA in general - it does not provide incentives to reduce the consumption of cement or to accelerate the development of radical low-carbon technologies, both of which are necessary to deliver deep decarbonisation.