Nicolas Koch

Politics Matters: Regulatory Events as Catalysts for Price Formation Under Cap-and-Trade

This paper investigates how the political process of making cap adjustments has shaped market outcomes in the world׳s largest cap-and-trade system – the EU ETS. Capitalizing on an event study method that incorporates an econometric technique designed to handle parameter instability and model uncertainty, we assess the news-implied price response to 29 hand-collected announcements about the EU ETS supply schedule. Our findings document a high market responsiveness to political events and reveal how market participants view the evolution of cap stringency in the light of a particular announcement. We provide evidence that a sequence of strong event-induced price drops evolve in the backloading decision process, which is consistent with the interpretation that market participant׳s confidence in the political support for reform, and probably the EU ETS in general, has been unsettled. We also document positive price reactions to the 2020 and 2030 policy packages, but not the 2050 roadmaps.

Options to Overcome the Barriers to Pricing European Agricultural Emissions

ABSTRACT Although agriculture could contribute substantially to European emission reductions, its mitigation potential lies untapped and dormant. Market-based instruments could be pivotal in incentivizing cost-effective abatement. However, sector specificities in transaction costs, leakage risks and distributional impacts impede its implementation. The significance of such barriers critically hinges on the dimensions of policy design. This article synthesizes the work on emissions pricing in agriculture together with the literature on the design of market-based instruments. To structure the discussion, an options space is suggested to map policy options, focusing on three key dimensions of policy design. More specifically, it examines the role of policy coverage, instruments and transfers to farmers in overcoming the barriers. First, the results show that a significant proportion of agricultural emissions and mitigation potential could be covered by a policy targeting large farms and few emission sources, thereby reducing transaction costs. Second, whether an instrument is voluntary or mandatory influences distributional outcomes and leakage. Voluntary instruments can mitigate distributional concerns and leakage risks but can lead to subsidy lock-in and carbon price distortion. Third, the impact on transfers resulting from the interaction of the Common Agricultural Policy (CAP) with emissions pricing will play a key role in shaping political feasibility and has so far been underappreciated. POLICY RELEVANCE Following the 2015 Paris Agreement, European climate policy is at a crossroads. Achieving cost-effectively the 2030 and 2050 European targets requires all sectors to reduce their emissions. Yet, the cornerstone of European climate policy, the European Union Emissions Trading System (EU ETS), covers only about half of European emissions. Major sectors have been so far largely exempted from carbon pricing, in particular transport and agriculture. While transport has been increasingly under the spotlight as a possible candidate for an EU ETS sectoral expansion, policy discussions on pricing agricultural emissions have been virtually absent. This article attempts to fill this gap by investigating options for market-based instruments to reduce agricultural emissions while taking barriers to implementation into account.

Permits vs. offsets under investment uncertainty

This paper investigates interaction effects between permit and offset schemes, using the framework on Reducing Emissions from Deforestation and Forest Degradation (REDD+) as a test bed for evaluating the cost and benefit of including low-cost offsets in mandatory emission trading schemes. We use a real options model of firm-level investment decisions under stochastic prices to compare alternative emission trading and permit-offset linkage schemes. By isolating the critical design factors that drive energy investments, we seek to identify policy regimes that balance the different concerns in the polarized debate for and against the inclusion of offsets. Our findings indicate that a moderate offset quota is sufficient to contain investment crowding-out effects, while it still has a positive effect on profit distributions. In contrast, the classical permit price collar will not effectively change investment behavior, precisely because in a framework with multiple compliance instruments the volatility of cheaper offsets is the driving force for investment. Under these conditions, a price collar for offsets emerges as a largely overlooked policy option to foster investment incentives. A combination of offset quota and offset price collar leads to investment patterns that are almost identical to a regime without access to offsets.

The European Emissions Trading System (EU ETS): Ex-Post Analysis, the Market Stability Reserve and Options for a Comprehensive Reform

The central pillar of European climate policy, the European Emissions Trading System (EU ETS), is currently under scrutiny, as the allowance price is persistently low at around 5€/tCO2. The cap was met and emissions actually declined in recent years, ensuring the environmental effectiveness of the scheme. However, the low price may affect the long-term cost-effectiveness of the instrument by reducing the incentive for investment and deployment of low carbon technologies. No significant increase in the allowance price is expected before 2020, and probably not beyond, without reform. While the reasons for the price decline are controversial, empirical analysis shows that only a small portion of price fluctuations can be explained by factors such as the economic crisis, renewable deployment or international offsets. Therefore, it is likely that political factors and regulatory uncertainty have played a key role in the price decline. As a consequence, any reform of the EU ETS has to deliver a mechanism that reduces such uncertainty and stabilizes expectations of market participants. The Market Stability Reserve proposed by the EU Commission is unlikely to address the current problem of price uncertainty and insufficient dynamic efficiency. The key element of the alternative reform proposal described in this paper is to set a price collar in the EU ETS with lower and upper boundaries. This is likely to reinforce the long-term credibility and reliability of the price signal. In addition, a price for GHG emissions not covered by the EU ETS has to be set. If additional market failures prevent the market from functioning efficiently, specific policy instruments related to innovation and technology diffusion should be implemented in addition to carbon pricing. Carbon leakage could be addressed through tailor-made trade policies. In parallel, increasing the coalition of countries included in the carbon pricing should remain a priority. This reform package would bring the EU ETS back to life, while avoiding a relapse into potentially costly and inefficient national climate and energy policies.

Agriculture: Sleeping Beauty of EU Climate Policy? Overcoming Barriers to Implementation

Although agriculture could contribute substantially to European emission reductions, its mitigation potential lies untapped and dormant. Market-based instruments could be pivotal in incentivizing cost-effective abatement. However, sector specificities in transaction costs, leakage risks and distributional impacts impede its implementation. The significance of such barriers critically hinges on the dimensions of policy design. This article synthesizes the work on emissions pricing in agriculture together with the literature on the design of market-based instruments. To structure the discussion, an options space is suggested to map policy options, focusing on three key dimensions of policy design. More specifically, it examines the role of policy coverage, instruments and transfers to farmers in overcoming the barriers. First, the results show that a significant proportion of agricultural emissions and mitigation potential could be covered by a policy targeting large farms and few emission sources, thereby reducing transaction costs. Second, whether an instrument is voluntary or mandatory influences distributional outcomes and leakage. Voluntary instruments can mitigate distributional concerns and leakage risks but can lead to subsidy lock-in and carbon price distortion. Third, the impact on transfers resulting from the interaction of the Common Agricultural Policy (CAP) with emissions pricing will play a key role in shaping political feasibility and has so far been underappreciated.

Accounting for institutional quality in global forest modeling

Abstract The current state of the art in modeling forest cover change is to combine a detailed representation of biophysical processes with economic decision-making principles. Yet, there is an increasing consensus that the quality of political institutions is another relevant component in determining forest cover change patterns. In this paper, the Global Forest Model is used to analyze whether including an index, measuring the capacity of political institutions to guarantee sustainable natural resource management, allows to improve the precision of the modeled forest cover trend. The analysis shows that incorporating the index indeed allows reducing the gap between the estimated and observed forest cover trends for the 2000 to 2010 calibration period.

A Framework for Assessing the Performance of Cap-and-Trade Systems: Insights from the European Union Emissions Trading System

The performance of the European Union (EU) Emissions Trading System (ETS) and other cap-and-trade schemes has been under scrutiny because of their inability to create a stable price for greenhouse gas emissions. This article seeks to inform the often confusing debate about the economic performance of cap-and-trade systems over time, with a focus on the EU ETS. Based on a simple intertemporal framework of emissions trading and a review of the literature, we show that different frameworks and notions of efficiency result in both different assessments of performance and different recommended strategies for improving performance. More specifically, we argue that if cap-and-trade systems have temporal flexibility (i.e., they include banking and borrowing of emissions allowances), it can be highly misleading to base the economic assessment on short-term efficiency. We seek to draw attention to the concept of long-term economic performance, which takes into account the intertemporal nature of emissions trading systems. In particular, we identify market and government distortions (e.g., myopia, lack of policy credibility, excessive discounting) that may depress allowance prices and hamper intertemporal efficiency. We then examine whether the recently adopted Market Stability Reserve and the alternative price collar are likely to address these distortions.

Shifting Paradigms in Carbon Pricing

The first pillar of the old paradigm of carbon pricing is the assumption that an emissions trading scheme is the most cost-efficient way to achieve a certain emission reduction target. However, it has become obvious that the old paradigm is unable to solve a number of challenges, e.g. market participants’ myopia.

Escaping the climate policy uncertainty trap: options contracts for REDD+

ABSTRACT Climate policy uncertainty significantly hinders investments in low-carbon technologies, and the global community is behind schedule to curb carbon emissions. Strong actions will be necessary to limit the increase in global temperatures, and continued delays create risks of escalating climate change damages and future policy costs. These risks are system-wide, long-term and large-scale and thus hard to diversify across firms. Because of its unique scale, cost structure and near-term availability, Reducing Emissions from Deforestation and forest Degradation in developing countries (REDD+) has significant potential to help manage climate policy risks and facilitate the transition to lower greenhouse gas emissions. ‘Call’ options contracts in the form of the right but not the obligation to buy high-quality emissions reduction credits from jurisdictional REDD+ programmes at a predetermined price per ton of CO2 could help unlock this potential despite the current lack of carbon markets that accept REDD+ for compliance. This approach could provide a globally important cost-containment mechanism and insurance for firms against higher future carbon prices, while channelling finance to avoid deforestation until policy uncertainties decline and carbon markets scale up. Key policy insights Climate policy uncertainty discourages abatement investments, exposing firms to an escalating systemic risk of future rapid increases in emission control expenditures. This situation poses a risk of an abatement ‘short squeeze,’ paralleling the case in financial markets when prices jump sharply as investors rush to square accounts on an investment they have sold ‘short’, one they have bet against and promised to repay later in anticipation of falling prices. There is likely to be a willingness to pay for mechanisms that hedge the risks of abruptly rising carbon prices, in particular for ‘call’ options, the right but not the obligation to buy high-quality emissions reduction credits at a predetermined price, due to the significantly lower upfront capital expenditure compared to other hedging alternatives. Establishing rules as soon as possible for compliance market acceptance of high-quality emissions reductions credits from REDD+ would facilitate REDD+ transactions, including via options-based contracts, which could help fill the gap of uncertain climate policies in the short and medium term.

Agricultural Productivity and Forest Conservation: Evidence from the Brazilian Amazon

A mix of public policy and market interventions in the mid-2000s led to historic reductions in deforestation in the Brazilian Amazon. The collateral impact of these forest conservation policies on agricultural production is still poorly understood, though evidence is sorely needed given the economic importance of agriculture in Brazil and many other forest-rich countries. We construct a ten-year panel dataset for agriculture and deforestation in the Brazilian Amazon (2004-2014), and use two complementary difference-in-difference strategies to estimate the causal effect of one of Brazil’s flagship anti-deforestation strategies, the priority list (Municípios Prioritários), on agricultural production and productivity in three sectors: beef, dairy, and crop production. We find no evidence for trade-offs between agriculture and forest conservation. Rather, reductions in deforestation in priority municipalities were paired with increases in cattle production and productivity (cattle/hectare), consistent with a model where policy-induced decreases in the value of clearing new land cause credit-constrained farmers to shift investments from deforestation to capital investments in farming. The policy had no effect on dairy or crop production. Our results suggest that in regions with large yield gaps and where technologies for increasing yields are readily available, efforts to constrain agricultural expansion through improved forest conservation policies may induce intensification.