Memorandum submitted by David Newbery,
Research Director, Electric Policy Research Group,[57]
University of Cambridge
SUMMARY
Whether, and under what circumstances, emissions
trading ought to be supplemented or replaced by tax or regulation
1. The EU ETS has many virtues, most obviously
that it was probably the simplest means of securing support from
EU member states (MS), as it allocated entitlements rather than
imposing obligations to set taxes, a hotly defended prerogative
of individual MS's. Its main limitation is that, as presently
operated, it cannot deliver the predictable and stable carbon
price needed for long-term low-C investment decisions. There are
sound economic reasons for setting a carbon price rather than
a carbon quota, and the system of feed-in tariffs is a good example
of one such approach. HMG should consider issuing options on the
carbon price for low-C technologies in the covered sector, and
encourage the EC to withhold enough EUAs to trade to stabilise
their price.
Extent to which the EU ETS carbon price will be
sufficient to drive low-carbon investment, in particular decarbonisation
of energy
2. Whether or not the EU ETS price will be sufficient
to drive low-C investment will depend on its predicted level and
investors' confidence that the price will not fall below the point
at which the low-C investments cease to be profitable. Additionally
whether the planning and licensing regimes and, critically for
electricity, grid access and charging regime, are adequately supportive
of the investments.
Allocation or auctioning of EU ETS credits, and
the use of auctioning revenues
3. HMG should press for the maximum extent of
auctioning, and should endeavour to find better ways of protecting
export-exposed carbon-intensive sectors from unfair competition
from countries lacking an adequate carbon price, preferably by
border tax adjustments, and only as a last resort via allocations
of EUAs. There is a strong case for hypothecating the auction
revenues for low-C RD&D, most immediately in providing the
subsidies required above the carbon price for renewable energy,
and not passing those subsidies through as charges for end-users.
HMG has already accepted the principle of hypothecation for its
earlier (and mis-named) Climate Change Levy (that was really an
energy tax), and it would be in line with the intent of the Renewables
Directive as a burden sharing agreement to finance such subsidised
deployment of immature, but promising, low-C technologies.
THE EU EMISSIONS
TRADING SCHEME
Whether, and under what circumstances, emissions
trading ought to be supplemented or replaced by tax or regulation
4. A price for carbon can be established
directly, either using a carbon tax or charge, or by setting a
quantity limit and letting companies trade the resulting emission
allowances, which is the approach adopted by the EU Emissions
Trading System (EU ETS). In the past various countries, notably
Scandinavia in the early 1990s, have imposed carbon taxes on fuels
(with exemptions for internationally exposed industries). With
complete information and no uncertainty, the efficient level of
emissions can be achieved either by issuing the correct number
of quotas or setting the pollution tax at the marginal damage
cost (measured at the efficient emissions level). This equality
of outcome breaks down under uncertainty or with asymmetric information.
Weitzman (1974) started a lengthy debate by observing that in
the presence of uncertainty, quotas are only superior to taxes
if the marginal benefit from abatement schedule (ie the marginal
damage of emissions) is steeper than the marginal cost of abatement
schedule. In the case of CO2 emissions the marginal benefit from
abatement should be almost perfectly flat, as greenhouse gas (GHG)
emissions contribute to an atmospheric stock with a very slow
rate of decay. The damage contributed by emissions today is thus
effectively the same as those tomorrow, and so the marginal benefit
of abatement is essentially flat at each moment, while the marginal
cost of abatement rises rapidly beyond a certain point.
5. Figure 1 (at the end) shows that if the taxes
and allowances are set on the basis of the expected marginal costs
and benefits, but the correct marginal costs are higher than expected,
then the deadweight or efficiency loss from incorrectly setting
a permit at level Q rather than Q* is considerably higher
than incorrectly setting the tax or charge at t rather than t*.
6. The scale of the hazard of global warming
is very uncertain, as are the future costs of reducing carbon
intensity. All these are arguments for a stable global carbon
price. As more information about the damage of global warming
arrives, so the optimal price can be adjusted (just as the allowed
level of emissions would have to be adjusted). The desirable stability
of the carbon price is not absolute, but only applies over (possibly
quite long) periods of time in which no significant new information
arrives, and should be adjusted as better information about future
climate change damage arrives. In contrast, tradable quotas can
give rise to volatile prices over quite short periods of time,
as illustrated by the experience of both phases of the EU ETS.
7. Thus the Stern Review accepts the force
of the Weitzman argument for the short term, but argues that we
should collectively aim at an equilibrium GHG concentration below
550ppm (CO2 equivalent). This is equivalent to specifying a stock
of GHGs, or a quantity limit on the amount of fossil fuel that
can be burned over the next 100-200 years. Thus while the carbon
price should be moderately stable over reasonable time periods
(1-15 years if no new information about the costs of climate change
arrives), over longer periods of time the price will need to be
adjusted to balance cumulative carbon emissions with absorptive
capacity. Hepburn et al (2006) discuss the relation between
a longer-run target quantity and the need to stabilise the carbon
price in the short to medium run.
8. There are thus good economic arguments
for fixing the price of carbon rather than fixing the total level
of emissions in each period and allowing the market to determine
the price. There are good political economy arguments for launching
climate change policies through issuing tradable permits, as in
the ETS. Pizer (2002) argues for an initial allocation of permits,
followed by selling additional permits at a fixed price (and being
prepared to buy back when the traded price fell below a floor).
This can be made cash positive or neutral to the EC by suitable
reductions in the allocations of EUAs each year to ensure that
on balance the EU were selling rather than buying.
9. A similar proposal termed the "safety
valve" is discussed by Jacoby and Ellerman (2004), while
Hepburn (2006) surveys the range of hybrid instruments, including
price ceilings and floors, and penalties for failing to deliver
permits (which effectively cap the price at the penalty level—the
method used in Britain for Renewable Obligation Certificates).
These alternative approaches to reducing or eliminating price
volatility differ in the financial risks they place on the agency
entrusted to stabilise the price. While there is little risk in
capping the price (and penalties would generate extra income),
the main problem is in providing a floor, as buying permits to
support the price could be costly. Of course, if sufficiently
few permits are issued in the first place, with the balance sold
at a fixed price, this risk can be made arbitrarily small, but
that is not the present design of the ETS, and any change to the
ETS would require the agreement of the member states. Such design
issues should be put on the agenda as soon as possible.
10. Price stability (or at least a price
floor) should be pursued at EU level, but it may also be necessary
to provide investor assurance in the UK in pursuit of the next
objective.
Extent to which the EU ETS carbon price will be
sufficient to drive low-carbon
11. Whether or not the EU ETS price will
be sufficient to drive low-C investment will depend on its predicted
level and investors' confidence that the price will not fall below
the point at which the low-C investments cease to be profitable;
and additionally whether the planning and licensing regimes and,
critically for electricity, grid access and charging regime, are
adequately supportive of the investments.
12. Uncertainty is not new: investors face it
all the time. There are, however, three things that make the low-carbon
investment fundamentally different:
(a) The risk associated with carbon price is
largely policy and political—risks that private investors
find particularly hard to judge and manage, and where alternate
strategies include investing in lobbying, or just waiting for
policy uncertainty to be resolved. That waiting is costly if it
undermines the UK's claimed leadership role in dealing with climate
change.
(b) The timescales of investment are very long,
and there is a marked disjuncture between the time horizons of
most corporate or equity investors (seeking typically 10-15% rate
of return for more speculative projects, though considerably lower
for low-risk mainstream utility investments), and those professed
by the government (discount rates that reflect ethical bases for
consistent intergenerational decision-making, as in the Stern
report (of about 1.4%), and the UK Government Green Book rate
of 3.5%). In itself this would not necessarily matter (other investments
are also long-lived but do not need special treatment), but it
is the combination of long timescales and policy risk that
is damaging.
(c) While fossil-fuel generation is at the margin
and setting the electricity price, conventional generators will
be largely hedged against both fuel and carbon price risk, as
these will determine the price of electricity. Investors take
comfort from the link between the marginal (fuel plus carbon)
cost of generation and the electricity price, and are thus able
to shift much of the input cost risk through to consumers, at
least if they have a balanced portfolio of plant. Companies that
specialise in renewables or nuclear power are exposed to an electricity
price driven by the volatile marginal fuel cost and a possibly
volatile carbon price, and so face more risk (Roques et al,
2006). Thus even with a fixed and guaranteed carbon price,
the structure of electricity markets places the risk associated
with uncertainties in the electricity price on low-carbon investors.
Again such risks are not necessarily indicative of market failure,
but they may amplify the underlying problem of policy risk.
13. It therefore follows that any measure
to reduce these risks should have a beneficial effect on low-C
investment, and should lower the cost of delivery, as the cost
of risk is reflected in higher discount rates or required rates
of return. At present, renewables are supported by a mechanism
(Renewable Obligation Certificates) that maximises the risk, as
the received revenue will depend on the price of electricity (driven
by gas prices and hence risky to renewables), the carbon price
(also volatile) and the ROC price that depends on supply and demand
for ROCs, and hence on the efficacy of the planning system and
the fragility of the financial system, as well as on changing
legislation about the number of ROCs offered for differing technologies.
14. There are a number of ways of reducing
risk and encouraging investment, of which in electricity the two
most important are to remove barriers to investment created by
planning delays and the queue to connect to the national grid.
The latter is not a problem for base-load stations such as nuclear
power, but is a real problem for intermittent and low-load factor
renewables, as they must be offered firm transmission rights under
the current Grid Code, and have to secure expensive balancing
services under the poorly designed Balancing Mechanism. Both (and
arguably also the entire market design of the wholesale market)
need reform, reaching beyond the very limited Transmission
Access Review of Ofgem and DECC.
15. If we return to reducing risk and ensuring
that low-C investments are profitable, the most direct way is
to ensure that the price of carbon is kept at a high enough level
to support socially profitable low-C investments. Within the UK,
HMG could issue a contract-for-difference (CfD) with investors
on the future carbon price.[58]
This could be a simple CfD in which the contract states a strike
price of eg 25 €/tonne CO2 (or 92 €/tC), and these are
either sold or issued in proportion to declared net capacity of
new zero-carbon generation (or in proportion to generation each
year). The holder would then be entitled to receive the strike
price less the actual carbon price implicit in any UK-wide carbon
instrument that applies to fossil generation (and if this price
were above the strike price then the holder would be obligated
to pay the amount by which the price were above the strike price).[59]
16. An alternative would be to issue or
sell a one-sided CfD with a floor price, say 20 €/tonne CO2,
with the issuer obligated to pay any shortfall below this floor
price, but the holder would benefit from any upside. Another variant
on this is to issue put options on the carbon price (Ismer and
Neuhoff, 2006). Such instruments would provide a powerful commitment
signal by the Government (or the European Commission) to the continuation
of the ETS or its successor, and would also help stabilise the
future (and hence, with banking, the present) carbon price.
17. A more direct method that would avoid
the need to underwrite the carbon price would be to offer long-term
electricity off-take contracts to low-C investments, following
the format of eg German Feed-in Tarrifs, (which specify a constant
real or nominal price per kWh for a set period for a particular
place and technology, or one that declines after a number of years).
Alternatively, HMG could hold a tender auction for the fixed and
per MWh amount that would be acceptable for the offered investment
opportunities, with penalties for failure to deliver (except where
these could be demonstrated to be a failure of an otherwise acceptable
planning application).
Allocation or auctioning of EU ETS credits, and
the use of auctioning revenues
18. As is now widely recognised, the price
of EUAs was passed through fully in the final price of electricity
(the industry for which we have the best data) and hence the free
allocation was cashed in at the EUA price by the fossil generators,
resulting in a massive windfall gain. There is no case for repeating
such a wilful misuse of the value of a common property resource
that should be owned by the country. The only sectors with any
case for free allocations are those for which the carbon cost
is material and which are exposed to vigorous international competition
from countries that have no carbon price. Aluminium, some kinds
of steel and cement may come in this category. There are, however,
better means of addressing the unfair competition from sources
that do not pay the social cost of the emissions they release.
19. The most direct way would be to ensure that
any imports are taxed on the deemed carbon content of the commodity
(based on moderately poor performance unless certified to come
from an efficient supplier), with rebates in proportion to any
carbon tax or quota price paid by the import; with an export rebate
of the EUA or carbon tax embodied in the export. Only until such
a system is in place might exposed industries be granted EUAs
in proportion to their output at some deemed (and high) efficiency
level.
20. There is a good case for providing additional
support for renewables (additional to the support received
for avoiding CO2 emissions through the EU ETS). If the renewables
technologies are not yet mature, then their costs should fall
as money is poured into their development and deployment. Just
as in the past huge sums were spent developing nuclear power (see
figure 2), and, through defence contracts, high-efficiency gas
turbines that have revolutionised electricity generation. We should
now spend large sums developing renewables to the point that they
are commercially attractive in developing countries. If that happens,
climate-damaging emissions will not just be reduced in the EU
but in the world as a whole, helping to mitigate damaging climate
change.
21. Wind generation costs have fallen dramatically
as more wind generation has been deployed, to the point that they
are already competitive (on-shore) with coal and gas generation,
providing the latter pay an EU carbon price of €30/tonne
(its projected level). Photovoltaic (PV) panels have also seen
dramatic falls in cost as chip technology driven by the IT revolution
has spurred development (although they are still far too costly
for most purposes). Figure 3 shows the results of increasing the
production of various technologies, where the suggestion is that
increased production from the technologies (proxying for the increased
deployment of these technologies) results in learning by doing
and with that a fall in costs. The numbers on the graph show the
costs as a percentage of the previous cost level after the scale
has been doubled. Thus PV falls to 65% of its earlier cost for
each doubling of output, while wind falls to 82%, or by 18% for
each doubling of scale.
22. The auction revenues should therefore
be hypothecated to deliver as yet uncommercial (at the EUA price)
but promising low-C technologies. HMG has already accepted the
principle of hypothecation for its earlier (and mis-named) Climate
Change Levy (that was really an energy tax), and it would be in
line with the intent of the Renewables Directive as a burden sharing
agreement to finance such subsidised deployment of immature but
promising low-C technologies. At present the (unnecessarily high)
cost of supporting renewables is passed through to final electricity
consumers. The SKM report commissioned by the Government
estimates that to meet the UK renewables target agreed with the
UK, some 120 TWh of electricity will have to come from renewables
by 2010. Although BERR estimates that the extra cost of the renewables
support per household might only be £32-£53 per year,
a more realistic estimate might be £82/household/year.[60]
23. Between 2004 and 2005 the cost of electricity
rose by £20/household/year and the number in fuel poverty
rose by 500,000, partly wiping out the reduction in the number
of fuel-poor, of 4 million, over the years in which the cost of
electricity fell by £100/household/year. On a simple extrapolation,
a further rise of £80 might return all those 4 million into
fuel poverty. These and other electricity consumers are paying
for the RD&D that is the justification of renewables support
and which will largely benefit people in the rest of the world
(assuming that it meets its objectives of making commercially
attractive other low-C renewables for deployment in the rest of
the world). It is hard to see why the poor in the UK should be
charged for this support.
26 February 2009
REFERENCESGrubb,
M and D Newbery (2007) "Pricing Carbon For Electricity Generation:
National And International Dimensions " (EPRG 07/22); Ch
11 in Delivering a Low Carbon Electricity System: Technologies,
Economics and Policy Editors: Michael Grubb, Tooraj Jamasb
and Michael G Pollitt (University of Cambridge) Cambridge University
Press.
Hepburn, C. (2006) "Regulating by prices, quantities
or both: an update and an overview", 22:2 Oxford
Review of Economic Policy, 226-247.
Hepburn, C, Grubb, M, Neuhoff, K, Matthes, F and
Tse, M. (2006) Auctioning of EU ETS phase II allowances: how and
why?, Climate Policy, vol 6, no 1, pp 137-160.
House of Commons (2006) New Nuclear? Examining
the Issues House of Commons Trade and Industry Committee available
at
http://www.parliament.uk/parliamentary_committees/trade_and_industry/tisc_nuclearnewbuildreport.cfm
IEA (2000) World Energy Outlookis: International
Energy Agency.
Ismer, R and K Neuhoff (2006) "Commitments through
Financial Options: A Way to Facilitate Compliance with Climate
Change Obligations" EPRG06/25.
Jacoby, H D and A D Ellerman, The safety valve and
climate policy, Energy Policy, 32 (4) 2004, 481-491.
Pizer, W. (2002). "Combining price and quantity
controls to mitigate global climate change." Journal of
Public Economics 85(3): 409-434(26).
Roques, F A, W J Nuttall, D M Newbery, R de Neufville,
S Connors (2006) "Nuclear Power: a Hedge against Uncertain
Gas and Carbon Prices?" The Energy Journal, 27,
(4) 1-24.
Stern, N H. (2006) The economics of climate change,
Cambridge: CUP.
Weitzman, M L. (1974) "Prices vs Quantities",
Rev. Econ. Stud. 41 (4), 477-91.
Figure 1
RELATIVE EFFICIENCY OF PRICES VS QUANTITIES
Figure 2
Figure 3
EXPERIENCE CURVES SHOWING COST REDUCTIONS
IN RESPONSE TO LEARNING
Source: IEA (2000)
57 The Electric Policy Research Group (EPRG) is the
culmination of a continuous series of projects starting in 1990
and at various times supported by the UK Economic and Social Research
Council, The Cambridge MIT Institute, and the European Commission.
The larger part of current funding comes from a 5-year £2.4
million ESRC research group grant. EPRG's membership within the
University is drawn from economics, management, engineering and
law and also includes associates from business, regulatory agencies
and government. EPRG engages in research, publication and informed
debate on the economics and public policy issues concerning the
efficiency, regulation, security and sustainability of electricity
in the wider context of European and global energy supplies and
environmental constraints, as reflected in the European Emissions
Trading System. Members of EPRG have published a number of reports
on carbon pricing, carbon markets, and emissions trading, of which
the most useful is probably the book Delivering a Low Carbon Electricity
System: Technologies, Economics and Policy (Grubb, Jamasb and
Pollitt, 2008). This submission draws heavily on Grubb and Newbery
(2007), but reflects the views of author alone. Back
58
See for example House of Commons (2006) at paras 179 et seq. Back
59
This would require the Government to be quite explicit about the
equivalent carbon value of any instrument that might replace the
ETS, particularly if this took the form of a carbon tax (not an
energy tax like the Climate Change Levy). If there were no such
instrument that specifically charged electricity generators in
proportion to the CO2 emitted, then the price would be deemed
to be zero. Back
60
This is based on the observation that the 14.6 TWh of renewables
were estimated to cost each household £10/year in 2006-07,
so that 120 TWh might cost 120/14.6 times £10 = £82. Back
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