2.3. The Role of Hot-Air
In addition to the project-based mechanism, the Kyoto-Protocol allows the transfer of AAUs (Assigned Amount Units under the Kyoto Protocol) between Annex B countries. As far as trade between countries with a binding cap is concerned, this option is of minor importance since the project credits are perfect substitutes and can in many cases be obtained at lower prices. This is not the case for countries, which do have a cap that is above their expected business-as-usual emissions in 2012. These excess emission rights are called hot-air. The countries with hot-air are mainly the countries ofthe Former Soviet Union and to a smaller degree the Eastern European countries. In an extreme scenario where these countries sell all their hot- air, most models, including DART (Klepper and Peterson 2003) predict that the excess supply of allowances is so large that the carbon price falls to zero. Thus, the Kyoto targets can be reached at zero cost, however without any emission reduction in the Annex B countries. Such a scenario is not very likely though. Different studies have estimated that it is optimal for the hot-air countries to restrict their sales of hot-air to around 40% (Haites and Seres 2004, Klepper and Peterson 2003). If some ofthe hot-air is supplied on the market, the use ofCDMandJI credits will be reduced and international carbon prices will fall.
complicates the linking with other trading schemes. 51
Therefore, we recommend retaining thetrading scheme in its pure form, instead of supplementing it with an MSR. Past mistakes, above all the generous issuing of offsets resulting from dubious international climate protection projects, should be corrected by a single intervention: de- leting the 900 million allowances that are planned to be brought back to the market in 2019 and 2020. Irrevoca- bly deleting this amount of allowances will certainly have stronger consequences than temporarily storing them in an MSR. Moreover, if it is politically desired to further stabilise the price, theemissions cap could be reduced more strongly than currently planned (2.2% per year) as of 2021, the start ofthe fourth trading phase. In sum, as a general rule, it must be recognised that any interven- tion into the mechanism ofthe ETS entails uncertainties, most importantly about the future amount of allowances, thereby implying negative consequences for investments.
2 1 Introduction
Currently, about 17 percent of global greenhouse gas (GHG) emissions are covered by emissionstrading systems that have either already been implemented or are scheduled for implementation. TheEUEmissionsTrading System (EU ETS) is still the largest of its kind worldwide. It covers roughly 40 percent ofthe EU27’s GHG emissionsand is considered to be the EU’s most important climate policy instrument. Due to an annual linear reduction factor (LRF), no further allowances will enter the market beyond a certain point in time. Calculations based on the current LRF of 2.2% p.a. indicate the year 2057, or shortly after, as the expected cut-off date. In the likely case of a more ambitious EUclimate target for 2030, the LRF would increase accordingly, so that the trajectory of newly issued allowances would reach the zero line some years earlier (European Commission 2018a). Given the recently agreed EU target of reaching net zero GHG emissions by 2050, there are even expectations that the installations covered by theEU ETS will generate net negative carbon dioxide (CO 2 ) emissions from 2045 onwards (European Commission 2018b).
The third segment of demand will emerge once the link between EU-wide Emission Allowance TradingandCDM / JI projects is established. Negotiations on a corresponding EU-directive regulating the access of emission certificates from the project-based mechanisms CDM / JI into theEUemissionstrading sys- tem have started recently. According to the proposal for a Directive “amending the Directive establishing a scheme for greenhouse gas emission allowance tra- ding within the Community, in respect ofthe Kyoto Protocol's project mecha- nisms” (European Commission 2003), operators of installations included into EU Emission Allowance Trading can on request hand in CDM / JI-certificates and receive Emission Allowances in exchange. TheEU member states themselves surrender these CDM / JI-certificates to the authorities oftheclimate regime that assess compliance with the Kyoto-Protocol. It must be said that the negotiations on this linking directive have only just begun. It is not yet clear whether the law making will be finished before the end ofthe legislative period ofthe European Parliament in June 2004. If adoption of this directive cannot be achieved before, a considerable delay must be expected. It is furthermore highly controversial among the different member states oftheEU when the conversion of emission certifi- cates from CDM / JI projects into EU emission allowances shall begin. Two op- tions are being discussed: 1.1.2005 or 1.1.2008.
Regarding the numerical illustration, it is explicitly not claimed to give accurate values but the focus is rather to exemplarily illustrate the magnitudes ofthe analytical results. This is especially important to note since the point in time when the number of allowances banked falls below the upper threshold is determined by the market which depends also on “the (unpredictable) expectations of market actors about future CO2 prices and costs” (Osorio et al., 2020, p. 28). Further, in reality it apparently cannot be said exactly when which certificates will be deleted. However, this is not the decisive question, but rather which long-term effects climate campaigns can have on total emissionsand therefore it is important that more allowances in the bank can contribute to more allowances in the MSR and thus potentially to more cancelation and a tighter cap. Furthermore, it can be critically noted that due to simplicity, the updated parameters were calculated based on data sets from 2018 but these parameters were used to calculate results for the whole time period from 2017 to 2057. However, comparing the updated parameters based on 2018 values with the parameters used by Perino based on 2011 values shows that the orders of magnitude are relatively similar and do not fluctuate too much. Also, the withdrawal or intake rate ofthe MSR is assumed to stay constant from 2024 onwards and in a similar manner, Osorio et al. (2020) “set all ETS parameters to their current values and assume that they remain at these values after 2030 (current regulation only defines values until 2030)” (p. 9). Another objection is that mainly Osorio et al. (2020) is used for projections although the estimates about the future EU ETS development partly vary significantly. However, this estimates by Osorio et al. (2020) are recent, based on a detailed model and should only give indications. A detailed review of methods and results regarding current projections and trends oftheEU ETS is beyond the scope of this thesis.
On 15 th of July 2015, the European Commission released its proposal for a reform oftheEUEmissionsTrading System (EU ETS). The reasons for a rather thorough reform are obvious: First, the mechanism of supply and demand is not working properly as the market for emissions allowances currently exhibits a surplus ofmore than one year’s emissions, thus causing the price for carbon to be very low and as a consequence postponing investment decisions into carbon reducing tech- nologies. Second, theEU ETS needs major adjustments regarding the long-term perspective of a possible carbon path that is relevant for low-carbon investment decisions under risk. Third, theEU ETS needs to be aligned with the 2030 frame- work for climateand energy policy, which in turn has to be updated in view ofthe Paris Climate Conference that took place in December 2015. Although the Commis- sion proposal addresses all these issues, there is emerging evidence that only addi- tional reform steps will bring theEU ETS back to its intended role of becoming the cornerstone ofEUclimate policy.
TheEUEmissionsTrading System (EU ETS) is the world’s largest carbon market andthe EU’s ﬂagship tool to combat climate change. The launch of this transboundary carbon trading system marked a severe tightening of environmental regulation in a uni- lateral way: Starting in the year 2005, EU ﬁrms in energy and manufacturing industries faced a strict cap on their total amount of greenhouse gas emissions while the perspec- tive for a widespread implementation of comparable regulations in other regions ofthe world was uncertain. Even though a number of regional and experimental carbon trad- ing programs were started subsequently to theEU ETS, these regionally or temporally conﬁned initiatives did not alter the unilateral character oftheEU ETS in comparison to the substantially lower stringency ofclimate change policies outside of Europe. Against this backdrop, concerns about potentially negative competitiveness impacts on regulated businesses under theEU ETS were voiced from its inception and have not died out since. The concern that unilateral environmental regulations might impose signiﬁcant costs, divert resources from productive activities and ultimately put the international com- petitiveness of regulated ﬁrms at risk is widespread among economists, policymakers and industry representatives. In case of a persistent international asymmetry in the stringency of environmental regulation, the pollution haven hypothesis is that aﬀected businesses may move production capacity to countries that impose a lighter regulatory burden. In the context ofclimate change policies, such a shift creates “carbon leakage”, since theemissions would move together with the relocated production. In this scenario, the uni- lateral environmental policy backﬁres economically and ecologically, combining a loss of economic activity in industrial sectors with, at best, environmental ineﬀectiveness, or worse, an outright negative eﬀect if production outside ofthe regulated area is carried out in a more carbon intensive way. Such a process would manifest itself in the form of an erosion ofthe regulated ﬁrms’ asset bases in Europe.
Furthermore, they emphasised the importance of unrestricted access to the credits from theCDMandJI “as they are fundamental to achieving theEU‟s emission reduction goals and engaging developing countries in a global emissions reduction process” (Eurelectric 2007: 7). Contrary to the power producing sector, the energy-intensive industries are not represented by one organisation, but submitted a common position paper through the Key Stakeholders Alliance for ETS Review as well as individual ones (Skjærseth and Wettestad 2010a: 112; European Commission 2016e). In general, they were rather averse to an EU ETS reform. In their joint position paper they requested policy makers remove distortions ofthe free market and create „regulatory stability‟ (Alliance of Energy Intensive Industries et al. 2007: 1). They refused an auctioning system of allowances as this would harm the competitiveness oftheEU industry on global markets (Alliance of Energy Intensive Industries et al. 2007: 1). Instead, they proposed “sectoral approaches and performance-based allocation based on actual production” for example through benchmarks, a baseline or a credit system (Alliance of Energy Intensive Industries et al. 2007: 1f.). The performance-based allocation should be applied for “large emitting, homogeneous processes [whereas] other more dispersed activities may remain with an allocation based upon grandfathering based on historical emissions” as this would create a level playing field (Alliance of Energy Intensive Industries et al. 2007: 2). BusinessEurope even lobbied for a total free allocation of allowances until a global emissionstrading system, which includes all main emitting countries, has been created. They argued that European companies would otherwise be disadvantaged on the global market (BusinessEurope 2007: 6). They further claimed to be „careful‟ about performance-based allocation as this might be a good option for some sectors whereas it would be „inappropriate‟ for others (BusinessEurope 2007: 8).
The positive outcome ofthe most recent climate negotiations (COP21) in Paris could well lead to renewed interest in linking existing emissionstrading systems and emerging offset schemes. In that respect, REDD+ offsets represent one source of low cost abatement options. Concomitantly, allowing forestry offsets from less developed and emerging economies into existing and new ETS can strengthen international cooperation. Yet, such a strategy has been met with the concern that it could entail the risk of crowding out low-carbon investments of ETS-covered entities. Therefore, we use a real options model to investigate the investment behavior of a firm which can comply by using REDD+ credits or permits. We particularly focus on the impact of different designs of linking the credits into the permit trading scheme. Our results confirm the investment crowding-out effect when ETS-covered entities have access to cheaper REDD+ credits. Although renewables investment (here represented by a wind park ofthe size comparable to the existing coal-fired capacity of a typical firm) increases over time, the speed of transition andthe magnitude ofthe investment frequency are higher when firms do not have the access to cheaper offsets that allow them to postpone the transition while still being in compliance. Yet, several important insights on price processes emerge from our results. First, low-carbon investment critically depends on price volatility. We find significantly more investment with lower volatility. On the contrary, highly volatile ETS and REDD+ prices entail a higher risk of carbon lock-in, as the transition to less carbon-intensive energy is delayed. Second, wind investment also responds positively – though to a very limited extent – to the degree of price correlation. This reflects the risk diversification opportunity provided by lower correlation, which increases the attractiveness of postponing clean investments in the face of carbon price uncertainty.
price floor in the electricity sector in 2017 (The Guardian, 2016). Germany discussed an additional “climate levy” for old coal power plants (BMWi, 2015) as well as a general carbon price floor (Bloomberg, 2016b). The former showed the potential to reconcile EUand national climate policies (Peterson, 2015) . However, both ideas have been dismissed at least for the moment. The general problem ofthe current additional national policies is that they are i) not effective in terms of additional emission reductions because with an unchanged amount ofEU ETS allowances any national emission reductions within theEU ETS are offset elsewhere and ii) not efficient since they drive further wedges between carbon prices. In this context, B¨ ohringer et al. (2008) and Heindl et al. (2014) show that an additional national carbon tax in the ETS sector in one or more countries further increase EU-wide inefficiencies. Both papers impose a tax on top ofthe allowance price in the ETS sector (which is equivalent to a carbon price floor for the ETS sector) in one region while keeping the overall joint emission quantity target constant. On the one hand, the higher carbon price in the taxing region leads to an increase of overall abatement costs. On the other hand, firms in the taxing region emit less and sell their excess emission allowances, resulting in a fall oftheEU allowance price. This leads to a decrease of overall abatement costs in theEU ETS because non-taxing regions face a lower price and abate less emissions. The authors find that the net effect is always an increase in overall abatement costs and thus higher inefficiencies. The non-ETS sector is disregarded because it is not affected by the tax policy in the ETS sector. Heindl et al. (2014) show that the general efficiency results also hold when allowing for uncertainty and correlation of abatement costs across countries as well as different country sizes in terms ofemissions.
WBGU (2011) argues that for the type of transformative change necessary to avoid (permanent- ly) trespassing planetary boundaries it is inevitable to internalise the external effects of carbon pollution into economic decision making. They argue for carbon pricing as a central building block ofthe regulatory framework to avoid dangerous climate change. However, WBGU also states that carbon pricing alone is not sufficient to redeem the various types of market failures that have led to the current unsustainable global socio-economic system. Grubb, Hourcade and Neuhoff (2014) go even one step further and opine that a global carbon price is a “false god” and argue that it is critical to complement it with policies that more immediately direct user behaviour and that actively govern or even steer innovation and strategic infrastructure development. The above assessment ofthe transformative potential oftheEU ETS resonates well with this verdict: Market-based mitigation instruments can put a price on carbon, but this alone is not suf- ficient to induce the required change in unsustainable practices. Therefore, even if the flaws on the implementational level can be dealt with, the ETS will need to be integrated in a wider policy mix. It can be an effective instrument that puts economic pressure on current unsustainable prac- tices, if prices are high and stable enough and free allocation of permits is repealed. As such the ETS can function as a ‘motor of destabilisation’ of unsustainable economic practices, but it fails to be a ‘motor of innovation’ (Kivimaa and Kern 2015). As a technology neutral policy it does not provide a protected space for emerging more sustainable technologies. TheEU ETS’s track record for spurring innovation is poor. More targeted policies are necessary to complement the ETS and make up for these deficiencies.
The second uncertainty concerns the fact that the impact oftheEU ETS will exercise its full force in 2012. It is therefore necessary to assess the ETS in the light oftheEU economy in the future; to be precise we choose 2012. This will be done with the help ofthe DART-model (Klepper, Peterson, Springer 2003), a computable general equilibrium model calibrated for the enlarged EU. Nevertheless, it is possible to identify key features and key impacts oftheEU ETS by scanning the range of likely allocation plans and by using a simulation analysis with the DART-model. This approach at the moment ignores some institutional details ofthe ETS such as the possibility for using the flexible mechanisms set out in the Kyoto-Protocol, i.e. Joint Implementation (JI) or the Clean Development Mechanism (CDM) which can potentially offer further inexpensive abatement options. It also ignores intertemporal issues such as banking and borrowing. Despite these omissions, the analysis highlights a number of interesting details about theEU ETS in terms of allowance trade flows between Member States, of allowance prices, and in terms ofthe role ofthe accession countries in the ETS.
The current financial and economic crisis should not delay cost-effective investments or programmed energy projects that would create jobs, enhance energy security, and help limit greenhouse gas emissions in the short and medium term. Innovation and knowledge are key factors for supporting the economic recovery and putting the world economy on a path toward more sustainable growth. There is a need to accelerate innovation in relation to the long-term challenges and to encourage the development of those new industries, companies and services which will be decisive to creating new sources of growth. The interlinked challenges ofclimate change, energy security andthe sustainable and efficient use of natural resources are amongst the most important issues to be tackled within the strategic perspective of ensuring global sustainability. The shift towards green growth will also provide an important stimulus to recovery from the economic and financial crisis.
TheEUEmissionsTrading System (EU ETS) is the cornerstone ofthe European Union’s climate policy and covers just under half ofthe EU’s greenhouse gas emissions. More than ten years since theEU ETS was first introduced, there continues to be substantial research interest regarding its functioning andthe behavior of participating companies. DIW Berlin conducted three econometric studies based on microdata at company and/or installation level. The findings suggest that, overall, there are only minor distortions in the behav- ior of companies regulated by theEU ETS. However, the studies also show that small companies exhibit distinctive behavior which could result in inefficiencies. For instance, during Trading Phase I, small companies participated less actively in trading allowances than companies with a higher turnover. Moreover, theemissions produced by small power plants depend, to a certain extent, on the allocation rules. Small companies also often fail to take full advan- tage ofthe cost reduction potential of international offset credits: for a total of 22 percent of all companies (predominantly small emitters), an average of 31,000 euros in cost reduction potential remained unused. The barriers causing this loss may be interpreted as fixed transaction costs. For further ex-post analyses, the timely provision of user-friendly emissionstrading data at the installation level would be very beneficial.
cement, glass, ceramics and paper). All other sectors, such as private households, ser- vices and transport are not covered. The sectors encompassed by the system all have to comply with the overall reduction target, which is set by the number of allowances that have been allocated. Each operator has to decide, therefore, whether to apply mitigation measures, or to purchase additional emission allowances (make-or-buy decision). If all German operators collectively intend to emit more CO 2 emissions than the quantity for which they have been allocated allowances, they then have to purchase allowances from abroad or can – as a result ofthe Linking Directive (2004/101/EC) – also purchase pro- ject-based Kyoto mechanism units (CERs or ERUs) from developing countries or coun- tries in transition. This decision is taken by each operator individually on the basis of microeconomic efficiency calculations, taking into account other factors such as risks and transaction costs. As soon as the legal framework for emissionstradingandthe use of project-based mechanisms is set, the operators decide on their own the extent to which they will purchase project-based mechanisms in order to comply with the reduc- tion targets. The size ofthe light blue section in Figure 47 is thus determined by the de- centralised purchase decision of each operator covered under theEU ETS. 47 In other words, the decision ofEU ETS operators to purchase project-based Kyoto units is inter- nalised, and can be taken in a decentralised manner without any discretionary govern- ment intervention. The government might, nonetheless, facilitate such decisions by help- ing to eliminate hurdles and barriers which hamper the use ofthe projects-based mecha- nisms (Sections 5.2 and 5.4).
the electricity industry? After a short description ofthe history ofemissionstrading in general andthe emergence and basic framework oftheEU ETS, the research question is first addressed from a theoretical perspective (chapter 3). The innovation incentives of several design options and their potential configurations are derived by means of an algebraic profit maximisation model which allows for identification of whether individual companies are encouraged to innovate by the respective configuration or not. Particu- lar focus is placed on the impact ofthe overall cap, of several allocation configurations, ofthe global climate change framework and its time frame as well as banking issues. Thereafter the core research questions are addressed from an empirical perspective. An important element ofthe research approach was a survey ofthe electricity industry (chapter 4). The main objective of this survey was to identify the innovation strategies which companies ofthe electricity industry developed in reaction to the introduction oftheEU ETS. For this purpose the companies were interviewed twice: once directly be- fore the start oftheEU ETS in the autumn of 2004 and once in the summer of 2007 after first experiences with the new instrument had been gained. As is the case with panel analysis, the set of questions and covered companies were kept rather similar in order to enable the detection of changes in perceptions and attitudes towards innova- tion in a horizontal comparison. The surveys were focused on changes in the compa- nies’ innovation strategies in general, on institutional changes, changes in the opera- tion of power plants, changes in their investment strategies and on the companies’ preferences with regard to the various design options and their potential configurations. Finally, the issue of whether emissionstrading has really encouraged innovation to- wards a more sustainable electricity system in Germany to date is examined
On the downside, the displacement ofJI in the energy and industry sectors by theEU ETS might perhaps backﬁre. It is as yet unclear in how far JI in general will contribute to technology transfer and efﬁciency improvements in the host countries, but it just might. Conversely, the current NAPs are very generous and it seems that the same will hold for the period 2008-2012. TheEU ETS’s stimulus for invest- ments will therefore probably be limited. As a consequence, an instrument that might have contributed to increasing en- ergy efﬁciency and emission reductions in the Accession Countries has been replaced by an instrument that at the moment seems rather likely not to contribute, unless alloca- tion becomes much more stringent in the future.
7 Discussion and conclusion
Climate change mitigation is often likened to the voluntary provision of a global public good in as much as the benefits of abating GHG emissions are reaped by many countries whereas the costs are borne by individual countries. Economic theory predicts that abatement will be ineffi- ciently low under these circumstances, because countries fail to internalize the external benefits of their abatement efforts. Moreover, the incentive to free ride makes it difficult for countries to coordinate on the globally efficient level of abatement. In fact, the United Nations’ initiative to establish mitigation targets and timetables under the Kyoto Protocol has failed miserably. Because co-benefits make unilateral mitigation efforts more worthwhile even in the absence of a global agreementare, they are bound to play a prominent role in climate policy going forward, as is alluded to in the article quoted in the introduction. 8
Emission Trading North underlined the necessity of a consistent treatment of new entrants (new installa- tions), ofthe replacement of existing installations by new ones andof capacity extensions. In order to avoid incentives that could lead to higher environmental im- pacts and to assure economic efﬁ ciency, new entrants or new installations should not be privileged over the modernisation or modiﬁ cation of existing facilities or over an increase in production. Therefore, the majority of Emission Trading North participants andthe expert advisory board favoured a strict buy-in solution for newcomers: any increase in absolute emissions – no matter whether due to an increase in production, ca- pacity extension, newly built plants or the substitution of existing ones – has to be covered by buying the re- sulting deﬁ cit of allowances on the market. As the as- pect of new entrants and shut-downs was regarded as a symmetrical problem of paying or receiving a price for a newly introduced input factor, it was consequent- ly argued that any operator shutting down his facility in a given compliance period should be allowed to keep the total allocated quantity until the end of that period. While the German NAP chose exactly the opposite strategy (end of allocation at shut-down, new entrants receive allowances for free), it maintains a certain consistency by making the transfer of allowances to replaced plants possible and treating capacity exten- sions as new entrants if there has been a technological investment for the extension. However, it should be noted that productivity increases in existing facilities balancing shut-downs of other facilities and leading to lower speciﬁ c and absolute emissions are not favoured by these rules as they could have been, compared to other emission reduction measures.
Furthermore, some ‘dirty’ ﬁrms may have faced such high environmental costs from theEU ETS that they had to exit the market. Similarly, multinational corporations with production units could delocalize their production outside theEU. In the end, only ﬁrms who were competitive in a clean environment could have kept their business running. In the aggregate, this would result in a more productive and cleaner business environment. This may explain ﬁnding no negative competitiveness eﬀects on ﬁrms that have stayed in the market. If ﬁrms or subsidiaries exit the market in order to relocate to places where environmental regulation is less restrictive ( ‘pol- lution havens ’), this is called the Pollution Haven Hypothesis (PHH; e.g. see Cole, 2004; Eskeland & Harrison, 2003; Kozluk & Timiliotis, 2016; Millimet & Roy, 2011; Wagner & Timmins, 2008; Yoon & Heshmati, 2017). In the case oftheEU ETS, the PHH is supported if signi ﬁcant evidence of carbon leakage attributable to theEU ETS is established. If ﬁrms were to start emitting more once relocated, we could observe an increase in total emissions worldwide, making theEU ETS an ine ﬀective mechanism. No empirical evidence of carbon leakage or ﬁrm closures attributable due to theEU ETS has been documented so far. Preliminary results using emissions data by Dechezleprêtre, Gennaioli, Martin, and Muûls (2014) and Wagner et al. (2014) ﬁnd no supportive evidence for carbon leakage within companies which have non-treated plants during Phase II. Besides emissions, indirect measures of carbon leakage may be used. While short-term leakage is usually detected through increased imports, long-term production relocation may be analysed through outbound foreign direct investments (FDI, see Koch & Basse Mama, 2016). Several trade ﬂow analyses show that the carbon price level did not lead to any signi ﬁcant carbon leakage in the European primary aluminium sector (Sartor, 2012), in the cement and steel sectors (Boutabba & Lardic, 2017; Branger, Quirion, & Chevallier, 2017) or in manufacturing sectors 11 (Naegele & Zaklan, 2017). Focusing on German and Italian multinationals, respect- ively, Koch and Basse Mama (2016) and Borghesi, Franco, and Marin (2016) show that theEU ETS did not lead to relocation through outbound FDI for the average ﬁrm. However, both studies reveal that particular sub-groups of enterprises did signi ﬁcantly react to theEU ETS stringency. Still, overall, the scarce evidence so far shows no evidence of carbon leakage for the average ﬁrm, and thus contradicts the PHH.