Pricing Carbon under EU-ETS

The question:

Can a Carbon Price Incentive (CPI) investment cycle such as the EU- ETS carbon market be effective in promoting investment in CO2 abatement/substitution and can it work efficiently?

If not, is it time for a fundamentally sound replacement rather than more and more sticking plasters?

Conclusion:

No, the EU ETS is inefficient in macro economic terms, un-aided it cannot perform its function without causing major disruption to the EU economy and it is investor unfriendly.

Europe would be best served by adopting an alternative to the EU ETS rather than retaining it and struggling on with more and more special purpose features.

Of the alternatives, the investment support payment (ISP) solution proposed here is preferred.

Summary:

The EU ETS is a Carbon Price (CPI) Incentive Investment Cycle. Under this program, for each CO2 price increment there will be an immediate and broad impact through purchase of emission permits (EUA) on the price of all emitting industry outputs.

However, the EUA has to reach a threshold price level that is equivalent to the cost of investment in abatement/substitution, before any incentive exists for even the very first real investment in abatement/substitution.

In the lead up to this threshold point and before any abatement investment has taken place, the price to industry from having to purchase EAU has already created a massive and increasing cost burden for the entire emitting economy. This is incredibly inefficient in macro economic terms.

Although EUA prices below the investment threshold under the EU ETS provide no incentive for new investment, the EU ETS will continue to provide EU governments with substantial un-ring-fenced income. This represents a very significant pseudo-tax for EU governments who, under the EU ETS are not responsible for making the investments.

The uncertainties inherent in the CCS business under EU ETS make the raising of investment capital difficult to achieve without separate external (government) support.

If a minimum EUA price is introduced to get investment underway the EUA price will operate within a collar having a range of (say) €20 i.e. €80-€100. There must be serious doubt about the value of preserving the EU ETS it to operate over such a restricted range

For all of the above reasons, the un-augmented EU ETS market system is therefore the wrong policy.

It would be preferable but still not ideal, to replace the EU ETS with a standard price for carbon (index linked perhaps to a function of bundled energy price and/or CPI) and let investors perceive and evaluate the risk/reward balance in a conventional way, raise finance on a secure basis and invest in the most appropriate way - i.e. business as usual. However, there are two better alternatives.

The two alternative solutions are presented here in the section headed “discussion”. The preferred alternative is the last of these and involves investment support payments (ISP).

Either of these solutions can be shown to be less complicated to design and regulate compared with a continuation of the EU ETS, augmented or not. Either solution would provide investors with clarity of purpose and predictability of outcome and understanding of risk which would allow normal investment decisions to be made, conventional financial models to be used and existing sources of funding to be accessed whilst, if ultimately found to be necessary, tax arrangements could be introduced to guard against the possibility for any unacceptable windfall profit to the investors as novel risks diminish. The second alternative solution also has the very important merit of delaying the full impact on the economy of investment in CO2 abatement/substitution.

Discussion:

· In Europe, the EU ETS was chosen as the mechanism to trigger investment in CO2 abatement.

· The EU ETS was designed to encourage investment in CO2 abatement via a market driven mechanism that set a charge for emitted carbon, embodied in the EU emission allowance (EUA). An EUA has to be purchased for every unit (te) of CO2 emitted. Yet, the EU ETS is dominated by the supply side – the availability of EUA not the demand for EUA to offset CO2 emissions. Thus, the desired outcome of the EU ETS - investment in CO2 abatement isn’t directly linked to the supposed stimulus - carbon price pressure.

· Essentially, the EUA has become a supra national currency who’s value is regulated by governments’ flexibility to create or restrict the supply of EUA.

· For the EU ETS to begin to promote investment, a significant rise in the EUA from present levels is necessary.

· Not before this tipping point has been reached and accepted as permanent by the investment community will investment under EU ETS commence. It will then take a long time to gear up and many years (and possibly decades) to complete.

· However, the cost to the economy through industry’s obligation to purchase EUA under the EU ETS has already begun. Thus, costs to industry and the consumer are already rising before investment in abatement even starts let alone before it becomes operational and long before it becomes universal.

· EU governments control this process:

o If governments remain relaxed about the over supply of EUA to the market, then carbon price (EUA) will rise slowly or not at all.

o If governments drastically ration the supply of EUA to the market then carbon price (EUA) will rise rapidly towards or even exceed, the threshold price for investment in CO2 abatement/substitution. The cost to the economy will be immediate and high. There is even a real danger of serious EUA price overshoot, (limited only by the fine levied for illegal emissions which effectively truncates the upper bound) so the cost to the economy might exceed the total investment cost.

· Even before the very first investment in abatement has taken place under EU ETS, the entire emitting economy has to be paying the going rate for EUA for all emissions. This is incredibly inefficient in macro economic terms.

· The income from the sale of EUA is paid to governments. Under the EU ETS, the money raised from carbon prices is not then actually used by governments to create the investment that is desired except for a small number of special incentives for early starts. These special measures (e.g. NER300 and UK competition 1-4) are outside the context of the EU ETS, are very limited in scope/longevity and have been necessary because of the failure of EU ETS to provide the necessary stimulus.

o Once the package of stimuli creates the conditions for investment and the first individual investment in abatement becomes operational, then the new entity does not need to buy EUA from governments. Eventually, real purpose of the EU ETS begins to bare fruit and in parallel, a process will start where the volume of EUA being purchased by industry begins to fall and the investors in abatement eventually start to reap the value of their investment in comparison with those still having to buy EUA but unless the price of EUA continues to rise, governments’ incomes from sale of EUA could begin to fall.

§ (NOTE: In the absence of any additional government funded incentive payments for investment, this could even be seen as perhaps an unintended but nevertheless perverse incentive for governments to manage the availability of EUA to the EU ETS market, sufficient to allow only a slow rise in carbon price and even then only to a level still short of the investment threshold.)

· Carbon price pressure incentive was the raison d' être of the EU ETS but without additional measures it has achieved nothing.

· In the UK, additional short term strategies are now in play and will hopefully result in an initial investment cycle but there is no real prospect of the EU ETS alone picking up the momentum and kick start a continuous investment cycle.

· Other long term strategies are being floated in addition to EU ETS and the competition funding for getting a long term investment cycle going in the electricity generation industry. These include Emission Performance Standards (EPS), Feed-in tariffs, Minimum carbon pricing, Carbon tax, etc. These either alone or in combination all have the same aim as that asserted for the EU ETS itself i.e. to trigger investment in abatement/substitution of CO2 emissions but are very different in character.

Alternatives:

· 1) A minimum price for carbon:

o a minimum carbon price could be set as is presently being advocated in the UK (at say €80? to ensure investment incentive)

o This is very simple change to the EU ETS. It could be made now, but by its very application it tends to negate the whole EU ETS edifice.

o The reason is that whilst not intended as such, an upper limit to carbon price already exists within the EU ETS. This is because a system of fines exists for unapproved emissions and is set at .c€100. There is therefore no value to an emitting plant to purchase EUA above this price and this mechanism acts as a cap on the market.

o In these circumstances the EUA price will operate within a collar having a range of only 20 i.e. €80-€100.

o There must be serious doubt about the value of preserving the dauntingly complicated EU ETS pseudo market for EUA just to operate in this restricted €20 range.

o The impact on the economy and all the other disadvantages of the EU ETS would still exist.

Two variant solutions can be proposed:

o 2) The first variant solution would retain some similarity to the EU ETS in that it would still be a charging process for CO2 emitted. The basis would be to select a charging rate of (say) €90/te for carbon emission permits (index linked perhaps to a function of bundled energy price and/or CPI). Many of the problems outlined against the EU ETS go away. Investors have secure price structure and therefore excepting exceptional risks, an investable proposition which they can finance both with equity and debt through conventional systems of commerce. They can decide in what to invest and when to do so in the light of their own perceptions/predictions of the market and the risks involved. Sizes and types of proposed infrastructure in which to invest become normal commercial decisions only regulated by governments for the standard reasons of health, safety and environmental impact. Investors will not invest if there is a perceived risk of under recovery so the charging rate must be high enough and must be dependable. If there is a perceived risk of exceptional profits arising, particularly once first of a kind risks diminish, then a super tax akin to SCT or PRT could be introduced but such decisions are probably a long way off. Nevertheless, some of the EU ETS problems still remain. When introduced, it has an immediate impact on the economy which instead of suffering a gradual erosion of world competitiveness, immediately suffers a huge shock from hikes in the price of energy, steel, aluminium, transport and refined products compared with other regions of the world that have not yet addressed the CO2 emissions issue. The income from selling emission permits still goes to general government revenue and is not used for investment unless special measures are again employed.

o 3) The second variant solution would be radically different. Instead of charging emitting plant owners for emissions they wish to make at a standard (say €90/te), investment support payments (ISP) would be made to the investor for emissions abated/substituted by his investment decisions (similar in style to the funding assessment under NER300).These ISP would only apply to investments that were committed and/or underway and so the burden on the economy would only grow at the pace of investment rather than investment only taking place when the whole economy has already been burdened by the gross cost of future investment across the entire emitting spectrum through sale of emission permits. These ISP would grow at the rate of investment and be funded by a levy on sales made by fossil fuel industries (abated, substituted & unabated). The system could be tuned for early bird incentive by introducing a sliding scale of ISP from 120% (to compensate for early start risks) to zero within a fixed time frame. This would represent a very strong pull for qualifying investment in the early stages and eventually as the point of near total investment was reached, the levy would be broadly equal to the ISP and the scheme could be discontinued. Again the simplicity and reliability of the scheme would attract conventional investment as in solution 2).

· Either of the variant options 2) & 3) would provide investors with clarity of purpose and predictability of outcome and understanding of risk which would allow normal investment decisions to be made, conventional financial models to be used and existing sources of funding to be accessed whilst, if ultimately found to be necessary, tax arrangements could be introduced to guard against any possibility for any unacceptable windfall profit to the investors as novel risks diminish.

This article is also available at: http://www.rcmconsultingltd.com

Direct link:

http://www.rexconsult.com/Pricing%20Carbon%20under%20a%20CPI%20program.htm