Message to Regulators: Emissions Trading Schemes Can Do Wonders Provided They Have a Strong and Rising Forward Price Curve
By Gareth Brydon Phillips
There is a general perception that the purpose of emission trading schemes is to reduce GHG emissions as cheaply as possible. This is not quite correct. It’s a subtle but important difference: The purpose of GHG emission trading schemes is to finance the conversion to low carbon technologies. These in turn reduce GHG emissions. If the revenues from the auction of allowances are recycled, then the price is somewhat irrelevant.
Emissions trading schemes which aren’t working are therefore not effective in financing the conversion to a low carbon economy, or producing long term reductions in emissions. For emission trading schemes to work, a strong and rising forward price curve is imperative.
Twice, multilateral groups have created emission trading schemes – i.e. the Kyoto protocol and EU ETS. In the process, they have created multi-lateral or sovereign commodities – Assigned Amount Units (AAUs) and European Allowances (EAs) – worth billions of dollars. And twice they have presided over a collapse in the value of those units. It’s a market, they say, and the market sets the price. But this misses the point that the supply of the commodity is artificial, created by the authorities that created the system. And since they designed it, the supply of allowances could be changed by those same authorities. Instead, regulators seem to think that the key deliverable is reduced emissions and if emissions are going down, all’s well. But it’s not.
In the absence of a strong and rising forward price curve, polluters such as utilities have no interest, and more importantly, no ability to finance a transition to low carbon technology. Companies have a responsibility to shareholders to maximize profits and when a rising forward price curve is missing, the rational and profit maximizing option is to purchase allowances and pass the costs on to consumers. On the other hand, when a rising forward price curve exists, the profit maximizing option is to raise finance to build new equipment using existing (free) allowances and projected cost savings which will accrue due to the reduced demand for allowances in the future. A wilting forward price curve encourages entities to raise the price of goods and services and sell excess allocations for (windfall) profits, whilst a rising forward price curve enables them to raise revenue to finance a transition to low carbon economy.
What evidence is there to support this?
The best evidence is the Kyoto Protocol’s Clean Development Mechanism (CDM). The CDM was designed, amongst other things, to promote technology transfer because it awards emission reduction units for the implementation of new and / or low carbon technologies in place of more carbon intensive technologies. From around 2003 to 2010, every carbon finance analyst was predicting strongly rising forward price curves. This triggered massive private sector interest in the mechanism, and despite the very real barriers to the final delivery of emission reductions (typically 2 to 3 years of more of regulatory risk and bureaucracy on top of the normal risks of deploying new technologies in developing countries), the private sector lined up investment in excess of USD500bn in a pipeline of over 7000 projects. Pricing carbon worked spectacularly well, even if the system wasn’t perfect and improved over time.
That’s USD 500 billion to invest in new technologies in developing countries in order to receive emission reduction units after the plant has been built and successfully operated, because the private sector expected the resulting units to have increasing value.
If AAUs and EAs had rising forward price curves like the CDM had, and considering that the allowances are issued ex ante and can be traded, transferred and monetized the day they are issued, polluters could have much, much more ability to raise the finance they need to invest in low carbon technology.
So, have we learnt anything and what can be done?
The Kyoto Protocol and the EU ETS have been important for teaching us the lessons but now we need Governments to implement them. It is very disappointing that the Australian Carbon Pricing Mechanism is being rolled back because it had built in provisions to control the supply of allowances as well as extensive measures to recycle the revenues raised by the program. The Korean ETS is even more explicit in maintaining controls on the price. The Quebec Emissions Trading Scheme contains provision to hold back allowances which fail to sell above the auction floor price. Other countries are designing and implementing their own ETS and in doing so, creating their own sovereign commodities. They have the right, the ability and the responsibility to their citizens, to ensure that their commodity remains valuable. If they can remain focused, above all else, on securing a robust rising forward price curve, carbon pricing will deliver: Their industries will be able to access international finance to pay for the transition to a low carbon technology and if the Governments recycle the resulting auction revenues, then everyone wins.
