Emissions Trading and Competitiveness

Allocations, Incentives and Industrial Competitiveness under the EU Emissions Trading Scheme

Michael Grubb, Karsten Neuhoff

• Publisher: Routledge
• Year: 2012
• Print ISBN: 9781844074037
• eBook ISBN: 9781136567490
• Edition: 1
• Topic: Politics & International Relations
• Subtopic: Environment & Energy Policy
• Index: Politics & International Relations

Complying with the forthcoming tightening of CO2 emission allocations in the EU may mean big bills for the industries affected. In this special issue of Climate Policy journal, leading experts examine the impacts on competitiveness and the commercial incentives available from the CO2 allowance allocations under the methodologies, and whether - and if so at what stage - the ETS itself may need to be amended.

The study is multidisciplinary, combining economic, legal and policy analysis with specific studies of impacts on electricity, cement and other industrial sectors and the allocation issues. It brings together the results of research conducted over the past two year from various research centres and consultancies in Europe, and in particular, work commissioned by the Carbon Trust and Climate Strategies Network. Through these, it presents the most comprehensive and detailed set of analyses yet conducted of the impacts of allocation on competitiveness - one of the most critical issues for the sectors affected and for the operation of the ETS.

Auctioning of EU ETS Phase II Allowances: How and Why?

Cameron Hepburn¹*, Michael Grubb², Karsten Neuhoff², Felix Matthes³, Maximilien Tse⁴

Abstract

The European Directive on the EU ETS allows governments to auction up to 10% of the allowances issued in phase II 2008–2012, without constraints being specified thereafter. This article reviews and extends the longstanding debate about auctioning, in which economists have generally supported and industries opposed a greater use of auctioning. The article clarifies the key issues by reviewing six ‘traditional’ considerations, examines several credible options for auction design, and then proposes some new issues relevant to auctioning. It is concluded that greater auctioning in aggregate need not increase adverse competitiveness impacts, and could in some respects alleviate them, particularly by supporting border-tax adjustments. Auctioning within the 10% limit might also be used to dampen price volatility during 2008–2012 and, in subsequent periods, it offers the prospect of supporting a long-term price signal to aid investor confidence. The former is only possible, however, if Member States are willing to coordinate their decision-making (though not revenue-raising) powers in defining and implementing the intended pricing mechanisms.

Keywords: EU ETS; Auctions; Phase II allocations; Windfall profits

1. Introduction

Whether governments could or should sell emission allowances, instead of giving them out for free, was one of the most hotly contested aspects of negotiating the original EU ETS Directive. It resulted in the compromise – after determined intervention by the European Parliament to raise the threshold – that governments could auction up to 5% of allowances in phase I and up to 10% in phase II (the Kyoto first period of 2008–2012).

This compromise reflects two empirical facts about auctioning. The first is that economists almost unanimously recommend more auctioning. The second is that business tends to oppose it. The result is that despite all the academic recommendations, auctioning in emission trading systems is the exception rather than the rule.¹ In phase I, only four out of 25 Member States used auctions at all, and in only one case were auctions fully employed to the 5% limit.² This contrasts sharply with, for example, the willingness of European governments to auction licences for the European ‘third-generation’ (3G) mobile telecommunications licences, where auctions raised enormous sums.³ The difference in approach can largely be explained by threef actors. First, emissions trading imposes costs on other sectors, producing strong lobbying by incumbents in these markets, whereas costs to other sectors by pricing the 3G spectrum were much smaller and less obvious. Second, emissions trading may affect national competitiveness in some export sectors. In contrast, competitiveness fears did not arise with the 3G auctions because international trade in spectrum licences (and downstream sectors) is obviously rather limited. Third, telecommunications is a fast-growing industry, where many powerful players were non-incumbents without the right to grandfathered allowances (Cramton and Kerr, 2002).

Box 1. Auctioning in the EU ETS – Key Findings

Auctioning in general:

• is likely to increase the macroeconomic efficiency of the EU ETS and offers scope to partially address its distributional impacts
• will have negligible competitiveness impacts
• reduces the distortions associated with free allocation and is correspondingly more compatible with EU State aid legislation
• will have a smaller impact on EU ETS prices than allocation cutbacks without auctioning
• will increase management attention and thus market efficiency

Auctioning may also provide a hedge against projection uncertainties, reduce price volatility, and increase investor stability. The recent EU ETS market collapse is a dramatic manifestation of uncertainty in emission projections. Reserving some allowances for periodic auctions:

• could assist transparency and liquidity
• offers a potential price cushioning mechanism (as in US transmission auctions), to create a more stable EU ETS market
• might facilitate ex-ante agreed target price ranges, thereby increasing predictability for investors

Auctioning poses no significant implementation difficulties:

• either ascending-bid or sealed-bid auctions could be used and based upon extensive experience, for example with securities auctions
• should be open to as wide a group of bidders as possible
• the concerns of small bidders can be addressed, for example through reserves guaranteed at the strike price

For the longer term (post-2012), auctioning could also:

• help protect industrial competitiveness by enabling WTO-compatible border-tax adjustments
• help provide a long-term carbon price signal by recycling revenue into carbon contracts

However, the political dynamics relevant to emissions allowance auctions may be changing. The great majority of participants in phase I (as measured by turnover or emissions) are making substantial profits from the system of free allocations, as economists had predicted. Additionally, there are now potential legal pressures arising from state aid considerations as a consequence of these profits (see Johnston, this issue). These considerations may increase the appeal of auctions. In this context, we re-examine the issues and arguments for and against auctioning, and also introduce some new considerations as follows: Section 2 reviews six ‘traditional’ arguments concerning EU allowance auctions; Section 3 considers how EU ETS auctions might be run, including an examination of the question of auction design; Section 4 examines some new issues, including whether auctions might reduce competitiveness exposure (through allowing border-tax adjustments); reduce price volatility, and support long-term price signalling.

2. The Pros and Cons of Auctioning Allowances

2.1. Economic Efficiency, Revenue Recycling and the Relationship with Eco-Taxation

Raising revenue from environmental policy is not a new idea. The classical recommendation is to tax activities with ‘external’ (such as environmental) costs, to make firms factor these costs into their decisions (Pigou, 1920). A secondary benefit of such eco-taxation, in addition to internalizing the environmental externality, is that the revenue raised can be ‘recycled’ to reduce other distortionary taxes on labour or capital in the economy.⁴

Despite the economic arguments for eco-taxation, implementation has been extremely patchy and highly contested.⁵ The divergence between theory and practice has gradually led to a much deeper appreciation of the crucial importance of the political economy of instrument choice. Policy decisions are strongly influenced, for understandable reasons, by the creation and allocation of economic rents. Environmental taxes have struggled to win political acceptance because they attempt to combine two difficult feats: transferring the rents created by environmental constraints to the public purse, and providing incentives to change behaviour at the margins.⁶ Attempting either feat alone, particularly the former, can generate strong opposition from powerful interest groups.

In addition to the political economy challenges, policies internalizing the carbon price (including taxes, and trading schemes whether the permits are grandfathered or auctioned) may have unwanted interactions with other taxes.⁷ For instance, imposing a carbon price by a tax or trading scheme raises the price of energy and derived products, which (other things being equal) reduces real wages and therefore labour supply. Some considerations and studies suggest that this indirect ‘tax-interaction’ effect more than offsets the efficiency gains from revenue recycling, although the net effects remain disputed and context-dependent.⁸

But any policy that internalizes the carbon price without raising revenue (such as emissions trading with free allocation) suffers these tax-interaction effects without the benefit of the revenue-recycling effect (discussed above).⁹ Because auctioning allowances does benefit from the revenue-recycling effect, it is almost certainly more efficient than free allocation, within the constraints of competitiveness effects. Thus, in practice, given that there is an emissions trading system in place, it is obvious that auctioning has the potential to improve the macroeconomic efficiency of the system.

Of course, efficiency considerations are merely the beginning, and we now examine five other considerations relevant to auctions, namely: the distribution of the economic rents created by CO₂ limits in the economy; competitiveness effects of auctioning compared to grandfathering; legal considerations; dynamic incentives; and transaction costs.

2.2. Rent Distribution and Equity Considerations

Limiting CO₂ emissions puts a price on carbon and thereby increases production costs. Firms will pass a proportion of this marginal cost increase through to consumers. The proportion passed through depends upon the market structure.¹⁰ When allowances are freely allocated to firms, some participating sectors will inevitably make profits.¹¹

It is now beyond doubt that the electricity sector generally profits from free allowances under the EU ETS, unless it is subject to direct price regulation or a regulatory threat in concentrated markets, because generators pass costs on to electricity consumers, including non-ETS sectors and domestic consumers. Whether other participating sectors may similarly profit depends upon two main factors: whether they receive enough allowances to cover any increase in their cost base; and the constraints on cost pass-through placed by international competition.¹² In practice, of course, these factors vary considerably between sectors, and indeed, companies and facilities within sectors. Non-participating sectors with high electricity consumption (such as aluminium) will face substantially higher costs due to higher electricity prices, and yet are not compensated through the receipt of free allowances.

Not only does the ETS have significant distributional consequences between the various sectors (participating or not), it is also clear that most of the economic rents from the current arrangements ultimately accrue to shareholders of the profiting firms, who tend to be wealthier than the general population. As such, in aggregate the current arrangements transfer resources from the poor to the rich.¹³

One of the widest economic misconceptions about auctioning is that it would simply add costs which would be passed through to ‘downstream’ companies and consumers.¹⁴ Yet if firms maximize profits, then even with free allocation they pass on the opportunity costs of allowances to downstream prices. Changing from free allocation to auctioning will have little impact on product prices.¹⁵ However, because auctioning raises revenue that may be reallocated, it has, prima facie, the potential to correct distributional impacts.

If auction revenues are employed to reduce general taxes, the distributional impacts will depend upon the nature of these other tax changes: for example, a reduction in income tax would tend to shift revenue from the electricity consumer to the taxpayer, and if focused on the base rate might be somewhat progressive. Alternatively, direct dedication of the auction revenue to domestic consumers would give consumers an income stream that increases with higher CO₂ prices, thereby compensating for product (especially electricity) price increases. This might also increase public interest in and support for the ETS. Few generalizations are meaningful at this level, however, since each country will have different political preferences and considerations in the context of wider tax and consumer debates.

If revenues are earmarked within the business sector, distributional impacts will similarly hinge upon how these revenues are targeted. One example of national earmarking is the UK Carbon Trust, which receives revenues from the UK Climate Change Levy that is then used to support investment by UK companies in improving energy efficiency, and in the process of commercializing new and emerging low-carbon technologies. The aim is both to reduce energy costs for British companies and enhance their longer-term competitiveness by accelerating the use of advanced technology. In general, the use of CO₂ auction revenues to support R&D, demonstration projects, regional development bodies, and possibly also supporting infrastructure, is likely to be...

Table of contents

• Cover
• Title Page
• Copyright
• Contents
• Preface
• Allocation and competitiveness in the EU emissions trading scheme: policy overview
• The impact of CO2 emissions trading on firm profits and market prices
• CO2 cost pass-through and windfall profits in the power sector
• Allocation, incentives and distortions: the impacts of EU ETS emissions allowance allocations to the electricity sector
• CO2 abatement, competitiveness and leakage in the european cement industry under the EU ETS: grandfathering versus output-based allocation
• Free allocation of allowances under the EU emissions trading scheme: legal issues
• Auctioning of EU ETS phase II allowances: how and why?