2/21/2023
DESIGNING REAL-WORLD
ENVIRONMENTAL MARKETS
BEPP/OIDD 2630
ENVIRONMENTAL & ENERGY ECONOMICS
Outline
What market design issues have governments faced when
implementing these markets in practice?
How were these issues tackled in real-world cap-and-trade markets?
We will discuss these issues in the context of early trading markets:
– EU Emissions Trading Scheme
– RECLAIM (NOx and SO2 trading in LA)
– In back-up slides: SO2 trading in the U.S. (“Acid Rain Program”)
ENVIRONMENTAL & ENERGY ECONOMICS
Designing Real-World Environmental Markets
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2/21/2023
In The News
China’s emissions trading system will be the world’s biggest climate
policy (Forbes, Apr 18, 2022)
ENVIRONMENTAL & ENERGY ECONOMICS
Designing Real-World Environmental Markets
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Market Design Issues for Cap-and-Trade
• Banking and borrowing
• Initial allocation of allowances
• Price caps and floors
Case study: RECLAIM
• Hot spots
• Price discovery auction
Case study: EU ETS
back-up
Case study: SO2 trading
not this
year
Case study: EU ETS
• Emissions leakage
• Offsets
• Linking carbon markets
ENVIRONMENTAL & ENERGY ECONOMICS
Case study: California
Designing Real-World Environmental Markets
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EU Emissions Trading Scheme
• The EU ETS is the second-largest carbon trading system in the world
• Cap initially based on Kyoto Protocol
– Goals: reduce EU-27 emissions 8% below 1990 levels by 2012; 21% below
1990 levels by 2020; 43% below 2005 by 2030
• Timing: trading takes place in several phases
– Phase 1: 2005-7; phase 2: 2008-12; phase 3: 2013-20; phase 4: 2021-30
• Coverage: 11,000 facilities; mostly heavy industry and electricity; about
40% of total emissions
• Monitoring based on inputs and specified efficiency & emissions factors
Lesson 1: keep it simple and focus on large emitters
ENVIRONMENTAL & ENERGY ECONOMICS
Designing Real-World Environmental Markets
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The EU ETS Started Off Reasonably Well…
• Initially performed surprisingly well, given the speed of introduction
• Opposition before 2005 had been limited, despite negotiations among
countries and sectors within a country
• Liquid markets quickly evolved (>100 million allowances traded per
year in 2007; 5% of cap), including forward and futures markets
• Price of CO2 at times consistent with social cost of carbon estimated
at the time
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… But the CO2 Price Collapsed in 2006-2007
35
EU ETS CO2 Price
30
April 2006
EUR/tonne
25
20
15
10
April 2008
5
0
What happened in April 2006?
How could the EU have avoided this?
ENVIRONMENTAL & ENERGY ECONOMICS
Lesson 2: get the cap right
Designing Real-World Environmental Markets
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Phase 2 Was Expected To Be Tighter
April 2006
ENVIRONMENTAL & ENERGY ECONOMICS
Designing Real-World Environmental Markets
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Design Issue 1: Banking and Borrowing
• Banking: saving excess allowances in a bank, for use in future
compliance periods
• Borrowing allowances from future compliance periods, thereby
committing to accept a lower future allocation
• When will firms “bank”? Why would a regulator allow banking?
• What is the risk of allowing for borrowing?
Banking and borrowing smooth allowance prices over time
Lesson 3: allow for banking; not borrowing
ENVIRONMENTAL & ENERGY ECONOMICS
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Design Issue 2: Initial Allocation of Allowances
• Allowance allocation does not matter for emissions, but a lot for profits…
• Free allocation: firms do not pay for (most of) their allowances
– Historical emissions vs. benchmarking
– What industries typically get the better deals?
• Auctioning: sell allowances to the highest bidders via periodic auctions
• Cap-and-trade with fully auctioned permits is similar to a carbon tax
ENVIRONMENTAL & ENERGY ECONOMICS
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Banking, Borrowing and Allocation in the EU ETS
• Mostly free allocation of allowances until 2012, ~50% auctioning
from 2013 (based on benchmarking)
• Power generation gets less generous allocations than heavy industry
• Banking and borrowing allowed within phases; banking allowed
between phases 2 & 3 (heavily used!)
• Non-compliance fee: €40 (phase 1) / €100 (phases 2 & 3) per ton of
CO2 plus need to surrender the difference
ENVIRONMENTAL & ENERGY ECONOMICS
Designing Real-World Environmental Markets
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In The News
European energy groups involved in carbon trading are manipulating the
scheme for profit, not principle (The Guardian, May 17, 2006)
EU industry got $27 billion carbon plan windfall, study says (Bloomberg,
Mar 14, 2016)
Companies were
better off with the
ETS than without it:
How is that possible?
Source: Carbon Market Watch
ENVIRONMENTAL & ENERGY ECONOMICS
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Windfall Profits in Cap-and-Trade Markets
Let’s consider the steel industry, first without emissions regulation
price
of steel
Supplyno regulation
p0
Demand
Q0
ENVIRONMENTAL & ENERGY ECONOMICS
quantity of steel
Designing Real-World Environmental Markets
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Windfall Profits in Cap-and-Trade Markets
Now let’s consider an output tax on steel to internalize pollution
price
of steel
Supply + tax
ptax
Tax on steel
Supplyno regulation
p0
Demand
Qtax
ENVIRONMENTAL & ENERGY ECONOMICS
Q0
quantity of steel
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Windfall Profits in Cap-and-Trade Markets
As always, consumers and companies lose when a tax is imposed…
price
of steel
Supply + tax
ptax
Tax on steel
Lost consumer
surplus
p0
Supplyno regulation
Lost corporate profits
Demand
Qtax
ENVIRONMENTAL & ENERGY ECONOMICS
Q0
quantity of steel
Designing Real-World Environmental Markets
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Windfall Profits in Cap-and-Trade Markets
… but consumers gain in their role as taxpayers
price
of steel
ptax
Supply + tax
Tax revenues
Tax on steel
Lost consumer
surplus
p0
Supplyno regulation
Lost corporate profits
Demand
Qtax
ENVIRONMENTAL & ENERGY ECONOMICS
Q0
quantity of steel
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Windfall Profits in Cap-and-Trade Markets
Now consider cap-and-trade with a tax-equivalent allowance price
price
of steel
Supplycap
pcap
Allowance price *
(CO2 / unit of steel)
Supplyno regulation
p0
Demand
Qcap
ENVIRONMENTAL & ENERGY ECONOMICS
Q0
quantity of steel
Designing Real-World Environmental Markets
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Windfall Profits in Cap-and-Trade Markets
If allowances are fully auctioned, firms lose the same as under the tax
price
of steel
Supplycap
pcap
Allowance price *
(CO2 / unit of steel)
Supplyno regulation
p0
Demand
Lost corporate profits
with full auctioning
Qcap
ENVIRONMENTAL & ENERGY ECONOMICS
Q0
quantity of steel
Designing Real-World Environmental Markets
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Windfall Profits in Cap-and-Trade Markets
But with free allocation, firms gain from the higher prices while they did
price
of steel
pcap
not have to buy any allowances: they capture the “tax revenues”!
Rents from
free allocation
Supplycap
Allowance price *
(CO2 / unit of steel)
Supplyno regulation
p0
Demand
Lost corporate profits
with full auctioning
Qcap
ENVIRONMENTAL & ENERGY ECONOMICS
Q0
quantity of steel
Designing Real-World Environmental Markets
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Free Allocation Leads To Windfall Profits
• Free allocation: firms pass through the carbon price to consumers, but do
not pay for (most of) their allowances: windfall profits
– On average, firms can gain (substantially) from cap-and-trade
– German power companies saw earnings increase by €6-8 billion
– Consumers lose, no government revenues
• Auctioning: firms pay for all or some of their allowances
– On average, firms lose, consumers gain as taxpayers
– Who gains depends on how the revenues are spent
• Remember: society at large also gains from a better environment
Lesson 4: sell a large share of allowances at auction
ENVIRONMENTAL & ENERGY ECONOMICS
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How to Test for Windfall Profits in the EU ETS?
35
EU ETS CO2 Price
30
April 2006
EUR/tonne
25
20
15
10
5
April 2008
0
How can the market can tell us if windfall profits occurred?
ENVIRONMENTAL & ENERGY ECONOMICS
Designing Real-World Environmental Markets
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CO2 price (€/ton) or electricity price (€/MWh)
As Expected, Firms Passed Through the Carbon Price
Electricity
futures
contracts
CO2
allowances
CO2 price ↑ 10% → generator share price ↑ 0.23%
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RECLAIM
• The Regional Clean Air Incentives Market (RECLAIM) caps NOx and
SOx emissions from several hundred plants in the Los Angeles area
Pathways
VOCs
NOx
SOx
O3
PM
NB: pollutants covered; pollutants affected
• RECLAIM Trading Credits (RTCs) required from:
– Power plants
– Refineries
– Cement factories
– Other industrial sources
ENVIRONMENTAL & ENERGY ECONOMICS
Designing Real-World Environmental Markets
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In 1997, LA Was Far From in Attainment for Ozone
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The Situation Is Still Problematic
ENVIRONMENTAL & ENERGY ECONOMICS
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NOx (tons)
RECLAIM’s NOx Allowance Allocation…
Compliance year
ENVIRONMENTAL & ENERGY ECONOMICS
Designing Real-World Environmental Markets
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NOx (tons)
… Appears To Be Quite Generous
in retrospect, the cap has not seemed to
been binding since 2001
Compliance year
ENVIRONMENTAL & ENERGY ECONOMICS
Designing Real-World Environmental Markets
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Why Are Allowance Prices Positive?
NOx price ($/ton)
Average Prices for NOx RTCs near Expiration
Month of year
ENVIRONMENTAL & ENERGY ECONOMICS
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Price Volatility Was Another Complication
ENVIRONMENTAL & ENERGY ECONOMICS
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Design Issue 3: Price Caps and Floors
A price cap on allowances has the objective to reduce price uncertainty
$
MCArealized
MCAexpected
pmax
pexpected
additional allowances
(potentially up to some limit)
E*price cap
E*
Note: MCA = marginal cost of abatement;
E*
= emissions cap
ENVIRONMENTAL & ENERGY ECONOMICS
E0
aggregate emissions
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Design Issue 3: Price Caps and Floors
A price floor can be achieved by retiring allowances or through minimum
price levels in allowance auctions
Price caps and floors
$
create a hybrid
between a cap-andunsold allowances due to
minimum auction price
MCAexpected
pexpected
pmin
(used in RGGI, CA)
Lesson 5: use a(n
auction) price floor
and a price cap
MCArealized
E*price floor
trade and a carbon tax
E*
Note: MCA = marginal cost of abatement; E* = emissions cap
ENVIRONMENTAL & ENERGY ECONOMICS
E0
aggregate emissions
Designing Real-World Environmental Markets
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Design Issue 4: Hot Spots
• Damage per ton is higher near the coast due to wind patterns
• Response under
RECLAIM:
– Two spatial zones:
coastal and inland
– Coastal sources can only
use units from the coast;
cannot buy from inland
– Inland sources can use
either
• Ideal response: set trading ratio so trade does not affect total damages
ENVIRONMENTAL & ENERGY ECONOMICS
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RECLAIM Is Not a Textbook Market
• Cap non-binding for several years
• External shocks and price volatility
• Illiquidity and high transaction costs
• Hot spots
– Trading affects the geographical distribution of environmental damages
– Problem 1: moving pollution upwind increases overall damages
– Problem 2: increased emissions in high-pollution counties do more damage
than in low-pollution counties
Hot spots and price shocks triggered more and less subtle solutions
(removing high-emitting plants, price cap, trading zones)
ENVIRONMENTAL & ENERGY ECONOMICS
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Lessons from Emissions Trading
• Keep transaction costs low – target large upstream sources
• Include as many sectors as possible under a well-chosen cap
– Extending coverage reduces compliance costs
• Auction as many allowances as possible, but some free allocation can
make cap-and-trade politically feasible without windfall profits
• Reduce price uncertainty by allowing banking and setting price floors
and price caps
• Solve hot spots through trading restrictions or trading ratios
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Next Lecture: OPEC Game Debriefing
• What happened in the OPEC game, and why?
• How has OPEC behaved in practice?
ENVIRONMENTAL & ENERGY ECONOMICS
Designing Real-World Environmental Markets
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Designing Real-World Environmental Markets
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Back-Up
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The SO2 Trading (Acid Rain) Program…
• Introduced under 1990 Clean Air Act Amendments as the first largescale cap-and-trade program anywhere
• Previously discussed market design issues
–
–
–
–
Allowance allocation: freely allocated, based on historical emissions
Point of regulation: controls SO2 from electric utilities in the continental U.S.
Price cap/non-compliance penalty: $2,000/ton
Hot spots: treats U.S. as one air shed – no controls on spatial distribution
• Industry windfall profits of about $100 million a year
• Very low cost to administer (relatively few facilities, required continuous
emissions monitors, 100% compliance)
ENVIRONMENTAL & ENERGY ECONOMICS
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… Is Generally Considered a Major Success
• Phase 1 (1995 – 99)
– 263 generating units at 110 power plants
– Cap going down from 8 to 6.3 million tons of SO2 per year
• Phase 2 (2000 – today)
– Virtually all fossil fueled electricity generators
– Capped at 9 million tons of SO2 per year
• A major success and example for other trading systems
–
–
–
–
Liquid market for allowances and financial derivatives
SO2 emissions were cut by 40% between 1995-2008
Command-and-control would have been about twice as expensive
Rapid innovation in scrubber technologies
– Low-sulfur coal has ended up being cheap and abundant
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The Use of Banking…
Allowances banked in Phase 1…
… were used in Phase 2
New EPA rules have made SO2
trading obsolete
ENVIRONMENTAL & ENERGY ECONOMICS
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… Added to the Cost Reductions from Trading
• Gains from spatial trading are relative to command-and-control
• 30% of units in Phase I were banked, which further improved efficiency
– Reduced Phase II costs by 1.3 billion
– Helped to smooth costs across years – avoiding the problems in RECLAIM
cap-and-trade: $15 bln
old standard: $35 bln
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Design Issue 5: Price Discovery Auction
• The creation of an EPA auction helped price discovery
– 2.8% of allowances withheld for annual auctions; revenues redistributed
pro-rata
– Auction prices close to subsequent trading prices; high trading volumes
price discovery auction
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