Price Floors for Emissions Trading
1
Price Floors for Emissions Trading
Pre-publication version of manuscript for Energy Policy
Peter John Wood
(Corresponding Author)
Resource Management in Asia Pacific Program,
Crawford School of Economics and Government,
The Australian National University,
Canberra, ACT 0200, Australia.
Email: Peter.J.Wood@anu.edu.au
Phone: +61 2 6125 6284
Fax: +61 2 6125 1635
Frank Jotzo
Crawford School of Economics and Government,
The Australian National University,
Canberra, ACT 0200, Australia.
Email: frank.jotzo@anu.edu.au
Abstract:
Price floors in greenhouse gas emissions trading schemes can guarantee minimum
abatement efforts if prices are lower than expected, and they can help manage cost
uncertainty, possibly as complements to price ceilings. Provisions for price floors are
found in several recent legislative proposals for emissions trading. Implementation
however has potential pitfalls. Possible mechanisms are government commitments to
buy back permits, a reserve price at auction, or an extra fee or tax on acquittal of
emissions permits. Our analysis of these alternatives shows that the fee approach has
budgetary advantages and is more compatible with international permit trading than
the alternatives. It can also be used to implement more general hybrid approaches to
emissions pricing.
Keywords:
Price floor; hybrid emissions pricing; emissions trading.
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1. Introduction
This paper examines issues associated with the implementation of price floors in
emissions trading schemes. We look in detail at mechanisms for their
implementation, and at the interaction with international permit trading.
Price ceilings are a widely recognised option to limit the risk that carbon prices
exceed acceptable levels if constraining emissions turns out to be more expensive
than expected, providing greater cost certainty to emitters, and limiting the overall
potential short-term economic cost of mitigation. The mirror instrument is a price
floor, which would ensure a minimum price on carbon. Price floors would provide
more certainty for investors in low emission technologies, and allow emissions to go
lower than a given target, thus providing more abatement if costs are lower than
expected. The basic concept of a combined system of price ceilings and floors in
allowance trading goes back to Roberts and Spence (1976).
Both price ceilings and price floors can reduce risk and price volatility in carbon
markets, which has been of concern in the EU emissions trading system or ETS
(Grubb and Neuhoff, 2006), and can thus make the introduction of ETS systems more
acceptable. However, such ‘hybrid’ instruments also present specific challenges for
scheme design and for trading of permits between countries, and in terms of their
budgetary impacts.
There has been considerable discussion of approaches that include a price ceiling,
also known as a ‘safety valve’ (Aldy et al., 2001; Jacoby and Ellerman, 2004; Pizer,
2002; McKibbin and Wilcoxen, 2002; McKibbin et. al., 2009; Philibert 2000). Price
ceilings have been proposed for various carbon trading schemes, for example in
Price Floors for Emissions Trading
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Australia (Commonwealth of Australia, 2008)1, and in less direct ways for the US
Regional Greenhouse Gas Initiative (RGGI, 2008), and the Waxman-Markey Bill as
passed by the United States House of Representatives in June 2009 (H.R. 2454,
2009)2.
The academic debate on price floors is much less developed, though the concept of
price floors has begun to find its way into policy and legislative proposals. One of the
novel aspects of the Waxman-Markey Bill is that it stipulates a reserve price of
US$10/tCO2-e when permits are auctioned, which would increase by 5% above the
consumer price index each year. This reserve price could function as a price floor.
The US Regional Greenhouse Gas Initiative (RGGI) scheme has a reserve auction
price in place. In March 2010, approximately 40 million tons of CO2 allowances for
the present compliance period (2009-2011) were auctioned at US$2.07 per permit,
but approximately 2 million tons of CO2 allowances for the next compliance period
were sold at the reserve price of US$1.86 per permit. Unsold allowances may be sold
in future auctions according to each state’s regulations (RGGI, 2010). These price
levels are substantially lower than prevailing prices under the EU ETS.
The ETS that has been proposed for California is expected to have a price floor of
US$10, which would be implemented as an auction reserve price that will increase by
5 percent above inflation per year. The Western Climate Initiative (an ETS proposed
for 11 US states and Canadian provinces) would also have an auction floor price at a
level that is yet to be specified (Hood, 2010).
1
The Australian emissions trading scheme proposal was shelved by government in the first half of
2010.
2
Complementary carbon pricing legislation has not achieved passage through the US Senate.
Price Floors for Emissions Trading
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Calls in early 2009 for a price floor to be introduced to the EU emissions trading
scheme, via an auction reserve price, were rejected by the European Commission.
The European Commission claimed that “a floor price may unduly interfere with the
market” (Gardner, 2009). This argument seems to overlook that permit markets are
entirely the product of government regulation in the first place – introducing a feature
like a price floor simply means adopting a different design that will result in a
different market outcome. The argument also runs counter to stated EU interests to
achieve ambitious climate mitigation outcomes.
Provisions for an effective floor price are under discussion in the United Kingdom
(Rebuilding Security, 2010). By contrast, the ETS earlier proposed in Australia did
not include price floor provisions. Analogous policies have also been implemented
for renewable energy – Belgium has a minimum price for renewable energy
certificates (Belgium Renewable Energy Factsheet, 2007).
The next section reviews how a floor price in an emissions trading scheme could
interact with various different policy objectives. In Section 3, we compare the
different approaches for implementing a price floor. In Section 4, we examine in
detail the mechanism where firms pay a tax or extra fee as well as buy permits; and
discuss international permit trading, budgetary implications, and political economy
considerations. Compared to the alternatives, this mechanism has budgetary
advantages and is compatible with international permit trading. In Section 5, we
examine how similar mechanisms could be used to implement more general hybrid
approaches for putting a price on emissions. One such approach is to use an
‘allowance reserve’, which is similar to a price ceiling, but where the total number of
permits remains limited. Section 6 concludes.
Price Floors for Emissions Trading
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2. Cost uncertainty, price volatility, and innovation
Price floors would influence price volatility, innovation, and the management of cost
uncertainty of greenhouse gas abatement policy. What instrument is chosen by a
policy-maker depends on their policy objectives. A common objective is to deliver an
economically optimal amount of emission reductions in an efficient manner, in the
presence of uncertainty. But policy-makers may have other purposes, such as
reducing emissions to a specific level, or promoting a specific technology. If the sole
objective is to meet a pre-determined emissions target, then the possibility of the
carbon price being lower (or higher) than expected is not a problem. But if the
objective is to set a carbon price that approximates the marginal damages of
greenhouse gas emissions, or more pragmatically to achieve a balance between
abatement costs and emissions reductions, then a carbon price that is much lower (or
higher) than expected may amount to policy failure.
2.1. Price floors and the economics of uncertainty
At the level of economic theory, uncertainties about abatement costs and benefits
affect the relative performance of abatement mechanisms in terms of their expected
welfare impacts. Weitzman (1974) showed that there is an efficiency argument for
setting the marginal cost of abatement rather than the quantity of abatement, when
abatement cost curves are uncertain and the marginal damage function of emissions is
relatively flat. It is generally thought that this is the case with climate change for the
Price Floors for Emissions Trading
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comparison between price and quantity instruments. In practice emissions pricing
policies have mostly taken the form of cap-and-trade.
Hybrid approaches under uncertainty were studied by Roberts and Spence (1976),
who examined pollution reduction when the costs of pollution reduction are
uncertain, but the benefits are known. It was found that the expected net benefits of
using a hybrid approach with both a price floor and a price ceiling are significantly
higher than for a purely price or quantity based approach. Quantitative modeling for
climate change mitigation (Pizer, 2002; Burtraw et al., 2009; Fell and Morgenstern,
2009) is consistent with this conclusion. Modeling by Philibert (2008, 2009) shows
that price ceilings and floors could help design a policy with similar probabilistic
climate results at lower expected costs. Further, Philibert argues that price floors must
be almost inevitably introduced to maintain the climatic effectiveness of the policy
when price ceilings are introduced, on top of some tightening of the emission targets.
Another interpretation of this point is that price floors are essential in mitigating the
disincentive effects of a price ceiling which would truncate possible upside returns on
low-carbon investment.
The economics of climate change mitigation under cost uncertainty therefore suggests
that hybrid approaches can be superior to both purely price-based schemes (carbon
taxes) and purely quantity-based schemes (cap-and-trade); and that such hybrid
approaches include price floors. The purpose of a hybrid scheme is not to
approximate a price-based system, but to turn it into an approach that is superior to
both price- and quantity-based schemes in terms on managing uncertainty.
If it turns out that a given short to medium term target can be more easily reached
than initially thought, the efficient response is to increase the abatement effort.
Price Floors for Emissions Trading
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Successful technological innovations lower the carbon price for a particular emissions
target, or increase the amount of emission reductions achievable at a particular carbon
price. The economically efficient response is to increase the amount of abatement, to
keep the abatement cost in line with the social cost of emissions. Under a pure capand-trade approach, innovation will only increase abatement if the regulator adjusts
emissions targets in response to a lower, or lower than expected, carbon price. A
price floor by contrast provides a mechanism for additional emission reductions to be
achieved automatically. However, it needs to be recognised that a price floor is no
panacea for dealing with all uncertainties pertaining to mitigation policy. For example,
a given minimum price may still fail to achieve a given policy ambition for overall
abatement or for making specific technologies commercially viable.
2.2. Managing carbon price volatility
Price floors (and ceilings) truncate the possible range of permit prices in the market
and hence can reduce excess price volatility. Price volatility can also be reduced by
banking and borrowing of permits; with short-term market fluctuations tempered
through longer term price expectations. But recent experience with the EU ETS
suggests that high levels of volatility still remain. The EU permit price ranged
between €15 to €25/tCO2-eq from mid-2007 to early 2008, spiked at €30 in mid-2008,
declined to a low of €9 in early 2009, and has ranged around €13-16 in the first half
of 2010.
The steep reductions in permit prices have in large measure been related to the global
financial crisis, which contributed to lower emissions and also constrained financial
resources for investment. The price falls occurred despite provisions for banking of
Price Floors for Emissions Trading
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permits being in place, which limits short-term downward fluctuation if markets
operate properly. Without intertemporal flexibility, the dip in permit prices would
likely have been larger.
It can be argued that falling permit prices in times of economic downturn are
desirable as an economic stabiliser. However, there are two important counterarguments. Firstly, it can be argued that policies should be designed in a way that
keeps incentives for long-term investments stable through temporary business cycle
effects. A short-term emissions price below the long-term optimum would exacerbate
presumed problems of underinvestment in technologies whose costs come down with
increased deployment (Sterner and Turnheim 2009). Second, an unanticipated
economic slowdown allows emission reductions further than originally targeted at the
same cost as originally expected. Under a specific mechanism design (variable extra
fee, see Section 3.3) it would also be readily possible to use extra government
revenue from implementation of a price floor to finance economic stimulus measures.
2.3. Increasing Certainty for Investors
Investment certainty would be improved by price floors. Investments such as power
plants, buildings, and infrastructure involve long-term time horizons. Uncertainty
about the future carbon price increases costs for both investors in mitigation and
investors in polluting technology. Policy design that reduces cost uncertainty can
therefore limit the overall effective cost of achieving a mitigation outcome, and is
more likely to attract political support from business constituencies. For example, the
CEO of the oil and gas company Eni has proposed a combined global carbon tax and
cap-and-trade system (Scaroni, 2009), where the carbon tax would function as a price
Price Floors for Emissions Trading
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floor. Coverage could differ between a carbon tax and a trading system, possibly with
a broad-based tax and a trading scheme applying to sectors with concentrated emitters.
In the light of recent failures or delays to implement carbon pricing policies in the
United States and Australia, increasing political support from key constituencies may
be a crucial advantage. A price floor gives investors in low-emission assets greater
certainty about the minimum return to their investments – it effectively provides
insurance against low carbon prices, analogous to the insurance function of a price
ceiling against cost blow-outs to owners of existing high-emissions assets.
2.4. Other issues
Coverage of a price floor is an additional issue to consider. It would be possible to
implement a ‘selective price floor’, covering only some sectors of the economy. 3
Such an approach may be desirable if a price floor with full coverage is politically
difficult, or if the objectives that can be met through a price floor apply particularly in
selected sectors. However if the main objective is to minimise the net costs from
mitigation and from climate change, then a price floor should apply throughout an
emissions trading scheme. If objectives such as providing greater investment
certainty relate only to specific sectors or activities, then this can be achieved through
other policy instruments.
Political and bureaucratic realities can lead to a carbon taxes and ETS’s having
significantly different coverage. Ireland, which is also part of the EU ETS, introduced
a carbon tax of €15 per tonne. This tax applies to fossil fuels, including fuels used for
3
Coverage of an emissions trading scheme may in itself be limited to emissions sources where
transaction costs are low, chiefly emissions from fossil fuel use (including through permit liability
upstream at the point of fuel distribution to indirectly cover small emissions sources) and industrial
emissions.
Price Floors for Emissions Trading
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transport, but does not apply to electricity. This carbon tax meets the policy objective
of increasing the coverage of a carbon price to new sectors of the economy (in this
case transport).
Other distinctions relate to whether a price floor is introduced when initially
designing an emissions trading scheme, as opposed to the addition of a price floor to
a pre-existing emissions trading scheme. The benefit from a price floor may be
greater in a new emissions trading scheme, as the uncertainty in emission reduction
costs will be greater. Nevertheless, introducing a price floor to an already existing
emissions trading scheme (such as the EU ETS) could also help with meeting some
policy objectives, though it must be balanced against concerns about excessive
‘fiddling’ with policy settings. Decisions may also be needed about the possible
future removal of price floors and ceilings.
The analysis in the rest of this paper starts from the assumption that policymakers
want to implement a price floor, possibly in combination with a price ceiling, and
examines what mechanisms and design options are best suited to achieve this. We set
aside issues of coverage and evolution of policy settings over time.
3. Mechanisms for a price floor
We compare three mechanisms for implementing a price floor in an emissions trading
scheme:
1. The administrator commits to buy back licenses at the floor price, thereby
reducing the amount of permits in the market (Hepburn, 2006). A similar
approach is for the administrator to commit to pay a subsidy to firms that
Price Floors for Emissions Trading
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possess more permits than required to cover their emissions, the subsidy being
proportional to the number of excess permits (Roberts and Spence, 1976).
2. A reserve price applies when permits are auctioned, again limiting the amount
of permits available to emitters (Grubb and Neuhoff, 2006; Hepburn et al.,
2006). This approach features in some current US policy proposals, and in an
existing US scheme (RGGI).
3. Emitters have to pay an extra fee (or tax) for each ton of carbon emitted, in
addition to having to surrender a permit. The effective carbon price then
becomes equal to the sum of the permit price and the extra fee. This approach
appears to have been largely overlooked in the current debate, though variants
of it can be found in earlier academic contributions.
3.1. A commitment to buy back permits
A commitment to buy back permits may be theoretically the ‘neatest’ way to
implement a price floor, because it allows for the price floor to be implemented
exactly with just one instrument. The market price will never go below the threshold
price, and the administration of the floor price remains within the cap-and-trade
scheme. However, the option would likely be unworkable in practice because of
budgetary aspects and because it would stand in the way of international permit
trading.
A buy-back commitment would create potentially large contingent liabilities to
governments, through budgetary costs of buying back permits in the market. This
would be especially problematic where large shares of the total permits available are
Price Floors for Emissions Trading
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given out freely to start with, or where revenue from the initial sale of permits is
earmarked for other purposes – one or both being the case for most existing and
proposed emissions trading schemes. If the contingent budgetary liabilities are large,
this might even undermine the credibility of the policy.
International trading in permits would exacerbate the budgetary problems faced by
any one country, as it would potentially create an unlimited liability for the
administrator (Garnaut, 2008, p. 310). Even if the buy-back commitment is limited to
domestic permits, international permits could be used by domestic emitters to
substitute for domestic permits, effectively extending any one government’s liability
overseas.
For a commitment to buy back permits to be compatible with international trading, it
would be required that all of the schemes involved have the same price floor
(PricewaterhouseCoopers, 2009). This would be difficult to achieve in practice
because of movements in exchange rates. Another way to address these issues is to
not have international permit trading, which has also been advocated for other
reasons (McKibbin et. al., 2009). However, this would fly in the face of a general
trend and widespread desire by policymakers to link schemes internationally (Tuerk
et. al., 2009), and would make it harder to achieve an internationally harmonized
carbon price and the associated efficiency gains.
3.2. A reserve price at auction
The reserve price approach is the one proposed for the United States under the
Waxman-Markey Bill, implemented under RGGI, and considered but rejected by the
European Union (see the Introduction). It would imply that there is no strict price
Price Floors for Emissions Trading
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floor, because although there would be a minimum price that firms would pay at
auctions, the market price could fall below the reserve price. An advantage of having
a reserve price is that independently of its function as a price floor, it is an auction
design feature that can protect sellers and in some cases buyers from unexpected
outcomes in the auction (Hepburn et al., 2006).
To what extent a reserve price translates into a floor price in part depends on the
share of permits auctioned. If a large proportion of permits are given out freely, then
a situation could occur where few or no permits are in fact auctioned, given the
reserve price. In this case, the market price would be above what it would be in a
‘pure’ cap-and-trade scheme with the full amount of permits available to emitters, but
below the reserve price.
International trade of permits could also result in the reserve auction price no longer
being a floor price. If permits from another country’s scheme or offset credits such as
from the Clean Development Mechanism can be imported at a price lower than the
reserve price, then this will become the source of purchased permits in the domestic
scheme rather than permits bought at auction from the government. Under this
scenario, there is an important negative budgetary impact for the country attempting
(but failing) to uphold a price floor, because rather than contributing to domestic
government revenue through purchases at auction, emitters transfer money for permit
purchases overseas.
Overall, a reserve price will not lead to a strict price floor, but it will lead to a
reduction in the quantity of permits when mitigation costs are low. It will limit
downward price flexibility, provided that a sufficient share of permits are auctioned.
Price Floors for Emissions Trading
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3.3. An extra fee or tax
Under this option, emitters have to pay an extra fee (or tax) for each unit of emissions,
independently of or in addition to their permit obligations.
We can write the effective carbon price as
MC = p + t
where MC is the marginal cost of abatement (the effective carbon price), p is the
permit price, and t is the extra fee. Firms would be expected to engage in emission
reductions if those reductions cost less than the sum of the permit price and the extra
fee.
There are fundamentally two ways that the price of the extra fee could be set:
a) A fixed fee on emissions. The fixed fee is equal to the floor price:
tfix = pmin.
b) A variable fee on emissions. When the permit price in the market is less than
the price floor, the extra fee is equal to the difference of the permit price and
the floor price; when the permit price is above the floor, the fee is zero. We
can write this as
{
tvariable =
pmin – p
if p < pmin,
0
otherwise;
where tvariable is the extra fee, pmin is the floor price, and p is the permit price.
3.3.1. Fixed fee
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Under the fixed fee approach, the effective carbon price is prevented from falling
below the level of the fee, and is always higher than the price of traded permits. The
approach is similar to what transpires when both a carbon tax and an emissions
trading scheme are in place simultaneously. The fixed fee approach is conceptually
similar to the ‘emission permit rental charge’ proposed by Grafton and Devlin (1996),
where holders of a permit are required to also pay a fee. Grafton and Devlin noted
that this approach has advantages for rent capture in the case that permits are given
out for free.
The fixed fee approach is similar to having a call option to buy a permit at a fixed
price, as described by Unold and Requate (2001). The difference is that what we
describe as a ‘permit’ is described as an ‘option’ by Unold and Requate; and the fixed
fee here is on emissions, while the fixed fee described by Unold and Requate is the
price of what they call a ‘permit’. Under their approach, the carbon price would be
equal to the ‘option’ price plus the ‘permit’ price, so the two approaches are
equivalent when the fixed fee is an integral feature of the permit being surrendered.
In the fixed fee context, it is worth noting that permit trading in any case already
interacts with various taxes and subsidies that discourage or encourage activities that
incur carbon emissions, for example energy taxes or subsidies. In that sense, the
effective carbon price, relative to a hypothetical situation of no taxes and subsidies,
can differ from the permit trading price, and it can differ between countries even if
they have the same nominal carbon price in place (Babiker et. al., 2004).
Several countries that take part in EU emission trading scheme also have a carbon tax,
including Sweden, Finland, and the Netherlands (Baranzini et al., 2000; Stavins,
2003). In September 2009, France announced that it would introduce a carbon tax in
Price Floors for Emissions Trading
16
2010 (Portail du Gouvernment, 2009), but this was postponed indefinitely in March
2010.
3.3.2. Variable fee
The variable fee approach by contrast more closely achieves the effects of a ‘classic’
price floor, as a predetermined minimum price with no effect if market prices are
above the threshold. It would be in operation only if and to the extent that the market
price falls below the threshold level.
A complicating factor is that permit prices fluctuate over time, and consequently the
variable fee may have to change over time or be determined at a chosen point in time.
There are several options for deciding what permit price is used when determining
the extra fee:

One option would be to use the permit price in the market on the date of
permit surrender. But under this option, firms with market power could have
an incentive to influence the market price near the compliance period to
minimize fee payments.

Another option would be to use the permit price that was paid by the firm
when acquiring the permit – this would require that information about permit
purchases is stored, possibly affecting transaction costs.

An alternative is to use the average permit price over the time period in which
emissions are being accounted for (usually a year).
Price Floors for Emissions Trading

17
It would also be possible to charge the fee when the permit is bought from the
government. This would be largely equivalent to having a reserve price at
auction (as discussed above).
The UK government is considering the implementation of the variable fee approach
(Rebuilding Security, 2010)4. The UK takes part in the EU emissions trading scheme,
and a minimum carbon price in the UK would be implemented by charging carbon
emitters an extra fee (known as the ‘reformed Climate Change Levy’) at a level yet to
be determined. Firms would be able to offset the costs of purchasing ETS allowances
against their liability for the Levy. If the EU ETS price is above the level of the Levy
no net charge would be payable; if it is below, the difference would be paid through
the Levy to the Treasury.
4. Further analysis of the extra fee approach
Perhaps the greatest advantage of the fee approach, compared to other methods of
implementing a price floor, is that it can be fully compatible with international
trading of permits. A fee or tax on domestic emissions can be implemented in any one
country without affecting the international tradability of permits. It affects the price
of permits in the international market only indirectly. What the fee will do is lower
emissions independently of the trading scheme, and so reduce the demand for permits
relative to the situation without a fee or tax. In the case of a country that imports
permits from overseas, imposing an emissions fee will result in lower emissions and
therefore fewer permit imports (Figure 1). This will tend to lower the (international)
permit price, but only in line with that country’s share in international permit markets.
4
This is being considered at the time of writing (2010).
Price Floors for Emissions Trading
18
Also, an extra fee does not affect arrangements for banking and borrowing of permits.
In this section we shall discuss in more detail the issues of international permit
trading; budgetary implications; and political economy.
4.1 Interactions with international permit trading
When the carbon price is greater than the floor price, an additional fee/tax
implemented in a purely domestic scheme (with no international permit trading), and
without banking or borrowing, would leave the effective domestic carbon price (the
marginal cost of abatement) unaffected (Figure 1a).
The reason for this is that for a fixed emissions cap to be met within the system, the
required marginal abatement cost remains the same irrespective of the pricing
mechanisms applied. The introduction of a fee simply lowers the permit trading price
by an amount exactly the same as the fee.
By contrast, when there is a fee system in a country that takes part in international
permit trading, the fee directly influences the effective domestic carbon price. The fee
is in addition to the international permit price, which only partly changes in response,
and thereby increases the effective domestic carbon price or marginal cost of
abatement. In the case of a ‘small country’ participating in a large international
permit market, the domestic fee is simply added to an unchanged international permit
price (Figure 1b), so the effective domestic price is increased by the amount of the fee.
Price Floors for Emissions Trading
19
Figure 1. We compare a purely domestic permit market with a large scale international permit
market. The curved dashed line denotes the marginal cost of abatement. With a purely domestic
permit market (a), the government sets a quantity of emissions eD, and an extra fee t. These
quantities determine the carbon price (marginal cost of abatement), MC, and the permit price is
given by pD = MC – t. Thus, the effective domestic carbon price is unaffected. By contrast, with
unrestricted international trading of permits (b), the international permit price pI is determined in
international markets. The domestic carbon price is given by MC = pI + t.
This relates to a broader feature in systems where the overall system-wide emissions
are capped, but distribution of effort between constituent parts (in this case countries)
is not determined, as is the case under emissions trading. Imposing an extra fee will
increase the effort in that country, and commensurately reduce effort elsewhere, if the
global cap is not adjusted. The same is true for ‘supplementary’ measures such as
national renewable energy support policies.
Such divergence in marginal costs between countries is a source of economic
inefficiency. Extra abatement will be undertaken in the country where the extra fee or
tax is in place, at costs above what would be the case in countries where no such
fee/tax is in operation. The magnitude of the distortion depends on the size of the
difference in marginal costs. It also depends on the interplay with other taxes or
Price Floors for Emissions Trading
20
subsidies, which may either exacerbate or run counter to the effect of emissions
prices, and any differential between countries.
Computable general equilibrium models could be used to help assess the likely
magnitude of benefits from price floors that apply only in one or some countries,
compared to the possible efficiency costs from divergences in effective marginal
costs between countries, though it may be difficult to achieve consensus on empirical
modelling results. In any event, the theoretical analysis presents a strong argument in
favour of not just international harmonisation of emissions prices, but also of design
rules of domestic trading schemes.
The situation regarding international tradability would be different if the requirement
to pay a fee was made an integral feature of the emissions permits. This is the case
with the approach discussed by Unold and Requate (2001). If different countries
attach different fee conditions to their permits, then emission permits from different
countries are no longer the same commodity. International trading could still occur,
either with different prices for permits from different countries, or with equal prices
achieved through cross-border arrangements between countries on the charging,
exempting and remitting of fees.
These possible administrative complications present an argument in favour of
separating any additional taxes and fees from the underlying permits, and in favour of
levying such additional payments at the time of acquittal of the permit rather than at
the time of issuing them. In that case, the permits themselves are then perfectly
interchangeable between countries, only the conditions accompanying the liability for
emissions differ between countries. However, we will see in the next section that
making the fee an integral feature of the permit can be used to implement allowance
Price Floors for Emissions Trading
21
reserves. If a policymaker decides to implement an allowance reserve in that way, it
could be desirable to implement a price floor in that way as well.
It could be argued that combining fees with permit trading would increase transaction
costs by an unacceptable amount. However, given that general taxation systems for
emitters already exist, and that permit trading systems are (or are likely to be) in
existence, the extra cost impost is likely to be small. The main transaction costs are
associated with measurement, reporting and verification, which are incurred only
once for both aspects of carbon pricing.
4.2. Budgetary considerations
The budgetary impacts of the fee models are positive or neutral. A fixed fee will yield
a highly predictable revenue stream, while a variable fee will yield revenue in the
event of low permit prices. Under a variable fee model, unpredictable government
revenue from a variable fee poses challenges to fiscal management, however it could
be an attractive feature in times of economic slowdown. If the emissions price falls
because of a recession, as has recently been the case in the EU, then a variable fee
provides additional revenue that could be immediately spent on fiscal stimulus
measures. In other words, the extra money levied on emitters could be returned to
consumers and industry, but without affecting the incentive effect of higher emissions
prices.
More generally, in the aftermath of large fiscal stimulus spending in all countries that
have or are considering emissions trading schemes, implementing emissions charges
in addition to permit trading could become an attractive option to help replenish
public finances, though it would no doubt also be subject to hard political bargaining
Price Floors for Emissions Trading
22
by concentrated lobby groups, as for example Australia’s recent experience in
preparing an ETS has shown (Pezzey et al., 2009; Menezes et al., 2009).
4.3. Political economy
The various options for implementing a floor price have distinct differences in the
likely political economy that may enable or preclude their implementation. We only
sketch some of the issues here.
Reserve prices may have a distinct advantage in terms of their political economy, as
their effect in upholding permit prices is not made strongly explicit in the
marketplace. They also do not impose extra costs on emitters that receive free permits.
For fixed emissions fees, the political economy is much the same as for carbon taxes,
possibly with an added difficulty that emitters are seen to be charged twice, once
through the tax and once through permit liability. A variable fee may generally prove
easier to accept for emitters, as it would only apply in cases where the cost of permit
liability is below the expected cost.
5. Floors, ceilings, and allowance reserves
Some proposals for putting a price on emissions combine both a price floor and a
price ceiling (Fell and Morgenstern, 2009), in what has been termed a ‘price collar’
(McKibbin et al., 2009). An alternative to a price ceiling is an ‘allowance reserve’
Price Floors for Emissions Trading
23
(Murray et al., 2009) in which there are extra ‘reserve’ permits, but the amount of
extra permits is limited.
Under the allowance reserve approach, the ceiling is no longer strict; if all of the extra
permits are used, the carbon price could exceed the ‘ceiling price’. The mechanisms
described in the preceding section for implementing a price floor can also be used for
implementing an allowance reserve. The extra permits could be auctioned with a
reserve price that is higher than the price floor; alternatively, firms could be required
to pay a higher ‘extra fee’ if they use the extra permits to account for their emissions.
Under the latter approach, the requirement to pay a fee would be an integral feature of
the permit issued.
The Waxman-Markey Bill includes an allowance reserve, known as the strategic
reserve. Each year a small amount (1-3%) of permits would be added to the ‘Strategic
Reserve Fund’ 5 . Each quarter, there is a strategic reserve auction, which auctions
these permits at a higher reserve price than the reserve price of the rest of the permits.
Roberts and Spence (1976) show in an appendix that by issuing an arbitrary number
of different kinds of permit, it is possible to approximate any convex damage function
arbitrarily closely (Figure 2). This could further increase the expected net benefits, by
providing a better match between marginal costs and marginal benefits. It would also
further reduce price volatility, and could reduce problems with market power
(Krysiak, 2008). This could be implemented by auctioning different ‘tiers’ of permit
at different reserve prices, or having firms pay different fees when they surrender
different types of permit. The second approach is equivalent to the options approach
5
We are referring here to the version of the Bill that was passed by the U.S. House of Representatives
on June 26, 2009 (H.R. 2454, 2009). The strategic reserve can also be replenished with unsold permits
from auctions, and proceeds from strategic reserve auctions can be used to purchase offsets in order to
replenish the strategic reserve.
Price Floors for Emissions Trading
24
of Unold and Requate (2001). Under the second approach, extra administrative
arrangements would be required for international permit trading, similar to those
mentioned above. The proposed ETS for California would set aside approximately 5
percent of allowances as a reserve, that would be offered at fixed price in three price
tiers: US$40/tonne, US$45/tonne and US$50/tonne. These prices would increase by 5
percent above inflation each year (Hood, 2010).
The effect of a strategic reserve in reducing mitigation cost uncertainty may however
be significantly weaker than under pure price ceilings, as indicated by Philibert’s
(2009) modeling. But it could be possible to simultaneously have an allowance
reserve of a fixed number of permits with a higher extra fee than the ‘normal’ permits,
and an unlimited number (or a very large number) of ‘safety valve’ permits with a
higher extra fee than the allowance reserve permits. When countries make use of
safety valve permits, they should not be net sellers of permits on the international
market (Jotzo and Betz, 2009; Philbert, 2000).
An allowance reserve could facilitate international cooperation to reduce greenhouse
gas emissions. International environmental agreements on issues such as acid rain and
pollution of the North Sea have had weak binding commitments, but also have had
ministerial level non-binding commitments that are significantly stronger (Victor,
2007). An allowance reserve could have the total number of permits based on a
binding commitment, and the number of extra permits based on the difference
between the binding and the non-binding commitment.
Price Floors for Emissions Trading
25
Figure 2. The curved dashed lines represent alternative marginal abatement cost functions. The
marginal abatement cost schedules will be unknown in advance, so two possible curves are shown.
The lower curve corresponds to abatement being cheaper. The solid line illustrates the carbon
price for different policy options. The carbon price and emissions level are determined by the
point where the curves intersect. We illustrate a carbon tax in (a), the carbon price does not
Price Floors for Emissions Trading
26
change for different marginal benefit curves but the amount of emissions changes; for cap-andtrade (b), the carbon price varies but the amount of emissions does not change; for cap-and-trade
with a price floor (c), if the cost of abatement is sufficiently low, the amount of emissions will be
lower than without the price floor; for a price ceiling (d), the upside risk for the carbon price is
reduced but the quantity of emissions may be greater than without a price ceiling; a price collar (e)
combines a price ceiling with a price floor; the price collar can be modified (f) so that the price
ceiling is replaced with an allowance reserve; more general price curves (g), as described in the
appendix to Roberts and Spence (1976), can also be implemented.
Price Floors for Emissions Trading
27
6. Conclusions
Price floors in emissions trading systems can reduce excessive price volatility, and
provide better management of cost uncertainty in the event of lower than expected
abatement costs, which in turn improves predictability of returns and increases
expected returns for low-emissions investments. Price floors are natural complements
to price ceilings, which limit price variability at the opposite end of the scale and
reduce the incentives for low-carbon investments. Downsides include greater
complexity, and the potential to exacerbate inefficiencies in global abatement through
differences in effective emissions prices between countries, if price floors are
implemented unevenly.
Price floors need to be carefully designed to avoid budgetary liabilities, and to avoid
barriers to international trade in permits. The most direct approach of a government
commitment to buy back permits at a threshold price is unlikely to be viable,
especially in the context of international permit trading, because it implies large
contingent budgetary liabilities. An alternative approach of a minimum reserve price
for auctioned permits, as pursued in the Waxman-Markey Bill, RGGI, and as was
earlier considered by the European Union, could yield the desired effect, but only if
the share of auctioning is large.
An alternative, and possibly superior option is to require the separate payment of a
fee or tax on domestic emissions, in addition to cap-and-trade. This approach carries
desirable budgetary implications for national governments, and is fully compatible
with international permit trading. In fact, this is precisely what governments do where
they have a carbon tax of levy in addition to emissions trading.
Price Floors for Emissions Trading
28
The fee or tax could be either fixed or variable, giving different results in permit
markets and for government revenue, and posing different questions for
implementation. A variable fee set equal to the difference between the market price
for permits and the floor price allows the exact implementation of a floor price but
may pose difficulties in defining the market price, and fiscal yields are difficult to
predict. A fixed fee or tax by contrast will deliver predictable revenue streams, but
raises the effective carbon price at any level of the traded permit price, which may not
be desired by governments.
The impact of an additional fee or tax on the effective domestic carbon price and
domestic abatement depends on whether permits are traded internationally or not. In a
purely domestic cap-and-trade scheme without international linkage, they will simply
result in lower permit prices. With international emissions trading, they will result in
a higher effective domestic permit price and more abatement in the country in
question. The extra fee approach can also be used to implement allowance reserves,
as well as more complex hybrid mechanisms.
All in all, price floors could fulfil an important supporting role in ensuring effective
and efficient climate change mitigation, they can be implemented without
compromising vital aspects of emissions trading, and their budgetary properties might
be attractive to governments. A final consideration relates to the political economy of
carbon pricing. Recent failures and delays to legislate emissions trading in the United
States and Australia can in part be traced to the influence of lobbying by highemitting industries and fears about the risk of high economic cost of climate change
mitigation. While price ceilings can help address these concerns, price floors address
the converse risk of lower than expected mitigation effort, and should thus find the
support of industries that own low-emitting technologies and be able to alleviate
Price Floors for Emissions Trading
29
concerns by environmental lobbies. These lobbies have however been shown to be
generally much less influential in policy formulation, and hence price floors may still
have a rocky road ahead before implementation.
Acknowledgements
We thank Warwick McKibbin, Jack Pezzey, Salim Mazouz, Erwin Jackson and Peter
Heindl for helpful comments on earlier versions. Anonymous referees provided very
helpful comments. This research was partially funded by the Australian Government
Department of the Environment, Water, Heritage and the Arts through the
Environmental Economics Research Hub.
Price Floors for Emissions Trading
30
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