Carbon Floor Pricing: Can Discourse Improve Carbon Markets?
Photo by Patrick Hendry
story highlights

Market-based Emissions Trading Schemes (ETS) face several risks that can compromise their effectiveness, including a market price that is too low to act as an incentive for emissions reductions.

Several EU members are considering implementing carbon pricing floors (CPFs) to address this risk.

The proposal has triggered a debate on whether such minimum prices are desirable and how they can best be implemented.

3 July 2018: Economists have characterized the carbon market as a mechanism that coordinates “promises of non-delivery of an invisible resource to no one,” noting that creating effective markets is challenged by numerous risks of market failure. Even non-economists can gather from this statement that creating an efficient market-based mechanism to determine a price on carbon is no easy task. While many emissions trading schemes (ETS) that have been implemented around the world over the last decade are proof that market-based pricing mechanisms can work, they have also revealed that concerns about their effectiveness in providing a long-term incentive to invest in climate mitigation were well founded.

One such concern is that an ETS may result in a price that is too low or too volatile to act as a meaningful incentive. The EU ETS has often been cited as an example of this problem with critics noting that the average price that resulted in past years is not meaningful to nudge large emitters into accelerated mitigation action. This policy brief reviews a recent debate on a tool to establish minimum prices on carbon emissions that emerged around proposals to improve the effectiveness of the EU ETS.

Is a Minimum Price on Carbon Desirable?

To address concerns around the effectiveness of the EU ETS, some EU Member States are considering introducing additional measures, such as an EU-wide or national carbon pricing floors (CPFs) that would guarantee a minimum price on carbon emissions for all market participants.

Germany and France for example agreed, in a Joint Declaration on further cooperation in Europe, to develop an ‘EU Strategy 2050’ for the long-term transformation towards carbon neutrality. The countries propose a high-level ministerial working group on climate change to build a common view on the energy transition as well as tools for triggering sustainable finance and economic incentives, including carbon pricing issues. [German Government Press Release: Meseberg Declaration – Renewing Europe’s promises of security and prosperity]

CPFs that apply to an entire ETS have been implemented using various mechanisms, including:

  • an auction reserve price that creates a minimum price below which a government withholds a number of allowances from sale;
  • a top-up payment or carbon price that is designed either as a tax that makes up the difference between the CPF level and the ETS allowance price or as a fixed price which is added to it;
  • or a system of permit buybacks, where the market operator commits to buying back permits at the floor price.

A key question for regional markets, such as the EU ETS, is whether national and regional prices can coexist. Under a national carbon floor pricing mechanism, a country would be allowed to set a minimum price for emissions that may or may not be higher than the supra-national ETS market price. Several institutions have recently published opposing views on this question.

Yes, if the Conditions are Right.

A study by the Cambridge Energy Research Group entitled “When is carbon pricing desirable?” supports the introduction of an EU-wide power sector CPF. The paper recommends that such a CPF be designed as a carbon levy to “top up” the European Emission Allowances (EUA) price to €25–30/tCO2, rising at 3–5% annually above the rate of inflation, at least until 2030.

The authors argue that this approach would not only address the risk of a “too low” carbon price, but also provide longer-term prices and bring forward low-carbon investment by guaranteeing a minimum return to emissions reductions. They further suggest the delivery of climate benefits through a CPF would be enhanced by the new market stability reserve (MSR) of the EU ETS. The MSR, which will begin to operate in January 2019, will withhold from the market 24% of the calculated EUA oversupply each year from 2019-2023, and 12% of the surplus each year thereafter. From 2023, if the MSR volume exceeds the EUA volume auctioned in the previous year, this excess will be ‘invalidated’ or removed from the MSR. This cancellation mechanism is expected to remove a substantial number of EUAs.

The research group also recognizes that national CPFs are easier to implement than an EU-wide CPF, but notes they pose the risk of intra-EU trade distortions. In addition, a national CPF may need to be accompanied by an emissions performance standard to enhance durability. [Cambridge Energy Policy Research Group Paper “When is carbon pricing desirable?”]

No, because it Increases Costs and Risks of Carbon Leakage

Taking a contrasting view, the International Emissions Trading Association (IETA) called on EU Member States to refrain from introducing national CPFs or taxes. Focusing on several industry sectors in addition to the power sector, IETA cautions such measures would lead to competitive distortions, negatively impact industrial low carbon investment strategies and reduce the EU ETS’s efficiency. The authors emphasize the risk of carbon leakage from the country imposing the national mechanism and the risk of creating a barrier to linking with ETS in other jurisdictions. They suggest instead of introducing additional taxes, Member States should assess the potential to extend coverage of the EU ETS to additional sectors and gases.

If Member States do decide to introduce additional carbon price measures, IETA recommends such measures be temporary, arguing that the system absorbs accumulated surplus through the MSR. They advise member states: ensure a high degree of coordination to minimize market distortions and fragmentation; transparently quantify their impact in terms of emission reductions within the scope of the EU ETS; and voluntarily cancel an adequate amount of allowances from their auction volumes in order to mitigate the impact of the measure on the functioning of the EU ETS. [IETA Position Paper]

Healthy Discourse Contributes to Improvements of Carbon Markets

These diverging positions on CPFs show that fixing the shortcomings of current carbon market mechanisms won’t be easy. On the other hand, the debate is also proof that both sides share an interest in improving the effectiveness of the EU ETS. In medicine, treatments are reviewed for improvements, and where such are not observed other treatments, including in combination, are tried aiming at increasing effectiveness and success. In a similar way, policy debates around measures to address climate change often reveal diverging views and heterogeneous preferences of experts and governments. While coming to an agreement may take some time, the commitment to a healthy, evidence-based debate is an encouraging sign that carbon mechanisms are maturing into an effective tool that will ultimately overcome the barriers predicted by economists.

related posts