Internal Carbon Financing with Transferable Offsets from Renewable Portfolio Standard.

AuthorYu, Jongmin
  1. INTRODUCTION

    At the 21th annual session of Conference of the Parties to the United Nations Framework Convention on Climate Change, countries initiated a new phase of international climate change regime for the post-2020 era called Paris Agreement by replacing the Kyoto Protocol. Many countries are running the market-based incentive mechanism such as Emission Trading Scheme (ETS) to control greenhouse gas (GHG) emissions and Renewable Portfolio Standard (RPS) to boost power generation using renewable energy sources rather than depending fossil fuels. They have different policy objectives but can reduce GHG emissions by using renewables as the primary abatement option to reduce GHG; therefore, ETS and RPS interact and influence one another. Policy makers have also operated ETS and RPS jointly: e.g. NOx budget trading program in U.S. has been operating a set-aside program to allocate quotas when generating electricity using renewable energy; California Air Resource allows to use offsets up to 8% (4% after 2021) to meet its obligation target (Latham. and Watkins, 2011); each member of EU-ETS has different offset limits although the market is integrated (about 13% in average); the Chinese-ETS has separated municipal schemes with 5% in Beijing, 8% in Chongqing, 10% in Gunagdong, 5% in Shanghai, 10% in Shenzhen, 10% in Tianjin; Korean-ETS allows 10% of total compliances. (1) The US Clean Power Plan has a carbon-intensive target, not total emissions: power plants must meet a certain threshold requirement on the ratios between GHG emissions and electricity output (MWh). Electricity generators using renewables can sell emission reduction credits which can be used at lower rates (lbs / MWh) than those of other emission plants. The UK has allowed the conversion of renewable power generation exceeding requirements of the RPS into ETS carbon credits. The value of REC (Renewable Energy Credits: generated from the renewable energy producers can be sold and traded under the compliance system of the RPS) can be converted into carbon reduction, allowing the UK-ETS to sell it as carbon credits but this system has been suspended due to integration with EU-ETS since 2005.

    Much academic research has been conducted on the links between multiple ETSs or RPSs implemented in different types or regulatory boundaries. (Rausch and Karplus, 2014; Curtis et al, 2014; Perez et al, 2016; Yu and Mallory, 2017). Amundsen and Mortensen (2001) show the price of REC the profit of renewable energy providers is affected by the targeted share of renewables, the GHG emissions cap, and uncertainty related to renewable investments. Once EU-ETS was implemented, a number of empirical studies on emissions trading and related policy instruments that discuss issues such as interaction between ETS and RPS have been published. (Fischer and Preonas, 2010; Gawel et al., 2013; Johnstone, 2003; Gonzalez, 2007; Sorrell and Sijm, 2003; Tsao et al., 2011). Tsao et al. (2011) show that economic incentives appear to be less effective in the California electricity market when the ETS and RPS are assumed to be linked highlighting the role of energy mix. Chen and Wang (2013) investigate the interactions among ETS, green pricing program, and RPS in the U.S. on how double counting and bundling affect each individual market prices or social surplus. Bird et al. (2013) illustrate simulations on dynamics of electricity prices in the presence of carbon market and REC market. Fais et al. (2014) analyse the REC market as being heavily dependent on FIT since the carbon price of EU-ETS collapsed. Thurber et al. (2015) note that markets are vulnerable to the strategic behaviour of market participants when market-based mechanisms with multiple goals interact.

    In this paper departing from previous studies, we construct an analytical model stylizing the features of the ETS and RPS mechanisms reflecting institutional conditions and realities. By deriving the closed-form solution, we explicitly demonstrate indirect market linkages and show how price equilibriums respond to policy changes of their own or of the other market to answer the following research question: how do the two markets interact differently when RPS and ETS are implicitly linked through the offset program as opposed to the case where both markets are not linked at all? This question starts from the fact that not all the amount of emission reductions by the capped sector achieved cannot be claimed as offsets; whereas, power generations from renewables outside of the capped sector are allowed to be claimed as offsets. In the long run, facilities using renewables can replace fossil fuels and consequently reduce emissions by rendering them obsolete; however, huge sunken costs make it difficult for power plants to replace existing facilities. Instead, they attach only a reduction device to the chimneys or convert fuel only from coal to natural gas, which disincentives to increase using renewables in response to ETS at least in the short term. Apart from existing carbon emissions facilities, outside the capped facilities have stronger incentives to increase renewables to comply with RPS. This is because GHG reductions with renewables outside the organizational boundaries can be claimed as "offsets" as the companies' voluntary reductions. If renewable energy is generated within the organizational boundaries, the power generation itself does not play a role in reducing the amount of existing emissions and, therefore, cannot be claimed as offsets: i.e., an individual firm can earn better profits by claiming offsets after pulling factories out of the regulated capped facility. Or, companies can choose this option only when the value of the offset is higher than the value of REC. The institutional background of this limited renewable offset usage for either ETS or RPS is as follows: most offset programs including Clean Development Mechanism (CDM) need "Legal and Regulatory Additionality" as a requirement for offset certification and a project can be considered as additional only if the project is not previously implemented under any official policies or regulations. Since ETS is the working regulation to reduce emissions and the purpose of the offset project should not be a means of compliance with existing regulations, only some projects could be considered as voluntary rather than policy enforcement satisfying the legitimate additionally requirement.

    We find the policy instruments have distinct effects depending on the linkage between RPS and ETS markets. First, we show relatively different policy impacts when the both markets are indirectly linked by renewable offsets and find a policy directly affects its own market with larger price changes but has an indirect effect on the other market with smaller price changes. Second, we calibrate the case when renewables are not transferrable.

    Our main contribution to the existing literature by constructing analytical partial equilibrium model is that we could describe the market dynamics in renewable certificates and carbon credits when policy makers use various tools affecting demand/supply in each market. They can compare price trajectories when the renewable conduit is open or closed between the two markets, and to estimate simultaneous policy effectiveness for both markets.

    The paper proceeds as follows: in section 2, a theoretical background of ETS with RPS is provided with a classic supply-demand analysis and the analytic models of representative parties in both markets are formulated; in section 3, the model is calibrated with parameters of typical ETS and RPS market systems and derives policy implications about the market linkage; and the study's conclusions are presented in the final section.

  2. PARTIAL EQUILIBRIUM MODELING

    2.1 Theoretical Background

    Previous empirical studies indicate that an enforcement of either RPS or ETS would lower the price of the other market. For instance, strong regulation of RPS accelerates penetration of renewables in electricity generation and ultimately lowers carbon price. Likewise, the impact of a strong emissions reduction target sends a strong price signal to the power market encouraging private investments in renewable energy; hence the increased supply of RECs results in falling prices. This general result is described using a classic supply-demand analysis in this section.

    Figure 1 illustrates prices adjustment between the ETS and the REC market. In Panel A, when the price of carbon increases from P0 to P1 caused by a shrinking cap in the ETS market, regulated firms should consider additional abatement instruments, including renewable projects, to reduce GHGs. This step shifts the supply in REC market such that the price of REC decreases from P0 to P1. Panel B explains the effect of RPS enforcement on the price movement in the ETS market. When the price of the REC moves from P0 to P1 according to the rule changes in mandatory renewable energy obligations under RPS, carbon prices fall from P0 to P1 due to supply surplus of offset credits in the emissions trading scheme. The theoretical results from Figure 1 coincide with the implications of the empirical analysis of Tsao et al. (2011).

    However, even if entities generate REC by achieving zero-GHG emissions, most of countries with ETS do not allow to use RECs to claim carbon credit because of a mismatch between policy objectives and the additionality issue. Therefore, carbon offsets originating from renewable projects can either be claimed as REC or as an offset credit to be used for compliance of ETS. This implies that double counting of renewable offsets for the compliance of both ETS and RPS is not allowed. Therefore, if renewables are used for one regulatory scheme, the other has fewer renewable outcomes available for compliance. Hence, it is intuitive that the strong regulatory enforcement of RPS (ETS) leads to...

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