The Political Economy of a Carbon Price Floor for Power Generation.

• Author: Newbery, David M.
• Position: Report

1. INTRODUCTION AND POLICY CONTEXT

   Stern (2007) argued that greenhouse gas (GHG) emissions give rise to "the greatest market failure the world has ever seen". Following the 2015 Paris Agreement, countries around the world have announced indicative plans towards meeting the goal of net-zero emissions by the second half of the century. The European Union (EU) has a 40% reduction target for 2030 (relative to 1990 level) and its "Energy Roadmap 2050" aims to reduce carbon emissions by 80-95% by 2050, with the electricity sector decarbonizing earlier and more strongly than other sectors. The pricing of carbon emissions is a key economic instrument to address the market failure associated with the external effects of climate damages. (1) An increasing number of jurisdictions are implementing carbon pricing as a cornerstone of climate policy at national and sub-national levels (World Bank, 2017).

   The EU has taken global leadership in carbon pricing, beginning in 2005 with the introduction of its Emissions Trading Scheme (ETS). The EU ETS has, however, so far failed to deliver the carbon price signal widely seen as necessary to incentivize the low-carbon transition. Its carbon price has mostly fluctuated within a band of [euro]5-10/tC[O.sub.2] since the early 2010s, well below estimates both of the social cost of carbon (SCC) and of "target-consistent" carbon prices. (2) Moreover, as there is virtually no forward-trading liquidity beyond a three-year horizon, longer-run carbon prices remain a "missing futures market" (Newbery, 2016). Reforms to the EU ETS have been complicated by its political economy, notably of achieving unanimity across EU Member States for measures "primarily of a fiscal nature" (as described in Article 192 of the Lisbon Treaty (EU, 2007)). The new Market Stability Reserve (MSR), due to begin operation in 2019, increases complexity and may still not ensure a sufficiently strong and durable carbon price signal. (3) In short, policy failure sits alongside market failure.

   Against this backdrop, the idea of a carbon price floor (CPF) is gaining prominence in the policy debate. Since April 2013, electricity generation in Great Britain (GB) has been subject to a CPF "to support and provide certainty for low-carbon investment" (House of Commons, 2018). It is structured as a "top up" to the EU ETS, with a Carbon Price Support for 2018-19 of [pounds sterling]18/tC[O.sub.2] (roughly [euro]20/tC[O.sub.2]). In October 2017, the new Dutch government announced a similar plan to introduce a national CPF. By contrast, President Macron of France has recently advocated an EU-wide CPF. (4) This policy debate sits alongside the proximate objective of closing (unabated) coal-fired power generation, which has emerged in several European countries, as well as the promotion of renewable energy technologies.

   This paper analyzes the desirability of both national and EU-wide CPFs. Given its central role for early decarbonization, we focus on the electricity sector; in doing so, we sidestep many issues of international competitiveness that arise for industries with significant non-EU trade. We take a political-economy approach that incorporates both market failures and policy failures. While our focus is on Europe, our analysis also offers insights for other jurisdictions seeking to implement well-functioning markets to deliver on climate targets.

   Our main arguments are as follows. First, there is a good economic case for the introduction of a price-based element into the quantity-led EU ETS, thus making it a "hybrid" instrument. A CPF is an attractive practical way to introduce such a hybrid instrument--which can be more efficient than a pure ETS or a carbon tax alone. (5) Second, an EU-wide CPF can help fill the "missing market" gap of longer-term carbon prices and bring forward low-carbon investment by guaranteeing a minimum return to emissions reductions. This makes CPF a "low regret" policy: it directly addresses the risk of a "too low" carbon price in the absence of stronger EU ETS reform--and it can reassure investors whether or not other reforms gain pace. Third, a well-designed national CPF can play a similar role but comes with greater intra-EU trade distortions. Member States seeking to stake out climate leadership by adopting stringent domestic emissions targets may nonetheless find a national CPF attractive because it is easier to implement than an EU CPF. To enhance its durability, such a national CPF may need to be accompanied by an emissions performance standard (EPS). We also discuss the potential for a policy dynamic leading to a regional CPF beginning in North-West Europe.

   We suggest that a power sector CPF should be designed as a carbon levy to "top up" the EUA price to [euro]25-30/tC[O.sub.2], rising at 3-5% annually above the rate of inflation, at least until 2030. This would yield significant coal-to-gas switching, with immediate C[O.sub.2] reductions, and is more practical than relying on contested estimates of the SCC. (6) We also argue that the new MSR, which is expected to begin cancelling surplus EUAs from 2023, enhances the medium-term value of such a CPF in delivering climate benefits. The reason is that the MSR mitigates the "waterbed effect" whereby unilateral action by an individual EU ETS country (or sector) reduces domestic emissions but not EU-wide emissions--as these are fixed by the overall ETS cap.

   This paper contributes to the academic literature in four principal ways. First, we discuss the rationale for and design of a carbon price floor in a world characterized by multiple market failures; by contrast, most prior research focuses solely on the narrow case of a single market failure--the climate externality. Second, and related, we combine standard economics with the underlying political economy of carbon pricing, including the possibility of policy failure (notably in the design of the EU ETS). Third, we update earlier literature in light of recent policy developments; most academic contributions on CPFs date back to the early 2010s or before. (7) Fourth, we focus specifically on the power sector.

   Finally, we must acknowledge that our analysis is based on simplifying assumptions. We analyze a CPF as a "sub-global" climate policy carried out by the EU (or parts of it), without addressing wider global coordination with jurisdictions outside the EU. Thereby we implicitly work on the premise that significant (unilateral) climate action by the EU is itself desirable, given that this is in line with stated European climate-policy commitments.

   The paper is structured as follows. Section 2 gives background on recent developments in EU ETS reform, Section 3 discusses the British CPF, and Section 4 summarizes international experience with CPFs (and price ceilings). Section 5 presents the case for a "hybrid" ETS design. Section 6 and 7 contain our political-economy analysis, respectively, of an EU and national CPF. Section 8 concludes with policy recommendations.

2. THE EU EMISSIONS TRADING SCHEME: BACKGROUND, CHALLENGES AND REFORM

   During the 1980s and 1990s, the EU failed to establish any European-wide energy or climate taxes, with several initiatives failing to secure the unanimity across EU Member States required for measures "primarily of a fiscal nature" (Article 192 of the Lisbon Treaty (EU, 2007)). Although there is still disagreement on what "primarily of a fiscal nature" means (Weishaar, 2018), the EU resorted to a non-fiscal measure in form of the EU ETS, as laid out in a green paper in 2000 which became the ETS Directive (Directive 2003/87/EC). The EU ETS now affects some 13,500 stationary sources in the power sector (for installations above 20 MW) and major energy-intensive industrial sectors, encompassing some 2 [GtCO.sub.2] annually from EU Member States as well as Norway, Iceland and Liechtenstein (Ellerman et al., 2016).

   The EU ETS began with a pilot Phase 1 from 2005-7 during which all emissions allowances were freely allocated to regulated firms. Phase 2 (2008-12, spanning the Kyoto Protocol compliance period) introduced auctioning of up to 10% of allowances as well as a tightened overall emissions cap. The current EU ETS Phase 3 (2013-20) then saw expansion to include domestic EU air travel and some additional energy-intensive sectors.

   The run-up to Phase 4 (2021-30) has seen active efforts at EU ETS reform, driven by the low price of allowances (EUAs) which had mostly fluctuated within a band of [euro]5-10/tC[O.sub.2] since the early 2010s. (8) A major focus of these reforms has been the accumulated EUA surplus, which rose steadily from 2009 as EUAs continued to be overallocated even as emissions were falling (Convery and Redmond, 2013). The EUA surplus stood at 2 billion after Phase 2, rose to 2.1 billion in 2013 before falling slightly to 1.7 billion by late 2016. However, securing even qualified majority agreement of 28 countries to change the ETS that, via its low carbon price, benefits the coal-intensive electricity systems of some EU countries (relative to a world with a high carbon price) has proven challenging.

   The European Council set out principles for ETS reform in October 2014, followed by the European Commission offering a proposed Directive in July 2015. The European Parliament and Council laid out their positions in February 2017, leading to six rounds of trilogue. The main debates have been over the rate at which the emissions cap will be reduced (the linear reduction factor), the number of allowances set aside in a Market Stability Reserve (MSR), a new mechanism to 'limit the validity of allowances in the MSR' from 2023 onward, and the need for regular review (European Council, 2017). Agreement was reached between the Council and Parliament in November 2017 and ratified by the Parliament in January 2018. The new EU ETS Directive (Directive (EU) 2018/410) entered into force on 8 April 2018. Since then, the EUA price has risen from around...