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Banking of surplus emissions allowances – does the volume matter?

March 8th, 2012 by Karsten Neuhoff, DIW, Berlin

The volume of unused allowances in the European emission trading scheme (EU ETS) will likely rise to 2.7 billion tonnes by 2013/2014. Nevertheless – the carbon price has remained for many years near 15 €/t because market participants bank unused allowances for future use. At the end of 2011 the carbon price declined to 7 €/t. This is often interpreted attributed to lower expectations about future scarcity in the EU ETS. We offer an additional interpretation.

The carbon price dropped because the volume of unused allowances increased beyond the need of market participants to hedge their carbon costs for future power and industrial production. Therefore additional investors are needed to bank allowances on speculative basis. They require high returns for such speculative investments and can only secure such returns, if the allowances prices are highly discounted relative to expected future prices. Thus the carbon price dropped until it reflected such a high discount.

Whether the drop in carbon prices reflects changing expectations about future carbon prices, or reflects higher discounts applied to these expectation matters for public and private decision makers. Carbon allowances are only actively traded for a couple of years, thus the associated carbon prices inform the strategy and investment choices of companies and also are used as reference price for public policy decisions. If future carbon prices are highly discounted, but decision makers do not consider this discount applied, then the accompanying efforts to decarbonize through low-carbon investment might be insufficient and inefficient.

In order to test our hypothesis, we pursued semi-structured interviews with power, industry and finance sector actors between November 2011 and January 2012.

We found that the power sector banks allowances to hedge carbon costs of future power sales, typically selling power one to four years ahead of production and securing costs for fuels and carbon at the same time. We estimate for 2012 that the power sector has the flexibility to bank between 0.5 to 1.8 billion emission allowances.

It was frequently reported that financial investors, in principle, would be prepared to pursue speculative investments in carbon if rates of return exceed 10 or 15%. This is consistent with evidence we find from other commodity markets in which similar rates of return are required by speculative investors.

Across all sectors, interview partners made a clear distinction between banking of allowances for hedging purposes and as speculative investment. This implies that once the hedging needs for allowances are exhausted, the rates of return required and therefore the discounting of future carbon prices increase from 5% to levels exceeding 10-15%. This step change of discounting of future carbon prices has not been previously identified.

Thus, we answer the question “Does the volume of surplus allowances matter?” It matters for discounting of future carbon prices. According to our quantification, the increasing supply of allowances exceeded the hedging demand by 2011, and could explain the drop in the carbon price at the end of 2011 (see Figure above). However, within the uncertainties of our analysis, it would also be possible that the hedging demand is only exceeded during 2012 and that the drop in carbon prices during 2011 reflects lower expectations about future carbon prices.

Irrespective of the precise time when the high discounting starts, in the next few years a high discounting will be applied by actors to future carbon prices. Over the longer-term, other investors might be attracted to investment in allowances beyond hedging needs at lower discount rates. This has two policy implications:

• The scale of policy interventions to reduce the surplus of allowances can be informed by the analytic framework provided in our paper. According to our calculations, the proposed 1.4 billion set-aside of allowances (Environment Committee of the European Parliament 2011) would reduce the volume of unused allowances such that it can be met by hedging needs and allow for banking at low discount rates. Given uncertainties in emission trajectories and evolving hedging needs, a smaller set-aside increases the risk of reverting to a situation where speculative investments are required to meet the volume of unused allowances.

• A set-aside on its own only reduces the discounting applied to future carbon prices. Therefore, the set-aside needs to be combined with a process to review, and if necessary, strengthen emission targets post 2020. In this process, a clear strategy for the future use of allowances retained from the market under the set aside needs to be formulated. Furthermore, the recent experience with quickly changing emission patterns raise concerns how to appropriately design emission trading schemes to cope with such uncertainties. A reserve price for allowance auctions in Phase IV (from 2020) could avoid the future risk of very low carbon prices.

Karsten Neuhoff and Anne Schopp, DIW Berlin

P.S. Read further details of the analysis in Banking of Surplus Emissions Allowances – Does the Volume Matter?”, DIW Discussion Paper 1196 (http://www.diw.de/documents/publikationen/73/diw

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One Response to “Banking of surplus emissions allowances – does the volume matter?”

  1. Steven Stoft Says:

    This is likely right, but it’s missing the forest for the trees, or perhaps for the twigs.
    Global warming is a global problem, and cooperating to solve it is a global game.

    That game is a multi-player prisoner’s dilemma, which, on repeated play, produces less cooperative outcomes than the standard two-player version, which is know for its uncooperative outcomes.
    The global cap-trade game simply formalizes the climate-change problem and reveals its uncooperative nature more plainly, which helps players free-ride more efficiently, in the very ways we have observed.

    “Global Climate Games: How Pricing and a Green Fund Foster Cooperation” reports on the considerable progress that has been made analyzing the international cap-trade game. These results are up to ten years old, and explain the failure at Copenhagen. Those who understood, were not disappointed in Copenhagen; they knew the outcome years in advance. The article proposes a different game, one that also achieves the efficiency of a uniform carbon price, but it is designed to induce cooperation instead of free-riding.

    http://www.iaee.org/en/publications/eeeparticle.aspx?id=25

    Cooperating in an extremely long-term, global, public goods game, is the challenge. Until that is understood and becomes the focus of research, design and diplomacy, little progress will be made.

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