How to Fix Climate Policy and

Why It Would Help Electricity Markets

EEM 13, 30 May 2013Conference on the European Energy Market

Peter Cramton, Axel Ockenfels, Steven Stoft

For details see: priceCarbon.info

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Carbon Pricing Is the Key

1. A uniform carbon price is efficient. So, It can fix the waste in renewable electricity.

2. A uniform carbon price is a focal point of global agreement. So,

It can fix global abatement policy.

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ELECTRICITY AND CARBON

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Electricity and Carbon

• We work hard to make fossil electricity efficient:

We use the cheapest MWh available. We set one price with no subsidies.

• But the cost of CO2 has been omitted. So, We should include emission costs, and Set one carbon price with no

subsidies.

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Actual Carbon Policy

• Uses a low and unpredictable carbon price.• Mostly, we subsidize renewable MW-hours

• But such subsidies are wasteful because:1. A renewable MWh ≠ X tons of CO2 abatement.2. Renewable subsidies do not help Gas vs. Coal.3. Favoritism has become rampant (e.g. solar is

preferred to biomass).4. Under a cap, subsidies don’t reduce emissions.

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Subsidies Harm the Climate• 2006 – 2010 cost of carbon abatement =

$692/ton on 17 GW of German solar.—MIT, CEEPR WP 2013-005

• Under the EU ETS cap, those 17 GW do not reduce CO2 emissions at all (emissions = cap).

• Solar subsidies could buy actual abatement of perhaps 10 times the fictitious solar abatement.

• "Dear Daniel, sorry, but the Renewable Energy Law [EEG] won't do anything for the climate anyway.“ —internal Green Party email, 2008

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How should carbon pricing work?

• A feed-in subsidy is meant to Reduce Risk.– That’s good.

• The point of cap-and-trade is to shift risk from climate policy onto business. (That’s bad for investment)

• The electricity market needs– A low-risk carbon price– Not a feed-in subsidy– Not a high-risk, market-based tax (EU ETS)

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What should we do?

We could …• Stabilize the ETS price• But, at what level? We need a stable global carbon price, P*

• Then we could use P*1. as a benchmark for stabilizing the ETS price.

Or 2. to set a tax rate for CO2 emissions from generation.

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How pricing electricity-carbon works

• P* raises the cost of fossil fuel.• This raises the price of electricity• That subsidizes renewables — efficiently.• The revenues could – pay for the grid, or– be refunded per-capita– or per-household.– refunded on a per-MWh basis

(but this blocks the demand-side signal)

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What would we gain?

• More efficiency (cost savings) than the EU’s “third package” can deliver.

• Greatly increased carbon abatement because the ETS price would not collapse.

• Increased long-run public acceptance of climate policy.

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CLIMATE AND CARBON

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The Global Carbon Pricing Project

• We are proposing a Global Carbon Price Commitment.

• The Statement about this can be found at:priceCarbon.info

• Also an explanatory note byCramton, Ockenfels and Stoft.

• Policy experiments are underway at:Cologne Laboratory of Economic

Research

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Statement on a Global Carbon-Price Commitment(Abbreviated version)

We propose that countries commit to a common global carbon-price path. This will …

• Accommodate each country’s combination of cap-and-trade, fossil-fuel taxes, and use of carbon-pricing revenues.

• Reward poor, low-emission countries for their compliance.

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To Fix Global Climate Policy

Just understand two points:

1. A common commitment is required to modify self interests.

2. Only price can serve as a basis for a common commitment.

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WHY A COMMON COMMITMENT?Climate

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A Problem of the Commons• Emissions affect everyone because the

atmosphere is a shared commons.• So, if a small country abates emissions, it will

get only a small fraction (say 3%) of the benefit.• Without a treaty it will abate too little (unless

it’s very altruistic).

• This is the problem of the (atmospheric) commons.

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There are two “Possible” Solutions

1. Countries could act with great altruism2. We could change their self interest

• Some countries act somewhat altruistically.• That’s helpful.• Most act mainly out of self interest.• Consider the history of the 20th century.• Why bet on altruism? There’s an alternative.

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Climate Is a “Public Goods” Problem

• A problem of the commons is just a public goods problem.

• The public good is “emissions abatement.”

• There are many public goods problems:– Highways ― Parks– Toxic cleanup ― National defense

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Solution: Vote for a Common Commitment

• For a national public goods problems: Vote• We don’t ask for voluntary contributions at the

gas pump to build highways.• We vote for a gas tax—a common commitment• Why?• If you contribute voluntarily, you act alone.• When you vote for a tax,

If you must contribute, then everyone must.

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What Changes Your Self Interest?

• Being able to vote for a common commitment changes your self interest.

• Because people are willing to help others if others help them.

• A common commitment says “I will if you will,”not, “I will even if you won’t.”

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This Is Not a Minor Point• If climate were not a problem of the commons,

each country would control its own climate.• The US and China could not harm other nations.• Each would be highly motivated to save itself.

• Free riding on the global commons is the essence of the climate problem.

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The Only Solution Is a Common Commitment

• Voluntary contributions won’t work.– That’s what we do with no treaty at all.– They depend on altruism.– Countries are less altruistic than people.

• Changing national self interest is the only path to success.

• That requires a common commitment.

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USE PRICE (NOT QUANTITY)FOR A COMMON COMMITMENT

Climate 2B

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Why Use “Price” not “Quantity”? (for a Common Commitment)

Roadmap:1. What is a price commitment?2. Why not use a common quantity

commitment?3. Why a common Price is easy.4. How to make it strong.

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1. What Is a “Price Commitment”?

• Pricing = Cap-&-Trade OR Fossil-fuel taxes• Or a combination (or a few other possibilities).

• It’s really a revenue commitment.– Suppose the global price = $30/tonne.– And a country emits 1 Gt /year.– Then it must collect $30 billion/year in carbon

revenue with caps or taxes.– What is cap-&-trade revenue?

The value of retired permits.

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2. Why Not Use a Common Quantity?

• It just doesn’t work.• Kyoto tried to find a formula for two years

(1995-’97). They gave up.• Stiglitz shows it is much harder globally.• Official US policy: “it is hard to imagine.” • The US & EU favor individual pledges.• Almost everyone agrees: It’s impossible.

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3. Why a common Price is easy?

• Because “Cappers” and “Taxers” agree.• A key purpose of cap-and-trade is a uniform

global price, because it’s efficient.• A key goal of a global carbon tax is the same.• Almost everyone agrees: the right formula is:

PCountry = PGlobal

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4. A Strong Price Commitment

• Using “price” instead of “quantity” reduces three barriers to a strong commitment:1. Quantity risk (being tested in the lab)2. The capping bias3. The lack of a standard for quantity-fairness

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What’s Quantity Risk?

• Imagine two parallel worlds:– Cap and Trade & Carbon Tax

• In both worlds:– Country X will emit 1Gt/year more CO2 in 10 years

than expected at the time of commitment.• Under a carbon tax, X taxes 1Gt more carbon

but keeps the tax revenues.• Under cap-and-trade, X pays “taxes” on 1Gt

more to other countries (to buy permits).

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The Capping Bias

• Suppose India caps its emissions 10 years from now at 1% less than business as usual.

• That cap will be lower on a per-capita basis than US emissions in 1900.

• Indians will ask “why should the US be allowed to emit more just because they emitted more in the past?”

• There no bias with a common price.

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Fairness: Quantity versus Price

• There is no fairness standard for quantity commitments, hence the disagreements.

• But a price commitment provides a fairness focal point:

Choose the fairness standard to maximize global abatement.

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Just an Example

• The following mechanism is just one example of how to choose a fairness standard to maximize the global carbon price, P*.

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How to Agree on Fairness

• “Differentiated responsibilities” are addressed by the Green Fund.

• Rich, high-emission countries pay• Poor, low-emission countries are paid

• Payment into Green Fund = G × XE × P*• G = Generosity parameter• XE = eXcess Emissions (above global per-capita avg.)• P* = global carbon price

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The G – P* Linkage

• If G is very high, rich countries will want P* low to reduce Green-Fund payments: G × XE × P*

• If G is very low poor countries will want P* low to reduce the burden of a P* carbon tax.

• Some moderate G will maximize the P* that (for example) the US and India will both accept.

• Choose G to maximize the P* accepted by the right-size coalition.

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Who will set G?

1. Countries with emissions near the global average will pay little and receive little from the Green Fund.

2. They will want a G that maximizes global cooperation on climate policy.

3. Their median choice will be a good estimate of the G that maximizes P*.

4. This G must treat rich and poor countries fairly.

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Why everyone is safe and can agree

• If a “bad” G is chosen, any country that dislikes it can protect itself by naming a low Pi.

• No country commits to a P* > their Pi .

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Summary

1. Climate is a public good implies:– Rely on altruism (nice but weak), OR– Change self interest (the right choice)

2. That requires a common commitment.3. A common quantity commitment has failed.4. So commit to a global common price path.5. A uniform price implies uniform effort, but6. Use the Green-Fund to help poor countries.