In California, the reserve price in auctions of emission allowances has proved successful in maintaining a minimum carbon price. This should encourage others, especially the EU, to introduce similar arrangements, writes climate change economist Adam Whitmore. The Californian experience does show the importance of political commitment and stability, Whitmore adds.
This is the second of two posts looking at experience of carbon price floors. My previous post looked at UK carbon price support, which guarantees a minimum price by means of a tax. I concluded that the UK carbon price floor has led to big, quick and cheap emission reductions.
This post looks at an alternative approach, which is used in California and the other Western Climate Imitative systems, Quebec and Ontario. Here, instead of imposing a tax, the floor is set by specifying a reserve price in auctions of allowances.
A different approach
If bids in auctions stay below the reserve price the allowances are not sold. Reserve prices such as this are common in practice in many commercial auctions, including those held by major auction houses and online.
Reserve prices give what is often called a “soft” floor. The market price can go below the auction reserve, but eventually the need to buy allowances at auction is likely to ensure that the price recovers.
Legal challenges to the system, and political uncertainty about the continuation of the system after 2020, which together reduced the demand for allowances
The chart below shows the auction reserve price in the California system (green line), which started at $10/tonne in 2012 and is increased each year by 5% plus the rate of inflation. The California market price (blue line) has generally stayed above this level. However, it did dip below the reserve price for a while in 2016, illustrating that the floor is soft.
Chart: Auction reserve prices and market allowance prices in the California cap-and-trade system to end of 2017
This price dip reflected a combination of legal challenges to the system, and political uncertainty about the continuation of the system after 2020, which together reduced the demand for allowances. Once those uncertainties were resolved the market price recovered.
The environmental effectiveness of price containment mechanisms depends in large part on what eventually happens to any unsold allowances
The Regional Greenhouse Gas Initiative (RGGI) has similar arrangements but with a much lower reserve price, and there too the price has been above the floor.
The environmental effectiveness of price containment mechanisms depends in large part on what eventually happens to any unsold allowances. In the case of California this issue particularly affects the upper Price Containment Reserve, from which allowances are released if prices go above defined thresholds. Allowances from this reserve appear most unlikely to be required in the current phase, as prices seem highly unlikely to reach the threshold levels.
If these unsold allowances in the reserve are cancelled, or otherwise put beyond use, cumulative emissions will be lower. However, if they eventually find their way back into the system, and enable the corresponding quantity of emissions to take place, the environmental benefit may not be realised, or at least not in full. Some sort of cancellation mechanism is therefore needed, for example cancelling allowances that have been in the reserve for more than a specified number of years.
So price floors can work. However in the case of the California system at least two things need to be agreed as the rules for the system after 2020 are debated this year.
The experience of auction reserve prices now proving effective should encourage other jurisdictions, especially the EU, to introduce similar arrangements
First, continuation of the escalation of the floor price needs be confirmed at least at the current rate, and ideally the rate should be increased.
Secondly, rules for cancelling unsold allowances from the Price Containment Reserve need to be defined. The cancellation of allowances from the Market Stability Reserve included in the recent reforms to the EU ETS sets a valuable precedent in this respect.
The theoretical advantages of a floor price in an ETS are well known. The experience of auction reserve prices now proving effective in practice over a number of years should encourage other jurisdictions, especially the EU, to introduce similar arrangements. And those jurisdictions such as California where they are already in place need to continue to develop and enhance them.
Reprinted with permission.