Does the EUA price constitute a signal or not? Should it?
Trevor Sikorsky of Barclays Capital argues in Barclays’ Quarterly Carbon Standard (26th March 2012) that:
“It is expectations that drive such investment [in clean technology] … not current prices.”
That is, energy investors do not look at the miserably low EUA price today but they look at what the EUA price will / would / might be in the future.
In the other corner are the august officers of no less than E.On (no, not the people who produce the James Bond films; that would be far too exciting for this blog) and Statoil and big investors. These gents and ladies argue that:
The EU ETS is bust. It gives no signal for new investment in low-carbon technologies (Johannes Teysson, CEO of German utility reported in Point Carbon, 8th Feb)
At under seven euros per ton, the carbon price is not even high enough to support a switch from coal to gas (IIGCC Executive Director Stephanie Pfeifer reported by Bloomberg, 18th April)
Europe’s low carbon price is incentivising coal-fired power generation over cleaner gas-fired generation (Rune Bjørnson, senior vice-president of natural gas at Statoil reported by EDCM, 18th April)
They are looking for a high EUA price to stimulate clean tech investment. Mark Lewis of Deutsche Bank in their special report of 12th April 2012 backs the side of people calling for reform of the EU ETS to ensure that there is a price signal.
We are seeing two different concepts of what the EU ETS is for.
The purist camp, where Barcap sits, sees the EU ETS as a pure cap-and-trade scheme whose job is one thing: to reduce emissions to a cap at lowest cost. The purists are agnostic as to how we cut emissions, even if it happens by way of economic decline. This is a free-market view.
The techno camp, which includes the European Commission itself, sees the EU ETS as not just a cap and trade scheme. It also sees it as a vehicle for promoting investment in clean technology. This is an interventionist view, where there is second goal to the scheme: the interventionist does care how we cut emissions. He assumes that clean technology is the right way to cut emissions. Technologists don’t like the Bustard’s beer, football and gardening approach.
Barcap’s view is that the headline carbon price is not so important. Investors, they would argue, are cannier than that. Investors know that sooner or later the carbon price will be high, and act on that expectation. Investors are big boys and they know there is a huge fine for non-compliance, so they’ll make sure emissions are cut.
But some investors, it seems, think that the headline carbon price is important. From what Mr Teysson says, you’d think that E.On has no intention to invest in renewables until the current carbon price goes up a bit.
Suddenly this gets a bit too complicated. Four thoughts:
The purist view ignores the power of lobbying. Say people don’t invest in clean technology, and, as a result, the carbon price gets really high. Does that necessarily mean they’ll start making the required investments? There is no guarantee. They might just lobby to get the cap loosened so the price goes down again. Investors know how they will behave if they are pushed into a corner with a 40 euro carbon price. Perhaps they want to avoid that by being forced to make clean tech investments now.
2. Game theory
If you think about the Barcap position, you can see that there’s something going on which looks a bit like game theory. The future carbon price will be high if people don’t take abatement measures. But if people do invest in low-carbon technology, then the carbon price won’t be high, because emissions will be beneath the cap.
Archimedes, an investor who owns a coal-fired power plant (in Greece, obviously), thought about this.
“Hey, coal is cheaper than wind and sun,” he said. “If I am cunning and wait for lots of other people to invest in wind and sun, then emissions will go down under the cap. That means that the carbon price will be low and I can continue to make money running my coal-fired plant, as long as there is enough demand for people to need my power as well.
“Now, if I invest in wind and sun and everyone else does, then I’ll look like a right fanny because I argued to the board that the carbon price would be really high, and look at it: it’s down at 5 euro (because emissions are so low), so I should have stuck with my coal-fired plant.”
“What happens if I wait and everyone else also waits, and we are still all running our coal-fired plants come 2020? Well, then the carbon price will balloon and we’ll all be in an unseemly scramble to cut emissions and there’ll be spikes in the power price and power cuts.”
As you would expect of a Greek, he found a stick and started to draw something in the sand. A table!
|I invest in green power||I don’t invest in green power|
|Everyone else invests in green power||Gloom. Low carbon price. I don’t make particularly high returns.||Yippee! Really low carbon price and I can stoke up my coal-fired boilers.|
|Everyone else doesn’t invest in green power||Eureka! High carbon price. Therefore high electricity price. I make a pile of cash.||Ok for now, but the carbon price will shoot up and we’re going to bang into a wall.|
“Look!” cries Archimedes. “See how the smart money does the opposite of what everyone else does. If everyone invests in green energy and I don’t, then I am laughing. If no-one invests but I do, then I am also laughing. So I have to the opposite of the mainstream. Given that the mainstream, like E.On, say they are waiting for a signal which will never come, I will crack on with my windmills.”
“But hold on,” I said. “They say the carbon price isn’t working as a signal, but Barclays points out that in 2010 to 2011 50GW of renewable capacity was installed in Europe, able to meet up to 2.5% of EU demand. It can’t be just because of the feed-in tariffs. How do you know that they aren’t saying one thing and doing another? After all they are Germans.”
“By gum,” said Archimedes (his father, a shipping magnate, had sent him to boarding school in northern England). “I see what you mean.”
A game theory situation can be very complex. But if we force the carbon price up to 20 euro or so we can get rid of that complexity. The high price takes away some of the uncertainty of whether it will or won’t be worth it, and what happens if I do and he doesn’t or he does and I don’t. There is less jigging about with complex models or speculating about our competitors’ behaviour. Life is simpler. You can see the pragmatic attraction of price intervention.
I wonder if there is also a problem of communication here. A current headline carbon price is easy to communicate. An argument that the carbon price might be high in the future is very hard to communicate.
Energy investors know the game very well. They know that it’s about the future carbon price and what the carbon price will be very high if people don’t cut emissions. But they have to be seen to convince their boards with spread-sheets (and power point presentations). It’s easy to do a spread-sheet which shows a high carbon price in, thereby justifying the renewable investment. But if you have to explain in your spread-sheet that, “well the carbon price isn’t going to be high, but if we don’t do this it will be high … and our game theory expert Professor Heinz Wechselstube-Schrimpf argues that …” then you will have lost the attention of the board and it’ll start raining outside and you won’t get the investment approved.
We all know that clear communication is critical, and for that we need a high, headline carbon price.
4. So what is the EU ETS?
It helps our understanding if we see a distinction between the EU ETS and a pure cap-and-trade scheme. Under pure cap-and-trade the quantity of reduction is fixed, and the price is volatile. (With a carbon tax, in contrast, the price of carbon is fixed and the quantity of reduction is uncertain.)
It looks like the European Commission takes a slightly different view of the EU ETS. It is a cap-and-trade scheme but one with an additional technology goal. That is: they are prepared to create some quantity uncertainty beyond the original cap and at the same time some price certainty, in order to achieve specific technological outcomes.
It is tough for economic purists to swallow this piebald horse. But, oddly, while it is less theoretically simple, it does make life easier for investors (well, for those investors whom the Commission wants to encourage).
“Here, have you ever been in a board-room presentation?” asked Archimedes, still thinking about the previous point. “How do you know it’s a simplistic world?”
Luckily, just then the phone rang. It was Günther.
“I’d like to discuss that idea of a compliance coefficient – you know, when we say 1.05 EUAs for one ton of carbon …”
“Ah, that old chestnut,” I said airily.
“Well, between you and me, old chap,” he said in hushed tones, “we’re rather desperate. To tell you the truth, we’ve made a bit of a hash on the old set-aside debate and we need something fresh. Come on, old fellow.”
“Now is not the time, Günther,” I said, noting that when a German starts trying to speak old-school English, there is something fishy going on. ”The Chelsea-Barcelona game has begun. We will speak tomorrow.”
I put the phone down. “Fancy an ouzo, Archimedes?” I asked.