Signal confusion

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:

1.       Lobbying

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.

3.       Communication

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.

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3 Responses to Signal confusion

  1. R Umour says:

    Well, well, dear Bustard, plenty of good points made.

    No doubt that your commercial heart would fancy a high carbon price, higher margins, better argumentation for renewable energies, better awareness of renewable energy and energy efficiency measures at the industrial and utility side. But what do you creed for? Purest techno uncertainty to fortify a consultants role?

    But didn’t you recently argue that a low carbon price is a signal for well working cap and trade scheme? And wouldn’t Guenther agree, that in a perfect carbon world, a low carbon price would mean that the EU ETS cap will be easily met? Couldn’t fellow Guenther then reduce the financial committment to other EU carbon instruments because the EU ETS overperformed and the other instruments do not face the full emissions reduction burden as initially planned? Lets call it communicating vessels. Heureka!!

    And that nice compliance coefficient, what the heck is this concept about? Why does Guenther even think about that? Easily the system will go down the drain when you make it more and more complicated. A ton carbon is a ton carbon is a ton carbon. Full stop. And in rumours view it should stay like that.

    Discuss timings and volumes of EUA auctioning for the power sector, probably discuss an annually revolving cross sectoral correction factor for fine tuning of the free allocation for the other industrial sectors or bring in ambitious carbon benchmarks for production of goods. No special law, decision or polish affirmation whatsoever needed because these valves have been installed already in the directive. And, go for a border adjustment tax for all goods on the carbon leakage list coming from outside the EU to prevent our industrials from leaving.

    Ok, I do fancy a nice cold german beer right now, hopefully the EU ETS will not close all the german micro breweries down. Cheers!

    • James Atkins says:

      I argued that a carbon price gives an ambiguous signal – it does not distinguish between a loose cap or success at cutting emissions. I think Gunther rather likes the idea of a high price to promote investment in windmills. I don’t care what the price is as long as emissions are down and stay down.

      The point of this post was that there are two understandings of the scheme – a purist one where the cap is the key and the promotion of one technology or another is not politically important; and a technologist view which wants to see the EU ETS stimulating investment in specific technologies. And that explains why some people say the price is too low and others say it doesn’t matter what the price is.

      Compliance coefficient – like the way interest rates get changed from time to time to manage the economy. But if it’s too complicated for people, then it’s probably no use. I expect Gunther was thinking about it because he thought people would get used to it and start to like it.

      I do like the border adjustment (although that also might be fairly complicated, mind). It might be as controversial as extending our borders to every airport on the planet!

      • R Umour says:

        Utilizing a compliance coefficent uttered by some EU authority to steer the EU ETS cap sounds like an easy thing to do, I do understand that it could be quite an efficent instrument for the authority. Yet from the view of an operator, how can s/he possibly plan the annual compliance? This coefficent will detach the compliance instrument ‘allowance’ from the commodity ‘carbon’. I do not know if the creditable course of lowering carbon emissions to the atmosphere is supported if both the price and the size of EUAs may fluctuate.

        Just imagine the EU commission wants to change the size of a barrel oil from time to time to manage the fuel economy. Here they use reserves, maybe, as carbon is somewhat closely attached to the oil price developments, why doesn’t Guenther follow that route for the EU ETS? Which brings us back to the central carbon bank thought. Did Guenther already drop that thought? We already discussed a little earlier about that:

        Border adjustment tax could be quite easy with the phase III carbon leakage setup: A prodcom code and the mass of the imported goods needs to be communicated anyways, fumble some carbon compliance ratio over EU produced and imported goods and let both the EU producer and the importer share the carbon compliance costs. In my view if a certain branch claims carbon leakage status but the EU does not import any of these units there is no reason why this certain branch should not be expelled from the CL list and face the steep carbon reduction path. The same mechanism could be used for exported goods from the EU, just detach the carbon costs by tax refunds and make EU products harshly competitive worldwide.

        Benoit btw talks about the three most discussed options for signal confusion in the latest carbon trading magazine: reserve price on auctions, set aside or do nothing. Rumours believes the more talk happens the less likely is any action. As in the famous ‘Yes Minister’ series, trialogues, working groups, informal meeting may most likely be held not to make decisions, but rather to postbone them.

        Yep, ready for another ouzo in the mean time..

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