An Analysis of Allowance Banking in the EU ETS

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1 An Analysis of Allowance Banking in the EU ETS Aleksandar ZAKLAN, Vanessa VALERO and Denny ELLERMAN EUI - DIW Berlin and EUI AWEEE, 26/07/2014 Allowance Banking in the EU ETS ( AWEEE, EUI - DIW26/07/2014 Berlin and EUI) 1 / 14

- DIW Berlin and EUI AWEEE, 26/07/2014 Allowance Banking

2 Introduction Context (1/2) - Cap and Trade System The cap and trade principle: A cap on the total amount of greenhouse gases emitted by installations is xed. The allowances for emissions can be traded. Spatial trading: The installations that need to increase their emissions must buy allowances from those that require fewer allowances. Intertemporal trading: Banking: units can save their allowances for future use or sale. Borrowing: units can borrow allowances from their future allocations. Allowance Banking in the EU ETS ( AWEEE, EUI - DIW26/07/2014 Berlin and EUI) 2 / 14

Spatial trading: The installations that need to increase their emissions must buy allowances...... from those that require fewer allowances.

3 Introduction Context (2/2) - EU ETS The EU ETS: Phase I: , Phase II: , Phase III: Banking: Allowances from Phase I not bankable into Phase II, From Phase II no limitations on banking. Borrowing: Possible only one year ahead because of the schedule, Not allowed otherwise. Allowance Banking in the EU ETS ( AWEEE, EUI - DIW26/07/2014 Berlin and EUI) 3 / 14

Banking: Allowances from Phase I not bankable into Phase II, From Phase II no limitations on

4 Introduction Motivation At the end of Phase II of the EU ETS: 2 billion unused EU allowances (EUAs) out of 10.2 billion EUAs distributed during Phase II. Policy debate about the imbalance of EUAs: Shortcoming of the EU ETS, Proposals to x the imbalance. No consideration of intertemporal trading: Important in the U.S. s SO 2 trading system as shown by Schennach (2000) and Ellerman and Montero (2007). Allowance Banking in the EU ETS ( AWEEE, EUI - DIW26/07/2014 Berlin and EUI) 4 / 14

Policy debate about the imbalance of EUAs: Shortcoming of the EU ETS, Proposals to x the imbalance.

5 Introduction Objectives To adapt the theory of intertemporal trading to a smoothly declining cap. To present simulations of plausible banking outcomes for the EU ETS. Allowance Banking in the EU ETS ( AWEEE, EUI - DIW26/07/2014 Berlin and EUI) 5 / 14

To present simulations of plausible banking outcomes for the

6 The Model of Intertemporal Trading Problem Formulation We consider the planner s solution: min fe t g R 0 e rt C (u t e t ) dt s. t. B t = Y t B t 0 where u t : Counterfactual emissions in t B t : Addition to bank in t e t : Actual emissions in t B t : Accumulated bank in t Y t : Cap in t C (.) is the abatement cost function where C 0 (.) > 0 and C 00 (.) > 0. r is the discount rate, r > 0. e t Allowance Banking in the EU ETS ( AWEEE, EUI - DIW26/07/2014 Berlin and EUI) 6 / 14

B t = Y t B t 0 where u t : Counterfactual emissions in t B t : Addition to bank in t e t : Actual emissions in t B t :

7 The Model of Intertemporal Trading Assumptions Assumptions of the model: 1 Constant parameters, 2 Perfect foresight, 3 Competitive market for permits. Allowance Banking in the EU ETS ( AWEEE, EUI - DIW26/07/2014 Berlin and EUI) 7 / 14

8 The Model of Intertemporal Trading Result Intertemporal cost minimization yields the following equilibrium condition: C 00 (u t e t ) = rc 0 (u t e t ) Φ t where Φ t is the multiplier associated with the constraint on borrowing, B t 0. Evolution of the marginal cost: If B t > 0, Φ t = 0 : the marginal cost increases at the discount rate;. If Φ t > 0, B t = 0 : the marginal cost increases less than discount rate. Allowance Banking in the EU ETS ( AWEEE, EUI - DIW26/07/2014 Berlin and EUI) 8 / 14

Evolution of the marginal cost: If B t > 0, Φ t = 0 : the marginal cost increases at the discount rate;.

9 Intertemporal Trading in the EU ETS Simulation Results (1/3) Cap, Emissions, Price Path, Baseline Case Allowance Banking in the EU ETS ( AWEEE, EUI - DIW26/07/2014 Berlin and EUI) 9 / 14

10 Intertemporal Trading in the EU ETS Simulation Results (2/3) Optimal Cumulative Bank, Varying Discount Rates Allowance Banking in the EU ETS ( AWEEE, EUI - DIW 26/07/2014 Berlin and EUI) 10 / 14

11 Intertemporal Trading in the EU ETS Simulation Results (3/3) Optimal Cumulative Bank, Varying BAU Emissions Growth Allowance Banking in the EU ETS ( AWEEE, EUI - DIW 26/07/2014 Berlin and EUI) 11 / 14

12 Conclusion It is rational to bank with a smoothly declining cap. E cient banking behavior might at least partly explain the observed imbalance. Consideration of banking in the evaluation of the measures proposed by the European Commission. Allowance Banking in the EU ETS ( AWEEE, EUI - DIW 26/07/2014 Berlin and EUI) 12 / 14

Consideration of banking in the evaluation of the measures proposed by the

13 Open Questions 1 Are there shocks? 2 Are rms risk-neutral? 3 Is the discount rate the same for every rm? 4 What is the time horizon of rms? Allowance Banking in the EU ETS ( AWEEE, EUI - DIW 26/07/2014 Berlin and EUI) 13 / 14

14 End Thank you for your attention! Allowance Banking in the EU ETS ( AWEEE, EUI - DIW 26/07/2014 Berlin and EUI) 14 / 14

. In this case the leakage effect of tax increases is mitigated because some of the reduction in disposable income would have otherwise been saved.

. In this case the leakage effect of tax increases is mitigated because some of the reduction in disposable income would have otherwise been saved. Chapter 4 Review Questions. Explain how an increase in government spending and an equal increase in lump sum taxes can generate an increase in equilibrium output. Under what conditions will a balanced