Re-scheduling Production Due to the Banking Restriction in EU Emissions Trading

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1 Emission Trading Abstract Various studies claim that the ban of the European emissions trading regime to transfer unused emission allowances from 2007 to 2008 is likely to result in a significant increase in the certificate prices in In this paper, we investigate the decisions of firms regarding the time schedules of their production plans in response to this expected price jump. We argue that companies that are able to advance their production and to store the produced goods are induced to shift production activities partially prior to the banking prohibition and, thereby, imitate the banking of emission allowances by storing their output. Since this leads to a temporal demand shift on the allowance market, the anticipated price jump in the first Kyoto period might be mitigated. Perfect arbitrage, however, will not be possible because utilities, which account for more than two-thirds of the CO 2 -emissions, are unable to store their output and companies from other industry sectors only dispose of limited storage capacities. Hence, the law of one price is unlikely to hold.. Introduction In 2005, the European Union emissions trading system (EU ETS) started in the EU 25. Each year, obliged companies have to submit allowances for cancellation corresponding to the amount of CO 2 emitted by their installations. About,500 installations from energy intensive industry sectors are covered in this system. Motivated by theoretical economic models that are based on rather restrictive assumptions, Christian Hoppe, WiOR, University of Karlsruhe, Zirkel 2, 7628 Karlsruhe, Germany, hoppe@wiwi.uni-karlsruhe.de Prof. Dr. Joachim Schleich, Fraunhofer Institute for Systems and Innovation Research, Breslauer Straße 48, 7639 Karlsruhe, Germany, e- mail: joachim.schleich@isi.fraunhofer.de Dr. Stefan Seifert, IISM, University of Karlsruhe, Englerstraße 4, 763 Karlsruhe, Germany, stefan.seifert@iw.unikarlsruhe.de Re-scheduling Production Due to the Banking Restriction in EU Emissions Trading such as perfect markets and the absence of transaction costs, the goal of the EU ETS is to reach given emission targets at lower costs compared to traditional command-and-control type approaches. Moreover, the ETS is supposed to help the EU to meet its overall greenhouse gas emissions target under the Kyoto- Protocol of 997 and possible subsequent international climate treaties more easily. Surprisingly, the economic impact of EU ETS design elements on neither the social welfare nor individual incentives has been thoroughly explored by theoretical or experimental means. Among these design elements, the restriction on banking (i.e. the prohibition to transfer) unused allowances from the first ( ) to the second EU trading period ( ) is of particular interest, as it is expected to result in significant price distortions which are likely to affect the economic efficiency of the system negatively. 2 For actual implementations of emissions trading systems, the validity pe- In the Kyoto Protocol, the EU 5 has committed to reducing CO 2 and other greenhouse gas emissions by 8% by the years , compared to 990 levels. In the so-called Burden- Sharing agreement this target was broken down to give EU 5 individual Member States' emissions targets, which range from -2% for Denmark and Germany to +27% for Portugal. The targets for most new EU Member States are -8% with the exceptions of -6% for Hungary and Poland (CEC, 2000). 2 See Ehrhart et al. (2003, 2006) and Schleich et al. (2006). Karl-Martin Ehrhart, Christian Hoppe, Joachim Schleich, Stefan Seifert riod of emission allowances is an important issue. In the economic literature, however, early works ignore this aspect and focus on (static) cost minimization and efficiency. 3 Later, the cost-minimization property is extended to a dynamic context, applying a control cost approach. 4 In early periods, even suboptimal excessive damage tends to occur when banking and borrowing are allowed without any restrictions. 5 Furthermore, the effects of future changes in demand, regulations and technology on present allowance prices when banking is allowed are also investigated. 6 To our knowledge, there is only one experimental contribution that analyses the impact of a one-time ban on banking. 7 The EU Emissions Trading Directive generally allows banking, 8 with one exception: Member States (MSs) are authorized to decide individually if they restrict banking from the first into the Prof. Dr. Karl-Martin Ehrhart WiOR University of Karlsruhe Zirkel Karlsruhe ehrhart@wiwi.uni-karlsruhe.de 3 See Montgomery (972). 4 See Rubin (996). 5 See Kling/Rubin (997). Analogously to banking, which refers to transferring unused emission allowances into future periods, borrowing denotes the use of allowances prior to the period they are allotted. 6 See Schennach (2000). ZfE Zeitschrift für Energiewirtschaft 30 (2006) 4 267

2 K.-M. Ehrhart, C. Hoppe, J. Schleich, S. Seifert second trading period, i.e. from 2007 to The reason MSs favor the prohibition of banking is obvious: a MS that allows unrestricted banking of surplus allowances from 2007 into 2008 may fail to meet its national Burden-Sharing target for the years if firms transfer unused allowances into that period and the non-trading sectors (traffic, households, etc.) cannot make up for the deficit. Therefore, all MSs, except for Poland and France, which both allow a limited number of allowances to be transferred into 2008, decided to ban banking from the first into the second EU trading period. 9 If emission allowances can be shifted without restrictions between two periods (i.e. unrestricted banking and borrowing), one would expect that, due to arbitrage and speculation, at any point in time allowances for both periods will trade at the same (discounted) price ( law of one price ). Provided that emissions targets become tighter over time in the EU ETS, it is reasonable to assume that prohibited borrowing would not affect the law of one price if unrestricted banking is allowed. If, however, banking is also prohibited between the two periods, divergent prices are possible and in the EU ETS expected to increase. 0 The hypothesis of increasing emission allowance prices is supported by observations in a business simulations game as well as an experimental investigation. Both studies consistently confirm the above argu- 7 See Ehrhart et al. (2006). 8 See CEC (2003). 9 Schleich et al. (2006) characterize these political decisions as a Nash-equilibrium outcome of a prisoners' dilemma game. 0 As the emissions targets would need to become tighter over time to meet medium- and long-term emission reduction targets, allowance prices in the EU ETS are expected to increase from the first to the second trading period. For example, the EU Council considers greenhouse gas emission reductions of 5-30% (compared to 990 levels) by 2020 as a necessary mid-term target for industrialized countries in order to limit the mean global temperature increase to 2 degree Celsius compared to pre-industrialized levels (European Council 2005). See Schleich et al. (2002) and Ehrhart et al. (2006). ment that suggests an extreme price jump from 2007 to 2008 due to the ban on banking. 2 So far, empirical evidence in the EU ETS actually matches the findings of these experiments quite well. In particular, prices for EUAs lost about 60% of their value by the end of April 2006 when verified emission data for 2005 were published and indicated an EU-wide surplus of about 44 million EUA for that year. Prices have remained at a rather low level since. It is noteworthy that in a comparative statics analysis the restricted banking scenario imposes higher total abatement costs on firms than the unrestricted scenario: as allowance prices reflect marginal abatement costs, more expensive abatement measures are activated in the second trading period than in the first trading period. Thus, if banking was allowed, win-win trades would be possible. Companies with abatement costs in-between the market prices of the two trading periods could make a profit by abating more in the first period and sell their surplus allowances to firms that otherwise would have to implement more expensive abatement measures in the second trading period. Note, however, that total emissions (but not their timing) are equal in both scenarios. One way to bypass the restrictions on banking emission allowances is to (partly) advance production. If a good is storable, a company may prepone the point of time when a good is produced. Rather than using an (expensive) allowance in the second EU trading period, the good is produced in the first period, then stored and sold in the second period. Depending on the difference between the allowance prices in the first and the second EU trading period, advancing production can be prof- 2 Ehrhart et al. (2006) argue that the price jump is even larger than justified by the difference in abatement costs. In the first trading period the allowance price falls far below abatement costs (because of excess allocation) and converges to zero as the allowances become worthless at the end of Moreover, in 2008 the allowance price exceeds the theoretical abatement costs of a long-term planning. itable even if this shift in production itself is costly (storage costs, etc.). Bypassing the ban on banking by bringing forward production and storing the goods creates gains for the firms compared to a just-in-time production in the restricted banking scenario. Due to the mentioned additional costs, however, preponing production is far from being as efficient as abandoning the ban on banking itself. Since those firms deviate from their optimal production plan (which applies in case of unlimited banking, see Section 3), the preponement of production also comes along with an inefficient use of input factors. From an ecological point of view, however, forwarding and storing strategies do not affect the achievement of the emissions target because the amount of emissions is limited by the caps specified by the EU ETS and the national allocation plans. In this context, we allude to the possibility that credits created from projects under Clean Development Mechanisms (CERs certified emission reductions) may also be used for arbitrage over time because CERs can be transferred into the second phase of the EU ETS and then be used by companies to cover emissions in the EU ETS. The fact that current prices for CERs exceed those of EUAs (emission allowances under EU ETS) is consistent with this view. 3 In this paper, we investigate the effect of prohibited banking in EU ETS from 2007 to 2008 on the firms decisions with respect to the time schedules of their production plans and their storage behavior in response to the expected price jump. In our model, we assume that companies that produce storable goods, e.g. glass or cement, act as price takers in the allowance market. This assumption is justified by the fact that the power industry accounts for 3 Of course, prices for CERs and EAUs may differ for other reasons. For example, companies concerned about reputational effects, may be willing to pay a premium for CERs since CDMprojects contribute to a sustainable development in the host countries (Faure et al., 2006). 268 ZfE Zeitschrift für Energiewirtschaft 30 (2006) 4

3 Re-scheduling Production Due to the Banking Restriction in EU Emissions Trading about 70% of the CO 2 -emissions in the EU ETS and thus dominates this market. 4 The firms of the power industry, however, are not able to store their products in significant quantity for technical reasons. Thus, in the remainder, we focus on companies, which are able to store their goods and which are too small to affect the market price of EU- As. We conclude that storing output serves as a vehicle to substitute banking of allowances for some companies. This is expected to mitigate slightly the price jump from the first to the second EU trading period; the law of one price, however, will not apply because there are (technical and economic) capacity constraints that limit the excessive storage of goods. Thus, arbitrage by forwarding production will be imperfect. Nevertheless, the more a company can exploit differences in allowance prices between 2007 and 2008, the more the company profits from the banking restriction. In Section 2, we introduce our model and derive the cost-minimizing emissions abatement strategy of a single firm in a one-period approach. In Section 3, the model is extended to two periods. We first investigate properties of the storage behavior when banking is allowed. These properties then serve as a reference point for the analysis of the restricted banking scenario. Section 4 concludes. 2. Optimal Abatement Strategy The analysis of abatement decisions and the related storage decisions is based on a simple formal model in an Industrial Organization style. Throughout the analysis, both the allowance price and the firms output are assumed to be exogenously given. Based on the allowance price, we first derive a firm s 4 Note that Svendsen/Vesterdal (2002) doubt that even the market shares of the biggest emitters are high enough to exercise market power in a liquid allowances market. optimal decision and then apply a common comparative static approach that makes use of the implicit function theorem. Proceeding stepwise, a static one-period approach regarding the firm s optimal abatement level and emissions volume are considered in this section, followed by the extended twoperiod model in the next section. For the sake of simplicity, we assume that every output unit causes the emission of one pollutant unit (of CO 2 ) if no abatement efforts are being made (status quo or business as usual case). We further assume that all so-called no-regret measures (measures that are profitable even in case of an allowance price of zero, i.e. no emissions trading) have already been implemented. Thus, each unit of pollutant must be covered by one allowance or has to be abated by a costly measure. We assume that the considered firm has to fulfill given delivery contracts which determine the firm s total output x > 0. Let v 0 denote the endogenously determined amount of emissions reduction compared to the status quo and m(v) 0 the abatement cost function which is assumed to be continuously differentiable and depend only on the amount of abated emissions. For the first and second derivative m v ( ) and m vv ( ) we assume m v (v) 0 for v > 0 and m v (0) = 0 as well as m vv (v) > 0 for v 0. This increasing convex abatement cost function corresponds to the assumption that cheaper abatement measures are implemented first. The price p > 0 for an allowance on the allowance market represents the opportunity costs of covering one unit of pollutant; i.e. either a firm has to buy an allowance on the market at the price p or cover an emission unit with an allowance in stock, which then cannot be sold for p. Since we assume that the allowance price p is exogenously given for the firm, we implicitly model firms as price takers on the allowance market. To minimize costs for covering its business as usual emissions, the firm faces the following optimization problem (with respect to v [0, x]): min v {m(v) + p(x v)} () Note that the output level x constitutes an upper bound for the amount of abated emissions. The first-ordercondition for determining the optimal emissions reduction v * is: m v (v * ) = p (2) If the allowance price is sufficiently low, i.e. p < m v (x), condition (2) yields an interior solution v * < x. Otherwise, i.e. p m v (x), the cost minimization abatement amount is v * = x. In the latter case, all potential emissions are abated. To give a drastic example, this would apply if a firm substitutes its own production by purchasing the products from a competitor abroad. 5 The solution of () determines the firm s (emissions) cost function CE(x, p) = m(v * (x, p)) + p (x v * (x, p)) (3) which depends on the output x and the allowance price p. The first term of the cost function (3) expresses the firm s optimal abatement costs and the second term the firm s costs for covering its remaining emissions by allowances. If the cost minimizing problem () has an interior solution, the optimal abatement level v * is independent of x, while in the case v * = x, the solution does not depend on the value of p. Thus, the marginal costs of potential emissions are given by: CE( x, p) MCE( x, p) = = x (4) mv ( x) : mv ( x) p p : mv ( x) > p Note that this function is continuous, but not continuously differentiable in x = m - v (p). 5 We do not need to take into account the constraint v 0, because m v (0) = 0 and m(v) is continuously differentiable and increasing, which implies that for each possible positive allowance price at least the first marginal amount of pollutant will be abated. ZfE Zeitschrift für Energiewirtschaft 30 (2006) 4 269

4 K.-M. Ehrhart, C. Hoppe, J. Schleich, S. Seifert 3. The Storage Behavior Model In this section, the two scenarios in which banking is allowed without restrictions and banking is prohibited are compared. From a theoretical point of view, if banking is allowed and if participants have complete information about emissions targets and prices, the increase of prices from 2007 to 2008 is limited by the interest rate (Hotelling s rule, i.e. prices develop in line with the discount rate δ or more slowly: p δp 2 ). Otherwise, arbitrage between the two periods is possible. 6 In the banned banking case, this is no longer true in general. As has been argued in Section, prices are likely to be lower in the first period than in the second period. Moreover, since in the restricted banking scenario, first-period allowances cannot be used as flexibly as in the free banking scenario, firstperiod allowances are assumed to trade for less in the former than in the latter scenario. Analogously, the price of second-period allowances is assumed to be higher in the restricted banking scenario due to the higher scarcity of allowances. This is supported by further theoretical considerations and the results of an EU emissions trading experiment mentioned previously: prices decline before and explode after a banking prohibition compared to the free banking case. 7, 8 In order to analyze the strategy of a company that can store its product, we extend our model to two periods. In the context of the EU ETS, the first period can be considered as the year 2007 (or earlier) and the second period as 2008 (or later). As before, we assume a firm with given delivery contracts, which total to x output units for the two periods. First, as a reference point, we consider the case with unlimited banking and assume that in this case the firm s optimal production schedule (according to cost 6 See Kling/Rubin, See Ellerman/Montero (2002). 8 See Ehrhart et al. (2006). minimization) is given by (x, x 2 ) with x + x 2 = x, i.e. the firm produces x units in the first period and x 2 in the second period. Second, we now consider the case of prohibited banking and ask if the firm is induced to produce additional units b 0 in the first period which are stored and transferred to the second period where the firm then reduces its output to the same extent. Let us assume that the market price for allowances p t in period t {,2} are known to all obliged companies. Furthermore, since sales prices do not depend on the storage strategies and the total output x is fixed, the firm s profit maximization problem can be reduced to the following cost minimization problem (with respect to b [0, x 2 ]): min b {CP(x + b) + CE(x + b, p ) + δcp(x 2 b) + δce(x 2 b, p 2 )} (5) Parameter δ denotes the discount rate and CP(z) the stationary production cost function, which is assumed to be non-negative, monotone, and strictly convex, i.e. CP(z) 0, MCP(z) = CP(z)/ z > 0, MCP (z) = MCP(z)/ z > 0 for z 0. For simplicity, we abstain from storage costs their impact, however, is straightforward: the higher the costs, the less will be stored. In case of an interior solution b * > 0, the first-order-condition of the cost minimization problem (5) is given by: MCP(x + b * ) + MCE(x + b *, p ) δmcp(x 2 b * ) δmce(x 2 b *, p 2 ) = 0 (6) In this case it is optimal for the firm to produce more than x units in the first period and store the additional amount b * > 0 which is then sold in the second period. In our comparative statics analysis, we are interested in the impact of the allowance prices in the first and the second period on the optimal storage amount. Thus, we examine the sign of b * ( )/ p t for t {,2} where b * (x, x 2, p, p 2, δ) is the optimal storage amount, characterized by (6). Lemma 3. The change in the optimal storage amount b *, caused by an increasing allowance price p is not positive. Proof. Applying the implicit function theorem to the optimality condition (6), we get MCE x + b, p * b p with () = ( ) p N 0 (7) N MCP (x + b) + MCE (x + b, p ) + δ(mcp (x 2 b) + MCE (x 2 b, p 2 )) > 0 It follows from equation (4) that for an interior solution for the first period, the derivative in (7) is strictly negative.! Analyzing the second period, the analogous argumentation leads to the following result. Lemma 3.2 The change in the optimal storage amount b *, caused by an increasing allowance price p 2, is not negative. Now, we can answer the question of how banking conditions influence storage behavior. Proposition 3. The optimal storage amount which is chosen by companies is not lower, and for the most part strictly higher, in a non-banking scenario compared with a free-banking scenario. Proof. The claim follows directly from the Lemmas 3. and 3.2 as well as the assumption that a banking restriction leads to a lower price p and a higher price p 2 compared to unrestricted banking. Note that it is sufficient to deduce a strictly higher optimal storage amount in the prohibited banking case if we have an interior solution to the abatement cost minimization problem () in at least one period.! Our analysis suggests that bringing production forward and storing the pro- 270 ZfE Zeitschrift für Energiewirtschaft 30 (2006) 4

5 Re-scheduling Production Due to the Banking Restriction in EU Emissions Trading duced goods into a later period is some kind of bypassing a prohibition of banking emission allowances. If preponing production and storing the output were feasible at no cost and to an arbitrary extent for all firms, then perfect arbitrage of allowance price differences would be possible. As a consequence, higher demand for allowances in the first period and lower demand in the second period would result in alignment of price levels and the law of one (discounted) price would apply. In reality, however, most of the installations under the EU ETS produce non-storable goods or goods whose production can be shifted only to a very limited extent. The production of electric power, the source of the largest share of anthropogenic CO 2 emissions, is just one example. Of course, no one will build additional water dams whose basins are filled with excess energy which can be set free in later periods. Obviously, the capacities are strictly constrained and the costs are too high for perfect arbitrage. Similar points are true for the production of cement, paper, or glass. It is surely not profitable to build up huge storing capacities that are used only once. Additional limitations may result from difficulties in varying the amount of input factors like manpower and raw materials or legal provisions for storing dangerous goods. Due to these limitations, we conclude that only partial arbitrage will be possible and, hence, price differences that are caused by a banking restriction can only be mitigated to a limited extent. 4. Conclusion Firms with the possibility of storing their production output will be able to compensate partly for the banking restriction in EU emissions trading. As a result, we expect an increase in the production of cement, steel, glass, or paper in the second half of Companies will carry over these excessive inventories from 2007 to 2008 as a substitute for banking emission allowances. The shift in production schedules may generate efficiency gains by exploiting expected differences in the market price of emission allowances between 2007 and The preponement of production, however, also leads to economic burdens caused by storage costs and the inefficient use of input factors. From an ecological point of view, pre-drawing production has no effect on the achievement of the emissions target: both in 2007 and in 2008 the amount of total emissions is concisely ruled by the caps imposed by the framework of the EU ETS and the national allocation plans. Overall, re-scheduling production plans might slightly mitigate the expected drop in allowance prices towards the end of the first period and the jump in prices in 2008, which is predicted by theory as well as business simulation games and experimental investigations. Due to restricted storing capacities and the limitations of storing products like electric power, arbitrage will be imperfect and the law of one price is not expected to hold. Literature CEC (2000): Communication from the Commission to the Council and the European Parliament on EU Policies and Measures to Reduce Greenhouse Gas Emissions: towards a European Climate Change Programme (ECCP). COM (2000) 88 final, Brussels 8 March CEC (2003): Directive 2003/87/EC of the European Parliament and the Council of 3 October 2003 Establishing a Scheme for Greenhouse Gas Emission Allowance Trading within the Community and Amending Council Directive 96/6/EC, OJ L275, 25 October 2003, Ehrhart, K.-M., C. Hoppe, J. Schleich, and S. 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