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Fixed price vs Fixed Quantity: Incentives to AdoptLow-Carbon Technology under Uncertainty

Federico Boa1 Stefano Cl2 Alessio DAmato3

1University of Macerata2,3University of Tor Vergata

May 09, 2012Rome, MEF Brown Bag Lunch Seminar

Boa Cl DAmato (MEF) price vs quantity under uncertainty May 09, 2012 1 / 42

Roadmap

Introduction to EU climate policy and ETS

Aim of the research

Literature Review

Model presentation

Discussion of the results

Policy applications

Boa Cl DAmato (MEF) price vs quantity under uncertainty May 09, 2012 2 / 42

EU Climate Policy: Goals and Instruments

Kyoto: emissions -8% below 1990 by 2012Climate Package: emissions -20% below 1990 by 2020Not only climate goal: promoting innovation

Reduce emissions without preventing economic growthpromote innovation and diusion of low-carbon technologyGreen economy: new markets and job opportunities

Carbon Emissions: external cost not incorporated in the market price

Need for a market-based instrument to monetize carbon emissionsand increase attractiveness of low-carbon tech.

Boa Cl DAmato (MEF) price vs quantity under uncertainty May 09, 2012 3 / 42

EU Climate Policy: Goals and Instruments

Directive 2003/87 establishes the Emissions Trading Scheme (ETS)Cap & Trade scheme

Cap: x a limit to emissions and distribute an equivalent amount ofemissions allowances among regulated agentsIf emissions > allowances ! reduce emissions internally or acquireallowances in the marketTrade: free bargaining among parties ! abatement at lower marginalcost, allowances allocated where are valued most (Coase Theorem)

Boa Cl DAmato (MEF) price vs quantity under uncertainty May 09, 2012 4 / 42

EU Climate Policy: Goals and Instruments

ETS

stimulate technological innovation and a progressive transition towarda low-carbon economy

Carbon emissions are priced for the rst timefossil fuels tech. more expensive low carbon tech. more attractive

Carbon price varies with uncertaintySupply is xed (cap), demand of allowances depends on:

GDP trend, energy consumption, power generation fuel mix, fuel priceCarbon price trend reects economic and energy marketsvariability

Boa Cl DAmato (MEF) price vs quantity under uncertainty May 09, 2012 5 / 42

EU Climate Policy: Goals and Instruments

Climate policy has slown downPolitics: unsuccessful international negotiations (EU unilateral policy)

Economics: With economic crisis, ETS lost momentum

Industrial production and energy production decreaseETS carbon emissions decrease (-11,6% in 2009)demand for allowances decreases, supply is rigidSurplus of allowances in the ETSCarbon price decreases (short-term)Carbon price trend lower than expected

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EU Climate Policy: Goals and Instruments

Climate policy has slown down

ineectiveness of the ETS in promoting low carbon technologies.

"A lower carbon price acts as a much less powerful incentive forchange and innovation" (EC 2010)

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EU Climate Policy: Goals and Instruments

Proposals of ex-post adjustments to the ETS insitutional designaimed at increasing the ETS eectiveness in promoting the adoptionof low-carbon technology

Support the carbon price through ex-post cap adjustment to increasethe scarcity of allowancesSet-aside proposal (withdraw allowances)Reduce the emissions target and the ETS capCreate a Carbon Central Bank to adjust the cap in order to x theprice at a level required to support low-carbon technologiesImpose a carbon price oor (option adopted in UK)

Boa Cl DAmato (MEF) price vs quantity under uncertainty May 09, 2012 8 / 42

Aim of the paper

Some open policy questions

Is the EU strategy of supporting the carbon price through ex-postquantity adjustment eective to promote adoption?Which ETS market design maximizes incentives of adoption wheninvestments are undertaken under uncertainty?

We distinguish between

Cap & trade with quantity control: Fixed quantity (standard scheme)Cap & trade with price control: Fixed price (like a carbon tax)

Focus on the role of uncertainty

Boa Cl DAmato (MEF) price vs quantity under uncertainty May 09, 2012 9 / 42

Aim of the paper

Analyze how uncertainty (variation of) impacts dierently on expectedprots (marginal benets and costs) depending on the market design

Determine under which market design expected prots and incentivesto adopt are maximized.

Policy applications - Identify which design best ts:

frameworks with shifts in the generation mix (such as that currentlybeing experienced by Germany);feed-in taris schemes adding to ETS regulations.

Boa Cl DAmato (MEF) price vs quantity under uncertainty May 09, 2012 10 / 42

Literature Review

First strand of literature:Choice of market-Based Instruments under uncertainty (Weitzman1974)

Focus on social welfare (MAC and MD)Without uncertainty and under perfect information carbon tax and capand trade are equally e cient to internalize externality (Weitzman1974)

Boa Cl DAmato (MEF) price vs quantity under uncertainty May 09, 2012 11 / 42

Literature Review

Under uncertainty:

Carbon tax: price is certain, quantity is notCap and trade: quantity is certain, price is not

Best instrument depends on the slope of MD and MAC

Boa Cl DAmato (MEF) price vs quantity under uncertainty May 09, 2012 12 / 42

Literature Review

slope MAC < slope MD ! High variability in price

slope MAC > slope MD ! High variability in emissions

Boa Cl DAmato (MEF) price vs quantity under uncertainty May 09, 2012 13 / 42

Literature Review

Second strand of literature:

Market-Based Instruments and technology adoption (not innovation)Focus on investment choice (MB and MC)

Milliam and Prince (1989 and 1992)

Focus on rm level: cap and trade scheme with auctioning providesmore incentive than taxes (no uncertainty)

Jung et al. (1996)

focus on market-level with heterogeneous rms compete: auctionedpermits provide the greatest incentives for adoption (no uncertainty)

Parry (1998)

tax and emissions permits have similar e ciency properties (nouncertainty and linear functions)

ndings criticized by subsequent analyses

Boa Cl DAmato (MEF) price vs quantity under uncertainty May 09, 2012 14 / 42

Literature Review

previous literature assumes exogenous price, not consider how a singlerms investment decision impacts on the market equilibrium

Denicol 1999, Requate and Unold 2003

Cap and trade with endogenous price: impact of adoption on carbonprice and free riding eect; asymmetric adoption might take place evenwith symmetric rms.tax system with xed carbon price: symmetric adoption with symmetricrms (at least as many as under cap and trade)incentives for adoption inferior under cap and trade than under taxesNo uncertainty

Boa Cl DAmato (MEF) price vs quantity under uncertainty May 09, 2012 15 / 42

Literature Review

We add uncertainty to the literature on technology adoption

Bousquet & Cret (2010)

how investments under environmental regulation depend on uncertaintyin input price ! price variability leads to an expansion of the existingcarbon intensive capacity.

Pindyck (1991), Chao e Wilson (1993)).

when the convenience of investment depends on the uncertain trend ofresource price, there is an option value associated with delayingadoption ! postpone irreversible investment

Boa Cl DAmato (MEF) price vs quantity under uncertainty May 09, 2012 16 / 42

The Model - Assumptions

Two risk-neutral rms k = i , j

prots expresserd as function of emissions (linear relation betweenemissions and output)

convex cost function

C (ek ) = cmek + dke2k2

cm fuel cost ! linear relation between costs and emissionsdke2k2 convex cost ! accounts for all the other inputs, for the capacity

constraints or decreasing returns to scale

Linear revenue: vekv is the per-unit revenue (willingness to pay)

Boa Cl DAmato (MEF) price vs quantity under uncertainty May 09, 2012 17 / 42

The Model - Assumptions

Unregulated prot maximization function

maxek

k = (v cm) ek dke2k2

(v cm) = ck

ck is the per-unit markup

Prot maximization FOCek =

ckdk

MB

MC

Q

P

profits

Boa Cl DAmato (MEF) price vs quantity under uncertainty May 09, 2012 18 / 42

The Model - Assumptions

Focus on uncertainty

Model uncertainty on the mark-up side but not on the (convex) costside

apply in case of output price volatility (state of the economy) or inputprice volatilitymarkup ck is stochastic

assume uniform distribution ck 2 (k , ck k ) ! k 20, ck2

k captures the level of uncertainty, through an inverse relation. larger implies a smaller degree of uncertaintyEach rm ex ante knows the distribution, but not the realization, ofboth its own and the rivals productivity parameter.

Heterogeneous rms face uncorrelated uncertainty

Homogeneous rms face the same uncertainty (perfectly correlated asthey use the same technology).

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The Model - Assumptions

After cap and trade is launched, rms have to buy a permit at a pricep for each unit of e