INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Lesson 1: Carbon markets: A case

study on EU-ETS
Module: Introduction to Carbon Markets
Introduction

• Climate change and climate finance

• Carbon pricing and abatement cost concept
• Direct carbon pricing mechanisms: Emission Trading Systems
(ETS) and Carbon Taxes
• Design of ETS
• Introduction to EU ETS
• Implementation of EU ETS across the three phases
Introduction

• Allowance allocation methods: Free and Auction based

• Free allowance allocation: Grandfathering
• Free allowance allocation: Benchmarking
• Auction based allowance allocation
• Issue of surplus allowances
• Short-term Measure-Backloading
• Long-term Measure-Market Stability Reserve (MSR)
Introduction

• Banking and Borrowing of allowances

• Exchange trading instruments in EU ETS
• Supply-Demand forces and price formation
• Effectiveness of an ETS
• Global carbon market dynamics
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Climate change and Climate Finance

Climate Change

• What is climate change: Climate change refers to long-term shifts in

temperatures and weather patterns
• Governments and international agencies are focusing on the projects and
policy instruments that can take the global economy towards a low carbon
emission and decelerate the pace of climate change risk
• In this regard, the United Nations Framework Convention on Climate Change
(UNFCCC) has provided a basis for international climate negotiations
Climate Finance

• UNFCCC officially recognizes this novel area as “Climate Finance” and

defines it as “local, national, or transnational financing—drawn from public,
private, and alternative sources of financing—that seeks to support
mitigation and adaptation actions that will address climate change.”
• In this regards, Carbon pricing, specifically, emission trading schemes have
emerged as an important market-based instrument for climate protection.
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Carbon Pricing
What is Carbon pricing

• Why price carbon?

• What is the role of abatement cost?
• What are the direct and indirect ways to price the carbon?
• Carbon pricing helps internalize the external costs of greenhouse gas (GHG) emissions
• This cost of carbon could, in principle, represent the abatement cost needed to meet a
mitigation goal
• The abatement cost is simply the cost of an intervention that will reduce greenhouse gas
emissions
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Direct Carbon Pricing- ETS vs. Carbon

Taxes: Part I
 Forms of direct carbon pricing
• What is ETS and how it works

• How carbon taxation works as direct

instrument of climate change mitigation

• What kind of revenues are generated from

these direct carbon pricing mechanisms
Evolution of global revenues from Carbon Taxes and ETS over
• In an ETS, Carbon revenues are a function of time
Source: STATES AND TRENDS OF CARBON PRICING 2023
the carbon price, the emissions covered, and
other design features such as the method of
allowance allocation or the availability of
rebates.
11
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Direct Carbon Pricing- ETS vs. Carbon

Taxes: Part II
 Difference between Carbon tax and ETS
Element Carbon Tax ETS
Uncertainty in Price certainty; tax rate can be Price volatility; cap adjustments can limit
Price periodically adjusted price volatility.

Certainty of It is difficult to estimate emission The cap provides certainty on upper limit of
Emission reductions achieved through a tax ex emissions for ETS, enabling its alignment to
levels ante rate, making it hard to align to an certain policy target.
emission target.
Cost A tax does not reap the economic An ETS allows for economic efficiency
effectiveness efficiency gains of trading between between and within sectors (as a result of
entities and across sectors and offers trading) and over time. However, market
less temporal price flexibility for power, lack of liquidity, and excessive
regulated entities. volatility in allowance prices can reduce
cost-effectiveness.

13
 Difference between Carbon tax and ETS
Element Carbon Tax ETS
Ease of Like an ETS, a tax requires a robust An ETS is more complex to implement
administration monitoring, reporting, and verification because in addition to the infrastructure
and scope (MRV) system. However, it does not required for a tax it also involves a
require setting up an infrastructure secondary market for trading allowances.
for trading allowances, and the ability to The regulator and regulated entities
rely on existing tax infrastructure makes therefore need to have additional
it easier to implement in a broad range of capabilities. This might make it more difficult
sectors. to include certain sectors in the scope.

Price The carbon price is set by predefined tax The carbon price is determined by the
predictability rates. This provides a stable price signal market forces. This automatically adjusts for
to inform investment decisions. economic conditions but might lead to price
volatility.

14
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Functioning of Emission Trading

Schemes (ETS)
Emission Trading Schemes (ETS)

• An ETS is a cap-and-trade based program

• The allowances to emit are distributed amongst the covered entities

• The supply and demand forces ensure price discovery process and promote investment
into green and renewable energy technologies

• An ETS – as opposed to a tax – is a quantity-based policy, i.e., it offers certainty over the
environmental outcome (i.e., “cap”) but leaves it to the market (i.e., “trade”) to set the price
of carbon
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

A Simple Illustrative Example

 How does EU-ETS work?
• The EU ETS is a ‘cap and trade’ system,
which works by capping overall GHG
emissions of all participants in the system

• The level of the cap determines the

number of allowances available in the
whole system EU-ETS Handbook
Source: http://ec.europa.eu/clima/policies/ets/index_en.htm

• At the end of a year the participants must return an allowance for every tonne of CO2e they
emit

18
 How does EU-ETS work?
• In this example, Factory B does not have
enough free allowances to cover its
emissions, so it can either comply with
the cap by buying allowances from factory
A or from the auction

• Participants can also decide to bank

EU-ETS Handbook
allowances for use in later years Source: http://ec.europa.eu/clima/policies/ets/index_en.htm

• Allowances have value because there is a limited or capped supply and there is demand for
them from those participants for whom the cost of making reductions are higher than for other
participants

19
How does EU-ETS work?

Source:
https://www.msci.com/www/blog-
posts/introducing-the-carbon-
market/
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Introduction to European Union

Emission Trading System (EU-ETS)
 What is EU-ETS?
• The European Union Emissions Trading Scheme (EU ETS) is a ‘cap and trade’ scheme

• The system allows trading of emission allowances

• The trading approach helps to combat climate change in a cost-effective and economically
efficient manner

• It covers more than 11000 installations in 31 countries

22
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Benefits of EU-ETS cap-and-trade

scheme
 Benefits of cap-and-trade scheme
• The EU chose a “cap-and-trade” structure as the best means of meeting the
GHG emissions reduction target at least overall cost to participants and the
economy as a whole.

• The flexibility of cap-and-trade played an important role in the choice of a cap-

and-trade structure

• A traditional command-and-control approach may mandate a standard limit per

installation, but provides little flexibility to companies as to where or how
emissions reductions take place
24
 Benefits of cap-and-trade scheme
• Certainty about quantity:

• GHG emissions trading directly limits GHG emissions by setting a system cap that is designed to ensure
compliance with the relevant commitment

• Cost-effectiveness:

• Trading reveals the carbon price to meet the desired target

• Revenue:

• If GHG emissions allowances are auctioned, this creates a source of revenue for governments

• Minimizing risk to Member State budgets:

• The EU ETS provides certainty to emissions reduction from installations responsible for around 50% of EU
emissions

25
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Evolution of EU-ETS Phase I

 Phase I (2005-2007)
Key features:
• 3-year pilot of ‘learning by doing’ to meet Kyoto protocol emission reduction targets
• Covered only CO2 emissions from power generators and energy-intensive industries
• Almost all allowances were allocated to installations for free
• The penalty for non-compliance was €40 per tonne

Phase 1 succeeded in establishing:

• A price for carbon
• Free trade in emission allowances across the EU
• The infrastructure needed to monitor, report and verify emissions from the businesses
covered.

27
 Phase I (2005-2007)
• In the absence of reliable emissions data, phase 1 caps were set based on
estimates.

• As a result, the total amount of allowances issued exceeded emissions and,

with supply significantly exceeding demand.

• The banking of EUA was prohibited between phases(phase 1 allowances

could not be banked for use in phase 2).

• The stated reasons led the EUA price fell heavily and eventually converged to
close to zero at the end of Phase 1.
28
 Phase I – EUA prices

29
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Evolution of EU-ETS Phase II

 Phase II (2008-2012)
Key features:
• Phase 2 coincided with the first commitment period of the Kyoto Protocol

• Lower cap on allowances, more new countries joined

• The proportion of free allocation fell slightly to around 90%

• The penalty for non-compliance was increased to €100 per tonne

• Businesses were allowed to buy international credits totaling around 1.4

billion tonnes of CO2-equivalent

31
 Phase II (2008-2012)
Key features:

• Union registry replaced national registries and the European Union Transaction Log
(EUTL) replaced the Community Independent Transaction Log (CITL)

• The aviation sector was brought into the EU ETS on 1 January 2012

• Verified annual emissions data from the pilot phase was now available

• However, the 2008 economic crisis led to emissions reductions that were greater
than expected.

32
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Evolution of EU-ETS Phase III and IV

 Phase III (2013-2020)
Key features:

• The reform of the ETS framework for phase 3 (2013-2020) changed the system
considerably compared to phases 1 and 2

• A single, EU-wide cap on emissions in place of the previous system of national caps
(NAPs)

• Auctioning as the default method for allocating allowances (instead of free allocation)

34
 Phase III (2013-2020)
Key features:

• Harmonised allocation rules applying to the allowances still given away for
free

• 300 million allowances set aside in the New Entrants Reserve (NER)

• The Union-wide cap for stationary installations decreased each year by a

linear reduction factor of 1.74%. The 2013 cap was set on the basis of the
average total quantity of allowances issued annually in 2008-2012

35
 Phase IV (2021-2030)
Key features:

• The allowances supply cap will reduce at a higher rate of 2.22% every year,
compared to 1.74% earlier

• The initial volume of the NER at the start of Phase 4 amounted to 331.3 million
allowances

• Unlimited banking has been allowed since 2008. Borrowing is not allowed

• As of 2020, the EU ETS and the Swiss ETS are linked

36
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Evolution of EU-ETS: Summary

 Evolution of EU-ETS

Source: https://www.msci.com/www/blog-posts/introducing-the-carbon-market/

38
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

EU-ETS compliance cycle

EU-ETS compliance cycle

The annual procedure of

monitoring, reporting and
verification (MRV), together with
all the associated processes, is
known as the ETS compliance
cycle.

EU-ETS Handbook
Source:
http://ec.europa.eu/clima/policie
s/ets/index_en.htm
 Monitoring, Reporting, and Verification (MRV)

• Monitoring is the process of gathering data that is used to determine emissions produced or
saved. It can be based on direct emissions monitoring or calculation methods that derive
emission from other parameters, such as fuel use.

• Reporting is the mechanism and infrastructure by which the regulated entity provides
emissions information to the regulator. This can employ a range of possible tools from use of
templates to electronic reporting systems and web interfaces. More sophisticated reporting
systems can include workflow management for more-holistic facilitation of engagements
between regulators, verifiers, and operators during the compliance cycle.

• Verification is the process for third-party checking of the correct application of the monitoring
method and the accuracy of the reported emissions. Verifiers will be independent from
operators and should be accredited to carry out their work in accordance with established
standards and protocols.

41
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Allowance Allocation: Introduction

 Allocation of allowances
• Methods of allocation:
1. Free allocation
• 1.1 Free allocation using grandfathering approach
• 1.2 Free allocation using benchmark approach
2. Selling allowances in an auction
• Free allocation is typically provided either based on historical
emissions (grandfathering) or on efficiency benchmarks
(benchmarking)

43
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Allowance Allocation: Grandfathering

 Allocation of allowances: Grandfathering
• Free allocation (grandfathering) = applicable historical emissions x adjustment factors

• Free allocation via grandfathering uses historical emissions to determine the allocation.

• Companies receive free allowances based on their historical emissions from a specified period

• Grandfathering has the advantage of being relatively simple with moderate data requirements

• However, it may reduce the need to trade in early years and can penalize companies that
invest in emission reductions early on, as these reductions may effectively lower their ‘historical
emissions baseline’ and cause them to receive fewer permits

45
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Allowance Allocation : Challenges

with Grandfathering
 Challenges with Grandfathering
• During phases 1 and 2, most allowances in all Member States were given out for free
based on historical GHG emissions, i.e., grandfathering.

• First, it has been blamed of causing undesired redistributive effects: The general
criticism regarded the unfairness of inducing consumers to pay for what producers
received for free.

• Grandfathering has been criticized also on an efficiency ground by arguing that it is

equivalent to a government subsidy

• This approach has been criticised as rewarding higher emitters while not taking early
action into account.
47
 Challenges with Grandfathering
• Weak impact on leakage risk: grandparenting does not affect the marginal incentives
that firms face under a carbon price, it does not protect against production leakage

• Penalizing early action of the early movers if they implement the abatement actions
early in time

• New entrants and closures: new entrants are at disadvantage as they have no historic
emissions and also delay the exit decision from the carbon intensive producers

48
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Allowance Allocation : Benchmarking

 Allocation of allowances: Benchmarking
• Allocation = Benchmark * Historical activity level *adjustment factors

• In contrast to grandfathering, benchmarking does not have the effect of providing more free
allocation to the highest emitting installations. Benchmarking allocates allowances based on their
production performance instead of their historical emissions; GHG-intensive installations will receive
less free allowances relative to their production compared to highly efficient installations, driving
inefficient installations to take action to cover their excess emissions.

• Benchmark = A benchmark is a reference value for the greenhouse gas emissions, in tCO2, relative
to a production activity. The applicable benchmark depends on the product produced.

• Historical activity level: The historical activity level indicates the historical production per year
corresponding to the applicable benchmark.

• From Phase 3 onwards, benchmarking is used for free allocation of allowances..

50
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Allowance Allocation : Auctioning

 Allocation of allowances: Auction

• Auctioning involves the allocation of allowances through a competitive bidding

process,

• Auctioning allowances can be a more straightforward method than free allocation

• It also creates a source of revenue that can then be distributed to a wide range of
potential beneficiaries.

• Auctioning helps improve price discovery, and market transparency

• Reduces the risk of distortions and rewards early action

52
 Auctioning Platforms
• From the start of phase 3, a Example of allowances and emissions from the installation in
the U.K.
large share of installations
will have to buy their
allowances
• One of the auction platforms
is the European Energy
Exchange AG (EEX)
• The second auction
platform is ICE Futures
Europe (ICE), which acts as
the auction platform for the
UK.

53
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Surplus of allowances- A challenge

 Surplus of allowances- A challenge
• A surplus of emission allowances has built up in the EU emissions trading
system (ETS) since 2009
• The European Commission is addressing this through short- and long-term
measures
• The surplus of allowances is largely due to the economic crisis (which
reduced emissions more than anticipated) and high imports of international
credits. This has led to lower carbon prices and thus a weaker incentive to
reduce emissions
• Short term measure: Back loading of auction in Phase 3
• Long term measure: MSR (Market Stability Reserve)

55
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Short term measure: Backloading of

auctions in Phase 3
 Short term measure: Backloading of auctions in
Phase 3
• As a short-term measure the Commission postponed the auctioning of 900 million
allowances until 2019-2020.

• This ‘backloading’ of auction volumes does not reduce the overall number of
allowances to be auctioned during phase 3, only the distribution of auctions over the
period.

• The auction volume is reduced by

• 400 million allowances in 2014

• 300 million in 2015

• 200 million in 2016.

57
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Long term measure: Market Stability

Reserve (MSR)
 Long term measure: MSR
• The European institutions decided in 2015 to introduce a market stability reserve (MSR) by
2019

• From 2021 onward, the annual linear reduction factor (LRF) of the emissions cap increases
from 1.74% to 2.2%.

• From 2019 till 2023, the intake rate of the MSR doubled from 12% to 24%

• From 2023 onward, the MSR cannot contain more allowances than the total number of
allowances auctioned during the previous year

59
 Long term measure: MSR
• The MSR aims to maintain a certain supply–demand in the EU ETS and improve the
system’s resilience to major shocks.

• It adjusts auction volumes according to pre-defined thresholds of the total number of

allowances in circulation (TNAC)

• As a long-term solution, it began operating in January 2019; “Fit for 55” plan

• The 900 million allowances that were back-loaded in 2014-2016 will be transferred to

the reserve rather than auctioned in 2019-2020

• Unallocated allowances will also be transferred to the reserve.

60
 Long term measure: MSR
• Thresholds: TNAC determines
whether the allowances will be placed
in reserve or released

• When the TNAC is above 833 million,

24% of its volume is withdrawn from
future auctions

• When the TNAC is less than 400

million allowances, 100 million
allowances are released from the https://climate.ec.europa.eu/eu-action/eu-emissions-
reserve and auctioned. trading-system-eu-ets/market-stability-reserve_en

61
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Banking of Allowances
 Banking of allowances
• Banking allows regulated entities to save unused allowances for use in future
compliance periods

• Banking can facilitate cost-effective abatement

• Moreover, it can reduce price volatility by creating additional demand for allowances
when prices are low

• In general, banking is central to the efficient functioning of most carbon markets

• Banking can however create some challenges: Unlimited banking can enable an
excess supply of allowances in one compliance period to be carried over into future
compliance periods
63
 Banking of allowances
• Banking means that changes in expectations of future market conditions can feed
back to today’s prices,

• In practical terms, there are several cases where policymakers have chosen to
impose limits on the banking or holding of allowances

• Prohibiting or limiting banking is a way to isolate a pilot phase from the subsequent
phase

• To control the ability of individual entities to acquire market power.

64
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Borrowing of allowances
 Borrowing of allowances
• Borrowing allows entities to use allowances they will receive in future compliance periods
within the current compliance period

• Borrowing provides firms with flexibility to meet targets

• However, there are challenges associated with providing intertemporal flexibility

• Governments may not be able to assess creditworthiness

• Increases political pressure to delay action

• A degree of short-term implicit borrowing is facilitated by offering early access to future

allowance allocations

• There is no vintage associated with the allocation

66
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Organized exchanges and traded

products
 Organized exchanges and traded products
Spot:
• This is a trade where settlement of the trade (payment and
delivery) is intended to take place ‘on the spot’.

Futures:
• This is a standardised contract between two parties to buy or sell
a specified amount of carbon units for a price agreed today

68
 Organized exchanges and traded products
Forward:
• A forward contract is similar to a futures contract in that the
contract terms are agreed at the time of the sale, but delivery and
payment occurs at a later date.
Swaps:
• This is a contract to exchange one security for another.
Options:
• Options are about giving buyers of the option the right, but not the
obligation to buy or sell allowances at a fixed price upfront.
69
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Price formation in ETS

 Price formation in ETS
Supply

• The level of the cap and the associated amount of allowances

• Any supply of allowances carried over (“banked”) from previous periods or drawn from future
periods (“borrowed”)

• Supply depends on parameters set by policymakers

71
 Price formation in ETS
Demand
• The total demand for emissions allowances in an ETS depends largely on technology,
expectations, exogenous shocks, and profit maximization by market participants

• The level of emissions under ‘business as usual (BAU)’

• The costs of abating emissions within the covered sectors

• The outcomes of companion policies that reduce emissions within covered sectors

• The expectations and uncertainty regarding future allowance prices

• Technological change, including that driven by the expectation of future stringency in

regulations
72
 Price formation in ETS
Price Levels and Volatility
• The market will set the price that
balances supply and demand at any
one point in time

• Expectations about the allowance

market also drive price formation

• Various system design features

enable regulated entities to respond
to short-lived price volatility

• Promoting financial-sector EU-ETS Handbook. Source:

http://ec.europa.eu/clima/policies/ets/index_en.htm
participation in secondary markets
is important for managing volatility

73
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

ETS effectiveness
 ETS effectiveness
• An ETS should be designed so that it achieves its underlying economic and
environmental objectives

• Reduced emissions: Delivering emissions reductions to support jurisdictions

to achieve, and strengthen, emissions reduction targets consistent with the
Paris Agreement.

• Intertemporal efficiency: Ensuring emissions are reduced at the right time.

• Allocative efficiency: Ensuring that the least-cost mitigation options are

being used.
75
 ETS effectiveness
1. Reduced emissions

• The ultimate aim of an ETS is to deliver reductions in emissions to mitigate

climate change

• A robust and rising price level over time can encourage early investment in low-
cost mitigation, with a gradual movement to more costly abatement as lower-
cost options are exhausted

• Similarly, measures that increase governments’ ability to accelerate targets can

also play a role
76
 ETS effectiveness
2. Promote intertemporal efficiency

• Intertemporal efficiency requires that mitigation happens when it is most

efficient
• Intertemporal efficiency is driven by forward-looking firms anticipating and
responding to potential future costs
• Allowing entities flexibility over the point in time when they reduce emissions can
facilitate cost-effective action on climate change. It does so in two ways
• By allowing individual entities to abate in the most cost-effective way
• By facilitating investment in new technology
• Ensuring predictable prices by avoiding extreme high- or low-price outcomes is
important to support intertemporal efficiency

77
 ETS effectiveness
3. Promote allocative efficiency

• Allocative efficiency refers to whether the mitigation effort is appropriately split between
regulated entities

• Liquidity means that firms that wish to buy or sell allowances can do so at any point

• The secondary market for allowances can support allocative efficiency through
reducing transaction costs

• A liquid market with low transaction costs will support tradein allowances and help
ensure that prices reflect the latest information available to market participants

78
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Global Emission Trading Market

 Global Emission Trading Market
• Emissions trading for GHGs originated
in attempts to control local air pollutants
from power plants in the United States
in the 1970s

• The 1997 Kyoto Protocol established

provisions for the trading of
emissions/emission reductions among
its parties

• In 2005, the European Union (EU) and

Source: EMISSIONS TRADING IN PRACTICE- A
Norway established domestic ETSs Handbook on Design and Implementation

80
 Global Emission Trading Market

Source: World Bank

81
 Price Evolution of Different ETS

Source: States and Trends of Carbon Pricing 2023, World Bank Report

82
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Summary and Concluding remarks

Summary and Concluding remarks

• Climate change refers man made long term shifts in temperatures

and weather patterns
• Financing of projects that support mitigation of climate change is
refered to as climate finance
• Carbon pricing plays a very important role in quantifying these
adverse effects of GHG emissions on the environment
• Abatement cost is the cost of intervention to reduce per tonne
carbon equivalent of GHG emissions
Summary and Concluding remarks

• Carbon taxes is a direct policy instrument where resulting price is

certain by emission reduction objectives are not well controlled
and certain
• ETS provide more control and certainty with emission reduction
objectives, but resulting prices and volatile and uncertain
• EU ETS is a cap-and-trade based scheme, where overall cap is
decided based on emission reduction objectives, and these
overall objectives are distributed amongst the covered
installations
Summary and Concluding remarks

• At the end of operating cycle, installations have to furnish

allowances equivalent to their carbon equivalent emissions
• Those in surplus can sell or bank their allowances, those falling
short can purchase from ETS at market determined prices
• EU ETS has been implemented in four faces, phase I (2005-07),
phase II (2008-12) and phase III (2013-20) have completed
• While initially, there were some issues related to carbon prices
due to excess supply, now these issues are gradually being
resolved
Summary and Concluding remarks
• The two key allowance allocation approaches employed at EU
ETS are free allocation and auction based approach
• The free allowance allocation methods included grandfathering
and benchmarking
• Under the grandfathering approach historical levels of emission
were employed to allocate allowances
• Under the benchmarking approach, output based method, where
installations were compared against the emissions of the best
most efficient plants
Summary and Concluding remarks
• A more evolved approach is considered as competitive auction
bidding of allowances
• One of the legacy issues from Phase I and Phase II afflicting the
carbon pricing is excess supply of allowances
• Backloading – a short-term measure- delayed 900 Mn allowance
auctions by certain years, thereby immediately absorbing excess
allowances
• MSR- a long-term measure- operated by absorbing excess
allowances if TNAC exceeded by 833 million; and releasing the
same if TNAC is less than 400 million
Summary and Concluding remarks
• For covered installations, the provision of banking and borrowing
helped them in optimizing their emission objectives
• Banking allows covered installations to use unused allowances in
future compliance periods
• Borrowing allows the use of allowance allocated in the current
monitoring cycle to be used in the previous period compliance
submissions
• Both of these mechanisms help optimize the time-pattern of
carbon emissions and balance out excess supply demand
Summary and Concluding remarks
• They key instruments include spot, forward, futures, swap, and
options contracts used at the two major exchanges –EEX and
ECX
• These instruments contribute to carbon pricing efficiency by
removing excess volatility levels associated with emission related
uncertainties
• In the short-term, allowance supply is fixed and pricing is driven
by demand related factors such
• The effectiveness of an EU ETS is judged by level of emission
reduction and levels of abatement cost, that is cost of reducing
per tonne of carbon equivalent emissions
Summary and Concluding remarks
• Since the inception of EU ETS, a number of non-Euro developed
and emerging markets such as Indian, China, are coming up with
their own ETS
• Early phases of these ETS are characterized by weak prices that
are volatile
• Gradually, as the schemes mature, prices are increasing, and
becoming more stable and less volatile, reflecting the success of
this policy instrument
Thanks!