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SYNTHESIS

After monetary policy, climate policy: is delegation the key to EU ETS reform?

G. Grosjean Potsdam Institute for Climate Impact Research, P.O. Box 60 12 03, 14412 Potsdam, Germany; Technische Universität Berlin, Economics of Climate Change, Straße des 17. Juni 145, 10623 Berlin, GermanyCorrespondencegrosjean@pik-potsdam.de
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W. Acworth Potsdam Institute for Climate Impact Research, P.O. Box 60 12 03, 14412 Potsdam, Germany
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C. Flachsland Mercator Research Institute on Global Commons and Climate Change, Torgauer Straße 12–15, 10829 Berlin, Germany
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R. Marschinski Potsdam Institute for Climate Impact Research, P.O. Box 60 12 03, 14412 Potsdam, Germany; Technische Universität Berlin, Economics of Climate Change, Straße des 17. Juni 145, 10623 Berlin, Germany; Mercator Research Institute on Global Commons and Climate Change, Torgauer Straße 12–15, 10829 Berlin, Germany
Pages 1-25
Published online: 05 Nov 2014

SYNTHESIS

After monetary policy, climate policy: is delegation the key to EU ETS reform?

Abstract

Since the crash of carbon prices in phase II of the European Union Emissions Trading System (EU ETS), many have argued that the low price mirrors structural failures requiring intervention. A wide range of reform options have been suggested, including delegating the governance of the carbon market to an independent authority. This article analyses the debate by reconstructing the various arguments for or against reform. Three possible drivers of the price decline are investigated: (1) exogenous shocks; (2) insufficient credibility; and (3) market imperfections. It is argued that the extent to which a low price is problematic and warrants reform depends on the specific objectives associated with the EU ETS and the perception on the functioning of the market. A two-dimensional EU ETS Reform Space, comprising the degree of price certainty within the EU ETS and the level of delegation, is devised. Within the Reform Space, EU ETS reform options currently discussed are mapped. This descriptive structure offers a framework to clarify whether delegation responds to various concerns with respect to the EU ETS. Delegation might enhance flexibility under unforeseen circumstances, decrease policy uncertainty, and increase the credibility of long-term policy commitments. However, higher degrees of delegation face challenges including democratic legitimacy and political feasibility.

Policy relevance

In January 2014, the European Commission proposed a structural reform of the EU ETS characterized by a quantity triggered Market Stability Reserve, increasing flexibility in allowance supply. However, intense debate has revealed considerable differences in opinion regarding the need for and objectives of any adjustment mechanism. Other proposals, including various degrees of delegation to a rule-based adjustment mechanism or an independent authority as well as degrees of price certainty, were also suggested. This article offers a new framework, the EU ETS Reform Space, to compare reform options more systematically. This work therefore contributes to structuring the policy debate by providing a tool to better understand the merits and demerits of various reform proposals

1. Introduction

Whether the European Union Emissions Trading System (EU ETS) needs to be reformed – and if so how – is one of the most discussed questions of current European climate policy. The debate was mainly triggered by the marked and persistent drop of the EU allowance (EUA) spot price, which went from €30 in January 2008 to below €5 in January 2013, and has since remained around this level until the time of writing this article (January 2014). The EUA future prices closely followed the trend, and in 2013 ranged from €6 to €7 for a year 2020 allowance (Intercontinental Exchange (ICE), 2014). Based on the current academic debate and economic theory, the price deterioration can be attributed to several factors. These factors may be divided into three categories of drivers that could explain the current low price: (1) exogenous shocks (e.g. economic crisis, overlap of policies such as ‘renewable support schemes' and influx of Clean Development Mechanisms at the end of phase II); (2) political uncertainty and lack of long-term credibility; and (3) market imperfections (see e.g. Aldy & Stavins, 2012; Egenhofer, Marcu, & Georgiev, 2012; European Commission, 2014a; Koch, Fuss, Grosjean, & Edenhofer, 2014; Neuhoff, Schopp, Boyd, Stelmakh, & Vasa, 2012; Van den Bergh, Delarue, & D'haeseleer, 2013).

Nonetheless, there appears to be much less consensus on whether the current low price is per se a problem that warrants regulatory reform. This article argues that the divergence on this question originates partially from different fundamental objectives (usually implicitly) associated with the EU ETS, as well as on the perception of the functioning of the EU ETS. Officially, the 2003 Directive establishing the EU ETS states that it is intended to ‘promote reductions of greenhouse gas emissions in a cost-effective and economically efficient manner’ (European Union, 2003). However, it is silent on the timeframe at which cost-effectiveness should be assessed. In addition, the Directive does not clearly define the role the EU ETS should play, for instance, in the development of new technology. Such objectives are therefore implicitly assumed by various observers of the market. This diversity of opinions was reflected in interviews with experts from academia, industry, as well as policy makers, which were undertaken to inform this article.1 For instance, although some observers consider the EU ETS a pure quantity-based mechanism to implement emissions targets at least cost within a trading period, others expect the scheme to convey a credible long-term price signal to induce the technological innovation and investments required to reduce emissions costs effectively over time. Moreover, even if the case for EU ETS reform is accepted, the ranking of reform options might differ. This article therefore intends to shed light under what assumptions on the functioning of the EU ETS a reform is needed and identify the types of reform that are potential responses to the various market or governance imperfections.

To address the perceived problems of the EU ETS, the European Commission (2012a) proposed in 2012 six reform options, broadly falling into three groups: (1) a one-off change in the emissions reduction profile; (2) a change in the scope of the EU ETS (sectorally or geographically); and (3) price management. In January 2014, following stakeholder consultation and limited modelling, the European Commission announced it favoured a Market Stability Reserve (MSR) to introduce flexibility and improve the functioning of the EU ETS. While there are a range of policy instruments available to implement these and other reform options, a distinct question is what type of institution should have the control over the respective policy levers. Theoretically, control could remain with the EU – i.e. the current arrangement of legislating and implementing policy between the European Commission, European Council, and European Parliament. However, the idea of delegating some aspects of carbon market governance to an independent regulatory body such as a carbon central bank has also been discussed. For instance, the German Council of Economic Experts (2013) has suggested the creation of a ‘certificate central bank’ to stabilize carbon prices.

Delegation has been discussed extensively in the literature, usually as a mechanism to strengthen regulatory commitment in a context of potential time inconsistency (Barro & Gordon, 1983; Kydland & Prescott, 1977; Rogoff, 1985). Time inconsistency arises where policy makers have an ex post incentive to renege on commitments that may have been optimal ex ante, and where anticipation of this effect by regulated agents is not adequately considered in policy design. In that framework, delegation has also been put forward as a means to protect from overly short-term-focused policy making induced by electoral considerations or by incapacity to bind future legislatures (Gilardi, 2002; Majone, 1997).

Monetary policy provides the classic example where the short-run trade-off between inflation and unemployment decreases the credibility of anti-inflationary commitments by governments with short-term objectives. In other sectors requiring large and irreversible investments such as infrastructure, a rational regulator has the incentive to focus on broader goals such as increasing consumer welfare once sunk investments have been made (Trillas, 2010). Accordingly, investors anticipating such behaviour either hold off or underinvest in new infrastructure, relative to what would be socially optimal.

An often suggested remedy to time-inconsistent policies is delegation, either by setting rules that tie the hands of the politicians or by establishing an independent and credible regulator, which is bound by a firm mandate, but operates within various degrees of discretionary power (Barro & Gordon, 1983; Levine, Stern, & Trillas, 2005; Stern & Trillas, 2003). Those that favour delegation via rules argue that rules reduce human-induced policy mistakes and increase transparency for market participants (Van Lear, 2000). Proponents of discretion argue that rules are too inflexible and thus lead to an inability to adjust to new information or to (expectable) mistakes having been made in policy design (Barro, 1986; Bernanke, 2003).

In addition, delegation is also suggested to provide the required regulatory expertise in highly complex policy issues (Majone, 1996), address principal-agent problems (Bendor, Glazer, & Hammond, 2001; Eggertsson & Le Borgne, 2003), and shield against regulatory capture by interest groups (Miller, 1998). Nonetheless, it has also been argued that delegation does not solve the commitment problem but rather relocates it (McCallum, 1995), it may not be possible to find an agent with appropriate preferences (Trillas, 2010), and the independent agent might still be at risk of industry capture (Che, 1995). Finally, setting up independent agencies is a highly political process, where the agency may lack accountability and hence democratic legitimacy (Aziz, 2005; Ergas, 2010; Rodrik, 2014).

In the context of carbon pricing policy, delegation was first considered in view of potential time inconsistency problems (Helm, Hepburn, & Mash, 2003). In addition, it has also been discussed more recently as a response option to specific perceived failures of the EU ETS. For example, delegation has been proposed to give additional flexibility to manage the EUA permit market by either targeting prices (Clò, Battles, & Zoppoli, 2013; Taschini, Kollenberg, & Duffy, 2014) or quantities (de Perthuis, 2011; de Perthuis & Trotignon, in press; European Commission, 2014b; IETA, 2013). It is expected to introduce a transparent and predictable intervention framework capable of aligning short-term prices with long-term objectives (see de Perthuis, 2011; de Perthuis & Trotignon, in press). It has also been suggested as a mechanism to provide market supervision and to undertake policy coordination (de Perthuis, 2011; Edenhofer, Flachsland, & Marschinski, 2007). Similar proposals have also been made, applicable globally (Edenhofer, Knopf, & Luderer, 2010; Klingenfeld, 2012) or to any country (McKibbin, Morris, & Wilcoxen, 2009) but also specifically for the US (Whitesell, 2007, 2011) and Australia (Garnaut, 2012).

Much of the recent debate on EU ETS reform has focused on comparing and contrasting an independent carbon authority against instrumental reform options such as a price floor or price corridor. In our view, this is misleading, as the institutional set-up with various degrees of delegation and the type of instrument used – for instance introducing more price certainty – are different dimensions of policy design that cannot be directly compared. In that context, this article aims to clarify two important aspects of the current discussion. First, it intends to bring insight to the debate on the need for reform by grounding in economic theory the diverging perspectives on the low allowance price. Second, it proposes an EU ETS Reform Space, which offers a new descriptive framework to map EU ETS reform proposals along the two dimensions of price certainty and degree of delegation. This framework is then applied to structure the discussion of the merits and demerits of delegation as a reform option for the EU ETS.

The article is organized as follows. In Section 2, the possible explanations for the low permit price are attributed to three potential drivers, which are then linked to the different objectives associated with the EU ETS, and a case for (or against) reform is derived. In Section 3, options for reform entailing both instrumental and institutional changes that have been suggested in the policy debate are discussed. In Section 4, these options are mapped onto an EU ETS Reform Space, and the possibility to address the various perceived fundamental problems of the EU ETS through delegation is investigated. Section 5 provides a brief discussion of caveats and conclusions.

2. Drivers of the low permit price and rationales for intervention

As the EU ETS entered its third phase in 2013, the EUA price decreased and remained at around €5. Moreover, the annual schedule for releasing new permits into the market remained unchanged despite the existing annual surplus2. As a consequence, it is estimated that an oversupply of allowances will persist throughout phase III until 2020, with the EUA price remaining accordingly low (European Commission, 2014a; Morris, 2012; Neuhoff et al., 2012). At present, many analysts do not expect the EUA price to exceed €20 before 2020 (European Commission, 2013; Point Carbon, 2013a) or even 2030 (Egenhofer et al., 2012), although it was previously expected to reach €25–39/tCO2e over that period (European Commission, 2009).

But does the low permit price point to a structural problem within the EU ETS? And if so, what exactly is the problem with a low EUA price, and what should be done about it? These were two of the questions asked of 23 EU ETS experts. The answers to the first question were almost evenly divided between ‘low price does not indicate a problem’, ‘low price indicates a problem', and ‘cannot say’, thus revealing a strong divergence in the assessment of EUA prices. When asked about structural problems built into the EU ETS, most experts agreed that political uncertainty and a lack of credibility were key concerns, followed by inconsistency of long-term targets, overlap of climate policies, lack of flexibility, and over-allocation (see Figure 1(a)). Of the experts, 15% did not perceive any failures in the current EU ETS design that would mandate government intervention.

Figure 1 Results from expert interviews Note: Results are based on ex post assessment and categorization of responses. Hence, responses have not been coded and categories were established after the interviews. Respondents could give multiple responses.

Source: Interview results.
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In addition, Figure 1(b) shows that no clear consensus exists as to what constitutes the primary objective of the EU ETS. This suggests that the positions interviewees adopted on reform need to be explained both in terms of their assessment of current design problems and their understanding of the main objectives of the EU ETS.

In sum, the picture that emerges from the expert interviews is puzzlingly heterogeneous. In view of this, this section sets out to disentangle whether (and which) reform of the EU ETS is warranted based on different views on (1) the most relevant drivers of the permit price, and (2) the perceived objective(s) of the EU ETS. The aim of this article is to understand the various aspects of the debate, rather than to argue for or against a specific position. This section presents a comprehensive qualitative review of the literature on the possible drivers of the current price level. Against this background, each of the following subsections discusses a possible driver of the price level, including exogenous shocks (Section 2.1), lack of credibility (Section 2.2), and market imperfections (Section 2.3).

2.1. Exogenous shocks

Market response to a series of exogenous shocks reducing permit demand in the presence of a fixed supply schedule is perhaps the simplest explanation of the low EUA price. Those exogenous shocks included (1) the economic recession following the financial crisis; (2) overlapping policies like national ‘renewable support schemes' for renewable energy sources; and (3) the large influx of Certified Emission Reductions (CERs)/Emission Reduction Units (ERUs) at the end of phase II.

Regarding the first point, as shown in Figure 2, it is evident that the economic crisis has played an important role in the oversupply of allowances (Curien & Lewis, 2012; de Perthuis, 2011). The crisis has hit Europe for several years, depressing output and therefore demand for emission permits. The actual gross domestic product (GDP) growth of the EU turned out to be much lower than previously anticipated in the modelling exercises (European Commission, 2007) that informed the design of phase II (see Figure 2(b)) (European Commission, 2007). In fact, the total verified emissions of the facilities covered by the EU ETS decreased by 12% between 2008 and 2012 (European Environment Agency, 2013) and remained persistently well below the cap (Figure 2(a)) from 2009 onwards.

Figure 2 Drivers of the low price. (a) The EU ETS annual cap (Cap), annual verified emissions from sources covered by the EU ETS (Emissions), annual offsets surrendered for compliance (Offsets), and average annual future rolling prices (CO2 price). (b) Actual annual GDP (EU27) compared to the 2007 GDP baseline in PRIMES (2007) (see European Commission, 2007). (c) Deployment of total renewable energy (RE Energy (actual) and RE Energy (expected)), as well as the deployment of renewable electricity (RE Electricity (actual) and RE Electricity (expected)). Note that aviation was added to the EU ETS in 2012 (European Commission, 2014c) (it was limited to domestic aviation in 2013) and that the linear reduction factor of the cap was only implemented from 2013 onwards

Sources: Own compilation based on Beurskens and Hekkenberg (2011), EEA (2013), European Commission (2007), Eurostat (2013a, 2013b), ICE (2014), Point Carbon (2011a, 2011b, 2012, 2013a).
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Second, the EU ETS is currently interacting with a host of broader climate and energy policies that are administered both at the national and European levels. Countries such as Germany and Spain have introduced ‘renewable supporting schemes' to promote the development of renewable technologies in order to reach domestic energy policy objectives and the targets of the EU 2020 climate and energy package (European Commission, 2012b). The current evidence indicates that the total renewables deployment was indeed slightly higher than anticipated for the EU in 2011 (see Figure 2(c)). In addition, some countries participating in the EU ETS, including the UK, Sweden, Norway, and Denmark, have implemented carbon taxes in addition to the EU ETS (Fankhauser, Hepburn, & Park, 2010).

Third, when market participants use CERs for compliance, this automatically reduces the demand for permits in the EU ETS. As long as the price of CERs remains lower than that of EUAs, companies have an incentive to use international offsets until they reach the legislated (per company) quota on maximum CERs use. In 2012, firms had already surrendered more than 60% of the maximum amount of offsets permissible for the entire period 2008–2020 (Point Carbon, 2013b). This development was driven by two factors: (1) a change in the EU ETS regulation preventing the use of some offset types in phase III (e.g. credits originating from HFC and adipic acid N2O projects, World Bank, 2012); (2) the collapse in credit prices due to the non-ratification of the Kyoto Protocol by major emitters, which led to a low international demand for credits. This triggered an unexpectedly large use of offsets for compliance in the EU ETS in 2011 and 2012 (see Figure 2(a)), which further increased the size of the surplus of allowances at the end of phase II (European Commission, 2014a; Neuhoff et al., 2012).

Depending on the objectives associated with the EU ETS, explaining the current low price as the result of exogenous shocks actually allows for two opposing conclusions regarding the case for or against an EU ETS reform. If the focus is on cost-effective attainment of the short-term cap as the only objective of the EU ETS, there is clearly no reason for intervention. In this line of reasoning, changing the market rules now by, for example, revising the planned number of new permits, could even be counterproductive. If fact, it could damage the EU's credibility to adhere to announced emission targets (Egenhofer et al., 2012).

However, various authors have adopted a broader, multiple objectives perspective beyond short-term cost-effectiveness, resulting in a preference for a higher and more stable permit price as a means to meet these objectives. The first two objectives are (1) inducing the development of low-carbon technologies in a dynamically efficient manner (Clò et al., 2013; European Commission, 2014a) and (2) promoting Europe's goal of being a symbolic leader-by-example (Grubb, 2012; UK Government, 2013).

Given the first objective of achieving dynamic cost-efficiency, current (and forward) carbon prices would need to be sufficiently high to induce the desired level of low-carbon technology development (the optimal level of which seems methodically difficult to determine). In fact, due to the magnitude of the transition needed to achieve long-term decarbonization, innovation in low-carbon technologies will be essential to minimize the long-term costs.

From the perspective of the second objective, implementation of the EU ETS is intended to show leadership to bring other major emitters on board for a global climate agreement. Early and ambitious action in mitigation might be used to signal high benefits from emissions reduction to other players (Jakob & Lessmann, 2012) and also create technological learning spillovers, reducing the costs of energy transformation for the rest of the world (Golombek & Hoel, 2004).

In addition to these two objectives, there have also been concerns that an excessively low price will not reflect the marginal social costs of carbon and thereby fails to internalize the negative global externality associated with carbon emissions (Nordhaus, 2011). As is well known (e.g. Baumol & Oates, 1988; Stern, 2007), pricing externalities is one of the cardinal lessons distilled from environmental economics. While the adherence to emission targets under the EU ETS is guaranteed, it cannot be relied upon to generate a price consistent with the social cost of carbon. Against this background, it might be justified to intervene in the market if there is a pretence to establish such a correspondence (if only roughly).

From each of these multiple objectives perspectives, a (sufficiently high) carbon tax may appear the appropriate instrument in the first place. However, its implementation was not politically feasible in the EU due to the requirement of unanimity voting required to implement a tax at the EU level (Convery, 2009). Turning the EU ETS into a hybrid instrument featuring a price corridor would thus introduce the benefits of a taxation instrument into the EU ETS quantity system (Pizer, 2002). If the EUA price turns out to be lower ex post than anticipated ex ante (e.g. based on modelling studies), measures stabilizing the price in the presence of exogenous shocks would be justified in this multiple objectives perspective.

2.2. Lack of credibility

Although specific EU ETS targets have been legislated only until 2020, the cap is scheduled to be reduced linearly by a factor of 1.74% even beyond this date, unless changed otherwise by policy reform. In addition, EU leaders officially re-acknowledged in February 2011 the objective of reducing Europe's emissions to 80–95% below 1990 levels by 2050 (European Commission, 2011), but it is worth noting that this is not a legally enshrined target.3 In response to longer-term targets and a constant year-on-year reduction of the cap, firms should be expected to exploit the current low price by moving forward abatement and accumulating permits for later trading periods with inevitably higher permit prices. This would drive the current price up. Yet, if the EU's announcement of stringent emission targets in the trading periods leading up to 2050 lacks credibility vis-à-vis market participants, the permit price will not correctly reflect the scarcity implied by future targets.4

By deciding upon specific 2030 and 2040 ETS emission targets along with associated levels of technology support and energy efficiency targets, politicians could reduce uncertainty (Blyth & Bunn, 2011). However, even in the absence of uncertainty regarding future targets, it would be questionable whether such commitments can indeed be credible, if the envisaged policy programme suffers from time inconsistency (Helm et al., 2003; Laffont & Tirole, 1996). According to Helm et al. (2003), this is likely to occur due to several inherent features of climate policies, including (1) the multiple and conflicting objectives (abatement, public finance, low energy prices) faced by governments, (2) the irreversibility of large-scale energy investments. as well as (3) the possibility to ex post renege on ex ante regulatory pledges regarding emissions caps or carbon taxes. In that context, Koch et al. (2014) find preliminary evidence suggesting that policy events in the EU ETS such as the decision on back-loading5 permits in the period 2014–2020 might have affected price fluctuations to a greater extent than other market fundamentals. Yet, some of those policy events had a negative impact on the price rather than the envisaged upwards effect, indicating potential credibility problems of those regulatory changes.

In addition, doubts that the EU will stick to its announced climate policy targets are evidently fuelled by uncertainty about the future of international climate policy, including the prospects over the substance of the climate agreement envisaged for 2015 under the United Nations Framework Convention on Climate Change (UNFCCC), and beyond that date. In fact, it seems questionable whether the EU will implement aggressive emission reductions if the rest of the world does not participate in this effort in some meaningful way (Sartor, 2012; Schiller, 2011). This is also likely to be influenced by the level of support for climate policy within the EU.

Both the uncertainty of future targets and the credibility of long-term commitment may undermine the EU's announcement, and might therefore reduce inter-temporal price smoothing and push the short-term permit price below the efficient level vis-à-vis the planned emission trajectory. As a result, the long-term reduction target of the EU ETS might no longer be achieved cost-effectively, e.g. as indicated by long-term modelling of the EU ETS sector (European Commission, 2007). Hence, if the low price of the EU ETS was only, or in significant part, driven by insufficient credibility, a regulatory intervention promising to alleviate this problem would clearly be warranted.

2.3. Market imperfections

Finally, the permit price might be driven by excessive discount rates reflecting various capital market imperfections due to asymmetric information, resulting from strategic behaviour of firms, market power, or other market distortions. Additionally, disproportionately high discounting might also mirror an excessive short-term focus by some market participants combined with insufficient regard for long-term strategy that could have undermined the long-term price signal (Taschini et al., 2014). According to Neuhoff et al. (2012), there is an increase in the discount rate when the surplus in the market is larger than the demand for hedging the carbon costs of future power and industrial production, which they argue is currently the case. They conclude that the remaining investors in the market are speculators, who typically require higher returns than those participants that bank permits for future compliance.

Asymmetric information can result in a ‘ratchet effect’, where firms exaggerate current compliance costs and lobby to obtain an over-allocated cap (Grubb, Azar, & Persson, 2005) or lock-in to emission-intensive technologies in order to negotiate more lenient regulation (Brunner, Flachsland, & Marschinski, 2012; Harstad & Eskeland, 2010). The case for regulatory intervention would be compelling from an economic theory perspective if market imperfections could be confirmed to distort the permit market. The type of intervention or policy instrument would depend on the specific market imperfection as well as on its magnitude. Generally, it seems that further empirical or theoretical evidence than is currently available would be required to arrive at the conclusion that market imperfections drove the price to the current level (for a review of potential market imperfections and distortions in a climate policy context, see Staub-Kaminski, Zimmer, Jakob, & Marschinski, 2014).

Figure 3 summarizes the discussion of the three possible price drivers in the EU ETS and the implications for regulatory reform. On aggregate, some mix of these effects led to a price level much lower than anticipated. The annual cap was higher than the verified emissions from 2009 onwards, and a permit surplus of roughly 2 billion tonnes has accumulated (European Commission, 2013). However, even if a case for reform can be made, the question remains on the specific kind of reform required. The following section discusses EU ETS reform options in line with the different perspectives.

Figure 3 Three possible drivers of the low price in the EU ETS

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3. Reforming the EU ETS: instruments versus institutions

In this section, instrumental and institutional reform options are discussed before a conceptual framework to compare and contrast different reform proposals is introduced.

3.1. Instruments

In November 2012, the European Commission released a report outlining a number of options for reform based on the public and academic debate. These options can be categorized into three sets (see Table 1). Set I includes mechanisms to impose a one-off change in the emission reduction profile that could reduce the surplus of allowances.6

Table 1 Reform options proposed by the European Commission

Set II aims at changing the scope of the EU ETS either by extending it to other sectors or by reducing the supply of international credits. Set III introduces the possibility of some price management in the trading scheme but remains relatively open regarding its exact form (European Commission, 2012a). This option (Set III) therefore converts the EU ETS from a pure quantity-based instrument to a hybrid scheme in order to reduce the uncertainty of permit prices. A wide range of mechanisms introducing greater price certainty in a trading scheme have been discussed in the literature, including (1) price floors (Helm, 2008; Wood & Jotzo, 2011), (2) price caps (Jacoby & Ellerman, 2004; Pizer, 2002), and (3) soft (with allowance reserves) and hard price corridors (Burtraw, Palmer, & Kahn, 2009; Fell, Burtraw, Morgenstern, Palmer, & Preonas, 2010; Hepburn, 2006; McKibbin et al., 2009; Murray, Newell, & Pizer, 2008). A soft price collar normally includes a minimum price at auction, but is limited in its ability to control price hikes by an allocation reserve, whereas a hard price collar allows for unlimited quantity adjustments to achieve fixed price levels (see Fell et al., 2010, for a comparison). Conceptually, the more control is exerted on the price, the closer the hybrid scheme comes to a pure carbon tax. Cap-and-trade and carbon taxes would actually be equivalent under idealized economic conditions. However, in reality, with imperfections such as uncertainty, market power, or transaction costs, their efficiency generally differs (Hepburn, 2006).

Following stakeholder consultations on the proposed options, in January 2014 the European Commission published a legislative proposal for the European carbon market. This legislative proposal encompasses two key pillars: (1) drawing on set I, a possible increase in the linear reduction factor from 1.74% to 2.2% from 2021 onwards; and (2) the creation of a Market Stability Reserve (MSR), also from 2021. The latter had not been included in the previously proposed reform options.

3.2. Institutions

Most proposed reform options have focused on instrumental features such as the degree of price certainty introduced, but the level of institutional innovation embodied in a reform may be significantly different. For instance, proposals were made to legislate adjustment rules (European Commission, 2014b; IETA, 2013) or to delegate some elements of ETS regulation to an independent agency that could establish adjustment rules (Clò et al., 2013) or make discretionary-based interventions (de Perthuis & Trotignon, in press; Lieberman-Warner, 2007). However, it is not clear what form of delegation would be best suited to address the perceived problems of the EU ETS. As is evident from monetary policy and the regulation of other industries, various forms of delegation are possible. It is therefore important to have a systematic approach to contrast different institutional set-ups.

3.3. EU ETS Reform Space

This article offers a new framework, the EU ETS Reform Space, to compare the different reform options put forward. It is argued that the various degrees of instrumental and institutional change embodied in reform proposals can be mapped in a two-dimensional space (Figure 4).

Figure 4 EU ETS Reform Space Notes: Soft PC, soft price corridor; Hard PC, hard price corridor.

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The horizontal dimension relates to the extent to which an option leads towards more price certainty (right-hand side) as compared to the status quo of quantity certainty (left-hand side). On either end of the price vs. quantity certainty spectrum lie a pure cap-and-trade mechanism (left) and a carbon tax (right). Between these two extremes there are a wide range of hybrid schemes, such as hard and soft price collars.

The vertical dimension pertains to the continuous delegation of decisional power over the governance of the EU ETS away from the EU. The status quo represents a situation where the EU retains full decisional power and continues to implement reforms directly. Moving further on the continuum, adjustment rules are introduced. These rules could either be legislated by the EU in addition to the existing legal framework or by an independent agency operating within a predefined mandate, and they would define the way intervention takes place in the EU ETS. Towards the end of the continuum, the EU could relinquish most (if not all) decisional powers to an independent body that would manage the EU ETS, potentially including full control over the cap and/or price. In this context, the independent institution would have a mandate legislated by the EU specifying its objectives, such as achieving a certain emission target at least costs. However, this institution would be entitled to choose its instruments for interference. Such approaches to delegation most closely resemble the case of independent central banks having significant discretion over money supply, while being guided by some core objectives such as price stability, which were politically set at their inception.7 Within this basic framework, many of the options that have been put forward to reform the EU ETS can be compared. For example, if the existing EU institutions remain the main entity in charge of managing the market, various options exist. The status quo, where the EU ETS remains a pure quantity mechanism, is the first possibility. Set I, with reform options such as a revision of the linear reduction factor as suggested by the European Commission (2014d), is located in the top-left area of the EU ETS Reform Space. This is due to the limited changes in terms of delegation and explicit price certainty. Set II is located with set I, as adding another sector such as transport to the EU ETS, where short-term demand for permits is likely to be more predictable, could have a smoothing effect on price development but remains uncertain. Set III represents a set of options available to exert greater control over the emission price and could be located somewhere between a soft and a hard price collar depending on the specific design. The soft price collar entails less price certainty and also implies more quantity certainty than a hard price corridor. When implemented by the EU, this option lies in the upper-middle area of the EU ETS Reform Space. The hard price collar, on the other hand, is placed in the upper-right corner as it offers stronger price certainty by implementing a strict price floor and ceiling. Both options lie below the status quo in terms of level of delegation, as the price collar would need to be defined in legislated rules in addition to the existing framework.

3.3.1. Rule-based delegation

Other proposals combining various degrees of delegation with different levels of controls over quantity or price were also discussed, some with significant institutional changes.8 IETA (2013) proposes a type of rule-based approach to revise the quantity of permits in the market. However, the authors argue in favour of keeping the long-term carbon budget neutral.9 A rule to temporarily remove or add allocation from the market could be based on a mathematical formula or predefined triggers. This mechanism is likely to adjust to relevant and observable economic variables, such as primary energy demand, diffusion of renewable energy, estimated abatement costs, technology switching prices, size of the permit surplus, or GDP. Supply would then be adjusted in a predictable way according to the deviation of these variables from their expected trend.

The European Commission's January 2014 proposal can also be characterized as a rule-based approach, which targets the quantity of allowances. The proposed MSR is designed to adjust the supply of allowances in the market based on predefined rules surrounding the level of permit surplus.10 To facilitate price discovery between trading periods, the reserve can be carried over multiple periods.

Alternatively, Taschini et al. (2014) propose a quantity adjustment rule, which would respond to a price-indexed trigger mechanism. This proposal draws on Article 29a of the EU Emissions Trading Directive (European Union, 2009), which aims to avoid large temporary price hikes.11 Here the quantity adjustment would be triggered when the price deviates from its long-term trend for a certain period but would apply to both price hikes and price drops. The authors argue that such a mechanism would make intervention necessary only under exceptional circumstances. In fact, the expectations of a possible intervention would (at least partially) already correct the price. If intervention is necessary based on the triggers, its magnitude would be calculated by the European Commission based on projected emissions, the time remaining until the end of the period and the number of allowances still to be auctioned.

The European Commission (2014b), IETA (2013), and Taschini et al. (2014), propose that interventions are made by the EU and are governed by legislated rules. By contrast, Clò et al. (2013) suggest (1) the creation of a new institution that would (2) govern the permit market via a price-based rule such as a price corridor. The introduction of a new body with the ability to set rules for the carbon market reflects less decisional power for the current EU governance arrangement, locating their proposal further down the delegation spectrum (see Whitesell, 2007, for a similar proposal for the US).

3.3.2. Discretionary-based delegation

Finally, two proposals for delegation entailing significant levels of discretion have been put forward. First, de Perthuis and Trotignon (in press) propose the creation of an Independent Carbon Market Authority (ICMA). The mandate of such an institution would be to maintain the credibility and political ambition of climate policy over time by managing allowance supply. In the short term, this requires an adjustment of auctions to ensure ‘proper functioning’ and ‘liquidity’ in the trading market. Over the medium to long term, this could also entail adjustment of the allowance cap. Interventions would focus on discretionary quantity adjustment and hence the authors see no need for price management mechanisms. The role of the ICMA would be to ensure the compatibility of the EU ETS with other energy and climate policies as well as to monitor the interactions with international markets. In the current policy context, according to the authors, the revision of the cap would be downward if its objective is to avoid, for instance, an unexpected decrease in the demand for permits due to policy overlap and the import of offsets. To motivate its actions and allow for clear expectations, the ICMA would implement a transparent monitoring framework and report to the Council and the European Parliament. This option is located in the lower-left corner of the EU ETS Reform Space, as it entails no explicit price management.

Second, a Carbon Market Efficiency Board was suggested in the US Congress Lieberman–Warner legislative proposal (S. 2191) (see Lieberman-Warner, 2007). The proposed mandate was to achieve some price level that balanced emission reductions and economic growth (Manson, 2009).12 Consideration of short-term price certainty and its impact on industry competitiveness therefore appears to be at least equally important as short-term quantity concerns, locating this option at the bottom-middle area of the EU ETS Reform Space.13

4. Is delegation the key to EU ETS reform?

Would delegation ‘fix’ the EU ETS by solving the problems identified in Section 2? This section addresses this question using the EU ETS Reform Space to structure the discussion. For each possible driver of the low price, and taking into account potential EU ETS objectives, an appropriate policy space is identified (see Figure 5) and major strengths and weaknesses of specific reform options are discussed. This analysis is more descriptive than analytical. It aims to provide structure to the ongoing debate as well as a framework to better understand in which case and to what extent delegation of climate policy might be useful. Consequently, it does not aim to identify the optimal reform. Rather, the preferable reform option (including the option not to reform) depends on (1) the weight the analyst attaches to the actual drivers of the current price level (i.e. exogenous shocks, lack of credibility, or market imperfections) and (2) the relative importance of objectives assigned to the EU ETS (single short-term least-cost objective versus multiple objectives).

Figure 5 Perspectives on EU ETS reform Notes: Soft PC, soft price corridor; Hard PC, hard price corridor. EU set I and set II are not discussed in this graph as the analysis focuses on options entailing some minimum degree of delegation.

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4.1. Responding to exogenous shocks

As discussed in Section 2, two perspectives on reform can be taken if an exogenous shock is considered to be the cause of the low EUA price: a single short-term cost-effectiveness objective and a broader, multiple objectives perspective. The Reform Space for those that subscribe to the single, short-term objective perspective is the status quo. No regulatory change is required (see Figure 5).

Those that subscribe to a multiple objectives perspective, beyond short-term cost-effectiveness, argue that the price is ‘too low’ to induce the desired innovation, to signal EU leadership on climate policy, or reflect the social cost of carbon. In these perspectives, the extent of enhanced price certainty introduced by specific reform options is particularly relevant. Based on these considerations, the set of options within the EU ETS Reform Space for dealing with exogenous shocks under a multiple objectives perspective comprises the entire plane right of the vertical axis, introducing higher price certainty at various degrees (see green area in Figure 5). However, the exact location on the right-hand side of the EU ETS Reform Space will be based on the weight assigned to a stable and predictable carbon price.

In this framework, the MSR as a quantity-based adjustment rule reform is not tied to price formation and does not put a strong weight on price stability and predictability. According to Trotignon, Gonand, and de Perthuis (2014), such a mechanism may even increase price volatility as this automatic adjustment does not take into consideration changes in the adjustment of market participants to their economic environment. While perhaps having an upwards effect on short-term prices by reducing near-term permit availability, it is unclear how the MSR will shape the price expectations of market participants. In fact, the European Commission Impact Assessment indicates that such a cap neutral adjustment may increase short-term but depress mid-term prices (European Commission, 2014a), which is likely to have an uncertain overall impact on investment and innovation.14 Such uncertainty is compounded by the fact that a review of the rule is scheduled for 2026, and it is difficult to predict what the result will be.

In a pure exogenous shock perspective and adopting a multiple objective approach, it is not obvious why the creation of an independent body with discretionary power should be necessary. Indeed, the EU could implement a price management strategy (with more or less emphasis on price predictability) that would alleviate the perceived concerns associated with an unforeseen change in demand. Nonetheless, although institutional change with a higher degree of delegation is not necessarily required in a multiple objectives perspective, enhanced flexibility to adjust to sizeable shocks and new information might be valuable in order to decrease the transaction costs of a regulatory change (Newell, Pizer, & Raimi, 2013; Trotignon et al., 2014). Moving down the Reform Space (i.e. increasing the level of delegation) will therefore reflect the willingness to increase the responsiveness and flexibility to adjust to exogenous shocks (in particular unexpected ones).

4.2. Responding to lack of credibility

Whether one takes a single objective or a multiple objectives perspective is largely irrelevant if lack of credibility is seen as the main driver of the low price, because, in an acute form, it distorts the functioning of the EU ETS. A lack of credibility can have two sources: uncertainty over regulation, e.g. announced stringency of the cap or permanence of the overall system, and the time inconsistency related to long-term climate policies. The two problems are intertwined, but they are not identical. In fact, policy uncertainty in the EU ETS could be decreased by legislating the 2030, 2040 and 2050 targets. However, market participants can rationally expect that such commitment from the legislator might be overruled at some point in the future. Therefore, even in the presence of clearly defined caps and reduced political uncertainty (e.g. due to a strong global and EU consensus on the desired level of climate policy ambition and instruments), delegation may be warranted given the time inconsistency of climate policy.

In this perspective, the main raison d’être of an independent body in other policy contexts is precisely to deal with problems of credibility of long-term commitment and of time-inconsistent policies. Ideally, the independence of the agency (1) shields it from short-term political pressures that are considered detrimental to welfare (thus, implying a broad consensus on what welfare would imply, e.g. in terms of climate policy ambition), and (2) enables it to build a reputation for announcing and enacting its policy on the basis of a clear and transparent framework (Brunner et al., 2012). This is intended to enhance investors' confidence that the independent regulator will ensure that long-term targets are achieved.

The Reform Space from the credibility perspective (red area in Figure 5) suggested here includes three options promoting delegation to an independent carbon authority: one based on rules (Clò et al., 2013) and two on discretion (de Perthuis & Trotignon, in press; Lieberman-Warner, 2007).

To operate effectively, rules must be based on a sound theoretical model of how the carbon market should be adjusted in response to new economic conditions and other external shocks. Also, in defining such a rule, the objective function embodied must be linked clearly and explicitly to the political objectives of the EU ETS. However, given the complexity of the carbon market and the potential for further unforeseen circumstances, it is not clear which theoretical framework should be applied to set such a policy rule, or if indeed an adequate rule can be designed.

In view of this challenge, some analysts regard discretionary power as a potential solution to overcome the trade-off between credibility and flexibility (Bernanke, 2003) (for a discussion of this trade-off in climate policy, see Brunner et al., 2012, and Jakob & Brunner, 2014). Drawing on lessons from past experience, the possibility of unforeseen events or ‘unknown unknowns' that require a quick response beyond applying a predefined rule to ensure the efficiency of the ETS, makes the case for delegation to a carbon authority more appealing. While this constitutes an argument in favour of discretion to enhance efficiency in the presence of economic shocks (as argued in the previous section) it does not per se justify discretion as an adequate response to credibility problems. This holds only if the flexibility derived from discretionary power reduces uncertainty in a way that increases credibility. This might occur by offering a predictable framework to adjust EU ETS regulations in the presence of new information on, for example, learning over climate impacts, mitigations costs, and international climate policy developments. Nonetheless, the precise specification of the discretionary mandate will determine the capacity to overcome the credibility–flexibility trade-off. As discussed in Bernanke (2003), this is likely to require constrained discretion where the action of the independent authority is consistent and limited by a credible and clear mandate balancing short-term and long-term objectives.

Nonetheless, delegation to an independent body is unlikely to be a ‘silver bullet’. In fact, the ability of such a new institution to establish credibility among market participants will take time and is likely to depend on several factors such as its mandate, the profile of the head of the agency, and its historical record. It also requires political agreement on the objectives of the EU ETS as well as on the degree of ambition of EU climate policy, which is perhaps the major challenge this design option is facing and which can change over time. This therefore implies that future legislators might attempt to modify the mandate of the independent body, which could undermine its credibility if it is not sufficiently taken into consideration in the design of this institution. The success of implementing such an independent body will therefore depend on a well-crafted mandate.

4.3. Responding to market imperfections

Market imperfections distort the functioning of the permit market and, from both single and multiple objectives perspectives, are therefore undesirable. However, the case for delegation depends specifically on the nature of the market imperfection and its impact, in terms of direction and magnitude on the permit price. As discussed above, both theoretical and empirical evidence for EU ETS permit market imperfections is somewhat lacking and should be considered an area for further research. Accordingly, we focus here on the argument put forward by Neuhoff et al. (2012), for which some analysis is available and which could offer a rationale for the MSR (European Commission, 2014a). According to Neuhoff et al. (2012), when the permit surplus exceeds the hedging demand of covered entities, there is a jump in the discount rate applied to future carbon prices. Under such conditions, the EU ETS would no longer serve its intended purpose to incentivize abatement in a dynamically cost-effective manner, and a case for reform could be made.

The permit surplus currently exceeds 2 billion permits, and the hedging demand is estimated to be somewhere between 1.1 and 1.6 billion permits (Schopp & Neuhoff, 2013). If the hypothesis put forward by Schopp and Neuhoff (2013) holds, the appropriate reform could be a quantity-based intervention that maintains the permit surplus within the hedging corridor, such as the MSR proposal by the European Commission. This reform option is represented in Figure 5 (see discontinued black area). Again, there is a choice in designing this reform: the rule could be fixed and subject to modification through the legislative process only (such as the MSR), or discretionary flexibility to respond to changes in hedging demand could be enabled, e.g. via a body such as the ICMA proposed by de Perthuis and Trotignon (in press).15

5. Discussion

European climate policy is currently at a crossroads. Its central pillar, the EU ETS, is likely to be reformed following the collapse in EUA prices. At the same time, policy makers are discussing the 2030 framework for energy and climate policies, which will influence the functioning of the EU ETS. The complexity of the debate and the various reform options proposed make it difficult to systematically compare the different pathways possible. The EU ETS Reform Space offers a relatively simple framework to contrast the various reform options. Hence, it supports the identification of which options (differing in quantity and price certainty as well as their degrees of delegation) are the best responses to the perceived problems of the EU ETS.

If an exogenous shock is the main driver of the low price, and policy makers expect the price to be higher to reflect the social cost of carbon or induce innovation, reform options that allow for higher degrees of price certainty might potentially represent a solution. In this case, delegation is not necessary per se.

By contrast, based on the experience from monetary policy, delegation could represent an appropriate option to increase the credibility of long-term commitment and provide a higher flexibility. While this can be achieved both through legislated rules or an independent authority with some degree of discretion, the latter offers more flexibility to react to unforeseen circumstances and its independence might increase its credibility. However, this will be contingent on a clear and transparent framework introduced within robust institutions, which can be relied upon to guide any intervention. A broad political support to climate policy will also be necessary. In that framework, it is important to also note that major political barriers stand in the way of its implementation.

First, setting up an independent body with discretionary power requires a modification of the EU treaties (Egenhofer et al., 2012), which is difficult in the current political context. Second, an independent institution in charge of solving intra- and intergenerational distributional conflicts, as is the case in climate policy, might suffer from a democratic legitimacy deficit (Brunner et al., 2012). In that context, Ergas (2010) argues that the choice of emissions trajectory should remain in the hands of policy makers. According to the author, this is necessary due to the high level of uncertainty surrounding climate policy with respect to science, economics, as well as global politics, and the significant stakes involved.

The academic debate on the potential benefits and drawbacks of delegating elements of EU ETS governance is still at a very early stage. The debate would benefit first from a better understanding of the empirical weight that should be attached to the various drivers of the low price and second from a clearer definition of the long-term objectives of the EU ETS. Third, an interesting area for further research is the precise configuration of rule- or discretion-based institutions best suited to govern a large-scale complex system characterized by significant uncertainty such as the EU ETS. This should possibly be embedded in a broader reform discussion, including sectoral coverage, recycling of revenues from auctioning, and competitiveness measures (Edenhofer, 2014; Knopf et al., 2014).

Acknowledgements

The authors would like to thank all interviewees for their insights, as well as Ottmar Edenhofer, Sabine Fuss, Brigitte Knopf, Nicolas Koch, Michael Pahle and other colleagues from PIK and MCC for their valuable comments on this manuscript. We also thank the participants from the Euro-CASE workshop in Brussels in February 2014, the Envecon conference in London in March 2014 and three anonymous reviewers for their constructive feedback. The research leading to these results has received funding from the EU's Seventh Framework Programme (FP7/2007–2013) under grant agreement no. 308481 (ENTR'ACTE). The ideas expressed here remain those of the authors, who remain solely responsible for errors and omissions.

Supplemental data

Supplemental data for this article can be accessed 10.1080/14693062.2014.965657.

Notes

1. In total, 19 interviews with 23 experts were conducted between 15 January and 5 March 2013. Interview candidates were selected using a purposive sampling approach due to the high level of technical expertise needed to answer the questions. The sample included experts from academia (11), industry (6), as well as carbon traders (4) and senior policy makers (2). Four interviews were conducted face-to-face, and 15 over the phone. Interview participants were selected from various jurisdictions, including Australia, Belgium, France, Germany, Italy, the UK, and the US. For a list of the 23 interviewees, see Appendix. For the complete discussion guide, please refer to the online supplementary material.

2. A surplus occurs when there are more permits than needed, i.e. when the number of annually available allowances exceeds the annual emission level. In a multiple period framework, annual surpluses may add up, reducing further the scarcity in the market.

3. According to the European Commission (2014d), the linear reduction factor should be between 2.1% and 2.4% between 2020 and 2050 to achieve the 80–95% emissions reduction target.

4. Point Carbon (2013c) found that, between 2011 and 2013, market participants believing the EU ETS would still exist after 2020 dropped from 77% to 69%.

5. The term back-loading refers to a change in the auctioning timetable for period III of the EU ETS, where the auctioning of 900 million allowances was shifted from the earlier years of the phase towards the end (European Union, 2014).

6. Modifying the linear reduction factor or a modification of the 2020 targets will decrease every subsequent annual cap but represents a one-off reduction of the emission profile (and the cumulative cap).

7. This may also be achieved by endowing the Commission (specifically DG Climate) with some discretionary power. However, as part of the European executive, the question on its full independence remains.

8. The most complete suggestions in terms of the information provided on the mandate were chosen to be mapped in the EU ETS Reform Space.

9. The degree of quantity certainty is complex in this context. It depends on whether quantity certainty is understood as inter-period or intra-period certainty.

10. For more information on the functioning of the MSR, see European Commission (2014b).

11. Article 29a of the European Emissions Trading System Directive allows for an injection of EUAs if for more than ‘six consecutive months, the allowance price is more than three times the average price of allowances during the preceding two years' (European Union, 2009, p. 82).

12. Similar to the Federal Reserve Bank, which is mandated to balance the objectives of ‘maximum employment, stable prices, and moderate long-term interest rates’ (Federal Reserve, 2013).

13. The action of the Carbon Market Efficiency Board under the Lieberman–Warner Bill (2007) was designed to be cap neutral by borrowing. However, temporary increase of offsets and foreign allowances were allowed when necessary to contain potential harm to the US economy. Accordingly, it is located in the middle in terms of intra-period quantity certainty.

14. More generally, assuming perfectly efficient markets with perfect foresight, shifting the temporal allowance release schedule without changing the cap should not or should hardly change present prices (Newell, Pizer, & Zhang, 2005). However, assumption of an additional credibility problem or market failure could lead to a change in current EUA prices from shifting EUA releases through time, as foreseen in the MSR.

15. de Perthuis and Trotignon (in press) do not consider an MSR approach for the ICMA, but this is a theoretical possibility.

References

Appendix. List of interviewees, in alphabetical order

Table

 

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