OECD Taxation Working Papers No. 33: PERMIT ALLOCATION RULES AND INVESTMENT INCENTIVES IN EMISSIONS TRADING SYSTEMS

OECD Taxation Working Papers No. 33: PERMIT ALLOCATION RULES AND INVESTMENT INCENTIVES IN EMISSIONS TRADING SYSTEMS. Free allocation of emission permits can help gain support from industry for carbon pricing – a core policy for reducing emissions. Policy makers often envisage moving from free allocation to auctioning of permits over time. Gradually phasing out free allocation and increasing the share of auctioned permits allows raising valuable public revenue at relatively low social costs. However, evidence from the EU Emissions Trading System (ETS) and the California Cap and Trade (CTP) program shows that it remains challenging to increase the share of auctioned permits. A significant share of emitters participating in emissions trading will continue to receive free permits in the foreseeable future. The paper offers a fresh perspective on the effects of permit allocation rules on low-carbon investment and the long-term impacts of permit allocation rules. The analysis adopts the point of view of an investor that chooses between a low-carbon (clean) and a high-carbon (dirty) technology to produce economically similar outputs, based on total profits. Emissions from production are subject to an emissions trading system. The investor chooses the most profitable technology in an imperfectly competitive market, so there are economic rents. The main result is that free allocation of tradable emission permits under current allocation rules has the potential to weaken incentives for firms to choose low-carbon technologies, compared to the situation where permits would be auctioned or a uniform tax were levied. The reason is, in general, that the permit allocation rules affect economic rents and, in practice, that existing rules do so in a way that tends to favour more carbon-intensive technologies. Investors value carbon-intensive technologies higher than in the absence of free allocation, as free allocation increases profits, and this risks changing the ranking of technologies in terms of profitablity. In other words, current allocation rules are often an impediment to decarbonisation. Free allocation can affect technology choice Recent empirical evidence for the EU ETS shows a negative correlation between free allocation and emission abatement. While the negative correlation could result from emitters with high abatement costs receiving more free allowances, interviews with managers from industrial emitters instead reveal lower perceived incentives for abatement and less low-carbon innovation for firms with more free allocation. The paper provides a plausible economic rationale for this behaviour. Section 2 of the paper conceptually analyses the impact of allocations on emissions. It considers a stylised example in which an investor can choose between a clean and a dirty technology to meet a given demand (e.g. wind or fossil fuels to generate a given supply of electricity). Investors choose between projects on the basis of total expected profits. Free allocation of permits affects expected profits in ways that potentially differ between technologies. The average permit price captures the effect of free allocation on total expected profits. If average carbon prices equalled marginal carbon prices, then permit allocation would not affect project rankings, so would be technology-neutral. The same could hold if average carbon prices were equal across technologies and if also carbon-free technologies received permits for free. Current allocation rules lead to weak incentives for low-carbon investment Section 3 of the paper looks at permit allocation rules in two of the world’s most prominent greenhouse gas emissions trading systems, namely the EU ETS and the California CTP. It identifies three ways in which allocation rules can affect technology choices, other than through the price signal at the margin: first, the benchmarks by which allocations are decided are not always technology-neutral; second, sticking to older and more carbon-intensive technologies can be of strategic interest; third, producing more with older and more carbon-intensive technologies can be of strategic interest. Benchmarks turn out to be a key factor that, through their effect on expected profits, can alter project rankings. They generally favour carbon-intensive technologies if they are not technology-neutral. Benchmarks are defined for categories of products, implying that product varieties within each category are considered as interchangeable – perfect substitutes. Substitute products can differ in technological properties as long as they satisfy a similar economic need. For substitute products within a benchmark category the allocation is the same, and this guarantees technology-neutrality in the sense that permit allocations do not affect technology choices. However, when products under different benchmarks are in fact substitutes satisfying similar needs, there is an incentive to opt for high-carbon technologies as these generally come with more permits. A comprehensive analysis of the impacts of non-neutral benchmarks considers both short- and long-run impacts. In the short-run it is costly, yet possible, to become informed on which products are close substitutes. While benchmarks might thus be able to approximate technology-neutrality in the short-run, our analysis suggests that there is ample room for improvement. In the long-run one cannot know about the substitutability of goods, implying that benchmarks cannot be technology-neutral over longer time horizons. Technology-neutrality of a carbon pricing mechanism requires that the treatment of a technology under that mechanism only depends on the carbon emissions generated, and nothing else. Different benchmarks for close substitutes and low ex-post average carbon rates in the EU ETS and the California CTP imply weak signals for favouring low-carbon investment projects over high-carbon projects. This results in more carbon-intensive investment compared to the case where all permits would be auctioned or a linear carbon tax would be set. (Florens Flues, Kurt van Dender).