Price floors and ceilings

Mechanisms that limit prices under an ETS (price floors and price ceilings) are already in operation in North America.  Similar arrangements can easily be adopted elsewhere, including in the EU.

In previous posts I have alluded to the benefits for an ETS of price floors in the form of auction reserves and soft ceilings in the form of a price containment reserve taken from within the cap.  In this post I take a look at how such arrangements work in North America to demonstrate that they are not esoteric theoretical ideas, but existing practice that can easily be adopted in similar form in the EU or elsewhere.  California, Quebec and the Regional Greenhouse Gas Initiative (RGGI) have a soft price floor in the form of an auction reserve price.  Prices can fall below this floor, but if bids are below this level in the auction allowances are not sold, so supply quickly tightens to maintain the price at the floor.  When prices rise, allowances can be released from a reserve acting reducing upward price pressure, although California and RGGI differ in the extent to which allowances additional to the cap can be offered into the market.   They also have mechanisms to limit price rises in the form of allowance reserves, but differ in the extent to which additional allowances can enter the market.

Price floors

Under the California ETS (Quebec has very similar arrangements) there is an auction reserve price of $10/tonne in 2012, which rises at 5% p.a. plus an inflation adjustment, and is currently $10.71/tonne.  Any allowances that are not sold at auction are retained by the regulator, the Air Resources Board (ARB), in an Auction Holding Account. The holding account allowances are not made available again through the auction until the price has exceeded the floor price for two consecutive quarterly auctions, and return is subject to a limit of 25% of the total allowances available at each regular quarterly auction. As a result, a surplus in the Auction Holding Account may take time to be drawn down.   In practice all 2013 allowances were sold out at the first four auctions, and the market price is above the floor level, though only by a little in the first auction.

RGGI, which covers power sector emissions from several states in the north eastern USA, also includes an auction reserve price.  However, the reserve price is much lower than in California, at $2/short ton in 2014 rising at 2.5% p.a., approximately in line with inflation.  In the past the floor has often been binding, but the current price is above the floor.  Allowances unsold at auction prior to 2014 are retained by the authorities and can be auctioned again, but allowances unsold at the end of each 3 year control period (the current control period is 2012-2014) may be retired permanently at the discretion of individual states.  This gives a possible mechanism for automatically tightening the cap if there is a surplus allowances at the floor price over an extended period.

Price ceilings

In California there is an Allowance Price Containment Reserve (APCR) from which allowances are released at prices of $40, $45, and $50/tonne in 2013, rising at 5% p.a. plus inflation thereafter.  This is entirely separate from the Auction Holding Account used for the floor.  Allowances are sold from the APCR on a quarterly basis if there is demand.  The sale is held six weeks after the regular quarterly auction of allowances, allowing buyers to make up a shortfall after the auction. Buyers specify the number of allowances they want at any of the three fixed prices.

122 million allowances have been put into the APCR for the period to 2020 equal to 4.5% of the overall cap across all years (including the maximum allowed offsets), and relative to a single year (2015) is 29% of the cap including the maximum allowed offsets.  The APCR allowances are taken from within each year’s capped total.  The reserve is divided equally among the three price tiers.   ARB has proposed that the number of allowances in the APCR be increased to 207 million tonnes, which would be 7.6% of the overall cap.

RGGI also has a costs containment reserve (CCR) of additional allowances that can be released into the auction when the auction clearing price crosses a certain threshold.  As with the floor, the prices at which allowances are released are much lower than in California, being $4/short ton in 2014 rising at $2/short ton p.a. to reach $10/short ton in 2017, escalating at 2.5% p.a. thereafter. The CCR allowances are in addition to the cap, and balances are re-set annually to 10 million tons (which is just over 10 percent of the 2014 cap) if allowances are drawn down from the CCR.  Unlike California, the cap is thus effectively loosened if there is continuing demand for allowances from the reserve, and so functions much more like an absolute ceiling.  (These are the revised the rules for RGGI to apply from 2014 forward, which has yet to be fully enacted by all individual states, but I understand that adoption is expected to be completed shortly.)

Similar arrangements could readily be made for the EUETS.  A price containment reserve of the same proportion of the 1013-2020 cap as Californian (4.5-7.6% of the total cap for Phase 3 excluding aviation) would be approximately 690 to 1170 million allowances, very much in line with the quantities that have been discussed for set-aside or backloading.  A market stabilisation reserve would be, in effect, somewhere between backloading and permanent set aside.  This is because allowances placed into the stabilisation reserve could potentially return to the market (in contrast to permanent set-aside).  However, they would do so only in response to prices reaching threshold levels, rather than automatically (as is intended with backloading).  This type of reserve could be accompanied by an auction reserve price to stabilise the price at the lower end of the range.

Some in the EU continue to oppose price containment mechanisms.  Whatever objections may be advanced against price containment – and none seem compelling to me in principle, at least for an auction reserve price – a lack of practical examples elsewhere on which to draw is certainly not one of them.