Union Emissions Trading Scheme Research Articles

Climate regulation costs and firms’ distress risk

AbstractIn 2013, the European Union's Emission Trading Scheme (EU‐ETS) entered Phase III. The majority of emission permits in Phase III are auctioned instead of being allocated for free as in Phases I and II. Using a difference‐in‐differences method, we show that this change has led to an increase in the financial distress risk of the EU‐ETS‐regulated firms when compared to unregulated firms, suggesting that the EU‐ETS imposes a significant financial burden on regulated firms. This result is robust to an array of validation tests, alleviating concerns that it is driven by unobserved factors. In additional analyses we show that the increase in distress risk of regulated firms during Phase III can be explained by, (i) an additional climate regulation cost to purchase pollution permits and (ii) a low average environmental score that possibly (via high sustainability risk) lowers investors expectations regarding firms’ performance. Our findings also show that the distress risk increase is higher for regulated firms operating within countries with lower control of corruption, government effectiveness, political stability, regulatory quality, rule of law, and voice accountability before the EU‐ETS implementation.

Pricing carbon in the aviation sector: Evidence from the European emissions trading system

A policy change in the European Union's Emissions Trading Scheme (EU ETS) provides us with a unique opportunity to measure the impact of carbon pricing on aviation, the most climate-intensive mode of transport. We implement a difference-in-differences strategy on a sample based on all flights within Europe from 2010 to 2016 to examine the causal impact of the EU ETS on emissions and supply. We find that the EU ETS reduced emissions by 4.7% in the regulated routes relative to the counterfactual. When we restrict the sample to short-haul flights, routes on which competition from other means of transport may exist (less than 1,000 km), the reduction in emissions is 10.7%. Finally, the reduction in emissions is also high for low-cost airlines (−11%) but it is not statistically significant for network airlines. In sum, the EU ETS has helped to mitigate emission growth by 3 Mt CO2 per year during the period analyzed, but not to reduce absolute emissions in the sector, as needed.

Improving liquidity in emission trading schemes

AbstractThis paper constructs a model of an Emission Trading Scheme (ETS) market using bid‐ask spreads. We show that when such a market is dominated by a small number of traders with substantial market power, they tend to maximize their profits by widening bid‐ask spreads, thereby reducing market liquidity. We argue that adding more market participants, including derivatives traders, can alleviate this illiquidity problem. Policy changes at the European Union's ETS illustrate our theory, as the market significantly increased liquidity by enacting liquidity‐provision policies to attract more participants as it transitioned from Phase 1 to Phase 2.

An experimental investigation of bilateral oligopoly in emissions trading markets

Market power in emissions trading has been extensively investigated because emerging markets for tradable emissions permits, such as the European Union's Emissions Trading Scheme (ETS), can be dominated by relatively few large sellers or buyers. Previous studies on market power in emissions trading have assumed the existence of a subset of competitive players. However, a key feature of emissions trading markets is that emissions permits are often traded by a small number of large sellers and buyers. Using a laboratory experiment, our objective in this paper is to test the performance of an emissions trading market utilizing a double auction in a bilateral oligopoly. Our results suggest that the theoretical bilateral oligopoly models can better describe market outcomes of emissions trading. The effects of the slope of the marginal abatement cost function on market power in laboratory experiments are found to be consistent with those predicted by the theoretical bilateral oligopoly model. How market power is exercised depends on the curvature of the abatement cost function. If the marginal abatement cost function of buyers (sellers) is less steep than that of sellers (buyers), the price of permits is lower (higher) than that under perfect competition. This is because the market power of buyers (sellers) exceeds that of sellers (buyers). The price of permits is close to the perfect competitive price when all traders have the sameslope of the marginal abatement cost function.

Outward Foreign Direct Investment Patterns of Italian Firms in the European Union's Emission Trading Scheme*

AbstractWe consider the role played by the European Union's Emissions Trading System (EU ETS) as a possible driver of outward foreign direct investment (FDI) for Italian manufacturing firms. Using a panel dataset of about 22,000 firms covering the first two phases of the EU ETS and the period before the EU ETS, we measure the patterns of FDI towards countries not covered by the EU ETS. The results show that the EU ETS had a weak effect on the number of new subsidiaries abroad (extensive margin), while it had a larger impact on production taking place in foreign subsidiaries (intensive margin), especially in trade‐intensive sectors.

Stakeholder pressures and corporate climate change mitigation strategies

AbstractClimate change mitigation and its related reduction of greenhouse gas (GHG) emissions is one of the most important challenges facing society. The major cause of the problem and the key to its solution are GHG‐intensive firms that emit vast amounts of anthropogenic GHG emissions. The study reported herein aims to increase our understanding of the climate change mitigation strategies of these firms, in particular their antecedents and effects. A comprehensive conceptual model is proposed and tested empirically based on a survey of 247 firms that participated in the European Union's Emissions Trading Scheme in the first two trading periods. We find that market pressures for reducing GHG emissions, perceived GHG‐related regulatory uncertainty and environmental strategy focus are important determinants of corporate GHG reduction strategies which, in turn, enhance GHG‐related performance. We also show that the results vary depending on the type of emissions.

Carbon portfolio management

AbstractThe aim of the European Union's Emissions Trading Scheme (EU ETS) is that by 2020, emissions from sectors covered by the EU ETS will be 21% lower than in 2005. In addition to large CO2 emitting companies covered by the scheme, other participants have entered the market with a view of using emission allowances for the diversification of their investment portfolios. The performance of this asset as a stand alone investment and its portfolio diversification implications will be investigated in this paper. Our results indicate that the market views Phases 1, 2, and 3 European Union allowance futures as unattractive as stand alone investments. In a portfolio context, in Phase 1, once the short‐selling option is added, there are considerable portfolio benefits. However, our results indicate that these benefits only existed briefly during the pilot stage of the EU ETS. There is no evidence to suggest portfolio diversification benefits exist for Phase 2 or the early stages of Phase 3.

Carbon Portfolio Management

The aim of the European Union's Emissions Trading Scheme is that by 2020, emissions from sectors covered by the EU ETS will be 21% lower than in 2005. In addition to large CO$_2$ emitting companies covered by the scheme, other participants have entered the market with a view to using emission allowances for the diversification of their investment portfolios. The performance of this asset as a stand alone investment, as well as its portfolio diversification implications will be investigated in this paper. Our results indicate that the market views Phase 1, Phase 2 and Phase 3 EUA futures as unattractive as stand alone investments. In a portfolio context, in Phase 1, once the short-selling option is added, there are considerable portfolio benefits. However, our results indicate that these benefits only existed briefly during the pilot stage of the EU ETS. There is no evidence to suggest portfolio diversification benefits exist for Phase 2 or the early stages of Phase 3.

The Paris Agreement and its impact on cattle and food sectors of New Zealand

ABSTRACTThe Paris Agreement asserts that greenhouse gas emission pathways should be consistent with holding the increase in global temperature below 1.5 °C, or 2 °C above pre-industrial levels. The purpose of this paper is to assess the economic impact of this agreement on the cattle and food product sectors of New Zealand. We used a general equilibrium approach to evaluate the economic impacts, and the Global Timber Model to estimate forestry carbon sequestration. We simulated eight scenarios where we allow accounting/not accounting for sequestration, pricing/not pricing agricultural emissions, and linking/not linking the New Zealand Emissions Trading Scheme (ETS) with the European Union ETS. We found that significant negative impacts occur if sequestration is not accounted, the ETS remains unlinked and agriculture is priced. Competitiveness, in turn, is not significantly affected if sequestration is accounted, regardless of the linking scheme of the ETS.

The Potential of REDD+ for Carbon Sequestration in Tropical Forests: Supply Curves for Carbon Storage for Kalimantan, Indonesia

Abstract We study the potential of tropical multi-age multi-species forests for sequestering carbon in response to financial incentives from REDD+. Following existing carbon crediting schemes, the use of reduced impact logging techniques (RIL) allows a forest manager to apply for carbon credits whereas conventional logging (CL) does not. This paper is the first to develop a Hartman model with selective cutting in this setting that takes additionality of carbon sequestration explicitly into account. We apply the model using data for Kalimantan, Indonesia, for both private and government forest managers. The latter have a lower discount rate and are exempt from taxes. RIL leads to less damages on the residual stand than CL and has lower variable but higher fixed costs. We find that a system of carbon credits through REDD+ can increase carbon stored per hectare by 15.8% if the forest is privately managed and by 22% under government management if the carbon price equals the average 2015 price in the European Union's Emission Trading Scheme. Interestingly, awarding carbon credits to carbon stored in end-use wood products does not increase the amount of carbon stored, nor Land Expectation Value.

The potential of REDD+ for carbon sequestration in tropical forests: Supply curves for carbon storage for Kalimantan, Indonesia

We study the potential of tropical multi-age multi-species forests for sequestering carbon in response to financial incentives from REDD+. Following existing carbon crediting schemes, the use of reduced impact logging techniques (RIL) allows a forest manager to apply for carbon credits whereas conventional logging (CL) does not. This paper is the first to develop a Hartman model with selective cutting in this setting that takes additionality of carbon sequestration explicitly into account. We apply the model using data for Kalimantan, Indonesia, for both private and government forest managers. The latter have a lower discount rate and are exempt from taxes. RIL leads to less damages on the residual stand than CL and has lower variable but higher fixed costs. We find that a system of carbon credits through REDD+ can increase carbon stored per hectare by 15.8% if the forest is privately managed and by 22% under government management if the carbon price equals the average 2015 price in the European Union's Emission Trading Scheme. Interestingly, awarding carbon credits to carbon stored in end-use wood products does not increase the amount of carbon stored, nor Land Expectation Value.

The EU Emission Trading Scheme: sectoral allocation and factors determining emission changes

The European Union (EU) Emission Trading Scheme that covers 50% of EU greenhouse gas emissions is the biggest cap-and-trade scheme worldwide. In this article, for three emission-intensive sectors (‘power and heat’, ‘cement and lime’ and ‘pulp and paper’) allocation caps, emission developments and the main emission drivers are analysed. In order to assess what drives emissions and whether emission-saving actions were taken since 2005, a decomposition approach is applied. The analysis reveals pronounced sectoral disparities indicating some emission-reducing activities since 2005; for ‘electricity and heat’ and ‘pulp and paper’, these, however, do not deviate from the long-term trend prior to the introduction of the scheme. The occurrence of low CO2 prices emphasises the need for adaptation towards a more effective system.

Why the EU ETS needs reforming: an empirical analysis of the impact on company investments

The European Union's Emissions Trading Scheme (EU ETS) is so far the largest emissions trading system in the world. A rigorous ex post empirical analysis of the scheme is presented. The effect of the scheme on firms' investment decisions in carbon-reducing technologies is analysed by using detailed firm-level data from Swedish industry. Based on difference-in-difference estimation as well as a before–after difference estimation, the results reveal that the EU ETS has not had a significant effect on firms’ decisions to invest in carbon-mitigating technologies. However, although the EU ETS appears to have no direct effect on investments, it is too early to dismiss the system. Consideration is given to how the EU ETS can realize its potential to become an effective tool in the EU climate and energy policy portfolio.

Carbon Leakage and Competitiveness under the EU ETS

The introduction of a carbon price through an emissions trading scheme such as the European Union's Emissions Trading Scheme (EU ETS) can create the risk of carbon leakage. The European Commission presented a list of sectors which were deemed to be exposed to a significant risk of carbon leakage in December 2009. The listed sectors receive a share of emissions allowances free of charge between 2010 and 2014 as a policy response to the risk of carbon leakage within industrial sectors covered by the EU ETS. This paper analyses the effectiveness of the Commission's carbon leakage list in achieving two important policy goals - ensuring the global competitiveness of certain industry sectors covered by the EU ETS whilst maintaining the efficacy of the EU ETS in reducing greenhouse gas emissions.

Carbon Emissions and Stock Returns

This paper provides an empirical investigation of the effect of the European Union's Emissions Trading Scheme on German stock returns. We find that, during the first few years of the scheme, firms that received free emission allowances on average significantly outperformed firms that did not. This suggests the presence of a large and statistically significant carbon premium, which is mainly explained by the higher cash flows due to the free allocation of emission allowances. A risk factor can also explain part of the cross-sectional variation of stock returns as firms with high emissions have higher exposure to risk and exhibit higher expected returns.

Design, Performance and Interstate Collaboration: Insights from the Regional Greenhouse Gas Initiative

Given pressure to act on climate change, nations now use market-based approaches for reducing greenhouse gas (GHG) emissions. Cap-and-trade systems for reducing GHG are strongly debated. Policy designers must allocate emissions allowances effectively to ensure successful cap-and-trade systems; for example, some argue that the European Union's Emissions Trading Scheme has underperformed due to poor allowance distribution. We apply insights from auction design theory to analyse the performance of the Regional Greenhouse Gas Initiative (RGGI) emissions allowance auctions, and show how RGGI could serve as a model for a national cap-and-trade system.

Hot Air and Hot Heads: An Examination of the Legal Arguments Surrounding the Extension of the European Union's Emissions Trading Scheme to Aviation

The issue of carbon emissions in international aviation has proven difficult to deal with from a regulatory standpoint. Issues of a transnational character are regulated through co-operation and compromise, but there has been a lack of political will to achieve the necessary co-operation and compromise to deal effectively with carbon emissions in international aviation. The European Union is now trying to push for development in the regulatory sphere through the unilateral extension of its Emissions Trading Scheme to international aviation. This unilateral extension conflicts with international air law, but has recently been declared valid by the Court of Justice of the European Union in Case C-366/10. This article focuses on the legal arguments raised in that case, concluding that the judgment delivered by the Court is legally questionable, but may nonetheless prove constructive, as a political instrument, in the delivery of an international solution to the regulation of aviation emissions.

The inclusion of the aviation sector within the European Union's Emissions Trading Scheme: What are the prospects for a more sustainable aviation industry?

International aviation emissions of CO2 were excluded from the Kyoto Protocol. Global aviation has grown strongly, with traffic increasing at an average rate of 4.4% per year over the period 1989–2009 but there has been no regulatory action on CO2, owing to difficulties over agreeing how emissions should be allocated to Parties. Slow progress by the International Civil Aviation Organization to develop market-based mechanisms has resulted in the EU taking unilateral action, by including aviation within its emissions trading scheme, commencing January 2012. The cap for the allowances of the scheme is based upon the average 2004–2006 emissions for the EU-27, ∼219 million tonnes CO2. Aviation CO2 emissions for 2006 were calculated to be 587 million tonnes, globally, of which 135 million tonnes were attributable to international flights to/from the EU, 51 million tonnes for intra-EU, and 16.5 million tonnes for domestic EU-27. Thus, under the EU's emissions trading scheme, 35% of global aviation CO2 emissions would be captured. The EU's action has been opposed by a number of countries, airlines and trade associations, expressing concerns over its legality under ICAO's Chicago Convention. By contrast, non-governmental organizations have criticized the policy for not addressing aviation's non-CO2 impacts. Currently, there is no consensus on the most appropriate method for addressing aviation's non-CO2 impacts. A shift in policy governance from the EU to ICAO may help to alleviate some of the concerns that have been raised and a global scheme would facilitate a greater scope for emissions reductions.

Third time lucky

The rules guiding the third round of the European Union's Emissions Trading Scheme are about to be formally approved. Anna Petherick looks at how well they have set up the system until 2020.

Integrated EUA and CER Price Modeling and Application for Spread Option Pricing

In this paper we propose a market consistent futures price dynamics model for cap-and trade schemes, designed in the spirit of the European Union's Emissions Trading Scheme (EU ETS). Historical price dynamics for the EU ETS suggest that, both, European emission Allowances (EUAs) and Certified Emission Reductions (CERs), certificates which are generated through the Clean Development Mechanism (CDM) - a non-domestic offset mechanism - are significantly related. We use an equilibrium framework to demonstrate that compliance regulation singles out special joint futures price dynamics. Based on this result we propose an arbitrage free futures price model and apply it to the pricing of spread options between EUAs and CERs.