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Contingent certificate allocation rules and incentives for power plant investment and disinvestment

Abstract

The electricity generation mix of many countries is strongly dominated by fossil fuelled power plants. \(\hbox {CO}_{2}\) certificate trading is then advocated as a first best instrument for emission abatement in Europe, the US and beyond. An important element of the trading scheme is the initial allocation of allowances. This article is to show how permit allocation rules, applied within an Emission Trading System (ETS), interfere with the long-term pricing and investment on power markets. In particular it is demonstrated that free allocation of certificates contingent on plant availability and fuel used is likely to provide distorting incentives both for continued operation of existing plants and for investments. Consequently, marginal abatement costs within the ETS are increased above efficient levels and new power plant investments may crowd out excessively older power plants. Analytical results are derived for two technology cases and a numerical case study is devoted to the EU 27 power sector.

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Notes

  1. 1.

    We thereby follow the definition given by Buchanan (2008, p. 198): “Opportunity cost is the evaluation placed on the most highly valued of the rejected alternatives or opportunities”. The alternative to the usage of the \(\hbox {CO}_{2}\) certificates is to sell them—and the opportunity cost is consequently the market price of the certificates.

  2. 2.

    Note that this is no longer true if Grandfathering is repeatedly applied using updated reference years. If the emissions of the reference year for the second period are affected by actions during the first period, the opportunity costs for the operators change. The benefits of future allocation may then be taken into account in current operation (cf. Neuhoff 2006b).

  3. 3.

    These costs can also be labeled opportunity costs—again in line with the quoted definition by Buchanan (2008). The alternative of not closing the power station provides freely allocated certificates. The opportunity costs of closing the power station thus correspond to the value of the freely allocated certificates minus the avoidable costs associated with the continued operation capability.

  4. 4.

    Note that the Clean Energy Law started in July 2012 with a 3 year fixed price which rather corresponds to a carbon tax. Only from 1st July 2015, the transition to a flexible price is planned. A partly free certificate allocation is foreseen for coal units based on historical generation for a transitional period throughout until Mid-2017, but only in the case of continued operation. After the 2013 elections, the new Australian government has however announced to abolish the Clean Energy Law and replace it by a carbon credit purchase arrangement.

  5. 5.

    The actual emission trading legislation has retained a general “one for two surrender obligation” for all industry sectors and energy usages. Electricity generators do not receive free certificates beyond this reduced certificate submission obligation (which rather corresponds to a devaluation of industrial \(\hbox {CO}_{2}\) emissions compared to deforestation and afforestation activities). Yet free allocation contingent on operation is provided to emissions-intensive, trade-exposed industries.

  6. 6.

    At first sight, this may seem an over-complication of little practical relevance. Yet with \(\hbox {CO}_{2}\) prices being ex ante unknown, the reduction factor \(r\) is needed to ensure that possible overcapacities do not lead to excess \(\hbox {CO}_{2}\) emissions.

  7. 7.

    Such a reduction factor has e.g. been implemented in Germany during the second trading period of the European ETS.

  8. 8.

    Results could also be derived for the more general case with price-elastic demand, yet the analytical treatment is considerably simplified by dropping the price-responsiveness of demand.

  9. 9.

    Note that this somewhat clumsy definition of the inverse demand curve is due to the fact that we are formulating the problem in discrete time, considering time segments of arbitrary length.

  10. 10.

    This obviously only holds true as long as certificate allocation does not overcompensate the \(\hbox {CO}_{2}\) disadvantage of the second technology.

  11. 11.

    This reasoning does not take into account “pathological” specifications where certificate allocation inverts the ranking of capital costs of the technologies.

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Acknowledgments

We thank an anonymous referee and the editor for very helpful comments and suggestions. The usual disclaimer applies.

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Correspondence to Christoph Weber.

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Weber, C., Vogel, P. Contingent certificate allocation rules and incentives for power plant investment and disinvestment. J Regul Econ 46, 292–317 (2014). https://doi.org/10.1007/s11149-014-9257-8

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Keywords

  • Emission trading
  • Allocation of emission permits
  • Electricity markets
  • Power plant portfolio
  • Mixed complementary program

JEL Classification

  • Q54
  • Q58
  • Q56