ECBI 2008

1. ECBI 2008 THE MICROECONOMICS OF POST 2012 CDM Dr Cameron HepburnDeputy Director, Smith School of Enterprise and the Environment 5 September 2008 Dr Cameron Hepburn

2. SMITH SCHOOL Critical 21st century environmental challenges Demand from policy makers Demand from business Smith School of Enterprise and the environment Interest and input from academics and students Dr Cameron Hepburn

3. OTHER RELEVANT INTERESTS Dr Cameron Hepburn

4. AGENDA • What are the CDM’s objectives? • The two key challenges • Some microeconomics • Evaluating the options for reform Dr Cameron Hepburn

5. 1. CDM OBJECTIVES • Economics: Keep costs down of reducing emissions • Deliver subsidy to developing countries • Philosophy: “Common but differentiated responsibility” (equity) • Politics: Reality is that developing countries will not pay otherwise • Enhance “sustainable development” • Encourage buy-in to the UNFCCC process Dr Cameron Hepburn

6. CATEGORISING THE CDM • The CDM is both: • A market and • A subsidy • The subsidy paid is a function of a market clearing price • Unlike feed-in tariffs, or instruments such as ROCs and RECs, the subsidy is not simply paid upon generation of the desirable thing • Rather, the CDM imposes the extra test of additionality, namelythat emission reductions must not have otherwise happened without the subsidy. • This was considered important to provide an intellectual basis for a fungible market. • There are problems with both its functions: • As a market, additionality concerns undermine integrity • As a subsidy, paying the market-clearing price is non-optimal Dr Cameron Hepburn

7. AGENDA • What are the CDM’s objectives? • The two key challenges • Some microeconomics • Evaluating the options for reform Dr Cameron Hepburn

8. TWO KEY CHALLENGES • Additionality • Asymmetric information generates adverse selection and moral hazard • Ultimate solution is a global cap and trade scheme • Scaling up the mechanism • Project-by-project mechanism is very micro • A “wholesale” approach is needed to increase scale of support for developing countries and also to reduce emissions more rapidly Dr Cameron Hepburn

9. ADDITIONALITY CONCERNS • Blue: New Chinese Capacity Red: Applying for CERs Dr Cameron Hepburn

10. ADDITIONALITY CONCERNS Price EUR/t Supply of CERs Subsidy payment if scheme works P* Demand for CERs Q* Quantity of CERs Dr Cameron Hepburn

11. ADDITIONALITY CONCERNS Price EUR/t Supply of CERs Payment for non-additional projects Payment for additional projects P* Pn Demand for CERs Q* Qn Quantity of CERs Dr Cameron Hepburn

12. AGENDA • What are the CDM’s objectives? • The two key challenges • Some microeconomics • Evaluating the options for post 2012 Dr Cameron Hepburn

13. SOME MICROECONOMICS • Optimal subsidy design • How can given quantity of funds be used to do the most good? • Additionality results for different sector benchmarks • Minimise Type 1 errors (false positives) • Minimise Type 2 errors (false negatives) • Scaling up the mechanism • Project-by-project mechanism is very micro • A “wholesale” approach is needed to increase scale of support for developing countries and also to reduce emissions more rapidly Dr Cameron Hepburn

14. OPTIMAL SUBSIDY DESIGN Price EUR/t Supply of CERs Subsidy payment Demand for CERs Quantity of CERs Dr Cameron Hepburn

15. OPTIMAL SUBSIDY DESIGN Price EUR/t Supply of CERs Profit to project participants Demand for CERs MAC Quantity of CERs Dr Cameron Hepburn

16. OPTIMAL SUBSIDY DESIGN Price EUR/t Purchase more emission reductions Supply of CERs Demand for CERs Quantity of CERs Dr Cameron Hepburn

17. MODEL ASSUMPTIONS Dr Cameron Hepburn

18. UNCERTAIN ABATEMENT COSTS Dr Cameron Hepburn

19. RESULTS: TYPE I AND TYPE II ERRORS Dr Cameron Hepburn

20. SCALING UP: HOW Dr Cameron Hepburn

21. SCALING UP: INTERMEDIARIES Dr Cameron Hepburn

22. SCALING UP: TRADE OFFS Dr Cameron Hepburn

23. AGENDA • What are the CDM’s objectives? • The two key challenges • Some microeconomics • Evaluating the options for post 2012 Dr Cameron Hepburn

24. EVALUATING THE OPTIONS • CER discounting • Reducing the CER price signal faced by project developers • Disadvantages: perverse selection effects • Advantages: aggregate environmental additionality, provision of an incentive to transition to cap and trade. • Shift from the commodity to the currency conceptualisation of CERs. • Programmatic CDM • Continue to be supported and streamlined; • Government deals • Reduce emissions through infrastructure development • Welcomed if rich countries will provide the finance! Dr Cameron Hepburn

25. EVALUATING THE OPTIONS • Sectoral CDM • Provides incentives directly to firms in a manner that is consistent with overall environmental objectives. • In contrast, Policy CDM and Sectoral no-lose targets face the major challenge of leaving implementation to national governments; • Benchmarks trade-off between Type I and Type II errors; • Optimal benchmark will be different for different sectors, and individual country and technology characteristics (e.g. new or old build) will probably need to be taken into account; • CER procurement auctions • Likely to play an increasing role as national governments seek value for money from projects earlier on in the development stages, • Potential role for reverse auctions in paying for emission reductions currently outside the Kyoto framework (Montreal gases, forestry). Dr Cameron Hepburn

26. THANK YOU Thank you Comments and questions welcome! Dr Cameron Hepburn