Explore Financial Innovation for Linkage China ETS and EU ETS. Lan Wang, Dr Xi Liang University of Edinburgh

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1 Explore Financial Innovation for Linkage China ETS and EU ETS Lan Wang, Dr Xi Liang University of Edinburgh

2 Background Seven Pilots Trading Systems National ETS in 2017 European Emission Trading System 2

3 Background Why linkage China ETS with EU ETS? Why China? Why EU? China has higher per capita carbon dioxide emission and EU has launched ETS in its third phrase Why linkage? COP 21 Paris agreement for global climate treaty establishment introduced new concept of cooperative approaches in paragraph 6 The empirical research revealed benefits of linkage outweigh expected costs (Ranson and Stavins, 2013). Economics implication: short-term efficiency gains and dynamic efficiency gains Political implication: China-international cooperation in climate change and longterm climate policy commitment. EU ETS -linking with other systems approval other system s underlying efforts and is would like to burden-share Regulation implication: improvement ETS design and higher confidence of regulatory certainty; easy learning from experiences and best practices 3

4 Existing Methodologies of Linkage for ETS Unilateral linkage is a one-way link, under which the one cap-and-trade mechanism would allow qualified entities to surrender the other s allowances for the purpose of compliance (Mehling et al, 2009) A bilateral linkage would allow participants to purchase allowances from each other for domestic compliance. A bilateral linkage between two ETSs would call for a balance between supply and demand and equivalence in carbon prices (Turek, 2009) The incremental aligning of key elements in cap-and-trade programmes is called linkage with degrees (Dallas et al, 2013: 13). 4

5 Linkage in World Carbon Markets EU ETS Align Multilateral between EU countries Norway with EU ETS Unilateral in EU ETS Phase I; Bilateral in Phase II from 2009 California with Quebec Australia with EU ETS (proposed) Canada Official bilateral linkage with Quebec in 2013 Indirect linkage with EUA swap with AIIU in July 2015; Constructing bilateral linkage with EU ETS no later than 1 July, 2018 Manitoba, Ontario and Quebec 5

6 Motivations Objectives Barriers ETS parameters Policy objective Conflicts between political objective/policy priorities over ETS designs. These incompatibility of differences may reduce environmental effectiveness after linking. Co-benefits for linkage could reduce by shifting domestic abatement to other regions. Relax emission cap may damage reputation, threat of linkage benefits or significant penalties. Linking two mechanisms imply loss control over regulatory flexibility. Economics To assessment of economics benefits of linking mechanisms, distortions may occur and regional carbon price importing volatility of exposure for market shocks. Legal framework and enforcement The different degree of variation of emission reduction ambition needs to be tolerated by both parties 6

Motivations Time of linking Negotiation EU

7 Motivations Time of linking Negotiation EU linkage with Switzerland from 2010 until now Based on definition, one allowance from different carbon markets should represent same reductions in emissions. However, whether a ton is a ton needs to be considered Exchange rate International trade 7

8 Research Questions Whether exchange rate in financial market could extend in carbon market? What is the exchange rate in carbon market? How the exchange rate in carbon market to overcome these barriers in directly linkage methodology? How to determine exchange rate and apply to carbon market? How to apply exchange rate in financial innovation for linkage? 8

9 Methodology Covered entities Qualitative Policy decision procedure NGO Climate policy stringency Political power Key stakeholders Academic institutions Policy certainty Relevant policy makers ER Determine exchange ratio MAC Quantitative Derive working concept PE 9

10 Whether exchange rate in financial market could extend in carbon market? Literature reviews for exchange rate definitions in financial market Exchange Rate Financial Market Definition Exchange rate one currency to another currency in terms of gold Exchange rate one currency to another currency in terms of dollar asset price in theory by discounting sum of all economics variables to present market it could be summarized exchange rate in financial market is basically one currency to the other measured in different ways. 10

11 What is exchange rate in carbon market? In literatures, empirical predicting exchange rate in carbon market only referred to a roughly concept as a solution or a simply setting up an exchange ratio as scenarios for calculating carbon prices or energy prices Exchange Rate Carbon Market Definition Setting up exchange ratio for one regional allowance to the other regional allowance Measure of the effectiveness of mitigation efforts, providing third party due diligence about different mitigation outcomes with recognized rules and process Working definition: asset price for dynamic measure of effectiveness of mitigation one regional credit to another regional emission allowance in terms of price 11

12 Exchange Ratio Definition: Exchange ratio refers to relative value of a standard unit of reductions. Exchange ratio is unit in the carbon market not tons Benefits for exchange ratio: a) As an indicator when compare different emission trading systems-learn from the best b) Policy surveillance leading individual to enhance their ambition and increase abatement c) Step in overcoming barriers for linking two carbon markets. 12

13 How to determine exchange rate and apply to carbon market? There are two principle theories throughout exchange rate concept no matter how classifications are depends on its regimes, characteristics and calculations Purchasing power parity Standing of basic purchasing power parity is essential for understanding and determination of exchange rate. The fundamental law of economics in PPP is law of one price. For the open economy in domestic market, law of one price indicates if two goods are exactly identical, they must sell the same price Equilibrium of supply and demand The purchasing price parity (PPP) is always holding under any circumstances. Equilibrium refers to balance supply and demand in absence of external influences the values of economic variables 13

14 How to determine exchange rate and apply to carbon market? In carbon market, one allowance represents right of emitting one ton of carbon dioxide equivalent Empirical result: standard one-to-one exchange rate in carbon markets could even become more harmful (Howland and Juliet, 2009). The equalization of permit prices cannot yield an efficiency under the condition Exchange rate But it is different from other commodities No costs for transportation and storage Carbon allowance Consumption first then compliance later 14

15 How to determine exchange rate and apply to carbon market? There is no natural market for reducing GHG. Thus the mainly driven for demand is compliance- MAC curve Top-down procedure for MAC what and how could it be Bottom-up procedure for MAC how it should be Supply is government allowances allocation 15

Very Valuable Valuable Little Value No Value at all Can t say What are the main barriers to starting immediate direct linkage

16 Qualitative Findings What is the value in supporting the transfer of good practices and explore long-term robustness studies between the two markets? Very Valuable Valuable Little Value No Value at all Can t say What are the main barriers to starting immediate direct linkage negotiations? Shared governance and political accountability Currently incompatible market design Unclear future about the Guangdong ETS in Chinese The Guangdong ETS needs to mature further, in particular in The EU ETS needs to focus on inner reforms first Other

17 Quantitative Methodology Modelling approach i. Obtaining marginal abatement cost a) Quantity of emission reduction based on IPCC guidelines 3 GHG= k=1 E k GWP k (1) 8 E k = j=1 FUEL j NCV j EF jk (2) Where GHG means greenhouse house gas or equivalent carbon dioxide; variable E k (k=1,2,3) indicates CO 2, CH 4, N 2 O ; FUEL indicates terminal fuel consumption; NCV is net calorific value which provides by IPCC report based on laboratory tests; EF is emission factor, which is highly relevant to various abatement technologies. b) Derive MAC curve TC it =b 1 ER it3 +b 2 ER it2 +b 3 ER it +α+υ (3) MAC i = d(tci) d(eri) =3 b 1ER it2 +2b 2 ER it +b 3 (4) Where t is time t=1,2,..t; i represents different regional; α indicates the differences of abatement between regionals; υ is independent random error term; TC is total cost and ER it means quantity of emission reduction in region i at time t. 17

18 Quantitative Methodology ii. Equilibrium Assumptions Assume there exists a single agency in in the capped carbon market Banking or borrowing carbon credits for future usage is possible however this model only forces on single compliance period. In capped emission trading system, to avoid penalty for non-compliance, representative agency could purchase allowance, offset credits Participants in the model Capped agent (EU and Guangdong) u-emission q-quantities of purchasing allowances from the other agency Original emission abatement cost Price for Penalty Price for offset credits 18

19 Quantitative Methodology iii. Consider exogenous variables in exchange rate From findings Climate policy stringency Tax or ETS FIT: wind and solar Standard: reduction target Government R&D expenditure Levels Policy uncertainty Sensitivity Analysis Data collection China Energy Statistical Yearbook 2015 ; IPCC 2006 National Greenhouse Gas Inventories Guidelines ; National Development and Reform Commission (NDRC); European Commission energy consumption 19

indicates terminal fuel consumption; NCV is net calorific value which provides by IPCC report based on laboratory tests; EF is emission factor, which

20 Preliminary Results Obtaining marginal abatement cost a) Quantity of emission reduction based on IPCC guidelines 3 GHG= k=1 E k GWP k (1) 8 E k = j=1 FUEL j NCV j EF jk (2) Where GHG means greenhouse house gas or equivalent carbon dioxide; variable E k (k=1,2,3) indicates CO 2, CH 4, N 2 O ; FUEL indicates terminal fuel consumption; NCV is net calorific value which provides by IPCC report based on laboratory tests; EF is emission factor, which is highly relevant to various abatement technologies. FUEL NCV EF EF is emission factor, which is highly relevant to various abatement technologies. GWP 20

21 Preliminary Results Derive MAC curve TC it =b 1 ER it3 +b 2 ER it2 +b 3 ER it +α+υ (3) MAC i = d(tci) d(eri) 1ER it2 +2b 2 ER it +b 3 (4) Where t is time t=1,2,..t; i represents different regional; α indicates the differences of abatement between regionals; υ is independent random error term; TC is total cost and ER it means quantity of emission reduction in region i at time t. MAC curve for Guangdong province MAC (yuan/ton) ER (10000 ton) ER (10000 ton) MAC curve for EU MAC for EU MAC for EU $/per ton 21

22 Preliminary Results ii. Equilibrium and Climate policy stringency EU ETS Austria Belgium Czech Republic Denmark Finland Germany Greece Hungary Ireland.. Average EU Guangdong Year EX(EU/GD)

23 Contributions Working definition for exchange rate in carbon market Extend exchange rate theory in financial market to carbon market with modification Construct exchange rate model for carbon market Overcome directly linkage methodology barriers and provide an indirect methodology for linking two carbon markets 23

24 31 May 2017 Third Year PhD Programme 24

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