New Publication: Transformative Potential of the New Market Mechanism

by Lukas Hermwille, myself and Christof Arens

There is general agreement that preventing dangerous climate change requires a fundamental transformation of the global economy. Regarding carbon markets, the EU, for example, has called for the new market-based mechanism (NMM) to be established under the UNFCCC to “facilitate transition towards low carbon economy and attract further international investment” (EU 2012). Our paper discusses the transformative potential of the NMM and how it should be structured to maximize transformative impact.

Transformation research generally holds that transformations are not linear processes as result of intentional actions of powerful actors, but cases of interacting dynamics playing out on different timescales but congealing in one direction. They are co-evolutionary, that is, involving a multitude of changes in differing socio-technical (sub-)systems and take place at local, national and global levels.

A variety of climate finance institutions have expressed the ambition to focus their support on actions with transformational potential and have developed criteria to identify such actions. These criteria can be synthesised as follows:

  • Impact beyond the project scope,
  • building capacities,
  • diversion of investment flows, and
  • integration into wider political and social debates.

The negotiations on the NMM have so far not made much headway and its characteristics are hence not yet well-defined. The paper therefore does a case study of the EU ETS, the largest market-based system in existence, which shows that details in the arrangements of the scheme, such as allocation of allowances can significantly influence the incentive structure of the instrument.

Based on transition studies and the study of the EU ETS one can conclude that carbon pricing is necessary but is by itself not sufficient to redeem the various types of market failures that have led to the unsustainable global socio-economic system we are deemed to change. An NMM should therefore be tailored to complement national policies.

As for the NMM itself, based on the discussions held so far, four basic options for how the NMM could function can be conceived:

A) The host country government sets a sectoral target and implements non-trading policies and measures (PAMs) to reduce emissions.

B) The host country government sets a sectoral target and defines voluntary individual targets for the installations within the sector.

C) The government sets a sectoral target and defines binding installation-level emission targets, possibly forming the basis for a national ETS.

D) The host country government sets a sectoral target and installation-level targets, but instead of issuing credits to the host country government the international authority would issue credits directly to the covered installations if they beat their respective installation-level crediting thresholds.

Regarding the criteria for transformational potential explained above, option A) provides for some build-up of administrative capacity in the host countries and provides high potential for policy integration. However, most impacts would depend on the specific set of PAMs that would be utilised. Options B-D would provide direct incentives to installation operators. They would also provide for strong build-up of administrative capacity. Due to the voluntary participation, options B) and D) would entail the problem of how to ensure that well-performing installations are rewarded even if the overall sectoral target is not met. Option C) would solve this problem by making installation-level targets mandatory and would thus provide the highest investment certainty.

One of the motivations behind the NMM discussion is the aim to facilitate the establishment of domestic emission trading systems in more and more countries. Establishment of a domestic ETS opens up further design questions, allocation rules being the most problematic of design features. It may well be the case that free allocation mechanisms are a ‘necessary evil’ to be able to establish an ETS. However, an ETS and carbon pricing can only unfold its potential if this ‘evil’ is overcome. The question is how fast this change in allocation practices can practically occur.

Especially when a sectoral ETS under an NMM would be directly linked to international carbon markets, it is in our view highly unlikely that developing countries will do without free allocation of permits to their industries quickly enough to spur transformative change. Introducing emission trading as an NMM in a developing country, exposing the newly regulated industry fully to carbon price levels that reflect the mitigation costs and more importantly capacities to pay of developed country competitors would dramatically change the terms of business in the NMM host country. It is therefore highly unlikely that any developing country would voluntarily participate in an NMM without being able to protect their industries and buffering the effect of carbon pricing via some amount of free allocations.

A way forward could be not to open emerging ETSs in NMM host countries directly to international carbon markets but instead begin with establishing a protected carbon market with full auctioning of permits but price management in the form of e.g. a price collar. This would allow to limit the impact on the competitiveness of the domestic industry and at the same time meet a key precondition for the effectiveness of carbon pricing: certainty about future prices. The level of ambition and both minimum and ceiling price could gradually be increased to the point where it reaches the level of international carbon markets and linking of markets can be achieved without strong effects on the terms of trade. That is, rather than converging carbon prices by linking systems with each other, a convergence of domestic carbon prices is probably needed to actually make linking politically possible.

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