Watch the video accompanying these slides at http://www.policyexchange.org.uk/modevents/item/the-future-of-the-ets-in-europe-s-climate-strategy Slides from the German Institute for Economic Research's Dr Karsten Neuhoff. Presented at Policy Exchange's event "The future of the ETS in Europe’s climate strategy"

1. Policy Exchange , London 28.10.2014
The future of the ETS in Europe’s
climate strategy
Karsten Neuhoff

2. The future of the ETS in Europe’s climate strategy
1. What role plays ETS as European climate policy evolves?
2. Should the ETS remain the centrepiece of European climate policy?
How should it fit with other policy instruments, such as the
Renewables Directive?
3. What reforms are needed to keep the ETS relevant? Should
policymakers worry about a low carbon price?

3. 1 policy evolves?
Resource Use / Energy & Emissions
What role plays ETS as European climate
Price
“Optimising”
behaviour
Attent
ion
“Satisficing”
behaviour
Economic Output / Consumption
Target
“Transforming”
behaviour
Innovation &
evolution of
complex systems
Real-world individual and
organisational decision-making
Source: Grubb, Hourcade & Neuhoff (2014): Planetary Economics, Energy, Climate Change and the three
domains of sustainable development. Routledge.

4. How should EU ETS it fit with other policy instruments, such as the
2 Renewables Directive?
In 2013 70% of solar deployment was outside of Europe.
Source: Neuhoff et al. (2014): Staying with the Leaders: Europe’s path to a low carbon economy. www.climatestrategies.org.
DIW Berlin Calculations based on REN 21, 2013; EPIA, 2014; Clean Energy Regulator, 2014.

5. Securing a long-term economic energy supply & Jobs
Comparison of European fossil fuel 2 bill and capital costs for renewables
By 2013, annualised capital costs for renewable generation to replace fossil
fuels have declined to a level of the fossil fuel expenditures
Illustration excluding
system cost!
DIW Berlin Calculations based on BP Statistical Review of World Energy; Energy Statistics for the EU-27; Bundesverband
Solarwirtschaft e. V.; IEA; European Wind Energy Association.

6. 3 What reforms are needed for EU ETS to support an efficient
abatement pathway?
Banking
capacity
Speculation
Hedging
Surplus
Accumulated surplus
Rate of annual spot
price increase
at return requirements of
speculators (> 10-15%)
spot price increase with
slope of forward curve
Slope of forward
price curve
Schopp A., K. Neuhoff 2013 The Role of Hedging in Carbon Markets, DIW Discussion Papers 1271
Need for
Market
Stability
Reserve
(Early+
linked
to back-loading)
6
Risk-free aribtrage at cost of
carriage (3-5% offered by banks)
If accumulated surplus exceeds hedging demand:
1. Price falls until low enough allow annual price increases that attract speculators
2. High rate of annual price increases not reflected in forward curve
-> inconsistency undermines credibility of EU ETS
-> strategic investments are miss-guided by low spot price (ignoring future scarcity)

7. What reforms are needed for leakage protection post 2020 with
long-term perspective?
• Ensure leakage protection also for scenarios with differences on climate policy
ambition and emphasis on carbon pricing across regions
• While supporting investment in innovation and modernization opportunities
in energy intensive industries
3
7
Current
Output based
(OB)
Consumption
tax
OB & inclusion
of consumption
Inclusion of
imports
Current
Output based
(OB)
Consumption
tax
Incentives for efficiency + ++
++ +++
Framework for fuel switching + +
++ ++
Business case for break-through process + +
+++ +++
Moving to higher value steel and efficient use +
+++ +++ +++
Source: Climate Strategies – The Steel Report – www.climatestrategies.org
OB & inclusion
of consumption
Inclusion of
imports
Incentives for efficiency + ++
++ +++
Framework for fuel switching + +
++ ++
Business case for break-through process + +
+++ +++
Moving to higher value steel and efficient use +
+++ +++ +++
Free allowance allocation as leakage
protection provides limited
incentives for investments.
Sector needs to be able to
pass mitigation and carbon
costs to consumers.

8. Leakage protection with inclusion of consumption can focus on
energy/carbon intensive materials
• allocation of mitigation and carbon costs of steel, cement, (perhaps
aluminium and cooper) is essential for credible investment perspective
• coverage of competing materials avoids distortions
• focus on few materials limits administrative efforts and complexity
3
8
Industrial activities with the highest cost increase from carbon pricing, and their contribution to
UK GDP, assumed carbon price increase 20 €/t CO2, electricity price increase 10 €/MWh.

9. The future of the ETS in Europe’s climate strategy
1. What role plays ETS as European climate policy evolves?
2. Should the ETS remain the centrepiece of European climate policy?
How should it fit with other policy instruments, such as the
Renewables Directive?
3. What reforms are needed to keep the ETS relevant? Should
policymakers worry about a low carbon price?