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Design of Auction, Safety Valve and
Revenue Recycling
within the Energy Performance
Commitment (EPC)
Environmental Resources Management Ltd
& Market Design Inc
26 January 2007
Presentation Overview
• Project objectives
• Interim findings for each EPC design aspect:
• revenue recycling options
• auction design
• integrated analysis (including safety valve)
• Next steps
Project Key Objectives
• Many key EPC policy and design decisions have been taken
− Fixed price introductory phase (sales), cap-and-trade fixed
volume phases (auctions)
− Use of “safety-valve”; preference for “buy-only” link to ETS
− Revenue recycling to participants on basis of emissions
and/or energy management performance
• Design details have not yet been determined
•
how does EPC incentivise ‘good practice’ amongst
participants?
• Overall objective is therefore: to provide guidance on the auction,
‘safety-valve’ and revenue recycling aspects of the proposed
Energy Performance Commitment (EPC).
3 Aspects Linked – Impact Effectiveness
Task 1:
Task 2:
Task 3:
Design of auction
method
Design of revenue
recycling
Design of “safetyvalve”
Integrated analysis
Task 4:
Final Scheme
Proposal
Revenue recycling
Revenue recycling
Assessment of alternative options and proposed formulae
•
Option 1 (RR1): Auction revenues returned to participants in
proportion to average annual emissions
•
Option 2 (RR2): Performance ‘banding’ based on emissions
reduction performance (allows % reward/penalty)
•
Option 3 (RR3): Performance ‘banding’ based on emissions
reduction performance and other criteria e.g. use of HH
metering
Key criteria include: effectiveness, fairness and simplicity,
minimising cost/admin burden to Gov and participants,
rewarding early action/incentivising the installation of AMR
Revenue recycling
We model revenue recycling for x participants over 5 years
Key variables:
•
Basic recycling option design details - no. of bands, band
allocation, rate of reward/penalty
•
•
Number and size distribution of participants
Changes in emissions/behaviour across period
Key outputs:
•
•
•
Determine net winners/losers and extent of wealth transfer
Identify perverse incentives/’unfair’ outcomes
Identify optimal option according to key policy criteria
Revenue recycling
• Different options result in different winners/losers
• Simple payment proportional to emissions - insufficient incentive to
reduce emissions (mixed signals)
• Performance banding option - “league table”
− creates incentive to reduce emissions
− i.e. reinforces the signals of cap and trade
− equal number of participants in each band creates incentive
discontinuity (i.e. 1st place rewarded same as 500th place)
− equal number of participants in each band also requires
corrective factor to % reward/penalty
− equal number of emissions in each band may be an alternative
option, although outcomes are then highly dependent on
participant size distribution
Revenue recycling
• Use of continuous performance banding
− alternative is to have continual linear incentive, i.e. x bands for x
participants; simple, fair and no discontinuities
− Participants could still be reported in ‘performance bands’
• Increasing the % performance factor does the following:
− reduces auction price due to additional incentive to abate along
MACC
− shifts money from those with higher abatement costs to those
with lower abatement costs.
− shifts money from growing businesses to declining businesses
Revenue recycling
• Multi-criteria recycling option
− Participant administrative simplicity maintained (e.g. small
increase in reporting requirement only, payments still simple)
− encourages uptake of auto metering and may encourage early
action
− however, non-transparent in outcomes and adds complexity to
optimal bidding and abatement strategy
− winners and losers will depend on MAC of HH metering and
existing availability of the option for each participant
RR1: proportion to average annual emissions
RR2: emissions reduction performance
Revenue recycling
Net benefit or loss per tCO2 emitted
£15
RR1
RR2a
RR2b
RR2c
£10
£5
£0
-£5
-£10
1
2
3
4
5
6
participant number
7
8
9
10
RR1: proportion to average annual emissions
RR2: emissions reduction performance
Revenue recycling
RR3: RR2 + other criteria
Key policy criteria
Administrative simplicity for
participants
Understanding of optimal
strategy
Incentive for emissions
reduction
RR1
√√
√√
√√
√
X
√
RR2a
√√
√√
√√
√√
X
√√
RR2b
√√
√√
√√
√√
X
√
RR2c
√√
√√
√√
√√√
√
√√√
RR3
√√
√√
√
√√√
√√
√√
√√
meets criteria well
meets criteria
X
does not meet criteria
Recycling option
√
Distributional and equity
concerns
√√√ meets criteria very well
Incentives for early action
Administrative simplicity for
Government
Key
Auction design
Auction design
Key attributes of emissions allowances:
•
•
•
•
Product is a homogenous, divisible good
Product is actively traded in secondary market
Market is un-concentrated
Downward sloping demand curves
Impact of revenue recycling (1)
• Reduces the burden of the scheme on participants but complicates
bidding incentives
• Bidder’s quantity choice impacts its revenue share in complex way
• Performance factor: % bonus or penalty based on relative
performance
• Increasing performance factor
• Reduces auction price
• Shifts money to those with lower abatement costs
• Causes some shift of money from growing businesses to
declining businesses
Impact of revenue recycling (2)
• Scheduling of payments is important consideration
− Auction at start of year 1 + 6 month reconciliation with
payments in mid year 2 = 18 months without cash
− However, it is desirable that some time pass between
auction and recycled payment
− Solution 1: defer participant payment till start of year 2
− Solution 2: participants make net payments only: “settle-up”
− Solution 3: auction in mid-year or multiple auctions
• Solution 1 recommended: achieves simplicity whilst preserving
the strong signal/financial decision associated with payment
Auction design
Leading auction candidates:
•
•
One static (one round of bidding)
One dynamic (multiple rounds of bidding)
Uniform price auction
Price
Supply
P0
clearing price
Demand
(as bid)
Q0
Quantity
Ascending clock with proxy bids
Price
Supply
P0
Price
clock
Excess
demand
Q0
Demand
Quantity
Auction design
Proxy bids:
• Bidders can participate as in a static auction
• or can bid dynamically
Other features:
•
•
•
•
Internet auction
Demand schedules (step function)
Proportionate rationing
Report excess demand and distribution of % reductions
− can estimate revenue recycling impact
• Recommendation: clock auction with proxy bids, so
bidders can better estimate marginal incentive to abate
Integrated analysis
Integrated Analysis
•
•
•
Auction Design, Revenue Recycling and the Safety Valve all
impact on each other
Tasks 1-3 therefore being conducted as a whole using Case
Study modelling
Case Studies aim to predict potential outcomes of design
options
1. identification of the incentives to change behaviour
-
investing in abatement, participating in sales/auction
auctions must be understandable to participants
› i.e. participants must be able to form an initial
strategy and optimise their position within scheme
2. sense checking
-
are there perverse incentives or unintended
consequences?
- e.g. too much/too little abatement capacity
- how do abatement costs and auction prices interact?
Case Study Fundamentals
•
•
•
•
•
•
•
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Uses marginal incentives
• marginal costs modified by recycling payments
Informed by real data (NERA/Enviros etc)
Uses scenarios (recycle design, participants, ceilings, etc)
Outcomes include auction prices, wealth transfer, etc.
Case Studies developed by ERM in Microsoft Excel, with VB
coding
Models hypothetical cases rather than the system as a whole
• Aim is to analyse the effects of design details
Very flexible: multi-year, assumptions re: MAC curves,
behavioural aspects, etc.
Model largely operational but needs testing
Key Outstanding Questions (1)
•
•
•
•
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Recycling Formulae
Multi-Criteria League Tables
Distribution of Sizes of Participants
Distribution of Emissions Projections of Participants
Baseline Alternatives
•
•
•
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Average emissions since start of scheme, Phase 1 period
only, rolling x-year average, etc.
Payment Scheduling
Safety Valve
Buying-in (of alternative allowances)
Key Outstanding Questions (2)
•
Public/Private Sector split
•
Ensures that public sector is not a net loser
•
Technically possible
-
•
•
•
2 revenue pots
Both revenue neutral
•
Likely to reduce market efficiency
•
Ensures that there will definitely be public sector losers
Level of participation in abatement/auctions
Achievability of caps
Participant behaviour
Participant Behaviour
•
Perfect Solution
•
•
•
Companies act independently of recycling rules
Risk aversion
•
•
optimal system solution, perfect rationality and information
Over-abate
Others?
Next Steps
•
•
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Draft Final Report due week commencing Feb 5
•
Major addition will be Case Study results/conclusions
•
Will include final design recommendations
Final Report due week commencing Feb 19
Meetings scheduled after each Report delivered