Tuesday, May 18, 2010

On the Future of the Euro

I had floated the idea to some friends of Germany temporarily leaving the euro as the least bad of all available options. Edward Hugh seems to share that view:
Having Germany temporarily separate from the Eurozone would, in fact, have a number of evident advantages. The first of these would be that citizens in the South would not need to see their wages slashed, while those in Germany would not be asked to pay for bailouts via their tax bill, or lead to blame Greeks or Spaniards for having their hospitals closed or their pensions reduced: ie it would all be politically much easier to handle at this point.
Evidentally German banks would have to swallow a write-down, as loans paid back in Euros would not be worth the same in (new)marks, but 70% of something (say) is better than zero or 20%, and the big plus would be that as the Euro devalued sharply the peripheral economies could rapidly return to growth, and government finances could be quickly turned round as exports grew, tourists returned, and (in addition) many of those coastal properties that currently stand empty could be sold. At the end of the day, what would be left would be a private sector, and not a public sector, problem, and it was (in part) the private sector who got us all into this mess (wasn’t it?).
Indeed this solution does to some extent coincide with what could be termed the new economic reality, since economic growth in emerging markets mean that these are fast becoming key trading targets for German industry, as consumption in Southern and Eastern Europe looks to be increasingly “maxed out”. In fact, according to the recent March trade report from the German Federal Statistics Office, the rate of interannual growth in exports to ex-EU “third” countries (34.7%, as compared with 15.1% for the euro area) was significant, while the volume of trade (34.2 billion euros as opposed to 35.2 billion euros for the Euro Area) is roughly comparable, and indeed at this rate countries outside the EU will soon replace the Eurozone group as destinations for German exports.
I say I hope this move (if undertaken) would be temporary, since I think in the mid term the German economy is neither so strong, nor the peripheral countries so weak, as many commentators assume. But being out of the zone would give the Germans the opportunity to see this for themselves.
Germany, unlike the PIIGS, could exit the euro without causing "the mother of all banking crises", because the Deutsche Mark would only appreciate as a result. There would be a capital flight out of the euro, but it may only be a minor one, because most assets are presumably European owned, anyways, and there would be uncertainty about the timing of safe repatriation of that capital. The German exit would help correct EU's current account imbalances, and it would allow cost levels to adjust to better match productivity indifferences.

However, this would not solve the core problem. As Hugh points out, but doesn't address:
one thing seems evident: under the existing set-up the 16 economies are not converging.
One-off devaluation may help in the short-term, but how do you solve the structural differences? We lived under the illusion that a country such as Greece would have its economy restructured as a result of joining the EU and the euro. That never happened. The country still lives out of agriculture and tourism, and there is no reason to believe this will change anytime soon. The euro will keep pushing inflationary pressures to Greece (and Portugal, etc.) through tourism and real-estate, and it's getting increasingly difficult to keep the faith that productivity will radically increase in these countries in the near future. Another major problem is the lack of labor mobility, which is a prerequisite for optimal currency areas. You can't drag a Greek olive farmer to Germany, kicking and screaming, to start a new profession (or vice versa). The language and cultural barriers are in many cases too high.

Friday, April 2, 2010

More on the 'Success' of EU's Emissions Trading System.

According to The Financial Times, CO2 emissions in the EU declined by 11 % in 2009, thanks to the global economic crisis.
The 11 per cent decline means that companies will be left with millions of euros worth of surplus carbon allowances, which were awarded to them for free by member states. They can either sell those allowances on the open market or bank them for use in later years, when the reduction targets become more stringent.
Such surpluses have kept the ETS carbon price at €13 per ton, less than half what many analysts say is necessary to encourage investments in alternative energy. That has stoked concern that the ETS has gone astray by lavishing windfall subsidies on industrial companies rather than creating incentives for them to invest in low-emissions technology.
Ms Ulset argued that too much attention was being focused on the carbon price. “As long as you achieve the target, it doesn’t matter if the price is low or high,” she said. “As soon as the economy picks up, emissions will, too.”
But the price of carbon does matter. As soon as the economy picks up, so will emissions, because the low carbon price has yet again failed to encourage investments in cleaner technologies. There must be a price floor and ceiling in the system, whereby the ECB or another institution buys and sells permits to stabilize the price. Moreover, why not aim at exceeding instead of meeting the target when the former is economical and the market is playing ball? What we have now is yet another year of free handouts to major polluters in the ETS.

Wednesday, March 31, 2010

The German Experience with Promoting Renewable Energy

RWI, a German institute of economic research, recently published an article called Economic Impacts of Renewable Energy Technologies - The German Experience. Although I have no problem with the authors' arithmetic, per say, I do not quite understand their reasoning. 

The authors accept the astounding success of Germany's feed-in tariffs in expanding renewable energy capacity:
With a share of about 15% of total electricity production in 2008 (Schiffer 2009:58), Germany has more than doubled its renewable electricity production since 2000 and has already significantly exceeded its minimum target of 12.5% set for 2010.
However, they question the efficiency of feed-in tariffs for wind:
Although wind energy receives considerably less feed-in tariffs than PV, it is by no means a cost-effective way of CO2 abatement. Assuming the same emission factor of 0.584 kg CO2/kWh as above, and given the net cost for wind of 3.10 Cents/kWh in 2008 (Table 6), the abatement cost approximate 54 € per tonne. While cheaper than PV, this cost is still more than threefold the current price of certificates in the ETS. In short, from an environmental perspective, it would be economically much more efficient if greenhouse gas emissions were to be curbed via the ETS, rather than by subsidizing renewable energy technologies such as PV and wind power. After all, it is for efficiency reasons that emissions trading is among the most preferred policy instruments for the abatement of greenhouse gases in the economic literature (Bonus 1998:7).
This logic is false for at least two reasons. First, the emissions trading system (ETS) does not automatically and magically turn into emissions reductions. These reductions take place either through lower production levels and higher prices of conventional fossil fuel sources, or through a shift to sources such as wind, which the FIT system is supporting. In the absence of feed-in tariffs, the emissions permits (and hence electricity tariffs on average) would simply be higher. The authors see the low price of permits in the ETS as some sort of merit, but the lower the price, the slower the shift to clean energy sources. Second, the price of emissions permits, and therefore the cost of conventional power generation, is dependent on the amount and allocation of permits in the market (in addition to the opportunity cost). The authors continue:
With respect to climate impacts, the prevailing coexistence of the EEG and the ETS means that the increased use of renewable energy technologies attains no additional emission reductions beyond those achieved by ETS alone. In fact, the promotion of renewable energy technologies ceteris paribus reduces the emissions of the electricity
sector so that obsolete certificates can be sold to other industry sectors that are involved in the ETS. As a result of the establishment of the ETS in 2005, the EEG’s true effect is merely a shift, rather than a reduction, in the volume of emissions: Other sectors that are also involved in the ETS emit more than otherwise, thereby outweighing those emission savings in the electricity sector that are induced by the EEG (BMWA 2004:8).

In the end, cheaper alternative abatement options are not realized that would have been pursued in the counterfactual situation without EEG: Very expensive abatement options such as the generation of solar electricity simply lead to the crowding out of cheaper alternatives. In other words, since the establishment of the ETS in 2005, the EEG’s net climate effect has been equal to zero4.
The authors are certainly right to point out that feed-in tariffs in the range of 40-50 c/kWh for photovoltaics are not the most efficient way to expand clean energy capacity, but that does not mean that feed-in tariffs for wind have been inefficient. The fact that there have been "obsolete certificates" only means just that. There have been too many of them. In essence, the paper builds the whole case against the cost-efficiency of feed-in tariffs for wind by comparing the system to the current or historical prices of ETS permits. Moreover, the argument is based on two assumptions, both of which are false. 1) the current/historical prices of ETS permits reflect the social cost of carbon, and 2) the price of emissions permits would not change in the absence of feed-in tariffs - Wait, let me take that last one back:
These theoretical arguments are substantiated by the numerical analysis of Traber and Kemfert (2009:155), who find that while the CO2 emissions in Germany’s electricity sector are reduced substantially, the emissions are hardly altered at the European scale by Germany’s EEG. This is due to the fact that Germany’s electricity production from renewable technologies mitigates the need for emission reductions in other countries that participate in the ETS regime, thereby significantly lowering CO2 certificate prices by 15% relative to the situation without EEG (Traber, Kemfert 2009:169). In essence, this permit price effect would lead to an emission level that would be higher than otherwise if it were not outweighed by the substitution effect, that is, the crowding out of conventional electricity production through CO2-free green technologies.
By this point, one is inclined to think that the authors can't decide whether low ETS prices are a good or a bad thing, and which is driving the price of which. They essentially argue that the German feed-in tariff system is a subsidy for other countries in the ETS system. This is actually true and not just in the way described above, but also because feed-in tariffs are a form of R&D subsidy for technology companies in renewable energy (and not just for countries in the ETS system, either). However, is this a valid argument against feed-in tariffs? I don't think so. First of all, the ETS system itself, in particular phase 1, has been poorly designed as the market has been flooded with too many permits. Second, the same logic could be used to argue against fiscal stimulus in that it is not worth it because some of the benefits leak abroad. However, that just calls for more coordinated stimulus, not rejecting stimulus as an effective policy.

I am not arguing that the German feed-in tariffs are necessarily at the right level. They most certainly are not. The feed-in tariff for photovoltaics, in particular, is a grossly inefficient R&D subsidy for an immature technology. However, that does not mean that the FIT mechanism, in general, is not well suited to mitigate climate change. We must realize that any system has to be both effective as well as efficient. Efficiency alone is not enough. The ETS and feed-in tariffs are more complements than substitutes. Both are required. FITs have been a tremendous success in terms of expanding clean energy capacity, and in offering investors a safe and stable return on investment. The ETS system, while having lots of potential, needs much more work to induce a similar enthusiasm for clean energy investments. Not only have the permits been priced too low, but the volatility has also been very high, and those who know finance know what that means: higher required returns and hence higher costs of emissions abatement.

Sunday, February 7, 2010

A World of Uncertainties

I just ran into some comments that Daniel Yergin made in 2004 at a conference on U.S.-Saudi relations and global energy security at CSIS:
the U.S. really is on the threshold of a new era in natural gas, and this has major implications. In a sense the U.S. is today in natural gas where it was 30 years ago in oil, about to go from being a minor importer to being a major importer, and a decade from now the United States could literally overtake Japan as the world's number one importer of LNG.
I could have imagined myself in the audience taking notes, and accepting anything he had said about the future at face value, as a prophecy waiting to be fulfilled. Daniel Yergin knows the hydrocarbon business probably better than anyone, but even he couldn't see the unconventional gas revolution coming. Nobody could. There was uncertainty about technology, and hence about possible market outcomes. Here are Yergin's comments just over five years later.

I think I'm going to bookmark this post, and refer to it every time in the future when I get something completely wrong. Even the Daniel Yergins do.

Sunday, January 10, 2010

To Be or Not to Be

COP-15 ended over 3 weeks ago. The immediate outcome disappointed many optimistic observers, but the longer term outcome is still unclear (yes, I know what Keynes said). Personally, I expected nothing more. In essence, I think the outcome shows that none of the major emitters, like Shakespeare's Hamlet, consider suicide as a plausible option. In other words, the real issue not whether climate change is a real threat, the conflicts are about cost-effectiveness and justice. The most important lesson from the conference is that the UNFCCC may not be the right venue for an initial agreement among major GHG emitters.

There's been a lot of harsh criticism about the outcome of the conference, but considering the fact that UNFCCC's decisions require unanimity among its near 200 members; the "noted" Copenhagen Accord is probably as good as it gets. As Robert Stavins has pointed out, it would make much more political sense to initially forge a strict agreement among 20 largest polluters who account for 90 % of all emissions (i.e. a venue such as the Major Economies Forum on Energy and Climate or the G-20). That should be the first step, and it is challenging on its own. Only once that is achieved can the UNFCCC play a meaningful role.

In my opinion, the most realistic analysis on the outcome of COP-15 was offered by Robert Stavins, David Doniger, and WRI's Rob Bradley. Among others, CU Earth institute's Jeff Sachs, not surprisingly, hoped for much more.

On another but somewhat related topic, Ian Parry's recent paper on optimal taxes on highway fuels gives more evidence why corrective Pigouvian taxes make sense (I briefly commented on this topic last June). Not that the logic requires any more proof. It also applies to all other anthropogenic GHG sources.