Julien Chevallier
email: j.chevallier@imperial.ac.uk

Re-examining the concept of sustainable development in light of climate change

Keywords: climate change policy, sustainable development, prioritization, development, environmental protection, global warming

This article provides a critical appraisal of the concept of sustainable development in light of climate change. As the latest climate change science indicates strong effects of anthropogenic activity on global warming, we review the pros and the cons of prioritizing development over environmental protection. The methodology used consists in critically discussing the arguments of scientists and academic researchers in the environmental economics field to put a greater emphasis on the preservation of the environment vs. urging development issues. We show that the debate over prioritization does not make sense insomuch as the wider consequences of climate change are envisioned, i.e. it does not appear conceptually appropriate to think about environment and development issues in separate spheres. Our main contribution consists in embracing a holistic approach to discuss sustainable development issues within the new international framework of climate change policy and anthropogenic global warming concerns.

Introduction

According to the World Bank indicators (2001), 1.2 billion of the world's 6 billion people live on less than $1 a day. Even if the new methodology used for the poverty headcount has been criticized by [START_REF] Wade | Is Globalization Reducing Poverty and Inequality?[END_REF], those figures still represent the best estimates for the spread of worldwide poverty, with 18% of the population living under $1 a day and 53% under $2 a day. Compared to the costs of environmental protection in developed countries -estimated at 2.6% of GDP in the USA in 2000 by [START_REF] Jaffe | Environmental Regulation and the Competitiveness of U.S. Manufacturing: What Does the Evidence Tell Us?[END_REF] -some scholars have argued that scarce resources would be better spent on development rather than environmental protection. As Lomborg (2004a) puts it: "The Copenhagen Consensus was the first project to prioritize the major challenges facing the world. Morally, we must focus on the best priorities first, or we do less good for humanity. Prioritization means not everything is done first." By relying on general rules of thumb, the core idea of prioritization appears all too easy. On the one hand, governments are not able to address all problems at the same time, i.e. corruption, conflicts, malnutrition, climate change, etc. On the other hand, every dollar should be spent in the best achievable way [START_REF] Lomborg | Global Crises, Global Solutions[END_REF]. Prioritization shall not be confused with targeting, which consists in a specific econometric technique designed to identify the recipients of development programs, as explained by [START_REF] Duflo | Grandmothers and Granddaughters: Old Age Pensions and Intra-household Allocation in South Africa[END_REF] and [START_REF] Miguel | Worms: Identifying Impacts on Education and Health in the Presence of Treatment Externalities[END_REF].

The design of the Copenhagen consensus (CC) to spend an extra $50 billion over four years [START_REF] Lomborg | Global Crises, Global Solutions[END_REF] has been criticized as being unrealistic to tackle real problems.

According to Sachs (2004), it corresponds to investing 0.03% of annual donor-country income, while the current Official development assistance (ODA) totals $69 billion per year, i.e. 0.25% of donor GDP with a target of 0.7%.

The main difficulty lies in finding effective solutions to alleviate poverty, with reforms ranging from a more equal distribution of factors of production (land, labour, human and physical capital), to access to credit and insurance, the provision of good health and nutrition facilities. This complex web of reforms makes it unlikely to subscribe to the view that "for just half the cost of Kyoto we would give all third world inhabitants access to basics like health, education and sanitation" [START_REF] Lomborg | First Things First[END_REF].

Similarly, [START_REF] Lomborg | The Skeptical Environmentalist: Measuring the Real State of the World[END_REF] points out that weak institutions in developing countries might prevent them from honouring environmental commitments. But the problem of institutional quality is common to development, as explained by a new economic literature including [START_REF] Engerman | Factor Endowments, Institutions, and Differential Paths of Growth among New World Economies: A View from Economic Historians of the United States[END_REF], Acemoglu, Johnson and Robinson (2001), [START_REF] Mcarthur | Institutions and Geography: Comment on Acemoglu, Johnson and Robinson[END_REF] and [START_REF] Rodrik | Institutions Rule: the Primacy of Institutions over Geography and Integration in Economic Development[END_REF]. Without sound institutions, it seems unlikely that the fungibility of aid in poor countries will be reduced, or that political elites will change their consumption behaviours that lead to debts. This article re-examines the concept of sustainable development in light of climate change by critically analyzing whether it makes sense to prioritize development over environmental protection. In Section 1, we demonstrate that proponents of prioritization may draw misleading interpretations from environmental cost-benefit analysis (CBA). The issue of climate change is discussed as an example of environmental protection that was rated as a "bad" project by the CC; while other projects such as controlling HIV/AIDS and malaria, providing micro-nutrients and promoting trade liberalisation hit the top of the list. In Section 2, the concept of Sustainable Development (SD) is used to examine under which conditions development and environmental protection might be reconciled. Key assumptions of the proponents of prioritization are further scrutinized, dealing with technological optimism, the existence of an Environmental Kuznets Curve (EKC) and the "resource curse" phenomenon, the appraisal of uncertainty, biodiversity loss and irreversibility. Our analysis concludes to the preservation of critical forms of natural capital. Finally, an example of reconciliation between development and environmental protection is provided with the catastrophic bonds (CAT bonds) scheme.

Is It Possible to Prioritize Development Over Environmental Protection When

Allocating Scarce Resources?

The CC gathered only economists to come up with a list of the world's top priorities.

Critics like Sachs (2004) argued that the presence of natural scientists would have been beneficial. Nevertheless, the determination of the proponents of prioritization relies on a central argument, as expressed by [START_REF] Lomborg | The Skeptical Environmentalist: Measuring the Real State of the World[END_REF]: "(…) an economic analysis of the costs and benefits of an immediate reduction in CO 2 emissions clearly shows that the world as a whole would benefit more from investing in tackling problems of poverty in the developing world and in research and development of renewable energy than in policies focused on climate change."

We explain in this section how such conclusions are reached by focusing on several steps of CBA: the input of scientific facts, the choice of the discount rate, the valuation of non-market goods and the modelling phase. Cline, 2004c). But the best estimates for a doubling of CO 2 in the atmosphere consist in a climate sensitivity of +1.4°C (which would not be very significant for human activities) to +5.8°C (which could have catastrophic consequences) according to [START_REF] Andronova | Objective Estimation of the Probability Density Function for Climate Sensitivity[END_REF]. As for the United States Congressional Budget Office (CBO, 2005), this sensitivity "limits scientists' ability to accurately represent or predict the fluctuations of the climate system in great details". Another concern lies in the time-lag that affects reduction in CO 2 emissions. The French Council of Economic Analysis [START_REF] Guesnerie | Kyoto et l'économie de l'effet de serre[END_REF] -which advises the Prime Ministerindicates that "even a dramatic reduction in greenhouse gas emissions would only have a limited impact in the short-run " (2003). This goes in line with Lomborg's view that the economic costs of fighting climate change are too high compared to what can be achieved with the provision of HIV/AIDS medicines or chemically-treated bednets against malaria.

Scientific Information as an

However, [START_REF] Cox | Acceleration of Global Warming Due to Carbon-Cycle Feedbacks in a Coupled Climate Model[END_REF] recommend to take into account a "carbon-cycle feedback" that could significantly accelerate climate change over the twenty-first century under a business as usual scenario, i.e. with no preventive action against climate change. Such a phenomenon might occur as land ecosystems and the ocean cannot act as carbon sinks anymore if anthropogenic emissions of CO 2 are rising continuously.

Hence, scientific facts do not provide a clear basis for the need to prioritize development over environmental protection.

The Choice of the Discount Rate

Traditionally, there are at least two reasons to discount the future. First, individuals have positive time preference, i.e. they prefer benefits now to later. Second, because a positive interest rate exists in the economy, individuals incur an opportunity cost equal to the return on investment [START_REF] Pearce | Cost-Benefit Analysis and the Environment: Recent Developments[END_REF]. In presence of scientific uncertainty, [START_REF] Hanley | Cost-benefit analysis and environmental policymaking[END_REF] argues that no satisfactory way has been developed in CBA to include the complexity of ecosystems interactions. Therefore, "the practice of discounting in CBA (…) may lead to outcomes that are both undesirable on environmental grounds and unfair to future generations". Similarly, the CBO (2005) notes that "the discount rate chosen can dramatically affect conclusions about the appropriate stringency of policy today".

At this point, it appears useful to analyze the consequences of the discount rates used by proponents of prioritization. [START_REF] Lomborg | The Skeptical Environmentalist: Measuring the Real State of the World[END_REF] recommends to use a discount rate of at least 4-6%. Compared to an average rate of return on investment of 16% in the developing world (as estimated by the World Bank), this allows him to conclude that scarce resources would be spent more efficiently on development rather than environmental protection. In the CC guidelines, each review of the literature used its own typical estimates of the discount rate.

However, [START_REF] Lomborg | Global Crises, Global Solutions[END_REF] admits that it would have been preferable to provide upper-and calliper-bound estimates.

Little agreement was reached during the CC on how to discount projects with longterm environmental impacts like climate change. An ongoing debate exists between proponents of a prescriptive approach like Cline (2004a), and proponents of a descriptive approach like [START_REF] Manne | Global Climate Change: An Opponent's Notes[END_REF]. On the one hand, the descriptive approach is rooted in mainstream economics with the adoption of market oriented rate of returns. On the other hand, the prescriptive approach uses a lower discount rate to reflect market distortions that affect the preferences of current generations toward the welfare of future generations. The debate is not solved, as Cline (2004b) claims his approach is the only appropriate framework to deal with intergenerational equity; while critics such as [START_REF] Manne | Global Climate Change: An Opponent's Notes[END_REF] and [START_REF] Mendelsohn | Opponent Paper on Climate Change[END_REF] warn that the prescriptive approach might overestimate climate-related damages and underestimate future benefits. [START_REF] Weitzman | Why the Far-Distant Future Should be Discounted at Its Lowest Possible Rate[END_REF]in Neumayer, 2003) proposes to apply declining discount rate in the future, reflecting growing uncertainty over the long-term.

To sum up, the choice of the discount rate has a decisive influence on the decision to prioritize development over environmental protection -yet there is no clear answer to this debate.

The Valuation of Non-Market Goods

As the results published by the CC rely only on CBA, it appears necessary to examine also the difficulties encountered with the valuation of non-market goods. The valuation of damages from climate change such as harm to ecosystems and adverse health effects for humans may be problematic. For instance, the valuation of biodiversity using the contingent valuation method (CVM) is dependent on the absence of systematic bias, the sample choice and the writing of scenarios. Even if the National oceanic and atmospheric administration (NOAA) panel chaired by [START_REF] Arrow | Report of the NOAA Panel on Contingent Valuation[END_REF] recognized the validity of CVM in natural resource damage assessment -provided some best-practice guidelines are followed, specific values derived for biodiversity might not be accepted by all experts given those biases.

Another example may be found with the valuation of health effects in developing countries. Benefits transfer is routinely used by CBA analysts since it represents a costless means to access existing data instead of colleting new ones-simply by transferring them from developed countries. This methodology may be criticized for not matching the target population and it appears preferable to collect estimates on a case-by-case basis which tends to increase the costs of CBA studies.

Besides, the French Council of Economic Analysis [START_REF] Guesnerie | Kyoto et l'économie de l'effet de serre[END_REF] stresses the fact that non-market damages of climate change have the characteristics of a public good. For example, concerning species loss each country has the incentive to free-ride by not participating in global agreements to fight climate change and let other countries bear the costs of species preservation.

Both non-market goods valuation, which is inherently difficult, and public good characteristics of climate change damages make suspicious the accuracy of the results published by the CC. CBA does not seem to be well equipped to deal with these issues, which further undermines the claim for a prioritization of development over environmental protection.

The Modelling Phase

That [START_REF] Lomborg | The Skeptical Environmentalist: Measuring the Real State of the World[END_REF] denounces the lack of improvement of the basic range of climate change estimates over the past 25 years does not imply that the noise from the models is too big to formulate policy -as he wrongly concludes. It seems more useful to discuss the assumptions on which different sets of models are based, and then to derive conclusions concerning their ability to guide decision making.

As for the proponents of prioritization, the conclusion reached by the United Nations IPCC (2001) might lead to overestimates in the speed of climate change. [START_REF] Lomborg | The Skeptical Environmentalist: Measuring the Real State of the World[END_REF] criticizes the IPCC business-as-usual scenario for using a predicted +1% CO 2 emissions increase per year, while +0.6% seems more realistic. On the contrary, [START_REF] Nordhaus | Warming the World: Economic Models of Global Warming[END_REF] concludes that the impacts from climate change are likely to be quite modest for the next century. Their model has been considered as a milestone by many critics of immediate action to mitigate climate change, but it relies on strong assumptions. First, the climate sensitivity for a doubling of CO 2 was thought to be between +1-3°C when it was published.

Yet the new climate sensitivity of +1.5-5.8°C that was discussed earlier should be plugged into this model to determine if it affects the urgency of immediate action. Second, the hypothesis of a "carbon-cycle feedback" as described by [START_REF] Cox | Acceleration of Global Warming Due to Carbon-Cycle Feedbacks in a Coupled Climate Model[END_REF] should also be included. Third, Nordhaus and Boyer assume that in any catastrophic scenario a solution could be found. This assumption corresponds to what [START_REF] Böhringer | Assessing the Costs of Compliance: the Kyoto Protocol[END_REF] call "subjective judgements" that are implicit to the design of any model. Here, subjective judgements are tainted with the faith that human creativity can solve future problems. For instance, Nordhaus and Boyer conclude that the damages for the United States, Japan, Russia, and China are essentially zero around 2100, assuming that catastrophic scenarios do not materialize.

In our view, it appears more realistic to wonder today what we could do to minimize the dramatic consequences of catastrophic events if they were to materialize. Examples of challenges at stake can be found in Cline (2004a) with the shut-down of thermohaline circulation in the Atlantic ocean; and [START_REF] Biermann | Big Science, Small Impacts in the South?[END_REF] with changes in monsoon cycles in Southern and East Asia where farming practices have a limited ability to adjust. As Lélé (1991) suggests, empirical questions like these should be considered apart from mathematical models.

Consequently, the appraisal of models by the CC should not be taken at face value.

That Nordhaus and Boyer find an optimal reduction in global carbon emissions of 5% at present allows [START_REF] Lomborg | The Skeptical Environmentalist: Measuring the Real State of the World[END_REF] to compare this amount with five times the ODA. Our point is precisely to question whether such comparisons make sense by analyzing rigorously their underlying assumptions. Yet evidence suggests that proponents of prioritization are keen to jump to conclusions. For instance, Sachs (2004) notes that, during the experts meeting of the CC, alternative proposals -which could have changed the final ranking in favour of a low carbon tax -have not been properly assessed.

Additional evidence has been provided during the modelling phase to cast doubts on the necessity to prioritize development over environmental protection.

To sum up this first section, we demonstrated that development cannot be prioritized over environmental protection as easily as thought by participants of the CC when allocating scarce resources. Economic analyses based on environmental CBA are characterized by many sources of subjective judgments, i.e. with the input of scientific facts, the choice of the discount rate, the valuation of non-market goods and during the modelling phase, that may conduct to misleading interpretations. In the next section, we discuss under which conditions development and environmental protection might be reconciled.

Under Which Conditions Development and Environmental Protection Might Be

Reconciled When Allocating Scarce Resources?

"When it comes to dilemmas for choosing between the environment and today's poor, (…) it seems to me the debate has missed a key consideration." Cline (2004b) This quote from a participant of the CC suggests that development and environmental protection might be reconciled within the framework of SD, as defined by Neumayer (2003):

"development is defined (…) to be sustainable if it does not decrease the capacity to provide non-declining per capita utility for infinity". At the heart of SD lies the question whether natural capital is substitutable with other forms, i.e. man made, human and social capital.

The debate over the substitutability of natural capital has been polarized by proponents of weak sustainability (WS) -who accept it, and proponents of strong sustainability (SS)who reject it. The study of both paradigms will conduct us to the categorization of the forms of natural capital that need to be preserved.

The flaws of environmental CBA highlighted in the first part are complemented with an analysis of the key assumptions on which the proponents of prioritization rely. Technological optimism will be of particular importance, along with other issues such as the existence of an EKC, the appraisal of uncertainty, biodiversity loss and irreversibility. An example of reconciliation between development and environmental protection is also provided.

The Implicit Assumption of Substitutability and the Limits of Technological

Optimism

The optimists' creed consists in not worrying about depleting natural resources as long as it is possible to find substitutes for natural resources. By listing environmental protection alongside developmental goals, proponents of prioritization implicitly endorse the substitutability assumption in the spirit of WS. In our view, this assumption goes hand in hand with technological optimism.

Technological optimism is associated with [START_REF] Boserup | The Conditions of Agricultural Growth : the Economics of Agrarian Change under Population Pressure[END_REF] thesis of endogenous technical change according to which pre-industrial agricultural systems had changed in response to increases in population density. Scarcity plays a central role, as it becomes apparent through price changes and encourages technological innovations or changes. This view is expressed by [START_REF] Lomborg | The Skeptical Environmentalist: Measuring the Real State of the World[END_REF] when he states that under reasonable scenarios of technological change renewable energy will become cheaper, we will move towards cleaner way of living, and thus the impact of human activity on the environment will be far better than expected. This description is very convenient since it does not suppose to change our current consumption levels, and allows prioritizing scarce resources on development. But it does not seem to meet reality, as [START_REF] Edmonds | Global Energy Technology Strategy: Addressing Climate Change, Initial Findings[END_REF] conclude research and development effort over the last decade has been decreasing.

Interestingly, the technological optimism of proponents of prioritization does not support the Porter hypothesis (Porter and van der Linde, 1995) which consists in win-win agreements between environmental protection and profitable opportunities. On the one hand, [START_REF] Lomborg | The Skeptical Environmentalist: Measuring the Real State of the World[END_REF] remains skeptical about the existence of low-hanging fruits that companies would not have seized yet. On the other hand, the French Council of Economic Analysis [START_REF] Guesnerie | Kyoto et l'économie de l'effet de serre[END_REF] suggests the existence of so-called "ancillary benefits" whereby immediate action to reduce CO 2 emissions can also mean reduced pollution, which will make the social cost lower. This optimism appears also limited by [START_REF] Lomborg | The Skeptical Environmentalist: Measuring the Real State of the World[END_REF] fear of the failure of the Kyoto Protocol (KP) since developing countries are not included. In our opinion, a more realistic approach would consist in considering the KP as a first step for Annex 1 countries, whereby they develop expertise in this field, and then extend it after the first period (2008)(2009)(2010)(2011)(2012). The Clean development mechanism (CDM) within the KP also allows building projects involving clean technologies investments in developing countries.

Another example may be found in [START_REF] Lomborg | The Skeptical Environmentalist: Measuring the Real State of the World[END_REF] interpretation of the "pollution havens" hypothesis, whereby polluting factories would move to developing countries as a result of the KP. There is however no conclusive empirical evidence concerning this hypothesis as discussed by [START_REF] Neumayer | Greening Trade and Investment -Environmental Protection without Protectionism[END_REF]. Some activities cannot be exported for profit abroad and multinationals may be wary of their reputation if their practices are revealed.

Additionally, it might be cheaper to build factories with new technologies rather than end-ofpipe technologies. These remarks lead us to hypothesize that proponents of prioritization introduce a bias regarding technological change by adopting it when it allows avoiding immediate costs, and rejecting it when it favours environmental protection.

To summarize, the substitutability of natural capital on which proponents of prioritization implicitly rely is linked to technological optimism. But a critical analysis of this optimism does not provide more ground for prioritization. A bias against environmental protection has even been hypothesized.

The Existence of an EKC and the Resource Curse Phenomenon

It follows from technological optimism that an EKC exists, i.e. an inverted U-curve relationship between environmental degradation and per capita income. But there might be dangerous policy implications with the "pollute first, clean up later" logic of the EKC. [START_REF] Lomborg | The Skeptical Environmentalist: Measuring the Real State of the World[END_REF] predicts that once developing countries have grown they would be "rich enough to afford to help the environment, reforest and set aside parks." From this perspective, the environment is seen as a luxury good with an income elasticity of environmental amenities bigger than one, as described by [START_REF] Krutilla | The Economics of Natural Environments, Resources for the Future[END_REF]Fisher (1975 in Neumayer, 2003). Whether economic growth will be beneficial or harmful to the environment remains nevertheless highly uncertain. The existence of the EKC represents a best-case scenario, since many air and water pollutants are expected to rise in developing countries and the income thresholds are not fixed as discussed by Cole and Neumayer (2002). Besides, there is no definitive empirical evidence concerning the capacity of developing countries to "tunnel through" the EKC using cleaner technologies (Cole and Neumayer, 2002). Surprisingly, proponents of prioritization seem to ignore the "resource curse" phenomenon identified by recent econometric studies, whereby resource-rich countries like Nigeria or Argentina are growing slower on average than resource-poor countries like South Korea -due mainly to institutional quality. [START_REF] Lomborg | The Skeptical Environmentalist: Measuring the Real State of the World[END_REF] relies on the optimistic assumption that "many developing countries will be (…) considerably richer and better developed and therefore more capable of handling the problems of the future". But empirical evidence gathered by [START_REF] Sachs | The curse of natural resources[END_REF] does not confirm this statement.

The technological optimism that justifies prioritization does not seem to stand to further analysis. Empirical evidence concerning the existence of an EKC is mixed, while the resource curse phenomenon is surprisingly ignored. The assumptions dealing with uncertainty will be explored in the next section.

Different Approaches to Deal with Uncertainty

Uncertainty, as defined by Neumayer (2003), refers to a situation where different states of the world together with their outcomes and distribution of risks are not known with certainty. Uncertainty plays a central role in [START_REF] Beck | Risikogesellschaft. Auf dem Wege in eine andere Moderne (Risk-Society. On the Road Towards Another Modernity)[END_REF] risk-society where extreme poverty and extreme risks are linked, as illustrated by vulnerability to disasters. That [START_REF] Giddens | Environment, Modernity and the Risk-Society: the Apocalyptic Horizon of Environmental Reform[END_REF] stresses environmental problems acquire a global and irreversible dimension in the late modernity allows us to conclude that participants of the CC may underestimate low probability / high consequence risks. [START_REF] Manne | Global Climate Change: An Opponent's Notes[END_REF] recognizes that uncertainty exists, but solutions too. [START_REF] Lomborg | The Skeptical Environmentalist: Measuring the Real State of the World[END_REF] disagrees with spending 2% of the world's production on environmental protection based on the idea that the very presence of uncertainty undermines the positive returns on investment of a project. As the UN IPCC (2005) reinforced, it appears preferable to take short-term proactive action which may be complementary with intrinsic uncertainties of long-term predictions.

The option value of delaying immediate action may be insufficient for coping with uncertainty as reported by Neumayer (2003). In the case of climate change, [START_REF] Nordhaus | Warming the World: Economic Models of Global Warming[END_REF] estimated a net loss of $6 billion from waiting for more information, which is rather small compared to the $245 billion total mitigation costs of climate change. Yet Nordhaus and Boyer's computations rely on the strong assumption that appropriate action will be taken in the future, i.e. on a subjective judgement concerning the behaviour of future generations. This ignores the time-consistency problem of SD as explained by Neumayer (2003). If no immediate action in favour of the environment is taken today, then it might not be the case either in the future. Equally, if current generations devoted some of their income to protect the environment, there is no guarantee that future generations will be altruistic when facing the same choices. Hence, it is possible to conclude that proponents of prioritization rely on overly optimistic assumptions regarding uncertainty.

Concerning SD, Neumayer (2003) convincingly shows why both paradigms are nonfalsifiable. Under conditions of uncertainty, it appears difficult to conclude that natural capital will always be substitutable to other forms of capital in the spirit of WS. Similarly, there is little ground to conclude that all forms of natural capital need to be conserved because of their specific attributes in the spirit of SS. That is why the precautionary principle by O'Riordan and Jordan (1995) may be seen as a solution to protect the environment against potentially serious or irreversible damage based on sufficient scientific evidence -not proof.

In short, proponents of prioritization rely on optimistic assumptions when dealing with uncertainty and tend to ignore time-consistency problems. The appraisal of uncertainty within the framework of SD called for the application of the precautionary principle, and suggested that some forms of natural capital might not be substitutable. But there lacks a precise definition of what should be preserved.

Which Forms of Natural Capital Need to be Preserved?

Biodiversity loss and the need to account for irreversibility are discussed, followed by a non-exhaustive categorization of the forms of natural capital that need to be preserved in the spirit of SD.

Proponents of prioritization tend to rely on optimistic assumptions when dealing with biodiversity loss. That [START_REF] Lomborg | The Skeptical Environmentalist: Measuring the Real State of the World[END_REF] wonders "why there is any reason at all to worry about the loss of species" -since we are able to analyze only a tiny fraction of their potential benefits -seems to indicate he primarily values biodiversity as a potential source of medicines. However, this view of biodiversity as an input for profitable pharmaceutical products may underestimate the complex relationships existing in the biosphere. In our opinion, [START_REF] Escobar | Whose Knowledge, Whose nature? Biodiversity, Conservation, and the Political Ecology of Social Movements[END_REF] provides more ground for policy making by urging scientific research to assess the significance of biodiversity loss for ecosystem functioning. This approach seems more realistic, since with a better understanding of ecosystems it would be easier to decide where to allocate scarce resources. These considerations shall not be separated from the question of irreversibility, whereby changes are definitive once a series of events has occurred. The French Council of Economic Analysis [START_REF] Guesnerie | Kyoto et l'économie de l'effet de serre[END_REF] warned "there might exist a window of action that will not last" to protect the environment. Our ignorance of the capacity of resilience of ecosystems is further emphasized by Neumayer (2003), who presents a lottery game to explain how rational agents behave when confronted with the probability that biodiversity might provide a cure to a disease. To avoid the regret of not being able to cure the disease, the optimal solution would consist in preserving species and biodiversity. That is why proponents of prioritization may be too optimistic when stating that we should deal first with more pressing development issues such as HIV/AIDS. Maybe the cures for such diseases will come from biodiversity. This reflects Ciriacy-Wantrup's (1952) pragmatic solution with the definition of safe minimum standards (SMSs). In 1996, the IPCC proposed the adoption of "affordable" SMSs to mitigate climate change as reported by Neumayer (2003). This brings us to the categorization of the forms of natural capital that need to be preserved in the spirit of SD. Some useful guidelines may be cited with Neumayer (2003): "(…) the protection of global life-support systems such as biodiversity, the ozone layer and the global climate as well as the restriction of the accumulation of pollutants and of unsustainable harvesting and soil erosion appear to be sound insurance policies for achieving sustainability."

These critical forms of natural capital need to be preserved because they are considered as non-substitutable, unless the costs are "unacceptably high" as quoted by Neumayer (2003).

The optimistic assumptions of proponents of prioritization regarding biodiversity loss are sensitive to the introduction of irreversibility. In the spirit of SD, this leads to the adoption of SMSs and the preservation of critical forms of natural capital if development and environmental protection are to be reconciled.

The CAT Bonds Scheme

Such example of reconciliation may be found in the CAT bonds scheme described by [START_REF] Varangis | Can Financial Markets be Tapped to Help Poor People Cope with Weather Risks[END_REF]. Disaster aid (e.g. from shortfalls or excess rain, extreme temperatures, etc.) is provided depending on the performance of an index of catastrophic risk and the "trigger" (weather event) can be independently verified by private insurance companies. This scheme would allow eliminating systematic risks coming from the environment (such as droughts) in order to promote development in poor countries (such as preventing distress sales). As [START_REF] Morris | Can Insurance Break Ethiopia's Vicious Cycle of Hunger?[END_REF] from the UN World Food Program proposes, a pilot-project in Ethiopia will evaluate if this scheme encourages farmers to take more risks by planting higher yields crops with the certainty of being insured in case of failure. It shall be kept in mind however other political economy determinants of poverty, such as corruption or civil war, will remain.

What concerns SD, it can be concluded that the substitutability of natural capital determines under which conditions development and environmental protection might be reconciled. Optimistic assumptions to prioritization rely on the implicit endorsement of the WS paradigm. First, the EKC seems to be accepted too readily and the resource curse phenomenon is surprisingly ignored. Second, a bias against environmental protection may be hypothesized. Third, the option value of delaying environmental protection ignores timeconsistency problems when dealing with uncertainty. This in turn favours the adoption of the precautionary principle. Fourth, complex relationships existing in the biosphere are not taken into account when dealing with biodiversity loss and irreversibility, which calls for the adoption of SMSs. While not fully subscribing to the SS paradigm, our analysis showed that critical forms of natural capital need to be preserved when allocating scarce resources. An example of reconciliation between development and environmental protection was provided with the CAT bonds scheme.

Conclusion

"God does not play dice with the universe."

As [START_REF] Nordhaus | Warming the World: Economic Models of Global Warming[END_REF] recall Einstein's famous reaction to quantum physics, it has been demonstrated that giving priority to development could be perceived as indeed playing dice with the environment. This article re-examines the concept of sustainable development in light of climate change policy. In our view, the debate over prioritizationwhich shall not be confused with targeting -remains too simplistic if it is left to blunt statements about the relative costs of environmental protection.

In Section 1, the case study of climate change provided support to the proposition that development cannot be prioritized over environmental protection as easily as thought by participants of the CC. Subjective judgements are present in environmental CBA with the input of scientific facts, the choice of the discount rate, the valuation of non-market goods and the modelling phase that may conduct to misleading interpretations.

In Section 2, the concept of SD and the question of the substitutability of natural capital were put forward in order to examine under which conditions development and environmental protection might be reconciled. Prioritization is implicitly linked to the the WS paradigm. While not fully subscribing to the SS paradigm, our analysis recommends allocating scarce resources with a clear emphasis on SD and the preservation of critical forms of natural capital. Several shortcomings of prioritization were also identified, namely regarding technological optimism, the existence of an EKC and the "resource curse" phenomenon, the appraisal of uncertainty, biodiversity loss and irreversibility.

Meanwhile, the fight against poverty has become a sacred grail for multilateral organizations over the last decades, and much effort still remains to be done. The CAT bonds scheme that was provided as an example of reconciliation between development and environmental protection showed that it is very unlikely to deal with poverty reduction as quickly as assumed by proponents of prioritization.

  Input to CBA Scientific facts tend to blur the debate over climate change. It is possible to say with confidence that "global average surface temperature rose by a central estimate of 0.6°C from 1861 to 2000" (Intergovernmental panel on climate change, IPCC, 2001 in


Emilie Alberola
email: emilie.alberola@caissedesdepots.fr

Julien Chevallier
email: j.chevallier@imperial.ac.uk

Banking and Borrowing in the EU ETS: An Econometric Appraisal of the 2005-2007 Intertemporal Market

Keywords: Q28, Q52, Q58 Emissions trading, Banking, EU ETS, Hotelling rule

This article critically examines the EU ETS intertemporal market during its Phase I (2005-2007). We test the Hotelling rule as a key element of a competitive equilibrium to validate whether allowance prices rise at the same rate as the interest rate. Including readily observable characteristics of the EU ETS such as the presence of one endogenous structural break and the influence of other energy markets shocks, we argue the inter-period ban on banking undermines the ability of the EU ETS to provide efficient price signalling. We also find a significant relationship between allowance price changes and the expected scarcity of allowances approximated by the Ellerman-Parsons ratio. Finally, our results show evidence of institutional learning by market participants.

Introduction

This article aims at characterizing the dynamic efficiency of the intertemporal market on the European Union Emission Trading Scheme (EU ETS) during the first period [2005][2006][2007]. A fundamental statement on emissions trading is that allowances trading is efficient over time only if banking and borrowing are authorized under certainty [START_REF] Rubin | A model of Intertemporal Emission Trading, Banking, and Borrowing[END_REF]) and under uncertainty [START_REF] Schennach | The Economics of Pollution Permit Banking in the Context of Title IV of the 1990 Clean Air Act Amendments[END_REF]). With such provisions, market prices will reflect opportunity costs which will lead to an efficient choice of abatement measures [START_REF] Schleich | Banning Banking in EU Emissions Trading?[END_REF]). Each year, when abatement together with endowment of emission allowances are above emissions levels, regulated agents may bank surplus allowances for potential later use. Conversely, if regulated agents do not abate enough to cover their emissions level with their actual endowment, they may borrow allowances from future allocations. By allowing agents to arbitrate between actual and expected abatement costs over specific periods, banking and borrowing allowances form a complementary dimension of flexibility where agents can trade allowances not only spatially but also through time. The most prominent example of the key role of such provisions is the success 1 of the US Acid Rain Program where banking has been a major feature of this emissions trading [START_REF] Ellerman | Markets for Clean Air: The US Acid Rain Program[END_REF]).

Prices develop differently in the following two cases. If inter-period banking is allowed, it is reasonable to expect that allowance price changes do not exceed Hotelling's rule, rising at the market rate of interest 2 . If inter-period banking is restricted, lower Phase I prices and higher Phase II prices are ex-1 The notion of success may be approximated by various effects (pre-existing regulatory environment, technology innovation and diffusion, reduction of regulatory uncertainty, aggregate cost savings, etc) but we will focus on the efficiency of the permits price, i.e. its ability to reflect current information on spot and future prices.

2 If participants have complete information and emission targets are known. Hotelling (1931) shows that in an efficient exploitation of an exhaustible resource, the percentage change in net-price per unit of time should be equal to the discount rate in order to maximize the present value of the resource capital over the extraction period. Otherwise, arbitrage between periods is possible and the allowance price path will lead to non socially desirable outcomes such as a concentration of emissions on early periods [START_REF] Kling | Bankable Permits for the Control of Environmental Pollution[END_REF]). Note that if borrowing is allowed, then the allowance price follows the Hotelling rule for exhaustible resources; if borrowing is forbidden, then the allowance price rises at a rate inferior to the interest rate.

pected. The former result is due to the validity of allowances which is shorter than the time horizon required by investors. The latter is due to increased allowance scarcity compared to full inter-period banking.

The European Union Allowances (EUA) price path for the first and second periods seem to match the case of the ban on banking. Beginning at 8 = C on January 1st 2005, EUA prices increased to around 30 = C in July 2005, fluctuated during the six following months in the range from 20 = C to 25 = C, then to 30 = C until the end of April. On May 15th 2006, the release of 2005 verified emissions data had a depressive effect on EUA prices as shown by the sharp break in the price of all maturities of EUAs in Figure 1. Those data and subsequent updates revealed that verified emissions were about 80 million tons or 4% lower than the amount of allowances distributed to installations for 2005 emissions [START_REF] Buchner | The European Union Emissions Trading Scheme: Origins, Allocation, and Early Results[END_REF]). As most of the price adjustment occurred within four days, the EU ETS is now sending two price signals responding to different dynamics. First period prices are declining towards zero, whereas second period prices are increasing to levels up to 20 = C primarily due to institutional factors disclosed by the European Commission which has reaffirmed its will to enforce tighter targets in Phase II.

Among the main explanations of low allowance prices towards the end of Phase I, previous literature identifies over-allocation concerns, early abatement efforts in 2005 due to high allowance prices, and possibly decreasing abatement costs in 2006 due to abnormal temperatures and switching from coal-to gas-fired electricity in a context of falling natural gas prices compared to coal. Therefore, a thorough analysis of banking and borrowing provisions appears necessary to disentangle those effects on allowance price changes.

Within the first period 2005-2007, participants are expected to use unrestricted banking and borrowing. Based on this assumption, we test in an empirical approach whether the EUA spot price pattern is consistent with a competitive equilibrium in the intertemporal market where banking and borrowing provisions are allowed. [START_REF] Schennach | The Economics of Pollution Permit Banking in the Context of Title IV of the 1990 Clean Air Act Amendments[END_REF]'s theoretical model of the intertemporal permits market applied by [START_REF] Helfand | Testing for dynamic efficiency of the Sulfur Dioxide Allowance Market[END_REF] to the SO 2 market guides our empirical analysis. We conduct a test of the Hotelling rule to validate whether EUA prices follow the interest rate over time. Besides, we use the [START_REF] Ellerman | Shortage, Inter-period Pricing, and Banking[END_REF] ratio (EPR)3 to (i) approximate the scarcity of EUAs as perceived by market participants by the end of the first period, and (ii) test whether the EUA spot price pattern reacts to the scarcity of this environmental policy.

Including readily observable characteristics of the EU ETS such as the presence of one endogenous structural break and the correlation with other energy markets (brent and natural gas), our results show a significant relationship between the EPR and EUA price changes. We also reject the Hotelling rule and argue that the inter-period ban on banking undermines the ability of the EU ETS to provide efficient price signalling. Finally, we find evidence of institutional learning among market participants.

The remainder of the article is organized as follows. Section 2 describes the theoretical framework from which we derive our estimation strategy. Section 3 explicits our econometric specification to test the Hotelling rule. Section 4 summarizes the data used. Section 5 provides a discussion of the results. Section 6 concludes.

Economic Modeling

The model estimated is based on two articles by [START_REF] Schennach | The Economics of Pollution Permit Banking in the Context of Title IV of the 1990 Clean Air Act Amendments[END_REF] and [START_REF] Slade | Hotelling Confronts CAPM: A Test of the Theory of Exhaustible Resources[END_REF]. It was first applied on the US SO 2 market by [START_REF] Helfand | Testing for dynamic efficiency of the Sulfur Dioxide Allowance Market[END_REF].

Schennach (2000)

First, [START_REF] Schennach | The Economics of Pollution Permit Banking in the Context of Title IV of the 1990 Clean Air Act Amendments[END_REF] studies the banking behavior of regulated industrials in the Acid Rain Program and implicitly the behavior of spot prices in a stochastic, continous-time, infinite horizon model for allowance allocation, use and storage. Under certainty, the model predicts that the CO 2 price path would increase smoothly at the rate of interest according to the Hotelling rule. Under uncertainty, the optimization program of risk-neutral agents is modelled as follows:

         min et E 0 ∞ 0 e -µt c t ( t -e t )dt Ṡt = Y t -e t S t ≥ 0
with E(t) a Von Neumann-Morgenstern expected utility function, e t the emissions level after abatement, t the counterfactual emissions level, a t = t -e t the total amount of abatement by all firms at time t, c t (a t ) the minimum total cost incurred by all firms to abate a t , Y t the total amount of allowances distributed to agents, S t the number of allowances in the bank at time t, r the risk free interest rate, ρ the risk premium specific to holding allowances as an asset in a diversified portfolio of investments, and µ = r + ρ the rate specific to risky assets in the spirit of the capital asset pricing model (CAPM).

The solution to this problem is a continuous time version of Pindyck (1993)'s model of rational commodity pricing:

E t [P t+1 ] = (1 + µ)P t -ψ t (1)
with ψ t a convenience yield4 . Eq. (1) therefore represents the basic relationship we want to test.

Slade & Thille (1997)

Second, assuming an allowance may be considered as an exhaustible resource 5 , Slade & Thille (1997)'s model provides an analogous theoretical framework by maximizing the function V (R, p, φ):

                         max qτ E t ∞ t e -ρ(τ -t) π τ dτ Ṙτ = -qτ R τ ≥ 0, qτ ≥ 0 ∂φ φ = µ φ dt + σ φ dz φ ∂p p = µ pt dt + ρ p dz p with π τ = [p τ q τ -C(q τ , R τ , φ τ )
] the risk-adjusted profit at the discount rate ρ, φ a random productivity shock, Ṙ the state of the bank R as a function of the extraction rate q. The last two constraints represent a set of Ito processes with drift to model uncertainty.

At the equilibrium, the evolution of the allowance price P t is:

1 ∂t E t ∂P t P t = r + β(r m -r) ≡ ρ (2)
with E t expected utility, r the risk-free interest rate, r m the investment rate of return in a diversified portfolio, and β the risk premium specific to the asset. ρ represents to risk-adjusted discount rate used by firms to choose the emissions path that minimizes abatement costs. Against this economic modeling background, we detail in the next section our econometric specification.

Econometric specification

To develop an estimable form of equation, we use the CAPM empirical specification developed by [START_REF] Helfand | Testing for dynamic efficiency of the Sulfur Dioxide Allowance Market[END_REF] to yield an expression for the expectation at t of the allowance price at t + 1.

As developed in [START_REF] Helfand | Testing for dynamic efficiency of the Sulfur Dioxide Allowance Market[END_REF], we rearrange eq.( 1) to isolate firstthe demand for an extra unit of a non-renewable resource comes more often from a derived demand of another actor (e.g., a consumer).

difference prices on the left-hand side:

E t p t+1 -p t = r f t p t + ρ t p t -ψ t (3) Rewriting ρ t = σ am σ mm (r m t -r f t )
, which is standard practice for CAPM, yields:

E t p t+1 -p t = r f t p t + σ am σ mm (r m t -r f t ) p t -ψ t (4)
where r f t is the risk-free rate, r m t is the rate of return on the market portfolio, σ am is the covariance between the rate of return of EUA prices and r m t , and σ mm is the variance of r m t . The first term r f t p t represents the Hotelling rule for cost-minimizing intertemporal arbitrage in the EU ETS market. The second term σam σmm is the risk premium for holding allowances as part of a diversified portfolio. The expression (r m t -r f t ) is the excess return on the market portfolio at time t.

Since the expected value of p t+1 is known only with errors at time t, we substitute E t p t+1 by p t+1 + t+1 :

p t+1 -p t = r f t p t + σ am σ mm (r m t -r f t ) p t -ψ t + t+1 (5)
with the error term. Note we take we take first log-differenced EUA price series. Finally, assuming the convenience yield is constant (ψ t = ψ), we get:

p t+1 -p t = α + β 1 r f t p t + β 2 (r m t -r f t ) p t + t+1 (6)
where α = -ψ and β 2 = σam σmm . Eq. ( 6) represents the "base model" where β 1 = 1 tests the Hotelling rule and β 2 provides information on the CAPM risk premium for CO 2 allowances which is the difference between the expected return on allowances and the return of the risk-free asset.

Structural break

The dataset is divided into two sub-periods due to the presence of one structural break as displayed in Figure 1. Using the method developed by [START_REF] Lee | Testing the Null of Stationarity in the Presence of a Structural Break[END_REF] 6 that endogenously looks for structural breaks while testing for the existence of a unit root, we identify April, 20th 2006 as a breakpoint in our dataset.

For this reason, two sub-samples are considered: the sub-sample #1 goes from 01/07/2005 to 20/04/2006, and sub-sample #2 goes from 21/04/2006 to 31/05/2007. This endogenous structural break may be associated to institutional features of the EU ETS during Phase I. As 54% of the EUA spot prices adjustment was made within four days7 starting on April 24, 2006, this break eliminates prior speculative information and revealed agents' net short/long positions. The break point may be seen as an indicator of the number of allowances either banked or borrowed at the end of the first 2005 compliance.

Base model with the environmental policy constraint

The European Commission defined the environmental constraint by validating each NAP before the launch of the emissions trading program. In 2006-2007, MS are currently operating under their NAP II for the period 2008-2012.

Without banking and borrowing provisions between the two trading periods, [START_REF] Ellerman | Shortage, Inter-period Pricing, and Banking[END_REF] stated "it is virtually certain that the EU ETS will then be either long or short; the likelihood of a perfect match between 1 st period EUAs and emissions are extremely small. This binary outcome places a limit on 1 st period prices that, when coupled with the constraint on inter-period banking, allows a probability of shortage to be calculated taking into account all the uncertainties weather, economic growth, energy prices, and the abatement response to carbon prices."

From this perspective, Ellerman and Parson define the probability of scarcity expected by market's participants at any point in time as the ratio between the 1 st period future 2007 price and the 2 nd period future price 2008, plus 40 = C, which represent the penalty8 :

P r(scarcity) = EU A 2007 40 = C + EU A 2008
Therefore, the higher the perceived scarcity of allowances, the higher the CO2 prices. As shown in Figure 2, the expected allowance scarcity is largely reflected in spot price changes. Introducing in the "Base model" the epr variable as a proxy of the environmental policy constraint during Phase I, eq.( 6) becomes:

p t+1 -p t = α + β 1 r f t p t + β2(r m t -r f t ) p t + β 3 epr + t+1 (7)
3.3 Base model with the environmental policy constraint and energy market shocks Following [START_REF] Helfand | Testing for dynamic efficiency of the Sulfur Dioxide Allowance Market[END_REF], we use forecast errors9 lagged one period for energy variables and a temperatures index as explanatory variables in eq.( 7):

p t+1 -p t = α+β 1 r f t p t +β 2 (r m t -r f t ) p t +β 3 epr+β 4 brent+β 5 ngas+β 6 temp+ t+1 (
8) with brent the brent price series, ngas the natural gas price series and temp an European temperatures index defined below.

We detail in the next section the data used.

Data

Descriptive statistics may be found in Table 1 (see the Appendix).

CO 2 price

The price of European emissions allowances is determined in several markets: the Over-the-Counter (OTC), on spot and on futures markets.

Interest rates

The risk-free rate of return (r f t ) is the 3-months Euribor presented as annual percentages with daily data frequency. To convert each daily observation to a daily interest rate, we used the following formula: r = (1 + i 4 ) 4 -1 with r the annual interest rate with a daily data frequency and i the quarterly interest rate with a daily data frequency. Thus, r f t is expressed in percentage points at daily rates. (See Figure 2).

The rate of return on the market portfolio of risky assets (r m t ) is the Dow Jones EuroStoXX 50 Index annual return with a daily data frequency. To convert each daily observation to a daily interest rate, we used the following formula: r = (1 + i 250 ) 250 -1 with r the annual interest rate with a daily data frequency and i the daily interest rate. Thus, r m t is expressed in percentage points at daily rates. (See Figure 2)

Energy prices

On energy markets, we use the brent price (brent in $/baril) is the daily brent crude Futures price negociated from 01/07/05 to 31/05/207 on the Intercontinental Exchange (ICE), the Europe's leading energy exchange, futures. The euro-dollar exchange rate provided by the European Central Bank is used to ensure all variables are transformed to the same currency. The natural gas (ngas in = C /Mwh) is the daily natural gas price negociated from 01/07/05 to 31/05/207 on Zeebrugge Hub.

Weather

Concerning climate conditions, we use a temperatures index (temp in • C) as the daily data of European temperatures index published by Tendances Carbone 10 . It is equal to the average of national temperatures indices provided by Powernext weighted by the share of each NAP in the total of four countries. These national indices are the mean temperatures for the four countries: Spain, France, Germany and United Kingdom, calculated as the average of the temperatures at the representative regional weather station weighted by the regional population.

Stationarity tests

Because econometric results may be unreliable if the dependent variable is non-stationary, we first need to test the stationarity of allowance prices and their first-difference. One possible complication of unit root tests for stationarity is that the presence of structural changes during the time series may make rejection of a unit root more difficult [START_REF] Perron | The Great Crash, the Oil Price Shock, and the Unit Root Hypothesis[END_REF]). We performed usual unit root tests (ADF, PP, KPSS) for all price series and found that all of them are characterized by a unit root. When tests are applied on series in first differences, they are found to be stationary. In other words, all prices series are integrated of order 1 (I(1)) 11 .

10 Tendances Carbone is the monthly bulletin of the European Carbon Market published by the Caisse des Depots and Powernext Carbon.

11 Detailed results of the unit root tests are available upon request to the authors.

Results

Results of equations ( 5), ( 6) and ( 7) for each period are presented in Table 2 (see Appendix). The "Base model" is refered to as Model 1, the "Base model with the environmental policy constraint" as Model 2 and the "Base model with the environmental policy constraint and energy market shocks" as Model 3. Estimations are computed using OLS and the Newey-West procedure to correct for serial correlation and generate robust standard errors (NW-OLS).

The explained variable is the first log-differenced EUA price series12 .

Based on the correlogram of the first log-differenced EUA price series, the true data generating process is characterized as an ARMA(p,q) of order 1. This is confirmed by autoregressive and moving average coefficients being statistically different from 0 in Table 2. For each regression, the Lagrange-Multiplier test indicates residuals are not autocorrelated. When the White test shows evidence of heteroskedasticity, a GARCH(p,q) model of order 1 is implemented as robustness checks in Table 3 using Bollerslev Wooldrige robust standard errors and covariance. Since both estimation techniques yield to similar results13 , we comment only NW-OLS coefficients to simplify the exposition.

Failure of the Hotelling rule for the EU ETS 2005-2007 intertemporal market

For the validation of the Hotelling rule, the null hypothesis is that β 1 = 1 in eq.( 8). The confidence interval where the true value of the β parameter has a 95% probability to be is calculated according to the formula:

CI = [ β ± 2.11 * Std.error]
The Hotelling rule is rejected in all models: in full period the confidence interval is [0.0295; 0.0495] for Model 1 (Table 2, row 1), [0.0182; 0.0614] for Model 2 (row 2) and [0.0158; 0.0736] for Model 3 (row 3). Confidence intervals have also been computed for the two sub-periods, and yield to a similar conclusion.14 . Hence, the EUA price path does not appear consistent with a competitive equilibrium in the 2005-2007 intertemporal market.

Yet the non-validation of the Hotelling rule for the first two years of the EU ETS is not worrying in itself. At best, it has to be seen as an indicator of scarcity under certainty, while our test was conducted under uncertainty. [START_REF] Helfand | Testing for dynamic efficiency of the Sulfur Dioxide Allowance Market[END_REF] tested the Hoteling rule for the time path of SO 2 permit prices and reached the similar conclusion that the SO 2 price path was not consistent with a competitive equilibrium in the intertemporal market. This question of competitive equilibrium relates directly to the issue of the market efficiency. As noted by [START_REF] Helfand | Testing for dynamic efficiency of the Sulfur Dioxide Allowance Market[END_REF], "Under the first fundamental theorem of welfare economics, evidence of competitive equilibrium would imply dynamic efficiency. In this case, dynamic efficiency involves minimizing present-value cost of compliance with the intertemporal emissions regulation". [START_REF] Kronenberg | Should we worry about the failure of the Hotelling rule?[END_REF] provides other reasons to justify this failure, for instance by paying attention to the fact that permits are characterized by a costless extraction or by focusing on strategic interactions between firms.

As noted previously, the efficiency of allowance trading is linked to the authorization of full banking and restricted borrowing [START_REF] Schennach | The Economics of Pollution Permit Banking in the Context of Title IV of the 1990 Clean Air Act Amendments[END_REF], [START_REF] Kling | Bankable Permits for the Control of Environmental Pollution[END_REF]). With such provisions, market prices reflect opportunity costs leading to an efficient choice of abatement measures [START_REF] Schleich | Banning Banking in EU Emissions Trading?[END_REF]). The rejection of the competitive equilibrium assumption in the intertemporal market implies EUA price changes do not adequately reflect abatement costs at the installation level during 2005-2007. In terms of banking behaviour, after the 2005-2006 over-supplied compliance periods, most industrials have necessarily banked unused allowances before selling them on the market, whereas a minority of them may need to borrow allowances.

Another piece of information glanced from Table 2 concerns the lack of significancy of the β 2 coefficient, which means during 2005-2007 CO 2 allowances do not appear to bear a risk-premium as part of a diversified commodities portfolio.

Evidence of institutional learning within the EU ETS

As depicted in Figure 2, the perceived scarcity of allowances was increasing at the launch of the EU ETS despite early concerns of over-allocation. Our results tend to confirm this view by showing a positive influence of the environmental policy constraint on allowance price changes. During 2005-2007, we find a significant relationship between the EPR ratio and EUA price changes in Model 2 (Table 2, row 2) and Model 3 (row 3) both at 1%. While diagnostic tests indicate Model 3 performs slightly better than Model 2, it is worth underlining the stable coefficient and sign of the epr variable accross models. Allowance price changes are largely determined by the environmental policy constraint and react to the EPR ratio with the expected sign, i.e. the higher (lower) the perceived allowance scarcity the higher (lower) the allowance price.

In sub-periods, the EPR ratio is not significant before the compliance break (Table 2, rows 5 and 6), and becomes significant after the break at 5% (Model 3, row 9). Before the price adjustment, allowance trading may be characterized as hazardous or speculative, and only the release of first compliance verified emissions gave a hint about the net short/long positions at the installation level. After the break, market participants form their anticipations more accurately in a context of a low environmental policy constraint coupled to a ban on inter-period banking which explains why the EPR ratio becomes significant.

Therefore, a second main finding of our tests lies in the evidence of institutional learning within the first two years of the EU ETS. The April, 2006 structural break suggests EUA price changes are affected by institutional events such as the simultaneous releases of 2005 verified emissions by the Walloon Region of Belgium, France and Spain which serve as a proxy for the adjustment of agents' expectations. Most of the verified emissions were reported by mid-May. The fact that the EUA price responded quickly to such relevant information may be interpreted as a strong sign of efficiency of the EU ETS.

Influence of energy markets

Besides the structural break due to the first institutional compliance, another sign of the efficiency of the EU ETS is that the EUA price pattern responds to information related with energy markets. On the full period, EUA price changes respond positively to brent prices at 5% in Model 3 (Table 2, row 3)15 and to natural gas prices at 1%. This relationship holds true in sub-periods: before the compliance break, brent and natural gas prices are positive and significant at 1% (row 6); while after the break, only the brent variable is positive and significant at 1% (row 9). These results are consistent with [START_REF] Mansanet-Bataller | CO 2 Prices, Energy and Weather[END_REF] who identified brent and natural gas prices as key energy determinants of EUA price changes.

Our point is to show the influence of the environmental policy constraint is robust to the introduction of market shocks: coefficient estimates for the EPR ratio remain significant at 1% in full period (row 3), non-significant before the break (row 6) and significant at 5% after the break (row 9).

Robustness checks

Note that adding incrementally explanatory variables to the "Base model" also serves as robustness checks for coefficient estimates. Since financial market places are strongly correlated, the inclusion of the Euronext 100 Index instead of the DJ Euro StoXX 50 as the rate of return of a diversified portfolio does not change the results and the Hotelling rule is still rejected in all models. As an additional robustness check, we conduct a Chow breakpoint test for the determination of the structural break and reject the null hypothesis that the sample does not contain a structural break at a 5% confidence level16 .

Conclusion

This article may be seen as an attempt to characterize the efficiency of the intertemporal market during Phase I of the EU ETS. Due to the ban on inter-period banking between 2007 and 2008, we have highlighted a total disconnection between prices of first and second period allowances with a clear decline of the first period prices. Within the first 2005-2007 period, market participants are expected to use free banking and borrowing of allowances. In this context, we test whether the EUA spot prices follow the Hotelling rule as the key element of a competitive equilibrium and find evidence for the rejection of the rule.

A second main finding of our test lies in the evidence of an institutionnal learning within the two first years of the EU ETS. We show statistical evidence of an endogenous structural break stated in 20 April,2006, which serves as a proxy for the adjustment of agents' expectations and reveals EUA price changes are affected by institutional events. Our results also stress a significant relationship between EUA price changes and the environmental constraint proxied by the perceived allowance scarcity. Before the first compliance in April 2006, EUA prices path were influenced by the environmental constraint with a lag of five days whereas after the endogenous structural break EUA prices responded to it without lags. Market participants were basically learning how to use tradable permits. These results tend to counterbalance the previous analysis and provides some signs of efficiency of the EU ETS during Phase I.

We also find evidence that EUA prices are influenced by other market shocks. We incorporated energy and temperatures variables to isolate effects of the current economic situation on EUA prices, and validated brent prices, natural gas prices and the European temperatures index as influencing EUA price variations. The specific effects of energy markets and climatic conditions on the European carbon market needs to be further assessed.

Appendix

Notes on Tables:

Table 1 shows descriptive statistics for the energy price series under consideration. Table 2 presents the results of equations ( 5), ( 6) and ( 7) regressing by NW-OLS. The dependent variable is the first log-differenced EUA price series. * * * indicates significance at 1% level, * * at 5% level and * at 10% level. In Table 3, GARCH estimation are computed for the "full period" and the "after the compliance break period" when the White test indicated the presence of heteroskedasticity. The following diagnostic tests for the quality of the regressions are reported in each table: the simple R-squared, the adjusted R-squared, the p-value of the F-test statistic (F -Stat), the Durbin-Watson statistic (D.W.), the p-value of the the Breusch-Godfrey Serial Correlation Lagrange Multiplier test (LM ), the p-value of the White heteroskedasticity test (W hite test), the Akaike Information Criterion (AIC) and the Schwartz Criterion (SC).

Mean

  As a final step to explain 2005-2007 allowance price changes, the model is estimated with the environmental policy constraint and shocks from other energy markets related to the EU ETS. The purpose is to disentangle EUA price changes from the fluctuations of energy markets. According to[START_REF] Mansanet-Bataller | CO 2 Prices, Energy and Weather[END_REF], EUA prices are influenced by energy markets and weather.

Figure 1 :

 1 Figure 1: EUA Prices and Volume Exchanged from 01/07/05 to 31/05/07 Source: Powernext carbon

  The most liquid market is the OTC market. Dealing on the OTC market transactions are usually through indutrials or brokers, consequently price data is confidential, or available through commercial energy consultancies. The London Energy Brokers Association (LEBA) produces each trading day an index price using the volume weighted average of EUA trades since December 2006. The most liquid futures market is the European Climate Exchange and the most liquid spot market is Powernext Carbon launched in June 2005. We use the daily EUA spot price (p t in = C/tonne of CO 2 ) negotiated from 01/07/05 to 31/05/07 on Powernext carbon.

Table 1 :

 1 Descriptive Statistics

			Median Max.	Min.	Std.	Skew. Kurt. Obs.
						Dev.
	Full period
	p t	15.221 16.090 29.750 0.250	9.070 -0.353 1.834 492
	brent 0.002	0.016	57.919 -58.168 5.287 0.031	116.522 492
	ngas -0.016 -0.155 11.566 -10.550 1.654 0.976	14.868 492
	Before the compliance break
	p t	23.819 22.950 29.750 18.850	2.564 0.435	2.104 206
	brent 0.002	0.014	57.919 -58.168 5.804 -0.074 98.057 206
	ngas -0.005 -0.304 11.566 -10.550 1.947 1.024	14.056 206
	After the compliance break
	p t	9.029	9.520	29.430 0.250	6.715 0.118	2.017 286
	brent -0.013 0.033	57.776 -57.283 4.891 0.154	134.780 286
	ngas 0.001	-0.015 7.206	-6.844	1.410 0.783	11.927 286

Table 2 :

 2 Hotelling-CAPM Model Tests

	Model 3	(12)	-0.4156***	(0.0708)	0.6910***	(0.0664)	-0.0482***	(0.0123)	-0.0011	(0.0571)	-0.0108***	(0.0001)	0.1759***	(0.0441)	0.0062***	(0.0021)		-0.0287***	(0.0009)	1.0434***	(0.0014)	0.1499	0.1074	0.0001	1.9658	-3.2918	-3.1135
	Model 2	(11)	-0.6465***	(0.1236)	0.8118***	(0.0985)	-0.0451***	(0.0143)	-0.0241	(0.0579)	-0.0053	(0.0046)		0.1527***	(0.0536)			-0.0246***	(0.0002)	1.0402***	(0.0004)	0.0860	0.0447	0.0270	1.8277	-3.2336	-3.0702
	Model 1	(10)	-0.5851***	(0.1185)	0.7849***	(0.0895)	-0.0071	(0.0045)	0.0064	(0.0636)	-0.0314***	(0.0105)						-0.0229***	(0.0009)	1.0395***	(0.0004)	0.0538	0.0155	0.1878	1.8142	-3.2017	-3.0531
	Model 3	(9)	-0.6932***	(0.0866)	0.8135***	(0.0656)	-0.0066	(0.0052)	-0.0141	(0.0127)	-0.0060	(0.0045)	0.0275**	(0.0153)		0.0005	(0.0004)	0.5287***	(0.0502)	0.5993***	(0.0306)	0.0506	0.0284	0.0102	1.7281	-3.6239	-3.5200
	Model 2	(8)	-0.6927***	(0.0899)	0.8095***	(0.0682)	-0.0053	(0.0048)	-0.0132	(0.0134)	-0.0053	(0.0046)	0.0245*	(0.0145)				0.5399***	(0.0528)	0.5903***	(0.0313)	0.0435	0.0232	0.0199	1.7230	-3.6222	-3.5269
	Model 1	(7)	-0.6980***	(0.0955)	0.8159***	(0.0749)	0.0036	(0.0025)	-0.0135	(0.0131)	-0.0049	(0.0045)						0.5039***	(0.0462)	0.6099***	(0.0300)	0.0303	0.0119	0.0992	1.6894	-3.6243	-3.5377
	Variable		p t (-1)		ma(1)		Constant		r f t p t		(r m t -r f t ) p t		epr	epr(-1)	brent	ngas	temp	ARCH(1)		GARCH(1)		R-squ.	Adj. R-squ.	F-Stat	D.W.	AIC	SC

Table 3 :

 3 Robustness GARCH estimation

Briefly defined as the December 2007 maturity allowance price over the december 2008 maturity allowance price plus a

= C penalty for non compliance.

According to[START_REF] Ellerman | Markets for Clean Air: The US Acid Rain Program[END_REF], an agents may benefit from holding a stock of allowances on hand to buffer itself against unexpected changes in emissions, which is called a convenience yield.

According to[START_REF] Liski | On Pollution Permit Banking and Market Power[END_REF], the following differences may be highlighted. First, in a permits market with banking, the market may remain after the exhaustion of the bank; while the market of a non-renewable resource vanishes after the last unit extraction. Second, permits extraction and storage costs are equal to zero; while those costs are generally positive for a non-renewable resource. Third, the demand for an extra permit usually comes from a derived demand of other firms that also hold permits; while

An advantage of this method is that the data themselves suggest the possible timing of structural breaks. We provide the estimated break point for the EUA prices in first difference based on model 1, with a lag of four days and 436 observations.

See Buchner & Ellerman (2007).

The penalty will be 100 = C thereafter and companies will also have to surrender a compensating amount of allowances.

We compute forecast errors by using the method of one-step ahead forecast.

Thus, we are interested in the growth rate of the explained variable.

GARCH coefficients are stable with significant estimates in the mean and variance equations.

A journal of those results is available upon request to the authors.

While the negative sign of the brent variable lagged five days is due to price adjustments, we verify in the following regressions that brent prices indeed impact positively EUA price changes.

 16 A journal of those results may be obtained upon request to the authors