EMISSIONS TR ADING IN PR ACTICE A EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN A N D I M P L E M E N TAT I O N © 2016 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW, Washington, DC 20433 Telephone: 202-473-1000; Internet: www.worldbank.org Some rights reserved 1 2 3 4 19 18 17 16 This work is a joint product of the staff of The World Bank and adelphi, representing the International Carbon Action Partnership (ICAP), with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent, nor of ICAP and its members. The World Bank and adelphi do not guarantee the accuracy of the data included in this work. 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EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN A N D I M P L E M E N TAT I O N In collaboration with: Motu ii EMISSIONS TR ADING IN PR ACTICE ACKNOWLEDGMENTS This Handbook was prepared jointly by a team of experts from Motu Climate Economics – I4CE), Danira Baigunakova (Alexander von Economic and Public Policy Research and Environmental Defense Humboldt Foundation), Juan Carlos Belausteguigoitia (Centro Mario Fund, with significant contribution from Vivid Economics. Molina), Nicolas Bianco (EDF), Hendrik (Derik) Broekhoff (Stockholm Environment Institute), Chris Bush (Energy Innovation), Yong-Sung Suzi Kerr and Ruben Lubowski led the teams from Motu Economic Cho (Korea University), Suh-Yong Chung (Korea University), Brent and Public Policy Research and Environmental Defense Fund, respec- Cloete (DNA Economics), Brett Cohen (The Green House), Frank tively, which also consisted of Catherine Leining and Leah Murphy Convery (EDF), Margaret Cress (EDF), Antoine Dechezleprêtre (Motu) and Gernot Wagner and Katherine Rittenhouse (EDF). The (London School of Economics), Kristin Eberhard (Sightline Institute), Vivid Economics team was led by John Ward, and also included Cor Zeren Erik Yasar (Turkey), Carolyn Fischer (Resources for the Future), Marijs and Paul Sammon. Hubert Fallmann (Umweltbundesamt), Dirk Forrister (IETA), Meredith Michael Mehling (Massachusetts Institute of Technology), Felix Fowlie (University of California, Berkeley), Alexander Golub (EDF Matthes (Öko-Institut), and Duan Maosheng (Tsinghua University) and American University), Quentin Grafton (Australian National edited the Handbook, and also devoted their time and expertise to University), Sonia Hamel (Hamel Environmental Consulting), Anthea provide project guidance. Harris (Victorian Government, Australia), Takashi Hongo (Mitsui Global Strategic Studies), Max Horstink (SouthSouthNorth), Yu-Shim Pierre Guigon (World Bank), Constanze Haug and William Acworth Jeong (Korean Foundation for Quality, Republic of Korea), Cui Jing (ICAP Secretariat) provided substantive inputs and managed the (Baosteel), Nathaniel Keohane (EDF), Seong-il Kim (Seoul National project. University), Yong-Gun Kim (Korea Environment Institute), Xavier Labandeira (University of Vigo), Sang Youp Lee (Korea Environment We also wish to acknowledge the following contributing authors: Rob Institute), Franz Litz (Great Plains Institute), Andreas Löschel Fowler (Essential Change Advisory Services), Jürg Füssler (INFRAS), (University of Muenster), Diptiranjan Mahapatra (Adani Institute Alex Hanafi (EDF), Tang Jin (SinoCarbon), Joojin Kim (EDF), Joshua of Infrastructure Management), Claudio Marcantonini (European Margolis (EDF), Clayton Munnings (Resources for the Future), University Institute), Andrei Marcu (Centre for European Policy Juan-Pablo Montero (Pontificia Universidad Católica de Chile), Erica Studies), Ralf Martin (London School of Economics), Brian Murray Morehouse (EDF), Annie Petsonk (EDF), and Luca Taschini (London (Duke University), Michael O’Brien (EDF), Hyungna Oh (Kyung Hee School of Economics). University), Robert Parkhurst (EDF), Billy Pizer (Duke University), We sincerely thank representatives from ETS jurisdictions who Misato Sato (London School of Economics), Jonathan Schrag (EDF), shared their practical insights and knowledge related to designing PR Shukla (Indian Institute of Management), Thomas Sterner (EDF, and implementing ETS through meetings, interviews, and review Collège de France and University of Gothenburg), Jan-Willem van of the Handbook. These include John Storey-Bishoff (Alberta); de Ven (European Bank for Reconstruction and Development), Stacy Nicole Steinweg (Australia); Edie Chang, Mary-Jane Coombs, Sean VanDeveer (University of New Hampshire), Derek Walker (EDF), Donovan, Jason Gray, Ray Olsson, Rajinder Sahota and Mark Wenzel Bryony Worthington (EDF), Libo Wu (Fudan University), Matthew (California); Wang Shu (China); Maja Dittel, Johannes Enzmann, Zaragoza-Watkins (EDF), Xiliang Zhang (Tsinghua University). Hana Huzjak and Dalwon Kim (European Commission); Matti Kahra We wish to thank the following for research assistance: Margaret (Finland); Cécile Goubet, Yue Dong, Maxime Durande, Anais Maillet Cress, Rafael Grillo, Michael O’Brien, and Nicolas Taconet (EDF, USA) and Dimitar Nikov (France); Maria Martin (Ireland); Giulia Dramis and Iurii Banshchikov (ICAP Secretariat). We wish to thank the follow- (Italy); Gulmira Sergazina (Kazakhstan); Hyungsup Lee (Korea); ing for additional editorial assistance: Anna Brinsmade, Daniel Francis, William Lamkin and Will Space (Massachusetts); Erik van Andel Dana Miller, and Elizabeth Petykowski (EDF), Stephanie Gleissner and (the Netherlands); Lois New (New York); Peter Gorman, Amelia Charlotte Unger (ICAP Secretariat), and Inge Pakulski. Guy-Meakin, Ted Jamieson, Eva Murray, Matt Paterson, Kate Ryan and Nigel Searles (New Zealand); Dag Svarstad (Norway); Jonathan We thank our colleagues from the World Bank Group and the ICAP Beaulieu, Jean-Yves Benoit and Claude Côté (Québec); Hanna-Mari Secretariat who reviewed the report and provided helpful input and Ahonen (Sweden); Laurence Mortier, Reto Schafer and Sophie feedback: Adrien de Bassompierre, Pauline Maree Kennedy, Tom Wenger (Switzerland); Masahiro Kimura, Sachiko Nakamura and Yuko Kerr, Michael McCormick, Maja Murisic, Grzegorz Peszko, and Bianca Nishida (Tokyo); Ben Rattenbury (United Kingdom); and represen- Ingrid Sylvester (World Bank), and Alexander Eden, Michel Frerk, Aki tatives of the German Federal Ministry for the Environment, Nature Kachi, Lina Li, Marissa Santikarn, Camille Serre, Kateryna Stelmakh, Conservation, Building, and Nuclear Safety (BMUB), the German and Kristian Wilkening (ICAP Secretariat). ICAP staff also provided Emissions Trading Authority (DEHSt) and the Spanish Office of Climate significant research input and illustrations. Change. ICAP would also like to thank the BMUB for their financial contribu- We wish to acknowledge additional input and peer review provided tion to this report. by: Soffia Alarcón Diaz (Mexico), Emilie Alberola (Institute for CONTENTS iii CONTENTS SYNTHESIS SYNTHESIS – Emissions Trading: Bringing It All Together 1 BEFORE YOU BEGIN Why Emissions Trading?_____________________________________________________________________ 2 Emissions Trading or Carbon Tax?_____________________________________________________________ 3 How Does an ETS Work?_____________________________________________________________________ 3 Laying the Foundation for an ETS_____________________________________________________________ 4 Setting ETS objectives___________________________________________________________________ 4 1. SCOPE Tailoring an ETS to local circumstances_____________________________________________________ 4 Managing policy interactions_____________________________________________________________ 4 ETS Design in 10 Steps_______________________________________________________________________ 5 Step 1: Decide the scope_________________________________________________________________ 6 2. CAP Step 2: Set the cap______________________________________________________________________ 7 Step 3: Distribute allowances_____________________________________________________________ 7 Step 4: Consider the use of offsets________________________________________________________ 8 3. ALLOCATION Step 5: Decide on temporal flexibility______________________________________________________ 9 Step 6: Address price predictability and cost containment____________________________________ 9 Step 7: Ensure compliance and oversight__________________________________________________ 10 Step 8: Engage stakeholders, communicate, and build capacities_____________________________ 10 Step 9: Consider linking_________________________________________________________________ 11 4. OFFSETS Step 10: Implement, evaluate, and improve________________________________________________ 12 Applying the 10 Steps of ETS Design in Practice________________________________________________ 12 Shaping the Future of ETS Design____________________________________________________________ 13 5. TIMEFRAMES BEFORE YOU BEGIN 15 Understanding Emissions Trading____________________________________________________________ 16 Why emissions trading?_________________________________________________________________ 16 6. PRICE STABILITY How does an ETS work?________________________________________________________________ 16 ETS design in 10 steps__________________________________________________________________ 16 Extensive experience with emissions trading_______________________________________________ 17 Determining Objectives for the ETS___________________________________________________________ 18 Reducing GHG emissions at low cost______________________________________________________ 18 7. COMPLIANCE Driving economic transformation and sustainable development______________________________ 19 Reducing air pollution, improving health, and providing other co-benefits______________________ 20 Raising revenue________________________________________________________________________ 20 Keys to Effective ETS Design_________________________________________________________________ 21 8. STAKEHOLDERS Considering Interactions between an ETS and Other Policies_____________________________________ 22 Positioning the ETS relative to other policies_______________________________________________ 22 Understanding policy interactions that will affect the outcomes achieved by the ETS____________ 22 Understanding how the ETS may influence the attainment of other policy objectives____________ 23 Understanding where complementary policies might be needed______________________________ 24 9. LINKING Maintaining policy alignment over time___________________________________________________ 25 Emissions Trading and Economics: A Primer___________________________________________________ 25 Increasing marginal abatement cost curves________________________________________________ 25 10. EVALUATION A two-company example________________________________________________________________ 25 Regulating prices versus quantities_______________________________________________________ 26 Quick Quiz________________________________________________________________________________ 28 iv EMISSIONS TR ADING IN PR ACTICE STEP 1: Decide the Scope 29 At a Glance_______________________________________________________________________________ 30 1. Introduction____________________________________________________________________________ 31 2. Scope Design___________________________________________________________________________ 31 2.1 Sector and gas coverage____________________________________________________________ 32 2.2 Point of regulation_________________________________________________________________ 33 2.3 Thresholds________________________________________________________________________ 35 2.4 Level of reporting obligation_________________________________________________________ 36 2.5 Summary_________________________________________________________________________ 36 3. Scope Considerations in Practice___________________________________________________________ 37 3.1 Electricity generation_______________________________________________________________ 37 3.2 Industry__________________________________________________________________________ 38 3.3 Transport_________________________________________________________________________ 38 3.4 Waste____________________________________________________________________________ 40 3.5 Land use-related activities__________________________________________________________ 40 Quick Quiz________________________________________________________________________________ 41 STEP 2: Set the Cap 43 At a Glance_______________________________________________________________________________ 44 1. Defining an ETS Cap_____________________________________________________________________ 45 2. Fundamental Decisions to Address When Setting the Cap_____________________________________ 46 2.1 Cap ambition______________________________________________________________________ 46 2.2 Type of cap: absolute or intensity____________________________________________________ 49 3. Data Requirements______________________________________________________________________ 52 3.1 Historical emissions data____________________________________________________________ 52 3.2 Projections for emissions under a baseline_____________________________________________ 53 3.3 Technical and economic potential to reduce emissions__________________________________ 54 3.4 Relationship with other policies______________________________________________________ 54 4. Administrative/Legal Options_____________________________________________________________ 55 5. Setting the Cap__________________________________________________________________________ 55 5.1 Designating domestic allowances____________________________________________________ 55 5.2 Choosing time periods for cap setting________________________________________________ 56 6. Common Challenges_____________________________________________________________________ 57 6.1 Accommodating changes during the cap period________________________________________ 57 6.2 Ensuring allocation methodologies are compatible with the cap__________________________ 59 6.3 Providing a long-term price signal____________________________________________________ 59 Quick Quiz________________________________________________________________________________ 61 STEP 3: Distribute Allowances 63 At a Glance_______________________________________________________________________________ 64 1. Objectives When Allocating Allowances_____________________________________________________ 65 1.1 Managing the transition to an ETS____________________________________________________ 65 1.2 Reducing risk of carbon leakage or loss of competitiveness______________________________ 66 CONTENTS v SYNTHESIS 1.3 Raising revenue____________________________________________________________________ 66 BEFORE YOU BEGIN 1.4 Preserving incentives for cost-effective abatement_____________________________________ 67 2. Methods of Allocation____________________________________________________________________ 67 2.1 Auctioning________________________________________________________________________ 67 2.2 Free allocation using grandparenting_________________________________________________ 72 2.3 Free allocation using fixed sector benchmarking_______________________________________ 73 1. SCOPE 2.4 Free allocation using Output Based Allocation (OBA)____________________________________ 74 3. Identifying Sectors to Protect Against Leakage______________________________________________ 76 4. Other Issues____________________________________________________________________________ 76 4.1 New entrants and closures__________________________________________________________ 76 4.2 Allocation of allowances for removals_________________________________________________ 78 2. CAP Quick Quiz________________________________________________________________________________ 78 3. ALLOCATION STEP 4: Consider the Use of Offsets 79 At a Glance_______________________________________________________________________________ 80 1. What Are Offsets?_______________________________________________________________________ 81 2. Using Offsets: Benefits and Challenges_____________________________________________________ 84 2.1 Advantages of using offsets_________________________________________________________ 84 4. OFFSETS 2.2 Challenges of using offsets__________________________________________________________ 84 3. Designing an Offset Program______________________________________________________________ 85 3.1 Choosing geographic coverage______________________________________________________ 85 5. TIMEFRAMES 3.2 Choosing gases, sectors, and activities to cover________________________________________ 86 3.3 Quantitative limitations on offset use_________________________________________________ 86 3.4 Determining appropriate offset methodologies_________________________________________ 89 4. Implementing and Governing an Offset Program_____________________________________________ 91 6. PRICE STABILITY 4.1 Project registration and offset credit issuance__________________________________________ 91 4.2 Seller vs. buyer liability_____________________________________________________________ 91 4.3 Liability for reversals_______________________________________________________________ 92 Quick Quiz________________________________________________________________________________ 93 7. COMPLIANCE STEP 5: Decide on Temporal Flexibility 95 At a Glance_______________________________________________________________________________ 96 1. Benefits from Temporal Flexibility__________________________________________________________ 97 8. STAKEHOLDERS 1.1 Cost optimization over time_________________________________________________________ 97 1.2 Reducing price volatility_____________________________________________________________ 97 1.3 Long- versus short-term impact of GHGs______________________________________________ 98 2. Types of Temporal Flexibility______________________________________________________________ 98 2.1 Borrowing between compliance periods_______________________________________________ 98 9. LINKING 2.2 Banking between compliance periods________________________________________________ 100 2.3 Length of compliance periods______________________________________________________ 102 3. Financial Instruments___________________________________________________________________ 103 Quick Quiz_______________________________________________________________________________ 104 10. EVALUATION vi EMISSIONS TR ADING IN PR ACTICE STEP 6: Address Price Predictability and Cost Containment 105 At a Glance______________________________________________________________________________ 106 1. Price Formation in ETS__________________________________________________________________ 107 1.1 Supply and demand_______________________________________________________________ 107 1.2 Market balancing and the variation of prices over time_________________________________ 107 1.3 Price volatility and price variability__________________________________________________ 108 2. Market Intervention: Rationale and Risks___________________________________________________ 109 2.1 Common objectives of an ETS______________________________________________________ 109 2.2 Risks of market interference________________________________________________________ 110 3. Managing the Allowance Market__________________________________________________________ 110 3.1 Responding to low prices____________________________________________________________111 3.2 Responding to high prices___________________________________________________________113 3.3 Price corridor______________________________________________________________________114 3.4 Quantity-based mechanism_________________________________________________________115 3.5 Delegation________________________________________________________________________117 3.6 Summary of options________________________________________________________________118 Quick Quiz________________________________________________________________________________118 STEP 7: Ensure Compliance and Oversight 119 At a Glance______________________________________________________________________________ 120 1. Identifying and Managing Legal Entities___________________________________________________ 121 1.1 Identifying the regulated legal entities_______________________________________________ 121 1.2 Leveraging existing relationships with regulated entities_______________________________ 121 1.3 Managing regulated entities over time_______________________________________________ 121 2. Managing the Reporting Cycle____________________________________________________________ 121 2.1 Establishing monitoring requirements________________________________________________ 123 2.2 Establishing reporting requirements_________________________________________________ 125 2.3 Establishing verification requirements_______________________________________________ 127 2.4 Procedural considerations__________________________________________________________ 128 3. Managing the Performance of Verifiers____________________________________________________ 128 3.1 Accrediting third-party verifiers_____________________________________________________ 128 3.2 Balancing risks and costs in the verification process___________________________________ 129 4. Developing an ETS Registry______________________________________________________________ 129 4.1 Setting up a registry_______________________________________________________________ 129 4.2 Preventing fraud__________________________________________________________________ 130 4.3 Providing market information_______________________________________________________ 130 5. Designing an Enforcement Approach______________________________________________________ 131 6. Oversight of the market for ETS units_____________________________________________________ 133 Quick Quiz_______________________________________________________________________________ 134 CONTENTS vii SYNTHESIS STEP 8: Engage Stakeholders, Communicate, and Build Capacity 135 BEFORE YOU BEGIN At a Glance______________________________________________________________________________ 136 1. Objectives for Engagement______________________________________________________________ 137 2. Stakeholder Mapping____________________________________________________________________ 137 2.1 Identifying stakeholders___________________________________________________________ 137 1. SCOPE 2.2 Developing stakeholder profiles_____________________________________________________ 139 2.3 Prioritizing engagement___________________________________________________________ 139 3. Designing an Engagement Strategy_______________________________________________________ 139 3.1 Guiding principles_________________________________________________________________ 139 3.2 Different forms of engagement_____________________________________________________ 140 2. CAP 3.3 Engagement within government____________________________________________________ 143 3.4 Mobilizing champions outside of government_________________________________________ 143 4. Designing a Communications Strategy_____________________________________________________ 144 3. ALLOCATION 4.1 Tailored messages________________________________________________________________ 145 4.2 Sound communication practices and procedures______________________________________ 146 4.3 Media engagement________________________________________________________________ 146 5. Stakeholder Engagement Process Management_____________________________________________ 147 5.1 Risk management_________________________________________________________________ 147 4. OFFSETS 5.2 Transparency of engagement outcomes______________________________________________ 147 5.3 Evaluation and review_____________________________________________________________ 148 6. Capacity Building_______________________________________________________________________ 148 6.1 Identification of capacity-building needs_____________________________________________ 148 5. TIMEFRAMES 6.2 Methods and tools for capacity building______________________________________________ 149 6.3 Learning-by-doing________________________________________________________________ 149 6.4 Evaluation and review_____________________________________________________________ 149 Quick Quiz_______________________________________________________________________________ 150 6. PRICE STABILITY STEP 9: Consider Linking 151 At a Glance______________________________________________________________________________ 152 1. Different Types of Linking________________________________________________________________ 153 7. COMPLIANCE 2. Advantages of Linking___________________________________________________________________ 154 2.1 Lowering aggregate compliance costs_______________________________________________ 154 2.2 Increasing market liquidity and depth________________________________________________ 155 2.3 Improving price predictability_______________________________________________________ 156 8. STAKEHOLDERS 2.4 Reducing leakage concerns_________________________________________________________ 156 2.5 Increasing administrative efficiencies________________________________________________ 156 3. Disadvantages of Linking________________________________________________________________ 156 3.1 Challenges from price convergence__________________________________________________ 156 3.2 Imported risks____________________________________________________________________ 157 9. LINKING 3.3 Compromises on ETS design features________________________________________________ 158 4. Managing the Advantages and Disadvantages of Linking_____________________________________ 159 4.1 Choosing linking partners__________________________________________________________ 159 10. EVALUATION 4.2 Restricted linking_________________________________________________________________ 159 viii EMISSIONS TR ADING IN PR ACTICE 5. Aligning Program Design________________________________________________________________ 160 5.1 Aligning key design elements_______________________________________________________ 160 5.2 Aligning non-essential design features_______________________________________________ 165 6. Formation and Governance of the Link____________________________________________________ 166 6.1 Timing of the link_________________________________________________________________ 166 6.2 Choosing the linking instrument_____________________________________________________ 166 6.3 Establishing institutions to govern a link_____________________________________________ 167 6.4 Preparing a contingency plan for delinking___________________________________________ 167
 Quick Quiz_______________________________________________________________________________ 168 STEP 10: Implement, Evaluate and Improve 169 At a Glance______________________________________________________________________________ 170 1. Timing and Process of ETS Implementation_________________________________________________ 171 1.1 Before implementation____________________________________________________________ 171 1.2 Starting with a pilot_______________________________________________________________ 171 1.3 Gradual implementation____________________________________________________________174 2. ETS Reviews and Evaluations_____________________________________________________________ 177 2.1 Rationale for reviews______________________________________________________________ 177 2.2 Types of reviews__________________________________________________________________ 177 2.3 Gathering data for reviews and evaluations___________________________________________ 180 2.4 Processes for responding to a review________________________________________________ 181 Quick Quiz_______________________________________________________________________________ 182 CONTENTS ix SYNTHESIS LIST OF BOXES BEFORE YOU BEGIN Box S.1 The FASTER Principles for Successful Carbon Pricing_________________________________ 3 Box S.2 Checklist for the 10 Steps of ETS Design____________________________________________ 5 Box 0.1 Designing, Implementing, and Operating an ETS in 10 Steps_________________________ 17 Box 0.2 TECHNICAL NOTE: What the Paris Agreement Means for Markets_____________________ 18 1. SCOPE Box 0.3 TECHNICAL NOTE: Incentives for Innovation_______________________________________ 20 Box 0.4 TECHNICAL NOTE: Other Climate Policy Instruments________________________________ 23 Box 1.1 CASE STUDY: Upstream Regulation in New Zealand_________________________________ 34 Box 1.2 TECHNICAL NOTE: Regulation and Behavioral Impacts______________________________ 35 Box 1.3 CASE STUDY: Electricity Imports in the California ETS_______________________________ 37 2. CAP Box 1.4 CASE STUDY: Tokyo ETS and the Commercial Building Sector________________________ 38 Box 1.5 CASE STUDY: EU Measures to Regulate Aviation Emissions___________________________ 39 Box 1.6 CASE STUDY: Deforestation in the New Zealand ETS________________________________ 40 3. ALLOCATION Box 1.7 CASE STUDY: New Zealand and Agricultural Emissions______________________________ 41 Box 2.1 TECHNICAL NOTE: Determining the Level of ETS Ambition___________________________ 46 Box 2.2 TECHNICAL NOTE: Intensity versus Absolute Caps under Output and Emissions Uncertainty__________________________________________________________ 51 Box 2.3 CASE STUDY: Practical Experience with Emissions Trading under Intensity Caps________ 52 4. OFFSETS Box 2.4 CASE STUDY: Accounting for Uncertainty of Emissions Projections in Cap Setting for Phase I of the EU ETS (2005–07)_______________________________________ 53 Box 2.5 CASE STUDY: Eligible Units in the EU ETS__________________________________________ 56 Box 2.6 CASE STUDY: Reconstructing Historical Emissions Trends in China____________________ 58 5. TIMEFRAMES Box 2.7 CASE STUDY: The Linear Reduction Factor for the EU ETS___________________________ 60 Box 2.8 CASE STUDY: Australia’s Rolling Cap Mechanism____________________________________ 60 Box 2.9 CASE STUDY: Ambition and Cap Design in the California ETS_________________________ 61 Box 3.1 TECHNICAL NOTE: Updating_____________________________________________________ 69 6. PRICE STABILITY Box 3.2 TECHNICAL NOTE: Auction Design for ETSs________________________________________ 70 Box 3.3 CASE STUDY: Auction Revenue Use in California and Québec_________________________ 71 Box 3.4 CASE STUDY: Fixed Sector Benchmarking in Phase III of the EU ETS___________________ 74 Box 3.5 TECHNICAL NOTE: Impacts of OBA on Incentives to Produce_________________________ 75 Box 3.6 CASE STUDY: Approach to Identifying Activities at Risk of Leakage in Australia_________ 77 7. COMPLIANCE Box 4.1 TECHNICAL NOTE: Achieving a Net Decrease of Emissions through the Use of Offsets___ 81 Box 4.2 CASE STUDY: The Kyoto Flexibility Mechanisms____________________________________ 83 Box 4.3 CASE STUDY: Offset Use in the Chinese ETS Pilots__________________________________ 87 Box 4.4 CASE STUDY: New Zealand Reforestation Offset Protocols___________________________ 92 8. STAKEHOLDERS Box 4.5 TECHNICAL NOTE: Offsets and ETS_______________________________________________ 93 Box 5.1 TECHNICAL NOTE: Vintaged Allowances and Advance Auctions______________________ 100 Box 5.2 CASE STUDY: Banking in Phase II of the EU ETS___________________________________ 101 Box 5.3 CASE STUDY: Holding and Purchase Limits in California____________________________ 102 Box 5.4 TECHNICAL NOTE: Compliance, Reporting, and Commitment Periods_________________ 103 9. LINKING Box 5.5 TECHNICAL NOTE: Financial Products in Secondary Carbon Markets_________________ 104 Box 6.1 TECHNICAL NOTE: Recap of Price and Quantity Control_____________________________111 Box 6.2 CASE STUDY: Carbon Price Floor to Foster Investment in the UK______________________112 10. EVALUATION Box 6.3 CASE STUDY: California’s Allowance Price Containment Reserve______________________114 Box 6.4 TECHNICAL NOTE: Price Ranges Under a Price Collar Versus Allowance Reserve________115 x EMISSIONS TR ADING IN PR ACTICE Box 6.5 CASE STUDY: The EU ETS Market Stability Reserve_________________________________ 116 Box 6.6 CASE STUDY: Price Predictability in the Republic of Korea ETS________________________117 Box 7.1 TECHNICAL NOTE: Simplified Example of Annual Emissions Monitoring (Calculation) in a Hard Coal Power Plant__________________________________________ 123 Box 7.2 TECHNICAL NOTE: Monitoring Emissions from a Lime Kiln__________________________ 126 Box 7.3 TECHNICAL NOTE: Default Emissions Factors for Balancing Cost with Accuracy________ 127 Box 7.4 CASE STUDY: Fraud and the Evolution of the EU ETS Registry_______________________ 130 Box 7.5 CASE STUDY: VAT Fraud in the EU ETS___________________________________________ 133 Box 8.1 CASE STUDY: Designing Engagement Methods in the Tokyo ETS_____________________ 141 Box 8.2 CASE STUDY: California’s Formal Expert Engagement in ETS Design__________________ 142 Box 8.3 CASE STUDY: Germany’s Experience with the “Working Group Emissions Trading”_____ 142 Box 8.4 CASE STUDY: Government Coordination in New Zealand ETS Design_________________ 143 Box 8.5 CASE STUDY: The U.S. Climate Action Partnership_________________________________ 144 Box 8.6 CASE STUDY: Stakeholder Engagement During the Development of the New Zealand ETS__________________________________________________________________ 144 Box 8.7 CASE STUDY: Overcoming Legal Challenges: the Case of the Californian ETS__________ 147 Box 8.8 CASE STUDY: The Engagement Process As Part of Design and Implementation of the Tokyo ETS_______________________________________________ 148 Box 8.9 TECHNICAL NOTE: ETS Simulations for Capacity Building___________________________ 149 Box 9.1 TECHNICAL NOTE: Gains from Trade via Linkage__________________________________ 155 Box 9.2 CASE STUDY: EU ETS – Leading with Linking______________________________________ 156 Box 9.3 CASE STUDY: New Zealand and Imported Risk____________________________________ 158 Box 9.4 TECHNICAL NOTE: Networking Carbon Markets___________________________________ 158 Box 9.5 CASE STUDY: Linkage between Australia and the EU_______________________________ 162 Box 9.6 CASE STUDY: Linkage between California and Québec_____________________________ 163 Box 9.7 CASE STUDY: Intended Australia-EU Linkage – the Role of Registries_________________ 164 Box 9.8 CASE STUDY: Delinking in RGGI_________________________________________________ 167 Box 10.1 CASE STUDY: Korea’s Target Management System_________________________________ 171 Box 10.2 CASE STUDY: Chinese Regional ETS Pilots________________________________________ 173 Box 10.3 CASE STUDY: Lessons Learned from Phase I of the EU ETS_________________________ 173 Box 10.4 CASE STUDY: Structural Reviews of the EU ETS____________________________________ 179 Box 10.5 CASE STUDY: Comprehensive Review of RGGI_____________________________________ 181 Box 10.6 CASE STUDY: Review Processes in the New Zealand ETS____________________________ 182 LIST OF FIGURES Figure S.1 ETS Design In 10 Steps___________________________________________________________ 6 Figure S.2 ETS Design Interdependencies___________________________________________________ 13 Figure 0.1 Emissions Trading Around the World______________________________________________ 19 Figure 0.2 Example of Two Firms with Different Abatement Costs______________________________ 26 Figure 0.3 Applying a Uniform Standard to Each Company____________________________________ 27 Figure 0.4 Comparing Trade to an Allocation Prescribing Equal Emissions by Each Company_______ 27 Figure 0.5 Damages and Savings from Emissions and Mitigation Efforts_________________________ 28 Figure 1.1 Sector Coverage in Existing ETSs_________________________________________________ 32 Figure 1.2 From Upstream to Downstream__________________________________________________ 34 Figure 2.1 EU Emissions Reduction Targets, and Role of the EU ETS____________________________ 47 CONTENTS xi SYNTHESIS Figure 2.2 Top-Down and Bottom-Up Approaches to Cap Setting______________________________ 48 BEFORE YOU BEGIN Figure 4.1 Sources of Offsets for an ETS____________________________________________________ 82 Figure 4.2 General Process for Project Registration and Offset Credit Issuance___________________ 91 Figure 5.1 Stylized Model of Banking in an ETS over Time_____________________________________ 97 Figure 6.1 ETS Allowance Price Formation_________________________________________________ 107 Figure 6.2 Different Types of Price Predictability and Cost Containment Measures________________111 1. SCOPE Figure 7.1 MRV in the EU ETS____________________________________________________________ 122 Figure 8.1 ETS Stakeholders and Key Considerations in Stakeholder Mapping___________________ 138 Figure 8.2 Role of Stakeholders in ETS Decision Making______________________________________ 141 Figure 9.1 Types of Linkage______________________________________________________________ 153 Figure 9.2 Effect of Linking on Allowance Prices____________________________________________ 157 2. CAP Figure 10.1 Stylized Model of the ETS Policy Cycle___________________________________________ 177 3. ALLOCATION LIST OF TABLES Table 0.1 GHG ETS Milestones____________________________________________________________ 17 Table 0.2 Advantages and Disadvantages of Complementary Measures________________________ 24 Table 1.1 Gas Coverage in Existing ETSs___________________________________________________ 33 4. OFFSETS Table 1.2 Decisions on Scope_____________________________________________________________ 36 Table 2.1 Economy-Wide Emission Reduction Targets and ETS Caps in Existing ETSs_____________ 50 Table 3.1 Allocation Methods in Existing ETSs______________________________________________ 68 Table 3.2 Summary of Methods of Allocation against Objectives______________________________ 68 5. TIMEFRAMES Table 3.3 Summary of Data Requirements for Different Methods of Allocation__________________ 68 Table 3.4 Trade Exposure and Emissions Intensity in Different ETSs____________________________ 77 Table 4.1 A Simple Illustration of Offsetting in an ETS________________________________________ 81 Table 4.2 Offset Use in Existing ETSs______________________________________________________ 88 6. PRICE STABILITY Table 4.3 Aspects of Standardization of Methodologies______________________________________ 90 Table 4.4 Bottom-Up vs. Top-Down Approaches to Developing Offset Methodologies____________ 91 Table 5.1 Temporal Flexibility Provisions in Existing ETSs_____________________________________ 99 Table 6.1 Pros and Cons of Approaches to Market Management_______________________________118 Table 7.1 MRV approaches in existing ETSs________________________________________________ 124 7. COMPLIANCE Table 7.2 Quality Assurance Options_____________________________________________________ 127 Table 7.3 Penalties for Noncompliance with Surrender Obligations in Existing ETSs_____________ 132 Table 8.1 Misconceptions around an ETS and Possible Counterarguments_____________________ 145 Table 9.1 Linkages (and intended Linkages) between ETSs to date___________________________ 154 8. STAKEHOLDERS Table 9.2 Advantages and Disadvantages of Linking________________________________________ 159 Table 9.3 Importance of Alignment of Different Design Features_____________________________ 161 Table 10.1 Timelines of Significant Changes in Five ETS______________________________________ 175 Table 10.2 Examining Final ETS Impact by Evaluating Intermediate Impacts_____________________ 180 9. LINKING 10. EVALUATION xii EMISSIONS TR ADING IN PR ACTICE LIST OF ACRONYMS AAU Assigned Amount Unit JCM Joint Crediting Mechanism (Japan) APCR Allowance Price Containment Reserve JI Joint Implementation (Kyoto Protocol) ARB Air Resources Board (California) ktCO2e Kilotonne of carbon dioxide equivalent BAU Business as usual LRF Linear Reduction Factor CCER Chinese Certified Emission Reduction MRV Monitoring, Reporting and Verification CCR Cost Containment Reserve MSR Market Stability Reserve CCS Carbon Capture and Storage Mt Megatonne CDM Clean Development Mechanism MtCO2e Megatonne of Carbon Dioxide equivalent (Kyoto Protocol) MW Megawatt CEM Continuous Emissions Monitoring NDC Nationally Determined Contributions CER Certified Emission Reduction NDRC National Development and CO2 Carbon dioxide Reform Commission (China) CO2e Carbon dioxide equivalent NZ-AAU New Zealand-originated Assigned Amount Unit CPC Carbon Price Floor NZ ETS New Zealand Emissions Trading Scheme CPLC Carbon Pricing Leadership Coalition NZU New Zealand Units CPM Carbon Pricing Mechanism OBA Output-Based Allocation CPS Carbon Price Support OECD Organisation for Economic EC European Commission (EU) Co-operation and Development EDF Environmental Defense Fund PBL Planbureau voor de Leefomgeving (Netherlands Environmental EITE Emissions-intensive, trade exposed sectors Assessment Agency) EPA Environmental Protection Agency PMR Partnership for Market Readiness (United States) REDD Reducing Emissions from ERU Emission Reduction Unit Deforestation and Forest Degradation ETS Emissions Trading System REDD+ REDD plus Conservation, EU European Union Sustainable Management of EU ETS European Union Emissions Trading System Forests, and Enhancement of FSB Fixed Sector Benchmarking Forest Carbon Stocks GDP Gross Domestic Product RGGI Regional Greenhouse Gas Initiative GHG Greenhouse Gas t Tonne (= metric ton, in the United States) Gt Gigatonne tCO2 Tonne of carbon dioxide GtCO2e Gigatonne of carbon dioxide equivalent tCO2e Tonne of carbon dioxide equivalent GWP Global Warming Potential UK United Kingdom IAP2 International Association for UN United Nations Public Participation UNFCCC United Nations Framework ICAO International Civil Aviation Organization Convention on Climate Change ICAP International Carbon Action Partnership U.S. United States IEA International Energy Agency WCI Western Climate Initiative IPCC Intergovernmental Panel on Climate Change SYNTHESIS – EMISSIONS TR ADING: BRINGING IT ALL TOGETHER 1 SYNTHESIS – EMISSIONS TRADING: SYNTHESIS BRINGING IT ALL TOGETHER Why Emissions Trading?_________________________________________________________________ 2 Emissions Trading or Carbon Tax?_________________________________________________________ 3 How Does an ETS Work?________________________________________________________________ 3 Laying the Foundation for an ETS_________________________________________________________ 4 Setting ETS objectives______________________________________________________________ 4 Tailoring an ETS to local circumstances________________________________________________ 4 Managing policy interactions________________________________________________________ 4 ETS Design in 10 Steps__________________________________________________________________ 5 Step 1: Decide the scope____________________________________________________________ 6 Step 2: Set the cap_________________________________________________________________ 7 Step 3: Distribute allowances________________________________________________________ 7 Step 4: Consider the use of offsets___________________________________________________ 8 Step 5: Decide on temporal flexibility_________________________________________________ 9 Step 6: Address price predictability and cost containment_______________________________ 9 Step 7: Ensure compliance and oversight_____________________________________________ 10 Step 8: Engage stakeholders, communicate, and build capacities________________________ 10 Setting ETS objectives______________________________________________________________ 4 Step 10: Implement, evaluate, and improve___________________________________________ 12 Applying the 10 Steps of ETS Design in Practice____________________________________________ 12 Shaping the Future of ETS Design________________________________________________________ 13 2 EMISSIONS TR ADING IN PR ACTICE Currently, about 40 national jurisdictions and over 20 cities, states, and regions—representing almost a quarter of global WHY EMISSIONS greenhouse gas (GHG) emissions—are putting a price on TRADING? carbon as a central component of their efforts to reduce emis- To move to a low-carbon future and achieve the aim of sions and place their growth trajectory on a more sustainable holding the increase in the global average temperature to footing. Together, carbon pricing instruments cover about well below 2 degrees above pre-industrial levels, action will be half of the emissions in these jurisdictions, which translates to needed on multiple fronts, including: about 7 gigatonnes1 of carbon dioxide equivalent (GtCO2e) or about 12 percent of global emissions.2 An increasing number ▲▲ Decarbonizing the production of electricity; of these jurisdictions are approaching carbon pricing through ▲▲ Massive electrification (to increase reliance on clean elec- the design and implementation of Emissions Trading Systems tricity) and, where this is not possible, switching to cleaner (ETS). As of 2016, ETSs were operating across four continents fuels; in 35 countries, 13 states or provinces, and seven cities, cov- ▲▲ Improving energy and resource efficiency, and reducing ering 40 percent of global GDP, and additional systems were waste in all sectors; and under development.3 ▲▲ Preserving existing and increasing the number of natural Moreover, as the world moves on from the climate agreement carbon sinks in forests and other vegetation and soils.5 negotiated in Paris, attention is turning from the identification of emissions reduction trajectories—in the form of Nationally This will require a shift in investment patterns and behaviors, Determined Contributions (NDCs)—to crucial questions about and innovation in technologies, infrastructure, financing, and how these emissions reductions are to be delivered and practice. Policies will be needed that achieve this change in reported within the future international accounting framework. ways that reflect local circumstances, create new economic The experience to date shows that, if well designed, emissions opportunities, and support citizens’ wellbeing. trading can be an effective, credible, and transparent tool For many jurisdictions, GHG carbon pricing is emerging as a key for helping to achieve low-cost emissions reductions in ways driver of this transformation. By aligning profits with low-emis- that mobilize private sector actors, attract investment, and sions investment and innovation, a uniform price on carbon encourage international cooperation. can channel private capital flows, mobilize knowledge about However, to maximize effectiveness, any ETS needs to be mitigation within firms, and tap the creativity of entrepreneurs in designed in a way that is appropriate to its context. This hand- developing low-carbon products and innovations, thereby driving book is intended to help decision makers, policy practitioners, progress toward reducing emissions. A price on carbon makes and stakeholders achieve this goal. It explains the rationale for clean energy more profitable, allows energy efficiency to earn a an ETS and sets out the most important steps of ETS design. In greater return, makes low-carbon products more competitive, doing so, it draws both on conceptual analysis and on some of and values the carbon stored in forests. A growing number of the most important practical lessons learned to date from imple- firms and investors are advocating carbon pricing policies from menting ETSs around the world, including from the European government,6 and applying an internal carbon price to guide Union, several provinces and cities in China, California and investment in advance of government policy to that effect. Québec, the Northeastern United States, Alberta, New Zealand, Carbon pricing by itself cannot address all of the complex drivers Kazakhstan, the Republic of Korea, Tokyo, and Saitama.4 of climate change; some combination of regulations, standards, incentives, educational programs, and other measures will also 1 A tonne is known as a metric ton in the United States. be required. However, as part of an integrated policy package, 2 World Bank (2015) 3 ICAP (2016i) carbon pricing can harness markets to drive down emissions and 4 As of 2016, ETSs in force include the European Union Emissions Trading System (EU help build the ambition needed to sustain a safer climate. ETS), the Swiss Emissions Trading System, the California Cap-and-Trade Program, the U.S. Regional Greenhouse Gas Initiative (covering Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New York, Rhode Island, and Vermont), 5 For further discussion of the role of climate change mitigation in supporting eco- the Québec Cap-and-Trade System, the Kazakhstan Emissions Trading Scheme, the nomic development, see Fay et al. (2015). New Zealand Emissions Trading Scheme, , the Korean Emissions Trading Scheme, and 6 Recent examples of engagement of private-public coalitions advocating carbon Japan’s Saitama Target Setting Emissions Trading System and Tokyo Cap-and-Trade pricing include: World Bank (2014), supported by over 1,000 companies and investors Program. In addition, the Alberta’s Specified Gas Emitters Regulation (SGER) sets along with national and subnational jurisdictions, an open letter to governments and a facility-level emissions intensity target (as opposed to an absolute cap). A range the United Nations from six major oil companies calling for an international frame- of regional pilot ETS are in force in China, with a view to absorb these in an overall work for carbon pricing systems (UNFCCC, 2015a): and the launch of the Carbon Chinese cap-and-trade system by 2017. A further 15 jurisdictions are currently Pricing Leadership Coalition 2015, whose government and private sector participants considering implementing ETSs (see www.icapcarbonaction.com/en/ets-map for are committed to building the evidence base for effective carbon pricing (see Carbon up-to-date information on all operating and planned ETSs) Pricing Leadership Coalition, 2015). SYNTHESIS – EMISSIONS TR ADING: BRINGING IT ALL TOGETHER 3 EMISSIONS TRADING OR BOX S.1 The FASTER Principles for Successful SYNTHESIS CARBON TAX? Carbon Pricing The FASTER Principles for Successful Carbon Pricinga were Two kinds of market instruments can deliver an explicit price developed jointly by the World Bank and the Organisation on carbon:7 emissions trading and carbon taxes. They have for Economic Co-operation and Development (OECD), much in common. Both emissions trading and carbon taxes based on the practical experience of different jurisdictions aim to internalize the costs carbon emissions impose on soci- with implementing carbon taxes and emissions trading ety by placing a price on these emissions that can: systems. The FASTER Principles are the following: ▲▲ Fairness: Reflect the “polluter pays” principle and 3. Change the behavior of producers, consumers, and inves- contribute to distributing costs and benefits equitably, tors so as to reduce emissions, but in a way that provides avoiding disproportionate burdens on vulnerable flexibility on who takes action, what action they take, and groups; when they take that action; ▲▲ Alignment of Policies and Objectives: Use carbon 4. Stimulate innovation in technology and practice; pricing as one of a suite of measures that facilitate competition and openness, ensure equal opportunities 5. Generate environmental, health, economic, and social for low-carbon alternatives, and interact with a broader co-benefits; and set of climate and nonclimate policies; 6. Provide government revenue that can be used to reduce ▲▲ Stability and Predictability: Implement carbon prices, other taxes or support public spending on climate action within a stable policy framework, that give a consistent, or in other areas. credible, and strong investment signal, whose intensity should increase over time; The key distinction is that with a carbon tax the government ▲▲ Transparency: Be clear in design and implementation; sets the price and allows the market to determine the quantity of emissions, whereas with emissions trading the government ▲▲ Efficiency and Cost Effectiveness: Ensure that design promotes economic efficiency and reduces the costs of sets the quantity of emissions and allows the market to deter- emissions reduction; and mine the price. Hybrid systems, which combine elements of both approaches, also exist in different forms, for example, an ▲▲ Reliability and Environmental Integrity: Allow for a measurable reduction in environmentally harmful ETS with a price floor and ceiling, or tax schemes that accept behavior. emissions reduction units to lower the tax liabilities. In practice, the fact that emissions trading provides reasonable a World Bank and OECD (2015). confidence about the future level of emissions has served to make it an attractive policy option for many governments. In addition, empirical evidence suggests that the strategic use of free allocation of emissions allowances to manage the dis- HOW DOES AN ETS tributional and leakage effects of emissions trading has made it easier to secure political support. Last but not least, ETSs WORK? can be linked to other ETSs or to offset mechanisms, enabling Under an ETS, the relevant authority imposes a limit (cap) on international cooperation on carbon pricing through larger, the total emissions in one or more sectors of the economy, more robust markets. and issues a number of tradable allowances that does not exceed the level of the cap. Each allowance corresponds to Regardless of which instrument is selected for pricing carbon, one unit of emissions (typically one tonne).8 a common set of principles can be applied to guide effective design. These principles are presented in Box S.1. The regulated participants in an ETS are required to surrender one allowance for every unit of emissions for which they are accountable. They may initially either receive freely or buy allowances from the government, and participants and others 8 Allowances are typically issued in units of tonnes carbon dioxide, or tonnes of carbon 7 A host of other policies exist that aim to provide an incentive for emissions dioxide equivalent (CO2e). The latter includes carbon dioxide as well as other GHGs reductions. Often, the implied carbon price associated with these policies can be (e.g., methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons, sulphur hexaflu- calculated, the so-called “implicit carbon price.” However, the focus of this discussion oride, and nitrogen trifluoride) on the basis of their relative global warming potential is on explicit carbon prices created through either an ETS or carbon taxes. (GWP). 4 EMISSIONS TR ADING IN PR ACTICE can also choose to trade allowances or bank them for future use. They may also be able to use eligible units LAYING THE FOUNDATION from other sources, such as domestic offset credits (from FOR AN ETS sectors outside the cap), international offset mechanisms, or other ETSs. Setting ETS objectives The cap on allowances and the establishment of a market An ETS is a policy tool and it can be designed to achieve a range of to trade them result in a price for allowances, creating outcomes—environmental, economic, and social. Before proceed- an incentive to reduce emissions. A more stringent cap ing to ETS design, a jurisdiction must decide how much the system translates into lower allowance supply, so—all other things should contribute to the emissions reductions that it wants to being equal—the allowance price will tend to be higher, achieve globally and domestically, the rate at which to decarbonize creating a stronger incentive. The ability to trade on the its own economy, what level of cost is acceptable, how costs and market also results in price convergence and a uniform benefits will be distributed, whether revenue shall be generated price signal, which in turn favors lower-emission goods by selling or auctioning allowances and how those proceeds will and services. Setting the cap in advance provides a long- be used, and how the ETS and its co-benefits will contribute to term market signal so participants can plan and invest economic transformation and sustainable development. It will be accordingly. easier to come to a decision on the adoption of an ETS and deter- mine the specifics of ETS design and implementation once there is Allowances can be allocated for free—based on some broad public acceptance of the jurisdiction’s need to reduce GHG combination of past emissions, output and/or perfor- emissions—at least to a level below business as usual (BAU)—in mance standards—or sold, typically at auction. The latter the long term. supports transparent price formation and generates revenue for the government, which can be used for a variety of purposes, among others, to fund climate action, Tailoring an ETS to local circumstances support innovation, or help low-income households. There are many opportunities to tailor an ETS to reflect the Additional mechanisms can be used to support price jurisdiction’s specific circumstances and needs. Relevant aspects predictability, cost containment, and effective market include: local priorities; the motivation for choosing an ETS relative operation. to alternative policy instruments; the jurisdiction’s current and evolving emissions profile; the existing regulatory environment and The environmental integrity of the system is ensured confidence in market mechanisms; the size, concentration, growth, through requirements for emissions monitoring, reporting and volatility of the economy; trade and competitiveness concerns; and verification (MRV) and the enforcement of penalties institutional strengths and weaknesses; and relationships with for noncompliance. This is facilitated by the use of potential linking partners. registries into which allowances are issued with unique serial numbers and that enable allowances to be tracked as they are traded between different participants and can- Managing policy interactions celed. Market oversight provisions safeguard the broader All ETSs are developed within a broader policy and legal framework, integrity of trading activity. including other climate change policies. This will lead to important interactions that will often require careful attention. Additional Different jurisdictions can choose to link their ETS directly policies in sectors covered by the cap can counteract, distort, or or indirectly through mutual recognition of allowances duplicate the impact of an ETS. For example, other abatement or other units, such as offset credits. Linking broadens policies such as renewable energy and energy efficiency policies access to least-cost mitigation, attracts resources for may lead to emissions reductions in ETS sectors at costs above the further mitigation, supports market liquidity, and enables ETS’s carbon price, meaning that the ETS will not deliver least-cost political cooperation on carbon pricing. mitigation as a whole. On the other hand, those policies can also complement or even enhance the effectiveness of an ETS by creat- ing additional GHG mitigation opportunities or removing non-price barriers to reducing emissions. The role that an ETS is expected to play within a broader climate change policy package will often be an important determinant of its design. SYNTHESIS – EMISSIONS TR ADING: BRINGING IT ALL TOGETHER 5 ETS DESIGN IN 10 STEPS SYNTHESIS This handbook sets out a 10-step process for designing an the decisions and actions taken at each step are likely to be ETS (see Figure S.1). Each step involves a series of decisions interlinked and interdependent, which means that the process or actions that will shape major features of the system (see for working through these steps is more likely to be iterative Box S.2). However, as stressed throughout the handbook, rather than linear. BOX S.2 Checklist for the 10 Steps of ETS Design Step 1: Decide the scope Step 5: Decide on temporal flexibility Step 8: Engage stakeholders, communicate, and build capacities ✓✓ Decide which sectors to cover ✓✓ Set rules for banking allowances ✓✓ Decide which gases to cover ✓✓ Set rules for borrowing allowances ✓✓ Map stakeholders and respective and early allocation positions, interests, and concerns ✓✓ Choose the points of regulation ✓✓ Set the length of reporting and ✓✓ Coordinate across departments ✓✓ Choose the entities to regulate and compliance periods for a transparent decision-making consider whether to set thresholds process and to avoid policy misalignment Step 2: Set the cap Step 6: Address price predictability ✓✓ Design an engagement strategy for and cost containment ✓✓ Create a robust foundation of data consultation of stakeholder groups ✓✓ Establish the rationale for, and specifying format, timeline, and to determine the cap risks associated with, market objectives ✓✓ Determine the level and type of cap intervention ✓✓ Design a communication strategy ✓✓ Choose time periods for cap setting ✓✓ Choose whether or not to intervene that resonates with local and and provide a long-term cap to address low prices, high prices, immediate public concerns trajectory or both ✓✓ Identify and address ETS capacity- ✓✓ Choose the appropriate instrument Step 3: Distribute allowances building needs for market intervention ✓✓ Match allocation methods to policy ✓✓ Decide on governance framework objectives Step 9: Consider linking ✓✓ Define eligibility and method for ✓✓ Determine linking objectives and Step 7: Ensure compliance and free allocation and balance with oversight strategy auctions over time ✓✓ Identify linkage partners ✓✓ Identify the regulated entities ✓✓ Define treatment of entrants, ✓✓ Determine the type of link ✓✓ Manage emissions reporting by closures, and removals ✓✓ Align key program design features regulated entities ✓✓ Form and govern the link ✓✓ Approve and manage the Step 4: Consider the use of offsets performance of verifiers ✓✓ Decide whether to accept offsets ✓✓ Establish and oversee the ETS Step 10: Implement, evaluate, and from uncovered sources and registry improve sectors within and/or outside the ✓✓ Design and implement the penalty ✓✓ Decide on the timing and process of jurisdiction and enforcement approach ETS implementation ✓✓ Choose eligible sectors, gases, and ✓✓ Regulate and oversee the market ✓✓ Decide on the process and scope activities for ETS emissions units for reviews ✓✓ Weigh costs of establishing an own ✓✓ Evaluate the ETS to support review offset program vs. making use of an existing program ✓✓ Decide on limits on the use of offsets ✓✓ Establish a system for monitoring, reporting, verification, and governance 6 EMISSIONS TR ADING IN PR ACTICE Generally, broader system coverage is FIGURE S.1 ETS Design In 10 Steps desirable as it increases the range of low-cost mitigation options, allowing emissions reductions to be achieved at DEMAND SUPPLY the least cost. Broader coverage also 7. Oversight reduces competitive distortions, as and compliance 6. Market Stability competing firms and sectors operate 2. Cap within the same market rules, which enhances market liquidity. However, a broader system may impose greater 8. Stakeholders regulatory burdens on small and diffuse 5. Temporal emissions sources that may also be Flexibility 1. Scope relatively difficult to regulate. Therefore, the benefits of broader coverage must be balanced against any additional administrative effort and transaction costs. Using thresholds to exclude small 3. Allocation emitters and placing the “point of reg- ulation” upstream on suppliers of fossil fuels can help manage this trade-off. 4. Offsets 9. Linking 10. Implement, Evaluate, Improve LESSONS LEARNED: There is a great diversity across existing ETSs in terms of scope, suggesting there is no single Author: ICAP “right” approach. Almost all systems cover at least the power and industrial sectors. A phased approach can STEP 1: Decide the scope be useful to allow time to build the ✓✓ Decide which sectors to cover capacity to include smaller or more ✓✓ Decide which gases to cover complex sectors. All systems cover carbon dioxide; many cover up to ✓✓ Choose the points of regulation seven gases. While some jurisdictions ✓✓ Choose the entities to regulate and consider whether to have placed the point of regulation set thresholds for emissions from fuel combustion upstream to reduce administrative The scope of an ETS refers to the geographic area, sectors, emissions sources, and costs (e.g., fuels in California, Québec, GHGs for which allowances will have to be surrendered, as well as which entities will and New Zealand), others have opted have to surrender them. The ETS scope defines the boundaries of the policy. It there- for downstream options for alignment fore has implications for the number of regulated entities, the share of emissions with existing regulatory or reporting facing a carbon price, and effort sharing between the covered and uncovered sectors systems (e.g., EU, California, and to meet economy-wide emissions reduction targets. Québec for large point sources), or for hybrid options because energy In determining ETS scope, there are important differences across sectors and emis- prices are regulated and carbon price sions sources. Key considerations include the jurisdiction’s emissions profile (and its signals otherwise would not be passed expected evolution) and what this implies for the potential for emissions reductions. through the supply chain (e.g., Korean The ability and cost of monitoring and regulating across emissions sources and at ETS and pilot ETSs in China). different points in the supply chain will also be important; this will be influenced in part by existing regulatory structures and policies. Finally, consideration should also be given to the potential for non-price barriers to limit carbon price pass-through; exposure to international markets; and the potential for co-benefits. SYNTHESIS – EMISSIONS TR ADING: BRINGING IT ALL TOGETHER 7 STEP 2: Set the cap LESSONS LEARNED: A cap is only as good as the underlying SYNTHESIS data and assumptions. Cap setting will benefit from early ✓✓ Create a robust foundation of data to determine the cap data collection and greater reliance on historical data as ✓✓ Determine the level and type of cap compared to counterfactual projections. While most juris- ✓✓ Choose time periods for cap setting and provide a long- dictions have chosen absolute caps to facilitate alignment term cap trajectory between caps and targets as well as linking, they have also built in some flexibility over allowance supply to contain The ETS cap sets a limit on the number of allowances issued costs (see Step 6). Developing intensity caps introduces over a specified time period which then constrains the total some additional technical and administrative challenges. amount of emissions produced by the regulated entities. All In practice, partly because of a concern about high prices, else equal, the lower the cap, the higher the carbon price will initial caps in many existing ETSs have been set at levels that be and the stronger will be the incentive to reduce emissions. (in conjunction with other design features) have resulted in However, other design features, such as access to offsets, prices significantly lower than expected, which can cause its linking, and different cost-containment mechanisms, interact own set of problems (see Step 6). To support effective market with the cap to determine the overall emissions constraint operation and build confidence and support among market and the resulting carbon price. In practice, setting the cap is a participants, a long-term cap trajectory should be combined balancing act accounting for the relative values of emissions with transparent, rules-based processes for possible modifi- reductions, cost constraints, credibility, and fairness within the cations to the cap and advance notice of future changes. broader policy context. Setting the cap requires assessment of the jurisdiction’s histor- ical emissions, its projected emissions (which depend on both STEP 3: Distribute allowances anticipated improvements in emissions intensity and projected ✓✓ Match allocation methods to policy objectives economic growth and development), and mitigation opportu- ✓✓ Define eligibility and method for free allocation and nities and costs. It should reflect consideration of how other balance with auctions over time current or planned policies could influence ETS outcomes. ✓✓ Define treatment of entrants, closures, and removals The cap should be aligned with the jurisdiction’s overall mitigation target. In setting the cap, policy makers need to Whereas the cap determines the emissions impact of an manage trade-offs between emissions reduction ambition ETS, allowance allocation is an important determinant of its and system costs, aligning cap ambition with target ambition, distributional impacts. It can also influence the efficiency of the and assigning mitigation responsibility across capped and system and therefore merits careful attention. uncapped sectors. Absolute caps set targets for each com- The government can distribute allowances through free allo- pliance period in tonnes of emissions reductions, although cation, auctioning, or some combination of the two, as well as flexibility can be provided by banking provisions, allowance award allowances for removals. Free allocation methods vary reserves, offset credits, linking, and periodic reviews that may according to whether they are based on entities’ historical result in cap adjustments. Intensity(-based) caps prescribe emissions—referred to as grandparenting—or based on an the number of allowances to be issued per measure of output industry-specific benchmark; and depending on whether (e.g., GDP or kilowatt-hour of electricity), which allows them allocation changes when output changes. To differing degrees, to adjust automatically to fluctuations in economic output, but these options can protect against leakage (the concern that provides less certainty over emissions outcomes. Absolute and carbon pricing causes geographic relocation of emissions intensity caps can be equally stringent with respect to their rather than genuine emissions reductions) and can also help expected results, but can also produce different outcomes compensate for economic losses that compliance with the when actual output deviates significantly from projections. ETS might otherwise cause. Auctioning generates government ETSs with absolute caps are more common. Jurisdictions that revenue, which can pay for cuts in distortionary taxes, support choose intensity caps will have a smaller body of knowledge spending on public programs (including other forms of climate and experience to draw on, particularly if there is an interest in action), or be returned to households directly. program components such as linking and offsets. 8 EMISSIONS TR ADING IN PR ACTICE entities outside the jurisdiction’s borders; and early (pre-ETS) LESSONS LEARNED: Because large amounts of resources reductions. Allowing offsets can support learning and engage- are at stake, allocation decisions can become highly ment among uncovered sources, facilitate investment flows contentious and a key focus of stakeholder attention into other sectors where financial support is needed to stimu- and political discussion. The objectives of allocation (e.g., late low-carbon development, and often also yield co-benefits. managing the transition into the ETS, preserving incentives for cost-effective abatement) should be transparently stated By lowering allowance prices and creating a new political upfront, and subsequent decisions on particular allocation constituency for the ETS among the offset sellers, offsets may design issues should be explained and justified by reference allow policy makers to set a more ambitious cap and may to these objectives. Both the objectives of allocation and support policy stability. For a given cap, accepting offsets will allocation design features can be expected to evolve over lower prices, if there is eligible low-cost abatement potential time. Decisions on entities’ individual allocation should be available outside the system. Emissions by covered sources will made separately from decisions on the cap. The risk of leakage in emissions-intensive, trade-exposed (EITE) sectors rise, but global emissions should not. The quality of MRV of has been a major concern in ETS design and implementation, offsets needs to match that of the ETS to ensure environmental and is likely to remain a core consideration in the short to equivalence of offsets and allowances (see Step 7). This can be medium-term, even though empirical evidence on leakage is challenging because, unlike ETS allowances issued in relation to limited. This issue will also decline in importance if and when a cap, offsets are credited relative to BAU, using benchmarks or carbon pricing is adopted more widely or eventually even counterfactual baselines. Unless this is done carefully, without becomes harmonized globally. Auctioning has typically been conservative assumptions and rigorous monitoring and report- introduced on a limited scale initially, but with the intention ing, there is a risk that at least some offset activities may not to let it gradually displace free allocation. Allocation methods be additional to BAU and result in emissions shifts rather than can vary across sectors; for example, the power sector is a reductions (leakage). In addition, especially in relation to carbon typical candidate for auctioning as it is often less prone to sequestration activities, there is a risk that reductions may not carbon leakage than other ETS sectors, while manufacturing be permanent. Therefore, the use of offsets has to be consid- sectors have typically received some form of free allocation, ered carefully in order not to risk the environmental integrity of at least in initial years. Using auction revenue strategically the ETS. There is also a concern that extensive use of offsets can be a powerful selling point for proceeding with an ETS. and the reduction in abatement in the capped sectors increases the risk of the locking in of emissions-intensive infrastructure. STEP 4: Consider the use of offsets LESSONS LEARNED: Offsets provide a powerful tool for containing cost, expanding mitigation incentives beyond the ✓✓ Decide whether to accept offsets from uncovered cap, and generating co-benefits. Establishing an operational sources and sectors within and/or outside the domestic offset mechanism to produce a pipeline of units jurisdiction requires institution and capacity building, and involves ✓✓ Choose eligible sectors, gases, and activities considerable time, effort, and cost. Another aspect to ✓✓ Weigh costs of establishing an own offset program vs. consider is whether any credits generated are only expected making use of an existing program to be eligible in the domestic scheme or whether there is an ✓✓ Decide on limits on the use of offsets intention that they may be used outside the jurisdiction’s ✓✓ Establish a system for monitoring, reporting, boundaries. Valuable experience has been gained with verification, and governance international offsets under the Kyoto Protocol’s Clean Development Mechanism (CDM) and Joint Implementation (JI) as well as other project crediting mechanisms. Some An ETS can allow “offsets”—credits for emissions reductions in offset types and methodologies have been proven to uncovered sources and sectors—to be used by covered entities lack environmental integrity, and the future evolution of to meet compliance obligations under the cap. This expands international offset mechanisms is unclear at present. Most the supply of emissions units (although this can be counter- ETSs accept only some types of offsets and limit how many balanced with a reduction in allowance supply to maintain the can be used. Applying internationally established method- overall cap) and can significantly reduce ETS compliance costs. ologies, adapted for local circumstances, can help ensure environmental integrity and accelerate the development of Offsets can come from a variety of sources: entities from a new domestic offset mechanism, if desired. While offsets uncovered sectors within the jurisdiction (e.g., depending on have typically been generated at the level of individual the system, transport, forestry, or agriculture); uncovered SYNTHESIS – EMISSIONS TR ADING: BRINGING IT ALL TOGETHER 9 “projects” (e.g., facilities), jurisdictional or sectoral programs STEP 6: Address price predictability and cost containment SYNTHESIS prospectively offer the potential to lower transaction costs while maintaining or enhancing environmental integrity. ✓✓ Establish the rationale for, and risks associated with, market intervention STEP 5: Decide on temporal flexibility ✓✓ Choose whether or not to intervene to address low prices, high prices, or both ✓✓ Set rules for banking allowances ✓✓ Choose the appropriate instrument for market ✓✓ Set rules for borrowing allowances and early allocation intervention ✓✓ Set the length of reporting and compliance periods ✓✓ Decide on governance framework One of the attractions of an ETS is that it can provide some In an ETS, time-varying market prices provide the signals flexibility for entities as to when they wish to reduce emissions. that will allow firms to achieve a given quantity of emissions However, this flexibility in timing must be balanced against the at least cost. Just as in many commodity markets, it may be certainty of achieving reductions. Key policy decisions in this hard to predict longer-term ETS prices accurately, because regard include setting the length of reporting and compliance they depend on variations in economic activity, volatility and periods and enabling participants to bank (carry over) or variability in fuel markets, uncertain marginal abatement cost borrow allowances across compliance periods. estimates, and potential policy changes. Persistently low prices in an ETS could arise because mitigation turns out to be easier Longer compliance periods can offer companies greater than expected, because other climate and energy policies also flexibility around the timing of investments in emissions contribute to lower emissions and therefore reduced demand abatement, potentially lowering costs significantly. However, for allowances, or because of a recession that lowers eco- excessively long compliance periods can create incentives nomic activity and thus emissions; the reverse could be true to delay action and investment in reducing emissions, which for high prices. Policy uncertainty and other market or regula- might increase costs. Limiting compliance periods, typically tory failures could depress demand for banking, inhibiting the to 1–3 years, ensures early mitigation and market activity, formation of long-term credible carbon prices. which may be important to demonstrate early progress toward emissions reduction targets. Borrowing is effectively equivalent ETS design can reduce this potential volatility and uncertainty to longer compliance periods and raises similar considerations. about prices. Design options can vary according to whether they adjust the quantity of allowances or place constraints on Many existing ETSs allow for allowance banking, which encour- the price, and the extent of discretion they give policy makers. ages earlier reductions and helps smoothen costs (and allow- These design parameters aim to make prices predictable enough ance prices) across compliance periods. There may, however, to support investment in mitigation and new technologies, and be reasons to limit banking if there is high uncertainty about guide a gradual transition toward a low-carbon economy while the future of the ETS. In such cases, banking restrictions might avoiding costs that are politically or socially unacceptable. be needed to avoid negative impacts on the future supply and environmental integrity of allowances—for instance, during a LESSONS LEARNED: Prior to ETS implementation, the con- pilot that may differ significantly from the ETS that is to follow. cerns of policy makers have typically focused on the possibil- The transition process should also account for the existence of ity of high prices. However, in some of the ETSs currently in banked allowances. operation, low prices have actually become a greater source of concern. There is growing recognition that appropriate LESSONS LEARNED: Temporal flexibility in an ETS is critical to market management approaches can help sustain prices to managing costs and price volatility but should be balanced. promote investment and maintain auction revenue, control Banking between commitment periods is usually encouraged costs, and ensure mitigation is consistent with long-term because besides helping entities manage costs and (typically) goals. A range of different approaches are being trialled: reducing volatility, it brings forward emissions reductions. It also allowance reserves are becoming a more common tool to creates a constituency with a vested interest in the success contain costs and manage prices while limiting emissions; of the ETS and in one with more stringent caps, as this will and introducing a price floor at auction can help secure increase the value of their banked allowances. Borrowing also the value of mitigation investments by ETS participants and has advantages but creates risks; in particular regulators may offsets providers. find it difficult to monitor the creditworthiness of the borrowers. 10 EMISSIONS TR ADING IN PR ACTICE STEP 7: Ensure compliance and systems where relevant when establishing ETS compliance oversight and oversight. Making emissions data transparent strength- ens market oversight, but data management systems must ✓✓ Identify the regulated entities protect confidential and commercially sensitive information. ✓✓ Manage emissions reporting by regulated entities Underregulation of the trading market may allow for fraud ✓✓ Approve and manage the performance of verifiers and manipulation, while overregulation may increase ✓✓ Establish and oversee the ETS registry compliance costs, and eliminate many of the flexibilities ✓✓ Design and implement the penalty and enforcement that give carbon markets their efficiency. In some systems, approach the reputational implications of noncompliance, especially ✓✓ Regulate and oversee the market for ETS emissions when reinforced by public disclosure of ETS performance, units have proven to be a strong deterrent, but a binding system of penalties is still needed. When problems with compliance Like other climate policies, an ETS needs a rigorous approach arise, the ETS regulator and the government should respond to enforcement of participants’ obligations and to government quickly to safeguard the integrity and liquidity of the market and maintain the trust and confidence of market participants. oversight of the system. Lacking compliance and oversight can threaten not just emissions outcomes by noncompliant entities, but also the basic functionality of the market, with high economic stakes for all participants. STEP 8: Engage stakeholders, It can be useful to start implementing effective systems for communicate, and build capacities MRV of GHG emissions early in the process of ETS develop- ✓✓ Map stakeholders and respective positions, interests, ment to support later compliance assessment. This includes and concerns legal and administrative considerations around identification of ✓✓ Coordinate across departments for a transparent regulated entities and development of detailed methodologies decision-making process and to avoid policy and guidance for emissions monitoring. An initial stand-alone misalignment period of MRV or a pilot phase can enable capacity building ✓✓ Design an engagement strategy for consultation of before implementing a full-scale ETS. Emissions reporting can stakeholder groups specifying format, timeline, and use existing data collection activities for energy production, objectives fuel characteristics, energy use, industrial output, and trans- ✓✓ Design a communication strategy that resonates with port. Depending on the strength of existing auditing systems, local and immediate public concerns government regulators may need to play a stronger role in ✓✓ Identify and address ETS capacity-building needs verification during the initial phase while third-party verifiers are building their own capacities to fulfill new functions. The Developing a successful ETS requires both enduring public and approach to ETS compliance and oversight needs to balance political support and practical collaboration across government the costs to regulators and regulated entities against the and market players based on shared understanding, trust, and potential risks and consequences of noncompliance. The capability. The manner and, in particular, the transparency with existing regulatory culture will influence the optimal balance which ETS policy makers engage with others in government for each jurisdiction. Regulators can draw on experience and external stakeholders will determine the long-term viability with other markets dealing in commodities and financial of the system. Where possible, engagement should start at instruments. the beginning of ETS planning and continue throughout the process of design, authorization, and implementation. LESSONS LEARNED: A robust compliance regime is the backbone of the ETS and a precondition for its credibility. In relation to both external stakeholders and other branches of The government may need to actively identify new regulated government, communication about an ETS needs to be clear, entities, as firms are established and change over time. It can consistent, and coordinated, and the government has to main- be costly to monitor emissions with high levels of accuracy tain integrity and credibility throughout the process. Major and precision; lower-cost approaches such as using default changes to the system should be announced well in advance, emissions factors can provide unbiased estimates for predict- and the government should consider carefully how to manage able sources of emissions. Regulators should take advantage commercially sensitive information. of existing local environmental, tax, legal, and market SYNTHESIS – EMISSIONS TR ADING: BRINGING IT ALL TOGETHER 11 Developing an ETS also requires strategic capacity building. STEP 9: Consider linking Government decision makers and administrators need to build SYNTHESIS the specialized technical expertise and administrative capacity ✓✓ Determine linking objectives and strategy to develop and operate an ETS. ETS participants and market ✓✓ Identify linkage partners service providers hold specialized operational knowledge that ✓✓ Determine the type of link can help policy makers design an effective system, but they ✓✓ Align key program design features also need to build sufficient capacity to participate in the ✓✓ Form and govern the link system. Investing time and resources in capacity building will generate valuable returns. Linking occurs when an ETS allows regulated entities to use units (allowances or credits) issued under another jurisdiction’s LESSONS LEARNED: Government decision making on an system as valid currency for compliance, with or without restric- ETS can be facilitated by strong executive and ministerial tions. Linking broadens flexibility as to where emissions reduc- leadership, the clear allocation of responsibilities across tions can occur, and so takes advantage of a broader array departments, and the designation of interdepartmental of abatement opportunities, thereby lowering the aggregate working groups. Governments typically underestimate the costs of meeting emissions targets. It can also improve market strategic importance of meaningful stakeholder engagement liquidity, help address leakage and competitiveness concerns, and public communications in securing enduring support for and facilitate international cooperation on climate policy. an ETS. Some jurisdictions have found that it took 5-10 years of engagement and capacity building on climate change mar- Linking can also incur risks. It reduces jurisdictions’ control ket mechanisms to enable informed and broadly accepted over domestic prices and mitigation effort (including the policy making on an ETS. Tapping stakeholder expertise will potential loss of local co-benefits) and limits their autonomy improve ETS design and help gain trust, understanding, and over ETS design features. It also holds the potential for finan- acceptance. Cultivating ETS champions can help broaden cial transfers out of the jurisdiction. support for an ETS. How the government communicates the “story” of the ETS in the local context will be vital to gaining While full linkage may bring greater economic benefits, popular support. Because the process of decision making on restricted linking (typically allowing only a certain percentage ETS design can carry over across election or other political or amount of foreign units to be used for compliance, or cycles, it is important to consider from the outset the likely restricting trades to only one direction) may be easier to timing and impact of political changes and the potential to design and control, and may help address some of the secure enduring broad political support for an ETS or a clear potential disadvantages associated with linking. Another form public mandate for action. of restricted linking would be to assign different values to units deriving from different systems. This could reward more advanced systems, and provide less advanced systems with an “on-ramp” toward more fully participating in a linked system. LESSONS LEARNED:Although current experience with linking remains limited, it is clear that linking typically requires clear agreement on acceptable levels of ambition in each jurisdic- tion, and the ability to negotiate changes in ambition over time. In successful links to date, partners have generally had strong existing relationships, which facilitated the initial nego- tiation and governance of links. Key design features need to be harmonized to ensure environmental integrity and price stability when linking; additional design features may need to be harmonized for political reasons. This harmonization will take time and may be phased in. Poorly managed links can have unintended consequences. Jurisdictions should prepare early for linking, but link strategically and only when suitable. Some small systems, such as Québec’s, were designed from the outset to link to other markets or join another ETS. 12 EMISSIONS TR ADING IN PR ACTICE STEP 10: Implement, evaluate, and APPLYING THE 10 STEPS improve OF ETS DESIGN IN ✓✓ Decide on the timing and process of ETS implementation PRACTICE ✓✓ Decide on the process and scope for reviews ✓✓ Evaluate the ETS to support review The 10 steps of ETS design proposed in the handbook are interdependent, and the choices made at each step will have important repercussions for the appropriate decisions during Moving from design to operation of an ETS requires government other steps. As noted at the start of this chapter, in practice, regulators and market participants to assume new roles and the process of ETS design will be iterative rather than linear. responsibilities, embed new systems and institutions, and launch Figure S.2 illustrates key design interactions across the steps. a functional trading market. Gradual introduction of an ETS can help if existing institutions are weak and confidence in use of The point of entry to the process of ETS design is laying the ETS is low; it allows “learning by doing.” Key options are launch- groundwork by setting ETS objectives and beginning engage- ing an ETS pilot and phasing of sector coverage, ambition, and ment, communications, and capacity building with government the degree of government intervention in the market. and external stakeholders. Circumstances will change and experience will generate learn- Across the remaining steps, a series of initial high-level decisions ing about the ETS. Key drivers of allowance allocation, such serve as “keystones” of ETS design, defining its fundamental as equity considerations, potential for leakage, and concerns shape and direction. These can be broadly grouped as follows: about poor market function, will evolve. Regular reviews of ETS ▲▲ A first set of decisions about which sectors to cover performance supported by rigorous, independent evaluation (Step 1), where to place the points of regulation for will enable continuous improvement and adaptation. But covered sectors (Step 1), and whether the system may change should not be an end in itself, and where it becomes link with others in the near or longer term, and the system necessary, it should always be balanced against the benefits of design features that facilitate this (Step 9); policy stability. ▲▲ A second set of decisions concerns the form and ambition LESSONS LEARNED: Every ETS has required an extensive of the cap, both initially and over time (Step 2), and its preparatory phase to collect data and develop technical relationship to other sources of unit supply (Steps 4 and 9); regulations, guidelines, and institutions. Relying on existing ▲▲ In turn, these two sets of decisions influence the devel- institutions where possible can control costs. ETS pilots can opment of the allocation plan (Step 3) and mechanisms generate valuable learning, but they also risk leaving a legacy supporting market stability—price predictability, cost of negative public perceptions if they encounter difficulties, containment, and market management (Step 6); and and not all lessons may be applicable once the ETS is fully launched. Phasing in an ETS can ease the burden on institu- ▲▲ A final important keystone decision is whether to start with tions and sectors without obvious adverse effects. Providing a pilot, or plan for direct implementation, potentially with a predictable review process and schedule can reduce policy phased introduction of sectors or certain design features uncertainty, a major barrier to low-emissions investment, over time (Step 10). but additional unanticipated changes may be unavoidable. Detailed decisions and actions across all 10 steps can then be Evaluating an ETS as input for a review can be challenging; considered iteratively in the context of these keystone decisions. data are often limited and external drivers of economic activity and emissions make it hard to discern the effects of the ETS from that of other policies or macroeconomic devel- opments. Evaluation processes can be enhanced by starting data collection before commencement of the system, making entities’ data public where possible, and encouraging external evaluations. Good governance and stakeholder engagement processes are key to successful implementation. SYNTHESIS – EMISSIONS TR ADING: BRINGING IT ALL TOGETHER 13 FIGURE S.2 ETS Design Interdependencies SYNTHESIS STEP 8: Engage stakeholders, communicate, and build capacity STEP 1: Offset mechanism can STEP 4: Decide engage uncovered sectors Consider the use the scope in mitigation activity of offsets Lay the gorundwork: Define the ETS Objectives Offset supply is one lever for STEP 10: Implement, evaluate, and improve The cap is adjusted Offsets provide as scope changes managing market stability additional unit supply Offset rules must be harmonized across linked ETS STEP 6: ETS participants hold allowances; these STEP 2: Market stability Address price measures can operate determine how emission Set the cap inside or outside the cap predictability and reduction costs are cost containment distributed across the economy Linking impacts unit supply and The cap constrains joint cap ambition Banking and allocation Banking and borrowing Market stability measures borrowing support provide temporal flexibility may need to be harmonized market stability within the cap across linked ETS Allowances can be Linking affects STEP 3: STEP 5: banked and/or incentives for STEP 9: Distribute borrowed across Decide on banking and Consider linking allowances periods temporal flexibility borrowing STEP 7: Ensure compliance and oversight SHAPING THE FUTURE OF ETS DESIGN The fundamental concept of emissions trading is as simple ▲▲ Adapt the ETS to changing circumstances; and as it is powerful. While a large number of decisions have to ▲▲ Bring people with you. be made to set up an effective ETS, the practical experience gained over the first decade of GHG emissions trading can be The next decade of emissions trading experience lies in the distilled into five basic guidelines for effective ETS design: hands of the decision makers, policy practitioners, and stake- holders who rise to the challenge of developing an ETS in their ▲▲ Be informed globally, but design locally; specific geographic and socioeconomic context. In doing so, ▲▲ Build a strong foundation of data and institutions; learning from existing systems and finding creative new design ▲▲ Learn by doing and provide predictable processes for solutions that can be shared globally will be key to improving adjustment; the effectiveness of carbon pricing as a driver of low-emissions development. 14 EMISSIONS TR ADING IN PR ACTICE This page intentionally left blank. BEFORE YOU BEGIN 15 BEFORE YOU BEGIN BEFORE YOU BEGIN Understanding Emissions Trading________________________________________________________ 16 Why emissions trading?____________________________________________________________ 16 How does an ETS work?___________________________________________________________ 16 ETS design in 10 steps_____________________________________________________________ 16 Extensive experience with emissions trading__________________________________________ 17 Determining Objectives for the ETS______________________________________________________ 18 Reducing GHG emissions at low cost_________________________________________________ 18 Driving economic transformation and sustainable development_________________________ 19 Reducing air pollution, improving health, and providing other co-benefits_________________ 20 Raising revenue___________________________________________________________________ 20 Keys to Effective ETS Design____________________________________________________________ 21 Considering Interactions between an ETS and Other Policies_________________________________ 22 Positioning the ETS relative to other policies__________________________________________ 22 Understanding policy interactions that will affect the outcomes achieved by the ETS_______ 22 Understanding how the ETS may influence the attainment of other policy objectives_______ 23 Understanding where complementary policies might be needed_________________________ 24 Maintaining policy alignment over time______________________________________________ 25 Emissions Trading and Economics: A Primer_______________________________________________ 25 Increasing marginal abatement cost curves___________________________________________ 25 A two-company example___________________________________________________________ 25 Regulating prices versus quantities__________________________________________________ 26 Quick Quiz____________________________________________________________________________ 28 16 EMISSIONS TR ADING IN PR ACTICE Emissions Trading Systems (ETSs) are being implemented in The regulated participants in an ETS are typically required various forms to limit and cost-effectively reduce GHG emis- to surrender one allowance for every tonne of emissions for sions around the world—from California and Québec to China, which they are accountable. Participants that hold allowances from Kazakhstan to the Republic of Korea, from New York to can sell them, or bank them for future use; entities that New Zealand, and in the European Union (EU). These experi- require additional allowances may buy them on the market. ences build on the flexibility mechanisms of the Kyoto Protocol They may also be able to use eligible emissions units from and on a longer track record in using similar instruments for other sources, such as domestic or international offsets mech- reducing other pollutants, such as in the United States for anisms or other ETSs. sulfur dioxide and nitrous oxides in the 1990s.9 The cap on allowances and establishment of a market to trade The goal of this handbook is to draw on these experiences to them generate a uniform price on allowances (the “carbon assist with the design, implementation, and operation of an price”). This provides an incentive to reduce emissions, as long effective and credible ETS. as the cost of reducing emissions is lower than this price. The result is a price signal that favors lower-emission goods and services. A more stringent cap means less allowance supply, higher prices, and a stronger incentive to reduce emissions. UNDERSTANDING Setting the cap in advance provides a long-term market signal EMISSIONS TRADING so participants can plan and invest accordingly. Allowances can be allocated for free—based on some com- Why emissions trading? bination of historical emissions, output, and/or performance The attractiveness of an ETS is powerful: it limits total emissions standards—or auctioned. The latter generates revenue for the while enabling emissions reductions to be realized at the lowest government, which can pay for cuts in distortionary taxes, possible cost.10 In this way, it can channel entrepreneurial support spending on public programs (including other forms of activities and help move economies toward a low-carbon, climate action), or be returned to affected stakeholders directly. high-efficiency future. Emissions trading is ideally suited for Additional mechanisms can be used to support price predict- pollutants such as GHGs that are pervasive and where the ability, cost containment, and effective market operation. timing and point of emissions does not significantly affect the primary environmental impact of concern, climate change. The environmental integrity of the system is ensured through requirements for emissions MRV, and the enforcement of penalties for noncompliance. All of these are facilitated by How does an ETS work? 11 registries that are responsible for issuing allowances, tracking Under an ETS, the government imposes a limit (cap) on the them as they are traded between different participants, and total emissions in one or more sectors of the economy, and canceling them when they are used for compliance or social issues a number of tradable allowances not exceeding the responsibility purposes. Market oversight provisions safeguard level of the cap.12 Each allowance typically corresponds to one the integrity of trading activity. tonne of emissions.13 Different jurisdictions can choose to link their ETS directly 9 The three “flexibility mechanisms” of the Kyoto Protocol are Joint Implementation or indirectly through mutual recognition of allowances and (JI, Article 6), the Clean Development Mechanism (CDM, Article 12), and international emissions trading (Article 17). other emissions reduction units. Linking broadens access to 10 Hardin (1968) discusses the overall implications of open-access resources. For the least-cost mitigation, supports market liquidity, increases price specifics around assigning property rights, see Coase (1960). Glaeser et al. (2001) interpret the implications and limitations, including the crucial importance of predictability, and enables political cooperation on carbon transaction costs, something Coase himself identified years earlier (Coase, 1937). pricing.14 Among practical policy instruments, emissions trading is the one that most directly implements a Coasian solution. Medema (2014) has a more recent survey of the early reception of Coase’s insights. 11 For more on the economic logic behind the workings of emissions trading, see ETS design in 10 steps section 5 on “Emissions Trading and Economics: A Primer,” at the end of this chapter. This handbook sets out a 10-step process for designing an 12 Alberta’s Specified Gas Emitters Regulation (SGER) sets a facility-level emissions intensity target (as opposed to an absolute cap). ETS (see Box 0.1). Each step involves a series of decisions or 13 Allowances can be issued in units of tonnes (= U.S. metric tons) of carbon dioxide, actions that will shape major features of the system. However, or tonnes of carbon dioxide equivalent. The latter includes carbon dioxide as well as other GHGs (e.g., methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons, sulphur hexafluoride, and nitrogen trifluoride) on the basis of their relative global 14 The International Carbon Action Partnership (ICAP) has developed a series of ETS warming potential. It is also possible that an allowance corresponds to a different briefs that provide a basic introduction to emissions trading and its benefits. These weight of GHGs, as in RGGI, where an allowance corresponds to a short ton. briefs are available at: https://icapcarbonaction.com/en/icap-ets-briefs. BEFORE YOU BEGIN 17 BOX 0.1 Designing, Implementing, and Operating TABLE 0.1 GHG ETS Milestones an ETS in 10 Steps 1997 Kyoto Protocol signed Step 1: Decide the scope Emissions Reduction Market System (Chicago area) Step 2: Set the cap New South Wales (NSW) Voluntary ETS BEFORE YOU BEGIN Step 3: Distribute allowances 2002 United Kingdom ETS (voluntary) Tokyo ETS (voluntary) (Japan)  onsider the use of offsets Step 4: C 2003 Chicago Climate Exchange (voluntary) (United States)  ecide on temporal flexibility Step 5: D NSW Greenhouse Gas Reduction Scheme (GGAS) (Australia) Address price predictability and cost containment Step 6:  2005 Kyoto Protocol comes into force Step 7: E  nsure compliance and oversight European Union ETS (EU ETS) Step 8: E  ngage stakeholders, communicate, and build Norway ETS capacities Japan Voluntary ETS 2007 Norway, Iceland, and Liechtenstein join EU ETS Step 9: Consider linking Alberta‘s Specified Gas Emitters Regulation (SGER) (facility-level mplement, evaluate, and improve Step 10: I emissions intensity target) 2008 Switzerland ETS New Zealand ETS as stressed throughout the handbook, the decisions and Japan Experimental ETS actions taken at each step are likely to be interlinked and inter- 2009 Regional Greenhouse Gas Initiative (RGGI) (Northeast and Mid- dependent, which means that the process for working through Atlantic U.S. states) these steps will not necessarily be linear. 2010 Tokyo Metropolitan Government ETS (Japan) 2011 Saitama ETS (Japan) Extensive experience with emissions 2012 Australia ETS 2013 Kazakhstan ETS trading California ETS (United States) Emissions trading for GHGs originated in attempts to control Québec ETS (Canada) local air pollutants from power plants in the United States China ETS pilots (cities of Beijing, Guangdong, Shanghai, Shenzhen, in the 1970s.15 It was implemented in earnest during the Tianjin) phasedown of leaded gasoline in the country during the 2014 China ETS pilots (provinces of Hubei and Chongqing) 1980s, leading to an eventual phaseout.16 The U.S. Clean Air 2015 Republic of Korea ETS Act Amendments of 1990 established the first large-scale Paris Agreement adopted trading program with an absolute limit on emissions of sulfur dioxide emitted by power plants.17 Soon thereafter, the focus shifted toward climate, and some countries began experience with internal ETSs.18 GHG trading has spread since experimenting with GHG emissions trading. The 1997 Kyoto then, and jurisdictions have used a variety of designs and Protocol established provisions ffor the trading of emissions/ approaches (see Table 0.1). As of 2015, jurisdictions with an emissions reductions among its parties. In 2005, the EU and ETS in operation made up 40 percent of GDP (see Figure 0.1). Norway established domestic ETSs and Japan instituted a The Paris Agreement of December 2015 affirms the role of voluntary trading program as a means to help implement their voluntary mitigation cooperation between countries, together Kyoto commitments. Some large companies have also gained with provisions to ensure its environmental integrity, and sends an important signal that is likely to accelerate establishment and linkage of ETS (see Box 0.2). 18 Company-level trading systems have helped ease the transition to country-level systems. As of September 2014, 150 companies disclosed that they have an internal 15 Cap-and-trade was first introduced by Dales (1968). For a history of emissions carbon price. BP’s system, which lasted from 1999 until 2002, when the U.K. trading trading in the United States, including these early years, see, for example, Ellerman et system went into effect, was the first system of its kind and covered all BP opera- al. (2003). tions across the globe (Akhurst et al., 2003; Victor and House, 2006). In two years, 16 For more on the phasedown of leaded gasoline, see Kerr and Maré (1998), Kerr and the system cut GHG emissions by 10 percent. A similar system was implemented by Newell (2003), and Newell and Rogers (2003). Royal Dutch Shell between 2000 and 2002, covering 22 sites, accounting for around 17 Schmalensee and Stavins (2013) give a good history. one-third of its emissions. 18 EMISSIONS TR ADING IN PR ACTICE Important lessons can also be drawn from detailed policy BOX 0.2 TECHNICAL NOTE: What the Paris proposals that were developed but not implemented (as in the Agreement Means for Markets a case of the U.S. federal-level proposals), or implemented and The Paris Agreement, adopted by 195 nations in December then repealed (Australia). 2015 under the auspices of the United Nations Framework Convention on Climate Change (UNFCCC), recognizes the role of carbon markets through its provisions on trans- ferring mitigation outcomes among Parties. The Article stipulates that Parties to the Agreement can voluntarily DETERMINING OBJECTIVES transfer mitigation outcomes toward the achievement of FOR THE ETS their nationally determined contributions (NDC) in order to “allow higher ambition … and to promote sustainable An important first step in designing an ETS is to identify the development and environmental integrity” (Article 6.1). policy objectives. An ETS is a policy tool and it can be designed Specifically, such “cooperative approaches” may include:b to support a range of policy objectives—environmental, 1. Transfer “internationally transferred mitigation out- economic, and social—in addition to the primary objective comes” (ITMO), under Articles 6.2 and 6.3, resulting from of limiting GHG emissions. Before proceeding to ETS design, countries’ domestic mitigation actions. each jurisdiction may wish to consider how much the 2. Transfer mitigation outcomes generated through a system should contribute to the emissions reductions that it mechanism that operates under the authority of the wants to achieve, the rate at which to decarbonize its own Conference of the Parties (COP) and “contribute(s) to economy, what level of cost is acceptable, how the system the mitigation of greenhouse gas emissions and support will interact with other policies, how to distribute costs and sustainable development,” under Article 6.4. This new benefits, whether revenue will be generated and how it will mechanism (which some have called “Sustainable be used, and how the ETS and its co-benefits will contribute Development Mechanism” (SDM)) must “deliver an overall mitigation in global emissions,” and a share of to economic transformation and sustainable development. It proceeds from this mechanism will be used to assist will be easier to come to a decision on the adoption of an ETS, developing countries in adapting to the impacts of and determine the specifics of ETS design and implementation, climate change. once there is broad acceptance of the jurisdiction’s need For both types of approaches, clear provisions to avoid to reduce GHG emissions—at least below business as usual “double counting” are specified, which is a foundational (BAU)—in the long term. requirement to ensure the environmental integrity of carbon markets. The Agreement also highlights the role Some of the objectives frequently stated for adoption of an that tropical forests play in stabilizing climate (Article 5), ETS are described in more detail below. and is thus likely to thus help boost programs reducing emissions from deforestation and forest degradation, including potentially through market approaches. Reducing GHG emissions at low cost Under the decision accompanying the Agreement, “the In international negotiations, most recently through the Paris important role for providing incentives for emissions Agreement, countries have agreed on the need to reduce reduction activities, including tools such as domestic global GHG emissions to limit temperature rises and avoid policies and carbon pricing” was explicitly recognized the worst impacts of climate change. This is recognized as an (paragraph 137). Parties also agreed to develop guidance integral part of global sustainable development. Governments to ensure the avoidance of double counting (paragraph at all levels have set targets for reducing their GHG emissions 37) as well as the rules, modalities, and procedures for the over time, either on an absolute or intensity basis. SDM (paragraphs 38–39). In the meantime, jurisdictions are likely to continue work In this context, carbon pricing can play a key role. In particular, on domestic emissions trading, thereby generating knowl- both theory and empirical studies suggest that carbon pricing edge, standards, and practical experience which will be is one of the most cost-effective tools for reducing emissions, critical to the development of guidance under the UNFCCC. especially in the short to medium-term.19 In turn, these lower This may in turn facilitate future linkages and international costs open up the opportunity to take more ambitious action. trading. a For an in-depth analysis of carbon market provisions in the Paris Agreement see Marcu (2016). b UNFCCC (2015b). 19 In order to avoid the risk of lock in of carbon intensive assets over the longer term, policy signals that are complementary to a carbon price will also be important. This is discussed further in the section on Complementary Policies below. BEFORE YOU BEGIN 19 FIGURE 0.1 Emissions Trading Around the World ETS in force ETS scheduled BEFORE YOU BEGIN ETS considered Russia Manitoba Ontario Québec Washington Kazakhstan Republic European Switzerland Ukraine Tianjin of Korea Union Beijing California Regional Greenhouse Gas Japan Turkey China Initiative (RGGI) Hubei Saitama Chongqing Tokyo Shanghai Mexico Taiwan Thailand Shenzhen Vietnam Guangdong Brazil Rio de Janiero São Paulo Chile New Zealand Source: ICAP 2016i. Driving economic transformation and practice. Policies will be needed that achieve this change in ways that reflect local circumstances, create new economic sustainable development opportunities, and support the wellbeing of citizens. To achieve a low-carbon economic transformation, action will be needed on four fronts: For many jurisdictions, carbon pricing is emerging as a key driver of this transformation.20 By aligning profits with low-emis- ▲▲ Decarbonizing the production of electricity; sion investment and innovation, a price on GHG emissions ▲▲ Massive electrification (to increase reliance on clean elec- can channel private capital flows, mobilize knowledge about tricity) and, where not possible, alternative measures such mitigation within firms, tap the creativity of entrepreneurs in as switching to cleaner fuels; developing low carbon products and innovations, and hence ▲▲ Improving efficiency and reducing waste in all sectors; and drive progress toward reducing emissions intensity (see Box 0.3). A carbon price makes clean energy more profitable, allows ▲▲ Preserving and increasing the number of natural carbon energy efficiency to earn a greater return, makes low-carbon sinks through improved management of forests and other products more competitive, and values the carbon stored in vegetation and soils. forests. Emissions fall without firms being told by government This will require a shift in investment patterns and behaviors, and innovation in technologies, infrastructure, financing, and 20 Dechezleprêtre et al. (2011) find that climate policies have taken a leading role in driving innovation in climate mitigation technologies, as measured by patents. Martin et al. (2011) find that firms are responding to climate policy in the EU by spending more internally on R&D, particularly as they receive fewer credits for free during allocation. 20 EMISSIONS TR ADING IN PR ACTICE BOX 0.3 TECHNICAL NOTE: Incentives for Reducing air pollution, improving Innovation health, and providing other Potential innovators do not take into account the social co-benefits benefit their innovations will achieve, leading to less High GHG emissions often go hand-in-hand with high levels of innovation activity than is socially optimal. Just as pricing other pollutants, as well as traffic congestion, loss of forests, carbon can effectively internalize the negative externality and other socially negative impacts. For example: and make emitters face the true cost of their actions, sub- sidizing innovation can internalize this positive externality. ▲▲ Improving local air quality has been among the most When governments support the R&D of low-carbon and important considerations in establishing an ETS in California energy efficiency technology, innovators face price signals and China alike. Emissions-intensive processes are associ- that better reflect the true social value of their ideas and ated with high levels of local pollutants and poor air quality, activities. Once the technology starts to be deployed, the notably due to coal-fired power plants and road transpor- subsidies can be lowered again. tation. One study estimates that a 50 percent reduction in This process is known as “Directed Technical Change.” GHG emissions by 2050 relative to 2005 levels could lead By providing additional incentives for new technologies, to a 20-40 percent reduction in premature deaths over the through policies external to the ETS, and reducing those same time period.22 incentives as the learning-by-doing spillover takes hold, governments can help stimulate innovation within the ▲▲ Preserving local environments can be similarly important, market to a much greater extent than under an ETS alone. in particular when forests and land-use change are either The key challenge with this approach is to try and limit the included in the ETS or linked via emissions reduction credits support given to technologies that ultimately prove to be (“offsets”). For example, avoiding carbon losses from socially unproductive. tropical forest destruction can help reduce flooding and Practice shows that in some circumstances, direct drought, contribute to the preservation of biodiversity and intervention over and above the incentive provided by other ecosystem services, and support the livelihoods of the ETS may well be justified. California’s Solar Initiative forest-dependent communities. alongside its comprehensive cap-and-trade program is one notable example of directed technical change.a German ▲▲ Other co-benefits include, among others, increased energy feed-in-tariffs have a similar effect, subsidizing large-scale security from a more diverse fuel mix, induced technological renewables deployment, alongside the European Union change, the creation of green jobs, and lower traffic conges- ETS.b tion and accidents from reduced use of passenger vehicles.23 a See Acemoglu et al. (2012), who show that optimal climate policy involves both a carbon price and research subsidies. See also van Benthem et al. (2008), who Raising revenue look specifically at the case of solar subsidies in California. b See Wagner et al. (2015) as an example of how renewables relate to climate The government can distribute allowances through free policy more broadly. allocation, auctioning, or a combination of the two. Auctioning generates government revenue, which can be used for a variety of purposes, including to fund climate action or to help low-income households. The exact allocation of funds will how to act. An increasing number of firms and investors are depend on political decisions and local circumstances, which advocating for carbon pricing policies from government, and are often outside the purview of ETS designers.24 some are applying an internal carbon price to guide investment in advance of government policy to that effect.21 22 Bollen et al. (2009) surveys the literature on co-benefits of climate change policies, mainly focusing on local air pollution. Their empirical analysis shows that a global reduction of 50 percent in GHG emissions in 2050, relative to 2005 levels, could reduce the number of premature deaths due to air pollution by 20–40 percent in 2050. Under this scenario the benefits in China were valued at 4.5 percent of GDP. Parry et al. (2014) finds that domestic environmental benefits exceed the CO2 21 Recent examples of engagement of private-public coalitions advocating carbon mitigation costs, even leaving aside climate benefits. pricing include: the statement “Putting a Price on Carbon” (June 2014) supported by 23 The IPCC Fourth Assessment Report (2007), section 4.5.3, provides a good discussion over 1,000 companies and investors along with national and subnational jurisdictions on the various co-benefits of climate change mitigations policies. See, for instance, (see World Bank, 2014); an open letter to governments and the United Nations from Jochem and Madlener (2003) for an in-depth analysis of the nonenvironmental six major oil companies (June 2015) calling for an international framework for carbon benefits of climate change policies, including innovation and employment. pricing systems (see UNFCCC, 2015a); and the launch of the Carbon Pricing Leader- 24 ARB (2015a) gives an overview of how auction proceeds are used in the California ship Coalition (November 2015), whose government and private-sector participants ETS. Goulder (2013) analyzes the interaction between climate change policies and are committed to building the evidence base for effective carbon pricing (see Carbon the tax system, concluding that, if well designed, climate policies can produce double Pricing Leadership Coalition, 2015). dividend—both reduce GHG emissions and lower the costs of the tax systems. BEFORE YOU BEGIN 21 Auctioning has typically been introduced on a small scale ▲▲ Policy flexibility. Given the long-term nature of the climate in the first instance but with the intention to let it gradually challenge and various economic and scientific uncertainties, displace free allocation over time. Using auction revenue there is a need to preserve policy flexibility and allow strategically can be a powerful selling point for proceeding decision-makers to adjust the overall target or the schedule with an ETS. for achieving the target and specific design features in BEFORE YOU BEGIN response to changing conditions. However, there will often be some tension between policy flexibility and ensuring predictability. KEYS TO EFFECTIVE ETS ▲▲ Accountability and transparency. Strong MRV, enforce- DESIGN ment principles and robust registry design ensure the accountability and transparency of the system. Design Once objectives have been determined, policymakers may decisions must also be made transparently to help build wish to decide a set of criteria consistent with those objectives trust in the system and allow market participants to plan against which to assess ETS design option. Policymakers will ahead. need to strike an appropriate balance between a range of cri- teria that will determine the ultimate success of any ETS. Some ▲▲ Administrative cost-effectiveness. Administrative costs of the commonly used criteria are discussed below.25 are most directly impacted by the scope of the system, the choice of point of obligation, the frequency with which ▲▲ Contribution to mitigation. Environmental effectiveness data needs to be reported and compliance proven, and the is perhaps the key criterion for assessing whether an ETS requirements for compliance and enforcement. is successful. This requires a sufficiently tight emissions constraint coupled with effective MRV to ensure that ▲▲ Appropriateness to local conditions. ETS design is driven reported emissions are accurate and the cap is being by local objectives and context. While a common set of enforced. Minimizing carbon leakage (the shifting of pro- building blocks can be used to construct an ETS, in order duction or investment to areas outside the cap resulting in for it to function effectively, the precise features of each an increase in global emissions) is another determinant of system must be tailored to the jurisdiction. This includes environmental effectiveness, as is ensuring the integrity of the pre-existing regulatory context; the size, growth rate emission units, such as offset credits entering the system and composition of the economy; the emissions and abate- from outside the cap. ment opportunity profile of the economy; the ambition of policymakers; and the capacity and strength of relevant ▲▲ Cost-effectiveness of mitigation. Economic efficiency and institutions. cost-effectiveness are at the core of ETS design. Emissions trading is intended to keep abatement costs low given a ▲▲ Compatibility with other jurisdictions. Consistent ETS particular emissions reduction goal. The greater the flexibil- design features across jurisdictions allow for a coordinated ity as to when and where emission reductions take place, climate policy architecture, most directly in the form of the higher the potential for low-cost emissions reductions. linking that allows emissions units from other systems as The effectiveness of an ETS in delivering least-cost abate- valid compliance instruments within an ETS. ment across covered sectors can also be influenced by how ▲▲ Fairness. Emissions trading is not possible without political well the ETS is integrated with other policies (e.g., energy) support. Ensuring fairness to all involved, especially in the affecting emissions in those sectors. distribution of costs and benefits, is at the core of gaining ▲▲ Predictability. The more predictable the system, the and maintaining that support, and hence giving stake- smoother will be its operation and the closer to socially holders confidence that the system will endure. optimal the investments and resulting emissions reductions will be. Deciding on, and effectively communicating, key design features early in the process, and providing clear processes and parameters for future changes, enhances predictability. 25 See section 5.2 in Government of Australia (2008b) for a similar set of assessment criteria used in Australia’s ETS design. For alternative criteria, see: California Market Advisory Committee (2007), U.S. EPA (2003), Goffman et al. (1998), and Weishaar (2014), among many others. 22 EMISSIONS TR ADING IN PR ACTICE CONSIDERING This requires clarity on both the emissions mitigation outcomes of an ETS and the use of potential revenues from an ETS. INTERACTIONS BETWEEN Jurisdictions have taken different approaches to positioning AN ETS AND OTHER their ETS relative to other policies. For example, the EU ETS POLICIES was introduced to help meet EU-wide mitigation targets cost-effectively by introducing a common carbon price The design and introduction of an ETS will invariably take place signal across member states for electricity generation and in a context in which there are an array of other climate and energy-intensive industries, leaving other sectors to targeted energy policies, as well as other public policies that will either policies at the EU- or member states-level. The overarching support or run counter to mitigation objectives. GHG emissions targets and the respective caps for the EU ETS are an integral part of a broader set of objectives determined When designing an ETS, it is important to conduct a system- at the EU level, which also include energy efficiency and atic assessment of potential policy interactions with a focus on renewable energy. The EU ETS is, however, also operated in five key areas: the framework of a complex array of member states climate ▲▲ Positioning the ETS relative to other policies; and energy policies, based on national priorities and traditions. ▲▲ Understanding policy interactions that will affect the While the targets are set at the EU level, member states have outcomes achieved by the ETS; a clearly defined competence to formulate their own energy mix, ensure security of supply, and determine how they will ▲▲ Understanding how the ETS may influence the attainment achieve these targets. of other policy objectives; ▲▲ Understanding where new complementary policies may be In the case of California, the ETS was adopted within a needed; and broad climate change policy portfolio, alongside an array of sector-specific regulations and programs. The ETS price signal ▲▲ Maintaining policy alignment over time. was expected to have its primary impact on those parts of the Each of these five issues is explored in more detail below. economy that could not be reached by targeted regulation, while serving as a backstop ensuring that emissions targets To support an assessment of this sort, policy mapping tools would still be met if the other measures proved less effective and approaches can be helpful. While the most obvious than hoped (see Step 2 for further discussion of California’s policies to include in such a mapping exercise are other policies positioning of its ETS). focused on climate change mitigation or energy (see Box 0.4) it may also be helpful to include policies relating to environ- By contrast, New Zealand selected an ETS as its primary mental issues, market regulation, finance sector regulation, mitigation instrument, emphasizing that its ETS offered an equi- tax, trade, foreign policy, research and innovation, economic table approach by covering all sectors and gases over time, and development, social welfare, and education. 26,27 enabled linkages to international markets, which would support meeting its international commitments at least cost. Positioning the ETS relative to other policies Understanding policy interactions that will affect the outcomes achieved by It is important to (i) clarify how the ETS will contribute to achieving the climate policy objectives of the jurisdiction, rel- the ETS ative to other current or planned policies, and (ii) position the Other policies can also affect the mitigation ambition, carbon ETS strategically within the broader policy portfolio. Doing so price, and distributional effects of an ETS. can help build public support for the system and is of crucial In some cases, the impacts of other policies on an ETS may importance in navigating through different ETS design options. be negative or duplicative, particularly if they are not reflected appropriately in the design of the cap of the ETS or other provisions. Avoiding undesirable repercussions is most likely 26 For a summary on these major alternative policy instruments, see Chapters 3.8 and 15 in IPCC (2014) and Sterner and Corria (2012). See also PMR (2015a), p. 22 for a to be a challenge in relation to energy-sector policies and similar breakdown of policy instruments for reducing emissions. regulations, especially those addressing energy efficiency, low- 27 Hood (2013) provides a comprehensive list of questions to assist in mapping the po- tential interactions between carbon pricing and existing energy policies while OECD carbon energy, and technology innovation. If these policies (2015) provides a comprehensive overview on low-carbon policy alignment. BEFORE YOU BEGIN 23 lead to emission reductions in ETS sectors at costs BOX 0.4 TECHNICAL NOTE: Other Climate Policy above the ETS price, then this allows emissions from Instruments other sectors under the cap to rise: the ETS will not Taxes set a price on carbon emitted, without a firm emissions limit. deliver short-term, least-cost mitigation. Alternatively, Taxes, along with emissions trading (together called “market-based if an ETS forces greater emission reductions than BEFORE YOU BEGIN approaches”), are widely regarded as the most cost-effective would happen under co-existing policies, the latter policies to reduce emissions (see “Regulating prices versus quanti- will be rendered redundant, at least from the point of ties,” section 5, for a discussion of the similarities and differences view of cost-effective mitigation, at an administrative between and ETS and carbon taxes). cost to both the government and regulated entities. Standards and other “command and control” regulation typically set uniform rules that new and/or existing emitting facilities However, a significant part of these effects can often must follow, in regard to levels/rates of GHG emissions and/or be avoided or justified if: co-pollutants, technologies used in production, energy efficiency, or the end product itself. Standards for renewable energy or renewable ▲▲ Policy interactions are analyzed carefully and the fuels production and energy efficiency are especially relevant for outcome of complementary policies are reflected GHG emissions, as well as building codes and land use zoning and in the different design features of the ETS (cap regulations. Depending on how standards are set, they can be setting, price stabilization mechanisms, etc.) so complemented by market mechanisms that enable obligations to be that the different policies support each other as met in a more flexible way (e.g., U.S. Renewable Portfolio Standards much as possible; and for renewable electricity generation with tradable credits across systems or India’s Perform, Achieve, and Trade (PAT) system for ▲▲ The goals of complementary policies beyond energy efficiency). Such combinations of standards and flexibility short-term emission mitigation are clearly defined. mechanisms have similarities to an ETS, except that the quantitative These might include longer-term objectives that target is based on a different measure (e.g., renewable energy as a go beyond the time horizon of the foresight of an percentage of energy production or consumption) rather than on ETS such as technology innovation, encouraging emissions themselves. deployment of particular mitigation options to Government provision of public goods and services includes funding lower their long-term costs, or other strategic research, strategic infrastructure, public transportation services, objectives such as improved air quality or the conservation of state-owned resources, and any other government security of energy supply. action with the intent and result of reducing emissions. Subsidies, tax rebates, concessionary finance, or risk guarantees Other policies can also positively reinforce the can be used to encourage renewable energy production, energy impact of an ETS price signal. To the extent that efficiency, or other investments that will allow emissions reductions. non-ETS policies provide greater policy certainty to They may also correct for market failures in the research, develop- participants about the transition to a low-emission ment, and deployment process by supporting new technologies. economy, facilitate the pass-through of carbon prices However, giving subsidies to entities within high-emitting industries can perversely increase their output.a across the supply chain to change behavior, put in place enabling infrastructure, reduce disproportionate Information and education programs include raising awareness or regressive impacts of carbon pricing, remedy about the emissions impacts of decisions and about mitigation opportunities, and increasing the salience of price signals. principal-agent problems, or reduce other non-price Environmental certification or labeling programs, for example, help barriers to mitigation, they can enhance the positive consumers make more informed decisions. impact of an ETS.28 Voluntary measures refer to any agreement by private parties to achieve environmental goals above and beyond what is regulated. Examples might include companies focusing on achieving carbon Understanding how the ETS neutrality or other sustainability goals across their own supply may influence the attainment of chains and procurement practices. Policy measures may be other policy objectives designed to encourage just such steps. Aside from considering the impact of other policies a For example, Tsao et al. (2011) study renewable portfolio standards, concluding that on the effectiveness of an ETS, it can also be helpful increasing their level not only would not reduce emissions reduction, but could also benefit to consider how the implementation of an ETS might coal and oil, and make natural gas units worse off. Levinson (2011) discusses the interac- tions of different traditional regulations with an ETS and suggests that the administrative costs involved in traditional regulations would damage the cost effectiveness of the latter 28 For further discussion on developing an effective package of carbon (see Fischer and Preonas (2010), who draw a similar conclusion). pricing and complementary policies, refer to Matthes (2010), Hood (2013), and Schmalensee and Stavins (2015). 24 EMISSIONS TR ADING IN PR ACTICE affect other policies. For example, an ETS that prices emissions accommodate distributed generation from solar panels from the forestry sector might also provide co-benefits from or building developers may not be able to recover cost greater biodiversity, by creating a further financial incentive savings from energy efficiency investments that would for landowners to enter into long-term forest protection provide benefits to future tenants.30 The introduction of covenants. complementary policies such as energy efficiency stan- dards can reduce these regulatory or market barriers that Other considerations relate to economic or social develop- would otherwise discourage the use of low-cost mitigation ment. The combination of higher energy prices and increased options from covered sectors. incentives for efficiency and innovation could have both ▲▲ In the longer term, complementary measures can pave the positive and negative impacts on a government’s objectives way for additional emissions reductions, even if applied to for economic growth, fairness and distribution of welfare, sectors (fully) covered by the ETS. While an ETS provides international competitiveness, or technological development a price signal that at least partly addresses the externality and industrial policy. On the one hand, the promotion of associated with GHG emissions, it does not address another energy efficiency facilitated by an ETS may support policy positive externality: the spillover from low-carbon innova- objectives related to energy security. On the other hand, the tion, in the form of increased knowledge and other societal potentially regressive impacts of carbon pricing on low-income benefits. This may well provide a justification for additional households and small- and medium-sized enterprises could run policy action to create incentives for private investment in counter to other policies supporting their advancement. R&D for clean energy and other abatement technologies. Finally, the revenues raised from any allowance auctions can The advantages and disadvantages of considering complemen- be used to promote other policy objectives by, for example, tary measures are summarized in Table 0.2. reducing distortionary taxes or providing funds to identified policies and programs in line with policy objectives. TABLE 0.2 Advantages and Disadvantages of Understanding where complementary Complementary Measures policies might be needed + Advantages - Disadvantages Besides considering the interactions, in both directions, Can help to overcome high + Typically less cost-effective to - transactions costs and achieve short term targets than between an ETS and existing policies, the introduction of an other barriers to adopting ETSa ETS may also prompt policymakers to consider what comple- energy efficiency and other Can reduce price under the - low-emissions technologies mentary policies may be needed to increase the effectiveness ETS and, thus, lead to weaker Possible additional GHG emis- + emissions reductions signals in Covered sectors of the ETS or meet related policy objectives, as discussed in sions reductions in the long-run other sectors under the cap if the Table 0.2. New additional policies may be considered for a due to targeted technological cap is not adjusted to account innovation, enabling stricter for this number of reasons: future ETS caps ▲▲ As a broad price instrument, an ETS cannot necessarily be Easier to target where emissions + occur and, thus, decrease used to guarantee specific strategic outcomes in covered hotspots of local (air) pollutants sectors. The government may thus wish to consider and provide other local co-benefits whether additional policies are desired to influence where, No additional aggregate carbon mitigation benefits in the ± how, or when specific types of mitigation investments, short run for the same level of the cap technology changes, or structural reform occur. If these Emissions reductions in + Typically less cost-effective than - Uncovered sectors policies are applied in uncovered sectors they can help sectors or sources not otherwise including sectors or sources included in the ETS under the cap increase emissions reductions and also reduce leakage Lower potential leakage from + from the covered sectors. covered sectors ▲▲ In addition, even for sectors covered by an ETS, various a Over the medium to long term a policy mix is likely required to achieve cost- market and regulatory barriers can prevent the diffusion of effective net zero emissions targets. cost-effective technologies and practices.29 For example, electricity grid management regulations may not easily 29 Fischer and Newell (2008), and Lehmann and Gawel (2013), for example, suggest that policies to support renewables development and deployment would be good complements to ETS. 30 See Jaffe and Stavins (1994), Scott (1997), and Schleich and Gruber (2008). BEFORE YOU BEGIN 25 Maintaining policy alignment over The same logic applies to companies and economies: the first unit of emissions reductions a company might pursue can be time undertaken cheaply but as more ambitious emission reduc- In addition to seeking policy alignment at the time at which tions are sought, the cost per unit of emission reduction rises. an ETS is introduced, policymakers will need to ensure that Moreover, different companies will at different points in time BEFORE YOU BEGIN policies remain aligned over time. As part of a broader process face different marginal abatement costs; for some companies, for establishing and maintaining policy alignment, Hood (2013) reducing emissions will be cheaper than for others. recommends that policymakers initiate regular energy policy and carbon pricing policy reviews, and establish institutional setups that facilitate policy coordination, especially between A two-company example climate and energy policymakers. Next we look at the simplest example: two companies in the same industry, producing the same products that might be called High-Cost Corp. and Low-Cost Inc. High-Cost Corp. does not have many options for reducing emissions at a certain EMISSIONS TRADING AND point in time (depending on the structure of capital stocks, the ECONOMICS: A PRIMER recent stage in the modernization cycle, etc.). Low-Cost Inc., on the other hand, has several cheap carbon-reducing ideas While designing an ETS policy in practice entails a certain that it has not yet adopted (see Figure 0.2). amount of complexity, the economic theory of emissions trading is quite simple. The rest of this chapter provides a brief Without regulation, both companies pollute—even Low-Cost overview of the basic economics behind emissions trading as a Inc. finds it cheaper to emit than to install its clean energy policy tool. It proceeds through the following three steps: innovations and adopt its basic efficiency ideas. A government might decide to reduce the total emissions of these two ▲▲ An explanation of what a marginal abatement cost curve is; companies, for instance, by limiting emissions across the two ▲▲ An illustration of how trading facilitates cost-effective firms to 100 units total rather than by allowing both firms to abatement using the simplest possible example involving emit 100 units each. two firms; and The simplest way to achieve the limit may be to set a uniform ▲▲ A brief section comparing the regulation of quantities (ETS) standard (see Figure 0.3): both companies are required to limit versus the logic of regulating prices (carbon taxes). their emissions to the same amount (of 50 units apiece). While Low-Cost Inc. will find it relatively easy (and cheap) to comply, Increasing marginal abatement cost this will be considerably more costly for High-Cost Corp. This curves can be seen by comparing the vertical height of the curves at the point where each has delivered 50 units of emission Different abatement opportunities have different costs per reductions: it is significantly higher for High-Cost Corp than for tonne of abatement achieved. As a result, they require differ- Low-Cost Inc. As such, with this requirement, emissions are ent carbon prices in order to be profitable to undertake. Some limited to 100, but total compliance costs could be high. abatement technologies are cheap and, indeed, according to some analyses, some reductions have “negative” costs which It is in this context that cap and trade can be valuable. The means that they would be profitable to implement without any government still sets an overall limit on emissions equal to 100 carbon price—although in these cases there are likely to be units. But instead of telling each company how much to emit non-price barriers that prevent the abatement being under- directly, it distributes or auctions allowances to each covered taken. By contrast, other abatement technologies are more entity as well as potentially to other parties. Each allowance difficult to implement—and, thus, more expensive. provides the right to emit one unit. The total number of allow- ances adds up to the overall cap of 100. Putting these abatement opportunities in order results in an increasing marginal abatement cost (MAC) curve. The first unit Next comes trade (see Figure 0.4). Regardless of how allow- of emissions reductions costs very little, perhaps even less than ances are distributed, the initial allocation process is unlikely to zero, but the cost per tonne of reductions rises with emission have resulted in the allocation that establishes the least cost reductions as more expensive opportunities are pursued. (i.e., most “cost-effective”) distribution of emissions across the two companies. For example, in a case in which the allow- ances have been allocated equally to both firms, High-Cost 26 EMISSIONS TR ADING IN PR ACTICE Corp. will want to find extra allowances FIGURE 0.2 Example of Two Firms with Different Abatement Costs while Low-Cost Inc. will be willing to sell some—at a price. The resulting price will ensure that emissions are reduced in the least-cost Low-Cost Inc. (L) and Cost per unit of CO2 equivalent abated Marginal Savings from High-Cost Corp. (H) have manner. High-Cost Inc. will be willing to buy very different marginal Emissions for High-Cost allowances until the point where the cost Corp. (Avoided Marginal savings from emissions Abatement Costs, MACH) given very different for reducing emissions reductions is equal Marginal Abatement Cost curves (MAC) to the price of allowances on the market. Similarly, Low-Cost Inc. will be willing to reduce emissions and, thus, sell surplus Marginal Savings from High-Cost Corp.’s curve is allowances until the point where its costs Emissions for Low-Cost steeper; its savings from Inc. (Avoided Marginal for installing its own emissions-reducing Abatement Costs, MACL) not abating the 50th ton of emissions is almost measures equal the allowance price borne twice as high as for Low- Cost Inc.’s. Its cost of by the market. having to go to zero emissions is too high The overall outcome will be that Low-Cost to show on this graph. Inc. will pursue significant emission reduc- tions, limiting emissions to 30 units and 0 50 100 leaving it with around 20 to sell. High-Cost Emissions from High-Cost Corp. Corp., on the other hand, takes a handful of 100 50 0 measures on its own (limiting emissions to Emissions from Low-Cost Inc. 70 units) but then buys on the open market the rest of the allowances (20 units) that Note: Two firms with different “abatement” (emissions reduction) costs: High-Cost Corp., with emissions shown from left to right, and hence abatement from baseline emissions in reverse, has a steeper incremental or it needs to cover its emissions. The result marginal abatement cost curve and thus steeper marginal savings from emissions; Low-Cost Inc., with emissions is that the same total level of emissions is plotted from right to left, has a flatter curve. Note that the total emissions are the same (and equal to 100) at every point along the horizontal axis; what changes is how those emissions are allocated between the two firms. achieved—but at a lower total cost for both companies as well as for the system as a whole. Regulating prices versus quantities In reality, of course, things are more complicated, including Emissions trading is only one policy instrument available to the existence of many more firms, questions around market combat climate change. The most direct alternative is to tax power, and administration/transaction costs. But even this GHG emissions. Economists disagree on whether a carbon tax simple example raises some important questions: or an emissions trading system is a better policy instrument ▲▲ Is it fair to give each company an equal number of and in practice the optimal choice is likely to depend on the allowances? specific circumstance. ▲▲ Should allowances be given away—“freely allocated”—or A cap-and-trade system, in its purest form, ensures the should they instead be auctioned off? emissions limit is firm but keeps the price flexible. By contrast, ▲▲ If auctioned, should the proceeds be used to reduce taxes a tax sets the price, keeping emissions flexible. In a world of elsewhere, or should the money be spent on other mea- certain and known marginal abatement costs and societal sures to reduce emissions, protect vulnerable consumers or benefits, either approach could be designed to achieve the compensate stakeholders under the program? same outcome, as shown in Figure 0.5. One of the important features of cap and trade is that while However, the world is uncertain: there is imperfect knowledge the answers to these questions are crucially important from regarding both the marginal abatement cost curve and the a political and distributional perspective, they do not change marginal societal benefits curve. As a result, an ETS and a the overall effectiveness of the cap. Regardless of how a fixed tax—even if designed to be equivalent in expectation—will number of allowances are distributed, total emissions will not likely have different outcomes. Which one is preferred (on exceed the limit. BEFORE YOU BEGIN 27 economic efficiency grounds) will depend FIGURE 0.3 Applying a Uniform Standard to Each Company on the relative importance of minimizing marginal costs (favoring a carbon tax) or being certain over environmental outcomes (favoring a cap-and-trade BEFORE YOU BEGIN system).31 The political feasibility of either Avoided approach will also differ across different Cost per unit of CO2 equivalent MACH The goal is to cap emissions at 100 units. contexts. A uniform pollution standard would imply However, despite the differences between emissions of 50 units by each Low-Cost Inc. (L) an ETS and a carbon tax, there is wide- and High-Cost Corp. (H), regardless of their spread agreement among economists Marginal Abatement that a price on emissions, created through Avoided Cost curves (MAC). MACL either approach (or through a combi- nation—for instance, using price floors and ceilings) is critical to cost-effectively reducing GHG emissions. 0 50 100 The shaded areas Emissions from High-Cost Corp. represent total abatement costs to 100 50 0 each company. Emissions from Low-Cost Inc. Note: A uniform standard limits each company to the same amount of emissions: Low-Cost Inc. and High-Cost Corp. each emit 50 units, together accounting for a total of 100. FIGURE 0.4 Comparing Trade to an Allocation Prescribing Equal Emissions by Each Company Companies will trade their emissions permits until the point where Avoided their marginal costs for MACH an additional ton of Cost per unit of CO2 equivalent abatement are equal. This is also the point that maximizes cost savings. Cost savings with trade High-Cost Corp. now emits 70 and Low-Cost Avoided Inc. emits 30. If each MACL was allocated allowances for 50 units of emissions, High- Cost Corp. will buy 20 from Low-Cost Inc. to cover its higher emissions and compensate the 0 50 70 100 extra abatement by Low-Cost Inc. Emissions from High-Cost Corp. 31 Under a cap, if marginal abatement costs are higher than expected, the market price for one tonne of CO2— 100 50 30 0 and, thus, the overall cost of the policy—will be higher Emissions from Low-Cost Inc. than expected. Under a tax, a higher-than-expected marginal abatement cost will not affect the price, but it will lead to fewer emissions reductions than expected. 28 EMISSIONS TR ADING IN PR ACTICE FIGURE 0.5 Damages and Savings from Emissions and Mitigation Efforts Cost per Tonne of CO2 equivalent Marginal societal Marginal savings damage from from emissions emissions P* (avoided abatement costs) 0 Q* Note: With no uncertainty around marginal abatement costs and damages from emissions, by setting a cap at Q*, the market price will adjust to P*. Setting a tax at P* will result in emissions level of Q*. QUICK QUIZ Conceptual Questions ▲▲ How does an ETS work? ▲▲ What is the difference between an ETS and a carbon tax? Application Questions ▲▲ What might be the key goals of an ETS in your jurisdiction? ▲▲ What existing regulations in your jurisdiction could help or hinder an ETS? ▲▲ What policies might be useful in addition to an ETS in your jurisdiction? STEP 1: DECIDE THE SCOPE 29 STEP 1: DECIDE THE SCOPE At a Glance___________________________________________________________________________ 30 1. Introduction________________________________________________________________________ 31 2. Scope Design_______________________________________________________________________ 31 1. SCOPE 2.1 Sector and gas coverage_______________________________________________________ 32 2.2 Point of regulation____________________________________________________________ 33 2.3 Thresholds___________________________________________________________________ 35 2.4 Level of reporting obligation____________________________________________________ 36 2.5 Summary____________________________________________________________________ 36 3. Scope Considerations in Practice______________________________________________________ 37 3.1 Electricity generation__________________________________________________________ 37 3.2 Industry_____________________________________________________________________ 38 3.3 Transport____________________________________________________________________ 38 3.4 Waste_______________________________________________________________________ 40 3.5 Land use-related activities_____________________________________________________ 40 Quick Quiz____________________________________________________________________________ 41 30 EMISSIONS TR ADING IN PR ACTICE AT A GLANCE ✓✓ Decide which sectors to cover ✓✓ Decide which gases to cover ✓✓ Choose the points of regulation ✓✓ Choose the entities to regulate and consider whether to set thresholds The scope of an ETS refers to the sources of emissions and be downstream, at the facility or entity at which emissions types of GHGs covered by the scheme. Decisions about scope are released into the atmosphere. This case often sends are some of the most critical design elements of an ETS. the most direct price signal. However, it can also imply significant transaction costs, although these can be There are a number of arguments in favor of making the reduced if some regulatory infrastructure already exists at scope of an ETS as large as possible. A wide scope means the these points in the value chain, such as existing emissions ETS encompasses a greater portion of the covered region’s monitoring and reporting requirements for other air pol- emissions—this provides more certainty on the attainment of lutants. However, if the covered entities can be expected jurisdiction wide emissions targets, helps lower compliance to pass on the cost of compliance down the value chain in costs for entities, reduces competitiveness impacts among the form of higher product prices, emissions may instead covered sectors, and may improve the operation of the allow- be better regulated upstream, where the fuel that causes ance market. them is first commercialized. Upstream regulation may be attractive in increasing coverage, and reducing transaction On the other hand, an ETS with a wide scope can involve high and compliance costs, but a concern may be that it will be administrative costs because so many entities are involved. less effective at generating a behavioral response. Applying thresholds to exclude small emitters, and placing the “point of regulation” upstream, as discussed in detail in ▲▲ Should there be emissions thresholds to avoid including this chapter, can help manage this trade-off. In the context too many small entities? Such thresholds are more nec- of deep decarbonization targets, the expansion of an ETS to essary when emissions are regulated downstream. While sectors with comparably high marginal abatement costs can they reduce/remove compliance costs for smaller entities also trigger significant distributional effects and thus should be as well as bureaucracy and enforcement costs, they can considered carefully. also reduce their environmental effectiveness and cause competitive distortions between entities on either side of Consideration of the scope of an ETS raises the following the threshold. Any threshold needs to be calibrated to take important questions: into account jurisdiction-specific factors. Opt-in provisions ▲▲ Which sectors and gases should be included? In general, can offer some flexibility. it is preferable to include a sector or gas that accounts ▲▲ Where should the reporting obligation be placed? A for significant emissions, provided those emissions can more aggregated unit, such as a company, may reduce be easily monitored. Often, the areas worth including transaction costs but can be challenging if there are many are those where there is otherwise insufficient financial sites where multiple companies interact or partial owner- incentive to reduce emissions and where co-benefits may ship of facilities is prevalent. be realized from achieving emissions reductions. This chapter considers (i) the sources of emissions and types ▲▲ At what point should regulation be introduced? of GHGs that might be covered by an ETS and (ii) how their Emissions should be regulated at a point where they can regulation might be effected. Section 1 introduces the issue. be monitored and their compliance enforced, and where Section 2 considers some of the general design questions that the regulated entity has some ability to influence emissions policy makers need to address in this regard. Section 3 exam- either directly or by passing through costs. Sometimes the ines some of the specific issues that are likely to arise when accountable entity, that is, the “point of regulation,” will considering the coverage of certain emissions sources. STEP 1: DECIDE THE SCOPE 31 1. Introduction in cases where different sectors can achieve different degrees of cost pass-through. A number of factors point toward extending the scope of ▲▲ Emissions leakage: If some jurisdictions regulate emissions the ETS as broadly as possible. The advantages of a broad but others do not, there is a risk of production relocation coverage include: or changes in investment patterns to unregulated jurisdic- ▲▲ Certainty on predefined emissions target: By ensuring tions.33 This can have undesirable economic, environmental, coverage is broad (i.e., more emissions are encompassed and political consequences. Tools do exist to address by the ETS cap), policy makers can be more confident that such leakage concerns, but if a sector is thought to be a predefined emissions target will be met. particularly susceptible to leakage, one option is to exclude ▲▲ Lower compliance costs for individual sectors: Including it from the scope of the ETS. A further discussion on 1. SCOPE a larger number of sectors increases the potential to leakage, including on how to establish support for sectors achieve cost-effective emissions reductions because there susceptible to it, is provided in Step 3. is a wider array of abatement costs, thereby increasing Policy makers must balance the benefits of broader coverage the probability of entities being able to achieve gains from against the additional administrative effort and transaction trading (see "Before You Begin"). costs, but also the practical availability of alternative or com- ▲▲ Competitiveness impacts: A broad coverage reduces plementary policy mechanisms. Design features such as using the likelihood of competitiveness or distributional impacts thresholds to exclude small emitters and placing the “point of that may arise if one sector or type of emitter is included regulation” upstream on suppliers of energy can help manage but another is not. Such intersectoral competitiveness this trade-off. impacts are most likely between products which can be easily substituted. For example, steel and aluminum may Hence, there are four key questions that policy makers need be substituted as building materials and gas and oil could to consider when determining the scope of the ETS: be substituted for electricity. Substitutions may also arise ▲▲ What sectors or emissions sources will the program cover? because of technology change—for example, electrification ▲▲ What should be the points of regulation in those sectors? of transport, development of the wood pellet industry, etc. While substitutions away from emissions-intensive ▲▲ What is the minimum level of emissions below which industries and processes are an intended result of an ETS, emissions should not be regulated? those that arise only because one sector is included in the ▲▲ With whom does the compliance responsibility lie: with ETS while another is not are undesirable and distortive. companies or installations, or a combination of both? ▲▲ Market operation: A broader scope may improve the These issues are discussed in more detail in section 2, while operation of the resulting carbon market. A greater number section 3 provides more detail on key considerations relating of (diverse) trading entities in a market generally makes for to the inclusion of individual sectors within an ETS. a more stable price and reduces the potential for any one entity to gain market power.32 However, there are three key reasons to narrow coverage: 2. Scope Design ▲▲ Transaction and administrative costs: Technical and This section discusses factors policy makers must consider administrative barriers can make a broad scope infeasible— when deciding on the scope of an ETS: particularly if the logistics and cost of monitoring emissions ▲▲ Sector and gas coverage; differ across sectors and sources. The benefits of broad coverage may be outweighed by administrative or other ▲▲ Point of regulation; MRV costs faced by the covered entities and the regulator. ▲▲ Threshold; and ▲▲ Distributional challenges: Including sectors with compa- ▲▲ Level of reporting obligation. rably high marginal abatement costs in an ETS can trigger distributional effects because compliance costs may end up being borne disproportionately by some entities, especially 32 Geographic extension of the ETS through linking can also lessen competitiveness impacts and improve market operation (see Step 9). 33 A detailed discussion of leakage issues is given in PMR (2015g). 32 EMISSIONS TR ADING IN PR ACTICE 2.1 Sector and gas coverage emitters can provide high benefits relative to administrative effort. The small number of large emitters can be included and There are important differences across sectors and emissions thresholds used to exclude small, diffuse, or remote sources. sources that affect the extent to which specific sectors and emissions sources are worth covering. Whether it is beneficial By contrast, covering sectors composed of many small, diffuse, to include a specific sector depends on the proportion of or remote emissions sources may involve high administrative emissions it accounts for. In many industrialized countries, for costs relative to benefits. The transport sector is a typical instance, land use or waste account for only 5 to 10 percent example—tracking the emissions from each vehicle and of GHG output, while power and industry account for 40 or 50 holding individual vehicle owners accountable is not feasible. percent. While some sectors may seem to have more low-cost Upstream regulation is thus often used for transport emis- mitigation options than others, this is hard to predict. That dif- sions, if policy makers decide to include it in an ETS at all. ficulty is one of the major justifications for using carbon pricing: it unlocks private information and innovation. In the longer run, Co-benefits can also play an important role in the political abatement options are even harder to predict, and all sources calculus when determining sectoral coverage. Although the need to reduce emissions to achieve the global goal of zero net GHG benefits from emissions reductions are completely inde- emissions. If short-term mitigation opportunities seem to be pendent of the location of reductions and largely independent expensive and scarce, the sector may be targeted for research of their timing, many co-benefits are location-specific. and development to unlock future abatement potential. Figure 1.1 shows the global experience in terms of sector For an ETS to be effective, it must be possible to measure and coverage. It shows that nearly all ETSs globally cover electricity monitor emissions with low uncertainties and at reasonable generation and industrial emissions—both process emissions cost. Covering sectors dominated by a small number of large (e.g., from cement and steel production) and emissions from fossil fuel combustion in industry. Coverage of emissions associated FIGURE 1.1 Sector Coverage in Existing ETSs with building use is relatively com- All except: mon, while transport and domestic RGGI aviation are less so. The number of schemes covering emissions from waste or activities in the forestry All except: Saitama sector is the smallest. Switzerland Tokyo In “upstream” energy systems, decisions on scope are made New Zealand by type of fuel rather than final output sector. For example, when natural gas is covered, it is covered wherever it is used in the economy. Beijing Further practical considerations (California) on how to include a source in an (New Zealand) New Zealand (Québec) ETS—whether electricity generation, Republic of Korea Republic of Korea industrial fuel use and process Saitama Shanghai emissions, transport, waste- or land Shenzhen Tokyo use-related activities—are discussed in section 3. The decision on which sectors to EU Beijing (New Zealand) (California) include is closely related to the Republic of Korea (New Zealand) question of which gases to include— Shanghai (Québec) Republic of Korea considerations are broadly the same: increasing the scope increases the Source: ICAP 2016i. possibility for low-cost abatement Note: Systems in brackets indicates upstream coverage. and jurisdiction-wide environmental STEP 1: DECIDE THE SCOPE 33 TABLE 1.1 Gas Coverage in Existing ETSs CO2 CH4 N2O HFCs PFCs SF6 NF3 EU Alberta Switzerland NZ RGGI Tokyo California 1. SCOPE Kazakhstan Québec Beijing Guangdong Shanghai Shenzhen Tianjin Chongqing Hubei Republic of Korea certainty. However, depending on the local emissions profile, 2.2 Point of regulation these benefits may be exceeded by the corresponding admin- Once policy makers decide to include a sector or source of istrative cost. Table 1.1 shows the range of choices made by emissions in an ETS, a critical design feature concerns the current ETSs in terms of gas coverage. point at which those emissions are regulated. Globally, carbon dioxide makes up by far the largest portion Emissions must be regulated at points where they can be of GHGs and all ETSs include this gas. Many schemes include precisely monitored and where compliance can be enforced. some other gases as well. As methane sometimes represents For the ETS to be effective in changing behavior, the point of a significant portion of domestic emissions (for example, regulation must be able to influence emissions, either directly from landfills, fossil fuel extraction, and agriculture), coverage or by passing through a price. For a number of emissions of these gases may be important to consider, especially in sources—especially those involving fossil fuel use—emissions developing countries. could be regulated at multiple points (see Figure 1.2). The two main points of regulation for emissions from fossil fuel If GHGs other than CO2 are covered, their emissions need combustion are: to be expressed as carbon dioxide equivalent (CO2e). The Intergovernmental Panel on Climate Change (IPCC) provides ▲▲ Upstream: Where the source of emissions (typically a information on the conversion metric used in all systems to fossil fuel) is first commercialized by extractors, refiners, or date, global warming potential (GWP).34 Some GHGs have a importers. For example, in the California ETS, the point of much higher GWP compared to CO2. As noted by the IPCC, the regulation is where the fossil fuel that will be combusted fact that different gases have different impacts at different and thus causes GHG emissions enters commerce. In times means that value judgments must be made when practice, these are terminal racks and large refineries choosing conversion rates (see Step 5 for more discussion of where oil and gas are physically transferred. The owners of short- versus long-lived climate pollutants). these facilities pass the costs reflecting the embedded CO2 through to the consumer in the form of slightly higher fuel product prices. ▲▲ Downstream: Where the GHGs are physically released into the atmosphere. This is the approach adopted by the EU ETS. In the case of emissions associated with electricity 34 IPCC (2014). 34 EMISSIONS TR ADING IN PR ACTICE generation, a further choice can be made—emissions FIGURE 1.2 From Upstream to Downstream can instead or also be regulated at the point at which the electricity is consumed. Upstream The advantages of upstream regulation are: ▲▲ Administrative costs tend to be lower: Often there are far fewer entities involved in the extraction and Fuel commercialization of a fossil fuel than in its final extractors or refiners consumption, and those entities are more used to managing regulations. This in part reduces transac- tion costs. For example, California’s ETS applies to 85 percent of the state’s emissions by covering around 350 entities. New Zealand’s regulation, as discussed in Box 1.1, succeeds in covering 100 percent of Electricity generators fossil fuel emissions by regulating just 102 firms. By contrast, the EU ETS applies to only 45 percent of emissions with over 11,500 entities covered.35 Consumers ▲▲ Coverage across sectors tends to be higher and of electricity thresholds within sectors are usually avoided: Linked to the above point, upstream regulation does not require the thresholds often necessary in Downstream downstream systems in order to avoid very high Source: Adapted from U.S. EPA 2003. transaction costs (discussed in section 2.3). Such thresholds reduce coverage, can result in intra- sectoral emissions leakage, and may reduce the cost effectiveness of the ETS. These problems can be BOX 1.1 CASE STUDY: Upstream Regulation in New Zealand avoided by adopting upstream regulation.36 New Zealand has chosen a system that is as far upstream as On the other hand, downstream regulation may be possible for GHG regulation. Fossil fuels, whether for transport, preferred if: electricity, or direct energy use, are regulated at the point of production or import. In total, the government enforces ▲▲ Downstream data and compliance mechanisms compliance for only 102 firms, yet covers 100 percent of already exist: Existing permitting and licensing CO2 emissions from fossil fuel use.a The upstream approach regulation may require downstream users to provide has allowed for administrative simplicity while ensuring high-quality data. For example, in the EU, the 1996 comprehensive coverage. Integrated Pollution Prevention and Control Directive A few large downstream firms felt that their upstream fuel established a set of common rules for permitting suppliers—to whom they are tied because of small markets— and controlling industrial installations that facilitated were not managing the GHG liabilities efficiently and hence a downstream approach to regulation.37 In some passing on a GHG cost that was too high. In a few cases, this cases, institutional capability to monitor and enforce has been resolved through private contracts that allow the compliance may be stronger at a downstream downstream firm to manage its GHG liabilities and provide units level. This is particularly true when there are a small to the upstream regulated party as it buys fuel. Moreover, the government has enabled some downstream firms to “opt in” number of large emitters. as a point of regulation, avoiding double counting by providing ▲▲ There is low potential for cost pass-through: The a rebate to the upstream point of regulation for emissions effectiveness of upstream regulation in incentivizing associated with the fuel sold to these downstream firms.b, c 35 There are factors other than whether regulation is introduced at an up- a New Zealand Emissions Unit Register (2016). stream or downstream point that affect this comparison including whether b Eleven firms as of November 2015. These are so-called “schedule 4” participants. Three it is installations or companies that are regulated (see section 2.4). were already participants because of other emissions sources. New Zealand Emissions 36 Choosing an upstream point of regulation for energy so that emissions from Unit Register (2016). Schedule 4 also includes all post-1989 foresters. more sources are covered reduces leakage across firms within and between c Kerr and Duscha (2014). sectors (see Bushnell and Mansur, 2011). 37 European Council (1996). Directive 96/61/EC. STEP 1: DECIDE THE SCOPE 35 emissions reductions relies on the additional costs being Key considerations for the choice of threshold include: passed through into the price that is faced downstream. If ▲▲ Number of small sources: If there are many small sources this is not considered likely, potentially because of market of emissions, then a relatively low threshold may be power at the upstream part of the value chain, then down- needed in order to ensure that, in totality, a significant stream regulation may be preferred.38 proportion of emissions are covered. ▲▲ “Visibility” of regulation is considered important: While ▲▲ Capabilities of firms and regulators: If small firms cost pass-through from upstream to downstream users have limited financial and human capacity and the should mean that the latter face the same economic incen- additional costs of the ETS may influence their decision to tives to reduce their emissions as the former, organizational operate—and these problems cannot be overcome through and behavioral factors suggest that regulating at the point 1. SCOPE of emissions may be more effective in incentivizing entities to reduce emissions (see Box 1.2). ▲▲ The method of allowance allocation requires downstream BOX 1.2 TECHNICAL NOTE: Regulation and data: If company or installation-level data are required for Behavioral Impacts the free allocation of units to be implemented (see Step Regulating energy use at the point of emissions is 3)—in particular for “grandparenting” purposes—the admin- sometimes seen as more effective in incentivizing istrative cost savings that could be achieved by upstream decision makers to reduce emissions and has been a regulation will be reduced in the first years of the ETS. common choice in practice. Sources face the exact same incentives in economic terms to reduce their Emissions from fossil fuel combustion can be monitored emissions whether the cost is faced directly, per tonne accurately upstream and downstream. For other sources of of CO2 emitted, or indirectly, as increased fuel prices. emissions, changing the point of regulation may alter the Visibility of the regulation—“saliency”—to managers is accuracy of monitoring because different data will be available; particularly important. Some ETS regulators aim to achieve this reduces efficiency. productivity benefits from more careful management of energy use. This requires active engagement of managers and may therefore be achieved more easily with regulation 2.3 Thresholds at the point of emission. In order to minimize administrative and MRV costs while maxi- Other performance metrics faced by managers may be mizing the number of sectors covered in an ETS, policy makers important considerations, too. In nonmarket economies have tended to introduce thresholds on ETS participation. and where installations are owned by governments, the These establish that entities below a certain “size” (defined as contracts and performance evaluations of managers may GHG emissions per year, energy consumption level, production be critical in determining responses to carbon prices. level, imports, or capacity) are not subject to the ETS require- It is possible to address behavioral, noneconomic concerns ments. Thresholds can significantly reduce the number of through other means. Direct engagement and technical covered entities without losing much of the covered emissions advice, or mandatory reporting and emissions reduction and mitigation opportunities. They constitute a particularly plans, improve decision makers’ understanding of the potential to benefit from mitigation as well as the eco- important feature when emissions from fuel combustion are nomic costs of not doing so. These additional measures regulated downstream. could help shed light on the opportunities for companies to mitigate at any point in the energy supply chain, and What the best threshold is depends on each jurisdiction’s could be cheaper than changing the point of regulation context and specific mitigation goals, as well as upon to be at the point of emissions. For example, one of sector-specific issues. The capacity of firms to manage California’s complementary policies was to require indus- ETS compliance and the government’s capacity to enforce trial facilities (for example, refineries, cement kilns, and compliance are the primary factors. Others include mitigation food processors) to do energy-efficiency audits and invest options available to local entities of different scales, and size in any Net Present Value (NPV)-positive projects. The distribution of entities. The latter affects how many entities, policy was designed to induce facilities receiving updated and hence emissions, are included and excluded with different output-based allocation to invest in reductions even if they do not face net costs under the state’s ETS. The value of thresholds and may also affect the risk of production leakage direct regulator signals in terms of institutional incentives from covered to uncovered entities. varies by culture and organizational form. 38 Kim and Lim (2014). 36 EMISSIONS TR ADING IN PR ACTICE free allocation of units—then a more generous (higher) In Kazakhstan, the Republic of Korea, and in the Chinese threshold may be preferred.39 pilot ETSs, the regulated entity is the company. In the case of the Chinese pilots, energy statistics have traditionally been ▲▲ Likelihood of intersectoral leakage: A threshold above collected at the company level, making this approach a logical which entities are subject to a carbon price and below extension of the existing policy framework. By contrast, in which they are not, may distort competition between the the EU, existing environmental permitting, licensing, and two groups. It may thus be worthwhile to try to find a regulations were focused on individual installations. Adopting threshold that is consistent with the competitive dynamics the same approach for the EU ETS meant that it was possible within the sector. to combine the procedures for regulating air pollution and ▲▲ Possibility of market distortions as a result of thresholds: emissions trading.40 It was also consistent with the desire to A threshold for entity inclusion can create an incentive to place the liability at the point where technical mitigation could break up existing production facilities into smaller units in be achieved. order to bring each unit’s emissions below that threshold to avoid compliance obligations. Similarly, firms just below the threshold may choose to stay there, curbing their growth. 2.5 Summary Table 1.2 summarizes the key considerations regarding each of the four aspects of scope design discussed above. 2.4 Level of reporting obligation A further important design characteristic concerns who is legally responsible for complying with the ETS regulations, TABLE 1.2 Decisions on Scope that is, surrendering to the regulator a unit for each tonne of Sectors/ More Fewer emissions. Some of the main options are: gases covered ▲▲ Greater opportunity for ▲▲ Lower administrative and low-cost reductions transaction costs ▲▲ A company; ▲▲ Avoids risk of leakage ▲▲ Less risk of leakage ▲▲ A company at a specific plant site, or for a specific; between sectors between jurisdictions ▲▲ Greater control over production line or process; and achieving a target ▲▲ A specific plant site or installation (that could contain Point of Upstream Downstream regulation several processes and/or companies). ▲▲ Cheaper and simpler to ▲▲ Can build on existing for energy administer and monitor regulatory frameworks The choice depends on which entities can be held legally ▲▲ Greater coverage with ▲▲ Can provide incentives to fewer points of regulation electricity users in systems liable and where data are available and auditable. Often these with regulated prices ▲▲ Avoids risk of leakage factors depend on existing regulatory structures. between and within sectors ▲▲ Possible behavioral benefit of regulating at the point of Regulating a more aggregated unit like a company can reduce emission administrative costs for both the government and companies. Threshold Low High level It allows more flexibility regarding where emissions occur ▲▲ Greater opportunity for ▲▲ Lower administrative costs low-cost reductions Protects smaller firms within the entity without the need to report or trade units. ▲▲ ▲▲ Avoids risk of leakage where administrative and between firms above and transaction costs might be On the other hand, in cases where multiple companies interact below the threshold prohibitive within one installation, the attribution of emissions to particular Level of Installation Company companies can be difficult. These problems may be particularly reporting obligation ▲▲ Preferable where many ▲▲ Lower administrative costs pronounced, for example, in highly integrated chemical companies are likely to when reporting required by be operating at the same aggregated units such as at production sites, where several companies or subsidiaries may installation the company level run numerous production processes and where—in order to ▲▲ Ownership transfers of ▲▲ More flexibility for company improve the overall efficiency of production—different pro- installations between as it does not have to companies are easier to report for each installation cesses may constantly exchange energy (in the form of waste administer individually heat, waste gas, cooling capacity, power, etc.) or products (e.g., hydrogen, preproducts, and hydrocarbons.). 39 Betz et al. (2010) find that partial coverage, by excluding firms below a threshold, can reduce social costs, while maintaining emissions reductions, compared to blanket coverage. 40 EC (2000). STEP 1: DECIDE THE SCOPE 37 3. Scope Considerations in BOX 1.3 CASE STUDY: Electricity Imports in the Practice California ETS As a high share of California’s electricity is imported from This section considers some of the key issues that may arise neighboring states, policy makers decided to include emis- when deciding on the scope and point of regulation in some sions from electricity generated outside of California in key sectors often covered in an ETS. the scope of the California Global Warming Solutions Act, also known as AB 32, which authorized the adoption of 3.1 Electricity generation a Cap-and-Trade Program by the California Air Resources Board (ARB), and directed ARB to minimize leakage to the There are three possible points of regulation in the electricity extent possible. supply chain: 1. SCOPE The regulators require “first deliverers” of electricity into 1. At fuel source: Used in the New Zealand ETS, this involves California to report emissions associated with the pro- directly covering all fuels that are used in electricity gen- duction of that electricity and, consequently, to surrender eration at their source (production, import, or distribution) the appropriate amount of allowances in the ETS. Both as points of regulation. This option can allow high-quality, producers and importers of electricity must account for comprehensive monitoring of actual emissions provided all the emissions associated with it—at least for the amount consumed in California. When emissions associated with producers and importers can be identified and regulated. electricity delivered are unknown (for instance, when there By monitoring fuel, it is possible to monitor emissions is no existing power purchase agreement (PPA)), importers in the electricity sector as well as in other sectors using are allowed to claim the region’s “default emissions factor,” those fuels (see Step 7). For this approach to succeed, it which is roughly equivalent to the emissions of an older is important to cover all fuel sources to prevent market gas-fired power plant. distortions. There may be concerns that regulating a small number of entities may allow for monopoly power in the allowance market. These concerns may be addressed by If electricity suppliers are permitted to pass through cost separate regulation. increases to consumers, options 1 and 2 incentivize mitigation 2. Generators: Used in, for instance, the EU, California, throughout the supply chain: fuel switching, investment in Kazakhstan, and the Beijing ETS, this option involves less renewables, efficiencies in generation, efficient dispatch and overall regulation and administrative cost in some energy transmission, efficiency in use, and conservation. supply chains than the fuel source option described above. If it is accompanied by thresholds to reduce transaction However, in some regulatory frameworks, electricity prices costs on smaller generators, it may miss some small gener- are set (or heavily regulated) by the government, such that ation sources. emissions liabilities imposed on generators will not be reflected in higher prices downstream. In these cases, it can therefore 3. Electricity consumers: Used in, for example, Beijing, be valuable to provide incentives for emissions reductions Tokyo, and Saitama, this option requires electricity consum- through both reducing the carbon intensity of generation and, ers to surrender units associated with their consumption of separately, reducing the overall consumption of electricity. electricity. It provides incentives for energy efficiency and Several systems (for example, the Chinese pilots and Korea), conservation, and tends to focus on large energy users to therefore, combine option 2 with option 3 in order to provide avoid high administrative costs. It also tends to be used an otherwise lacking incentive to reduce electricity consump- in cases where emissions costs would otherwise not be tion.41 In these cases, combining the regulation of generators reflected in electricity prices or where the jurisdiction is (so long as any free allowances are allocated appropriately unable to regulate generators because electricity genera- (see Step 3)) with coverage of “indirect” emissions by elec- tion occurs outside the jurisdiction (see Box 1.3). tricity users strengthens the emissions reduction incentive of Regulatory characteristics concerning how electricity the ETS—although it still may not promote efficient dispatch generators dispatch their electricity, how they recover their across generators with different emissions factors. operational and investment costs, and how electricity prices are set at the wholesale and retail level can influence which of these approaches is most attractive. 41 This is different from the case in Tokyo where electricity is imported so there is no “direct” point of regulation, only regulation of large energy and heat users. Tokyo uses only Option 3. 38 EMISSIONS TR ADING IN PR ACTICE entity is also important. If an upstream point of regulation is BOX 1.4 CASE STUDY: Tokyo ETS and the chosen, these issues are largely avoided. Commercial Building Sector In the Tokyo ETS, landlords have a compliance obligation 3.2.2 Industrial processes for their buildings’ indirect emissions and, in addition, With the exception of the Regional Greenhouse Gas Initiative tenants that are large emitters (> 5,000 m2 area or > 6 (RGGI), all systems cover industrial process emissions—the million Kwh electricity) are required to submit an annual emissions intrinsic to chemical processes beyond the combus- reduction plan. The system is based on a long history of dialogue between the Tokyo Municipal government, tion of fuels, primarily cement (clinker), steel, and aluminum. owners, and tenants. Globally, these industrial processes cause about 21 percent of GHG emissions. Large reductions in electricity use, during extreme regional electricity shortages following the 2011 earthquake, For process emissions from cement, aluminum, and steel, may have led to long-term behavioral change as well as there is no real choice for point of obligation—emissions can more efficient lighting and heating in the building sector.a Companies in Tokyo have found that once reducing be monitored only at the point of emission. Producers are emissions was recognized as a goal, it became easier generally large. In ETSs that choose to regulate emissions to reach consensus on investments in energy-saving from energy use at the downstream level, such producers will technology through implementation of the ETS and better generally already be the points of regulation for energy-related cooperation between landlords and tenants. emissions. Chemical manufacture can also create process emissions. a TMG (2015). Where small industrial facilities are emissions sources, they are sometimes exempted to avoid excessive administrative costs. Using an ETS to reduce electricity consumption by end users A final source of industrial process emissions are those from may need to be complemented by other measures to address Fluorinated Greenhouse Gases (F-gases). While these gases related barriers to emissions reductions. For example, require- account for a relatively small proportion of total GHG emis- ments for electricity reduction plans by landlords, combined sions, their high GWP makes them an important contributor with regulation of electricity consumers in Tokyo and Saitama to climate change. Emissions of these gases from industrial has in part overcome split incentive problems in the commer- facilities are included in a number of ETSs (see Table 1.1). cial building sector (see Box 1.4). Even systems with deregulated electricity markets do not 3.3 Transport generally have perfect real-time price (and hence carbon Globally, transport accounts for about 14 percent of GHG cost) pass-through. This suggests a potential role for comple- emissions. Despite this, as Table 1.1 shows, a majority of ETSs mentary policies to improve emissions cost pass-through in do not cover transport emissions. electricity or to directly reduce peak demand. The perceived short-term mitigation potential of the sector 3.2 Industry is one reason for this: for essential travel, the behavioral response of drivers to fuel prices is low, meaning a relatively 3.2.1 Stationary energy use strong change in fuel prices causes relatively weak change to As in electricity generation, emissions from industrial the amount vehicle owners drive. However, for nonessential fossil fuel combustion can be regulated further upstream travel, price responsiveness may be greater, while for freight (California/Québec) or downstream (EU, China, and Korea). transport, carbon pricing may stimulate intermodal substitution While in many jurisdictions electricity generators are large, between, for example, road and rail use. A key determinant such that regulating them up- or downstream may involve a of the price responsiveness of transport users to fuel prices is similar number of entities; by contrast, industry and buildings the availability of alternatives, such as public transport, electric typically feature a combination of some large sources and vehicles, biofuel and low-emissions options for transporting many small sources. If a downstream point of regulation freight—these alternatives in turn depend on longer-term is chosen, thresholds will often need to be used to keep infrastructure developments. The effectiveness of carbon administrative costs manageable. Carefully choosing between pricing in stimulating this abatement will therefore depend on downstream companies and installations to become a legal other transport policies (see the discussion of complementary and competing policies in "Before You Begin"). STEP 1: DECIDE THE SCOPE 39 Existing policies can be another reason to exclude (road) BOX 1.5 CASE STUDY: EU Measures to Regulate transport emissions from the scope of an ETS. In the EU, Aviation Emissions ambitious vehicle emissions standards, high fuel taxes, and other regulations have a much stronger effect on transport In 2008, the EU included both flights within the EU and sector emissions than an increase in fuel prices commensurate international flights to and from non-EU ETS countries in the EU ETS Directive. All such flights would have to sur- with the EU ETS carbon price would. Thus, including vehicle render allowances under the EU ETS, with airlines facing emissions in the cap would not have much, if any, impact a fine of €100 per tonne of CO2 emitted if failing to do so. on promoting cost-effective abatement. Other jurisdictions Persistent offenders faced the possibility of bans from EU (for example California) have included transport in the ETS airports. as a backstop for emissions reductions primarily triggered by When the directive came into effect in 2012, the inclusion 1. SCOPE efficiency standards, low carbon fuel requirements, and other of international flights faced strong opposition from both transport-specific policies. In other cases, it may be preferable developed and emerging economies, including the US, to replace existing regulation or fuel taxes with inclusion of China, India, and Russia. These countries met in February the sector under the ETS cap, in order to achieve more cost- 2012 to discuss measures they would take if the EU effective mitigation and ensure absolute limits on emissions. proceeded with the extension of the scope of Europe’s ETS to international aviation.a As transport sector GHGs are emitted by millions of end users, These measures included: it is most likely simpler, and less costly, for the point of regula- ▲▲ Banning their airlines from participating in the scheme, tion to be upstream. In New Zealand, California, and Québec, a move that Chinese authorities made later in 2012; for example, this is done at the point of fuel producers or ▲▲ Filing a formal complaint with the International Civil importers. Aviation Organization (ICAO); By contrast, in the Republic of Korea and also in three of the ▲▲ Imposing levies or charges on EU airlines as a Chinese pilots (Shenzhen, Chongqing, and Tianjin) emissions countermeasure; associated with the vehicles owned by covered entities (based ▲▲ Halting talks with EU carriers on new routes; and on firms’ reports of fuel purchases) are also covered as part of ▲▲ Asking the WTO to rule on the legality of the EU’s compliance obligations set at the entity level. These systems move. regulate all energy emissions downstream, so this approach is consistent. However, it does carry the risk of intra-sectoral In 2013, the General Assembly of ICAO agreed to develop a leakage. For example, if a firm reduces the use of its fleet cars global scheme for reducing emissions from aviation based on market-based measures. Such measures were to be but switches to (unregulated) private taxi use, behavior may finalized in 2016 and implemented by 2020.b In response, change but emissions may actually rise. the EU limited the scope of its ETS to flights within Europe until at least the outcome of the 2016 ICAO meeting.c When the transport sector is included, the treatment of biofuels deserves special attention. On the one hand, the use of biofuels could result in lower net emissions when the carbon a International Centre for Trade and Sustainable Development (2012). sequestration from producing the feedstock is considered. On b Campos and Petsonk (2013). c EC (2016b). the other hand, the production of biofuels may lead to indirect land use changes (e.g., tropical deforestation) that actually increase net emissions. In cases where all fuel use is regulated upstream, domestic aviation and shipping are automatically covered. This is the case in New Zealand. In sectors where downstream regulation is adopted, the inclusion of aviation is a more active choice. Shanghai has included aviation, in part because it is a large contributor to emissions there. Since airlines have detailed energy consumption records, it is relatively simple to measure the emissions. Box 1.5 describes the experience of regulating aviation emissions in the EU ETS, which includes intra- European flights but not flights outside EU air space. 40 EMISSIONS TR ADING IN PR ACTICE 3.4 Waste is needed to monitor both sequestration (uptake), as forests grow, and emissions in the case of harvest. Proper monitoring, The waste sector is infrequently covered by ETS. It is a to ensure appropriate incentives, requires a broad range of relatively small source of emissions in most of the jurisdictions site-specific information. that have currently adopted ETSs, additional mitigation options are very limited (in part because of existing regulation around However, as juirisdictions with significant emissions from the waste disposal), and there is a large number of small sources. forestry and land use sectors consider the introduction of an To date, only the ETSs in the Republic of Korea and New ETS, the benefits from including the forestry sector could be Zealand feature design elements that cover parts of the waste high. The example of New Zealand (see Box 1.6) shows that it sector.42 is possible to include emissions from deforestation. While these factors may also be relevant in other countries, the emissions and potential for mitigation may be much larger BOX 1.6 CASE STUDY: Deforestation in the New in emerging countries. Significant emissions and abatement Zealand ETS potential may be associated with both waste incinerators and Owners of plantation forests that were established before landfills—further abatement may result from reducing the 1990 become compulsory participants in the New Zealand production of waste. Additional co-benefits may be derived Emissions Trading Scheme (NZ ETS) if they deforest their from reductions in other forms of pollution associated with land.a Deforestation is deemed to occur if they clear more better overall waste management. than two hectares of pre-1990 plantation forest and convert it to a nonforest use or do not meet minimum A challenging issue for landfill methane is that emissions arise replanting or regeneration requirements. They are obliged over long periods of time as the waste decomposes. During to either surrender emissions units to cover the emissions this period, the technology for managing emissions can that deforestation caused, which are calculated using change—while it may be attractive in terms of administrative look-up tables to estimate the carbon stock at the time of costs to place the emissions obligation at the point and time harvest, or undertake ”offset planting” by offsetting their estimated emissions by planting an equivalent new forest of waste disposal, the emissions factor may not be perfectly on nonforest land. Most pre-1990 forest landowners were aligned with actual emissions. That approach would also eligible to receive an allocation of units to compensate provide no incentive to reduce emissions from waste already them for the potential loss of land value due to the ETS. in the landfill. Thus, the best approach is one that not only Landowners with fewer than 50 hectares could apply for provides for improved technology and affects emissions from an exemption from the deforestation obligation. existing waste, but also provides a unique emissions factor for Deforestation of planted forests began in the early 2000s delivered waste. in response to the perceived increased profitability of some forms of pastoral farming (particularly dairy farming).b The 3.5 Land use-related activities anticipated introduction of the NZ ETS saw many forest owners bring their deforestation intentions forward to Agriculture, forestry, and other land use are together avoid liability. This resulted in large areas of deforestation responsible for 21 percent of emissions globally. Across occurring between 2004 and 2008. It had been expected regions, however, this percentage varies strongly—as does that the scale of deforestation would fall after the intro- the cost-effective mitigation potential within each sector. duction of the NZ ETS in 2008. However, the unit price has The discussion below focuses on emissions from forestry and been in steady decline since 2008 and more deforestation agriculture. has occurred than previously expected. The restriction of international units from the NZ ETS in June 2015 has led to a steady increase in the unit price and this is expected 3.5.1 Forestry to reduce deforestation. More recently, with high dairy To date, most ETSs have not covered the forestry sector, thus prices and very low carbon prices (see Box 9.3 in "Step 9"), leaving it as a potential source of offsets (see Step 4). This is deforestation has resumed—including on land harvested in due to the comparatively low mitigation potential of forestry in 2008–11 but not quickly replanted. many of the countries that have established an ETS. Forestry is also an administratively more complex sector to include in an ETS: often a large number of potential entities are involved and an efficient tracking system over the lifetime of a forest a New Zealand Ministry for Primary Industries (2015). b Dorner and Hyslop (2014) report that only 0.1 percent of plantation forest was cleared for pasture between 1996 and 2002 and 1.5 percent between 2002 and 2008. 42 Australia’s former ETS also covered the waste sector. STEP 1: DECIDE THE SCOPE 41 3.5.2 Agriculture BOX 1.7 CASE STUDY: New Zealand and No ETS covers agriculture’s “biological” emissions, primarily Agricultural Emissions nitrous oxide from both fertilizer and livestock, and methane from ruminant animals. The only agriculture-related emissions Unusually for a developed country, in 2012, methane and nitrous oxide made up 46 percent of gross emissions in covered are: New Zealand. The country’s ETS was intended to be an “all ▲▲ Farm electricity use, where electricity generation is covered sources, all gases” system but it has struggled to include and emissions costs are passed through to electricity prices methane and nitrous oxide from agriculture. Although (except for Chinese pilots and the Republic of Korea) legislation was in place to include these emissions starting in 2015, their entry into the ETS was recently suspended ▲▲ Farm energy use, such as combustion of liquid fuels for indefinitely. agricultural machinery, where emissions from these fuels 1. SCOPE The original legislation would have made meat and milk are regulated upstream (such as in California, Québec, and processors and fertilizer manufacturers the points of New Zealand). obligation, not the farms. This system would only have provided weak, indirect incentives for farmers to reduce There are four reasons agriculture tends to be excluded from the emissions intensity of their production, as it would not existing ETSs: have been assessed.a 1. Agricultural emissions represent only a small share of total The ideal scale for implementation is at the level of the emissions in most jurisdictions that currently have ETS; individual farm, as this provides incentives for a wider range of mitigation options. However, this creates 2. Actions taken to reduce the intensity of biological challenges in terms of monitoring and compliance, and emissions from agriculture per unit of product can only be in terms of how to distribute allowances to avoid severe measured on-site, and many farms are small and remote; distributional consequences for some farming families. 3. Mitigation options tend to be more limited in this sector In addition, understanding of mitigation options, both and are often poorly understood; and within the livestock sector and through the transition to production of alternative low-emissions nutrition sources, 4. Existing policy in some jurisdictions may focus on increas- is still weak. ing agricultural output, which may be at odds with the impact of emission pricing. a Kerr and Sweet (2008). To date, New Zealand is the only country that has attempted to cover agricultural non-CO2 emissions. As indicated in Box 1.7, it has only designed a system that would operate at the processor level—and hence cannot incentivize individual QUICK QUIZ farmer mitigation measures (other than reduced nitrogen fertilizer use). Conceptual Questions ▲▲ What are the relative benefits of “upstream” and “downstream” choices in the point of regulation for emissions from the energy sector? ▲▲ What factors should be considered when deciding whether to include sources from an additional sector in an ETS? Application Questions ▲▲ How do existing regulatory frameworks affect price pass-through—especially in the electricity sector? ▲▲ Whichemissions sources/sectors are likely to be the most important to cover? ▲▲ How strong is the capability of your administrators to manage participation of (and enforce compliance by) additional points of regulation—both new emissions sources and small facilities or companies? 42 EMISSIONS TR ADING IN PR ACTICE This page intentionally left blank. STEP 2: SET THE CAP 43 STEP 2: SET THE CAP At a Glance___________________________________________________________________________ 44 1. Defining an ETS Cap_________________________________________________________________ 45 2. Fundamental Decisions to Address When Setting the Cap________________________________ 46 2.1 Cap ambition_________________________________________________________________ 46 2.2 Type of cap: absolute or intensity_______________________________________________ 49 3. Data Requirements__________________________________________________________________ 52 3.1 Historical emissions data_______________________________________________________ 52 2. CAP 3.2 Projections for emissions under a baseline________________________________________ 53 3.3 Technical and economic potential to reduce emissions_____________________________ 54 3.4 Relationship with other policies_________________________________________________ 54 4. Administrative/Legal Options_________________________________________________________ 55 5. Setting the Cap_____________________________________________________________________ 55 5.1 Designating domestic allowances_______________________________________________ 55 5.2 Choosing time periods for cap setting___________________________________________ 56 6. Common Challenges_________________________________________________________________ 57 6.1 Accommodating changes during the cap period___________________________________ 57 6.2 Ensuring allocation methodologies are compatible with the cap_____________________ 59 6.3 Providing a long-term price signal_______________________________________________ 59 Quick Quiz____________________________________________________________________________ 61 44 EMISSIONS TR ADING IN PR ACTICE AT A GLANCE ✓✓ Create a robust foundation of data to determine the cap ✓✓ Determine the level and type of cap ✓✓ Choose time periods for cap setting and provide a long-term cap trajectory The ETS cap is the maximum quantity of allowances issued by take into account the relative capacity of capped versus the government over a defined period of time, which in turn uncapped sectors to reduce emissions. limits how much covered sources can add to global emissions. There are two types of cap: (i) an absolute cap, which provides An “allowance,” supplied by the government, allows the holder upfront certainty to both regulators and market participants to emit one tonne (= one metric ton) of emissions under the on the maximum quantity of emissions allowances that are cap in compliance with the rules established by the program. available to the regulated entities; and (ii) an intensity cap, Because the ETS limits the total number of allowances and which prescribes the number of allowances issued per unit establishes a trading market, each allowance has value (the of output or input. The choice of cap type will depend on so-called “carbon” price). The “tighter” or “more ambitious” the nature of the overarching economy-wide target; how the cap—that is, the lower the absolute number of allowances concerned policy makers are about constraining future issued—the greater is the scarcity of allowances and, thus, the emissions-intensive activities; the range of uncertainties higher will be their price, all else being equal. on future economic growth (for example, in fast growing The fundamental consideration underlying the ambition of and structurally changing economies); data availability; and the cap is how far and how quickly the jurisdiction wants to priorities for facilitating compatibility with any systems to reduce emissions within the capped43 sectors while contrib- which they may wish to link. uting to global mitigation. This consideration, in turn, breaks A range of data can help policy makers make informed deci- down into three key issues that policy makers should consider: sions on the type and ambition of the cap, including historical ▲▲ Trade-offs between emissions reduction ambition and emissions data; emissions projections under a baseline; system costs: Additional cap ambition implies additional estimates of technical and economic potential to reduce emis- costs on those covered by the cap. System compliance sions in covered sectors; and the role and impacts of existing costs should not be so high as to cause disproportionate policies and barriers to mitigation. harm to domestic competitiveness and welfare in the context of the broader commitment to addressing climate Policy makers will also need to consider legal issues and admin- change and achieving other ETS policy goals. The level of istrative processes relevant to cap setting, including designating cap ambition will generally also need to be perceived as the appropriate government authority with responsibility for environmentally credible and fair by relevant stakeholders, administering and, in some cases, also setting the level of the in order to gain (and maintain) political acceptability. cap as well as the merits of establishing an independent body International linking and trading partners are likely to judge to provide advice on setting or updating the cap. the system’s cap ambition in relation to the level of mitiga- Setting the cap requires: tion effort and price in comparable jurisdictions. ▲▲ Designating allowances to be issued: An ETS issues ▲▲ Aligning cap ambition with target ambition: An ETS is domestic allowances in units (e.g., tonnes) of GHG, either typically one of several instruments that may be used in CO2 or CO2 equivalent (CO2e). In addition, policy makers reaching an overarching, economy-wide emissions reduc- need to decide whether to recognize external units for tion target. The ambition of the ETS cap should align with compliance, and whether to limit their use in the system. this overarching strategy. ▲▲ Choosing time periods for setting the cap: Caps may ▲▲ Share of mitigation responsibility borne by capped and be defined on an annual or multiple-year basis. The cap uncapped sectors: The decision on how much responsibil- period will usually correspond to a commitment period or ity for mitigation to assign to sectors under the cap should ETS phase, during which other program design features are also specified. 43 “Capped” and “covered” are considered synonyms and are used interchangeably throughout the handbook. STEP 2: SET THE CAP 45 Policy makers face three common challenges when setting the unit of GDP, kilowatt-hour of electricity, or tonne of raw cap. First, they need to consider whether and how to accom- material. Under an intensity approach, the absolute amount modate changes during the cap period, such as system shocks of emissions allowed under the cap increases or decreases as that may destabilize the market, changes to the number of a function of the input or output.45 Both of these options are covered sectors, and firm entry or exit. Second, they must considered in the overview of this chapter. ensure that methods for allocating allowances, whether for The ETS cap is a fundamental determinant of the system’s free or through auctioning, are consistent with the cap and ambition to reduce emissions. However, a range of other do not inflate the cap. Finally, they must balance the trade- ETS design elements will also influence the total amount off between providing certainty on the cap’s trajectory to that capped sources are able to emit under the rules of the establish a long-term price signal against the need to preserve program in any particular year: flexibility for adjustments (see Step 10). ▲▲ The approach taken to regulate activities in the uncapped The ETS cap establishes the maximum quantity of allowances sectors and the potential for tradable offsets (see Step 4); issued by the government over a defined period of time, which ▲▲ The rules determining the extent to which allowances can in turn drives an ETS’s total contribution to domestic and 2. CAP be borrowed or banked (see Step 5); international emissions reduction efforts. The stringency of the cap and the time period for reducing it are key elements in ▲▲ The existence of a price stability mechanism and the determining a jurisdiction’s emissions reduction pathway. The impact this has on the supply of allowances, particularly process for setting and updating caps should provide sufficient whether such a mechanism can override the cap (see Step predictability to guide long-term investment decisions while 6); and maintaining policy flexibility to help respond to new informa- ▲▲ The rules governing a potential link with other ETSs and tion and evolving circumstances. resulting unit flows (see Step 9). This chapter first explains how an ETS cap is defined. Section 2 Given these various features, maximum emissions within discusses the fundamental aspects policy makers must address the capped sources in the jurisdiction may be greater or less when setting the cap: its ambition and type. Data requirements than the amount of allowances established by the cap in a are detailed in section 3, followed by administrative and legal particular year. As a result, decisions on defining and setting options in section 4. The process for setting the cap is dis- the cap should be made in conjunction with decisions on other cussed in section 5. The chapter concludes with a discussion of design aspects. Moreover, it should be underlined that some three common challenges associated with setting the cap. design issues related to cap setting not only affect the general ambition level but also the share of emissions reductions that take place within the system and the balance of costs between 1. Defining an ETS Cap linked jurisdictions and over time. The ETS cap limits how much capped sources within capped Engaging with stakeholders can be a crucial element of the sectors can contribute to global emissions. An “allowance,” cap setting process. Stakeholders may include ETS participants, supplied by the government, permits the holder to emit one groups that may be affected by the carbon price, researchers tonne of emissions44 under the cap in compliance with the who can help model the impacts of different choices, potential rules established by the program. Because the ETS limits the linkage partners, and broader trade partners. These groups total number of allowances and establishes a trading market, can be essential to gathering data, building public confidence each allowance has value (the carbon price). Parties regulated in modeling results, and gaining support for the ETS at large. by an ETS and other market participants trade emissions This is discussed fully in Step 8. allowances depending on the value they attach to the right to emit one tonne of emissions. There are two methods for defining caps. The first, setting an absolute cap on the quantity of emissions, which is fixed upfront, is the most common. The second method is to use an emissions intensity metric. This prescribes the number of allowances issued per unit of input or output, such as 44 Or other specified amount of emissions. 45 For example, some of the Chinese pilot ETSs use intensity-based caps. 46 EMISSIONS TR ADING IN PR ACTICE 2. Fundamental Decisions relation to the level and cost of mitigation effort and price in other, comparable jurisdictions. to Address When A jurisdiction may choose to maintain the overall ambition Setting the Cap of its ETS cap on a net global basis but moderate domestic Setting the cap requires decisions on two fundamental issues: compliance costs, by giving ETS participants access to units the extent of emissions reductions that will be sought and the outside the capped sectors, through offsets (see Step 4 and type of cap (absolute or intensity) that will be used to achieve this. This section highlights the issues involved in setting the BOX 2.1 TECHNICAL NOTE: Determining the Level cap as part of the system’s overall ambition. It then discusses of ETS Ambition the advantages and disadvantages of the two types of caps introduced above. Three metrics may be used to define program ambition with regard to GHG reductions:a 1. Quantity and speed of emissions reductions. The 2.1 Cap ambition primary goal of an ETS is to limit and reduce emissions. The fundamental consideration underlying cap ambition is how Consequently, a key measure of a system’s ambition far and how quickly the jurisdiction wants to reduce global is the amount of emission reductions achieved under GHG emissions. This, in turn, breaks down into four key issues the cap. This should be considered in relation to the that policy makers should consider when setting cap ambition: jurisdiction’s broader emissions reduction targets as well as global mitigation objectives for limiting temperature 1. Trade-offs between emissions reduction ambition and rises and reducing global emissions (e.g., as agreed system costs; under the UNFCCC). 2. Aligning cap ambition with target ambition; 2. Allowance price. In theory, the allowance price 3. Share of mitigation responsibility borne by capped and reflects the marginal cost of emitting a tonne of CO2 or equivalent GHG in a particular ETS. It thus depends on uncapped sectors; and the overall quantity of emission reductions achieved 4. Potentially, the intended share of domestic emissions up to that point and the cost associated with the last abatement efforts. increment of reductions. The allowance price indicates the magnitude of the incentive that the ETS is providing to reduce emissions by one more tonne.b The allowance 2.1.1 Trade-off between emissions reduction ambition and price may also be compared to estimates of the “social system costs cost of carbon,” which seeks to reflect the full cost to The fundamental objective of any ETS is to deliver a desired society of each tonne of CO2 emitted. level of emissions reductions cost-effectively and efficiently. 3. Total cost. Whereas price reflects the cost of reducing Box 2.1 discusses three metrics that can be used to assess an incremental unit of emissions, total cost reflects the how ambitious an ETS is in this regard: quantity and speed of overall cumulative resources devoted to achieving a emission reductions, allowance price, and total cost. certain amount of emission reductions.c, d, e For an ETS to be politically acceptable, relevant stakeholders generally need to perceive the level of ambition as environ- a For a further discussion of all three, see Aldy and Pizer (2014). In addition, the PMR (2015a) provides a practical step-by-step guide for assessing the level of mentally credible and economically fair. Credibility will depend ambition in emissions reduction pathways. on the level of mitigation required by the cap relative to b Similar price levels do not necessarily imply similar ambition, depending on the projections of emissions under business as usual (BAU) and emissions profile of the participants to the ETS. c Another caveat to using allowance prices as the sole criterion is the simple the total expected cost. Inherently, a more ambitious cap will example of how the prevailing ETS price would increase the more ineffective impose more costs on covered sectors than a less ambitious an ETS design is. For example, if the introduction of market rules prevented efficient exchange of allowances, the price would increase. That increase, how- cap. Fairness has both domestic and international dimensions. ever, clearly does not reflect an increased level of ambition; it simply reflects Domestic stakeholders will consider whether the cap might a less efficient market design. Conversely, laxer enforcement standards could decrease the price. The same conclusion applies here. cause disproportionate harm to domestic competitiveness d This approach, however, only gives information on the expenditure side of (including for firms at risk of carbon leakage, as discussed in the economic result of an ETS, but disregards the “returns” side: one should Step 3), national income, and welfare.46 International linking keep in mind the objective to achieve decarbonization scenarios where profits are equal to or even outweigh losses (termed GDP-neutral and GDP-positive and trading partners might judge the system’s ambition in scenarios respectively). e For an illustration at macro level of such scenarios, see for instance IEA’s 46 However, depending on the way in which revenues raised from an ETS are redistrib- “bridge scenario” in WEO 2015. uted and the specific country context, GDP and/or welfare may actually rise. STEP 2: SET THE CAP 47 linking (see Step 9). Similarly, if marginal abatement costs are and other jurisdictions adopt similar pricing approaches, the low, ETS participants could be enabled to sell units through emissions reduction ambition may rise. Moreover, starting with linking. The latter does not alter the overall ambition of the ETS a less ambitious cap that becomes more stringent over time cap on a net global basis but it does lead to higher domestic can also create incentives for long-term low-carbon invest- carbon prices and more domestic reductions. In either case, ment decisions while enabling a gradual adjustment to carbon the jurisdiction needs to decide how much they wish to direct pricing in the short term. However, there may be some risk ETS-related mitigation investment to achieve reductions within that this will “lock in” low ambition into the system. These risks capped (vs. uncapped) sources within their borders as well include continued investment in emissions-intensive assets as across their own jurisdiction (rather than globally), in order and an inability to tighten the cap further into the scheme, as to drive down emissions within their domestic economy and a result of political constraints. To prevent this, policy makers generate local co-benefits. may wish to consider incorporating a tighter future cap into the system when designing it. This can help ensure the ETS The decisions on the trade-offs between ambition and cost delivers long-term abatement. may change over time. In the early stages of an ETS, the gov- ernment may place a higher priority on getting the fundamen- A wide range of information can be collected to inform 2. CAP tal ETS architecture in place, building support for the system, modeling and assessment of the costs and production impacts and getting started with trading, rather than achieving an of differing levels of ambition in different future economic ambitious level of mitigation at potentially high cost. Applying scenarios. This is discussed further in section 2.3. a relatively higher and, thus, less stringent cap in earlier periods can also help lower the perceived initial risks to partic- 2.1.2 Aligning cap ambition with target ambition ipants and to the economy; reduce competitiveness impacts; In many cases, an ETS will be considered as one of the key and create an enabling framework for the necessary learning policy instruments to reach an overarching economy-wide processes for regulators, regulated entities, and other stake- emissions reduction ambition (Figure 2.1 shows how the holders. Over time, as the infrastructure is established, market EU ETS targets relate to economy-wide targets). Experience participants become more familiar with the ETS regulations, suggests it may also be politically more acceptable to set a FIGURE 2.1 EU Emissions Reduction Targets, and Role of the EU ETS 6,000 5,000 4,000 3,000 2,000 1,000 0 1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 EU 2050 Climate Roadmap Non-ETS Emissions EU Total GHG Emissions ETS Cap ETS Emissions ETS Target Pathway with Linear Reduction Factor of 2.2% Source: ICAP, 2015a. Note: The green line indicates the progressively declining cap, with a linear reduction factor of 1.74 percent until 2020, and a proposed factor of 2.2 percent beyond 2020. 48 EMISSIONS TR ADING IN PR ACTICE FIGURE 2.2 Top-Down and Bottom-Up Approaches to Cap Setting Top-Down Bottom-Up Overall emission reduction target National emission reduction target High-level assessment of mitigation potentials ETS Cap Non-ETS sectors ETS Cap Non-ETS sectors Assessment of emissions and mitigation potentials Free allocation Auctioning Author: ICAP more ambitious cap when there already is an overarching more of a partial nature, the bottom-up elements of the commitment in place to reduce emissions. cap setting will be even more important. 3. A hybrid approach: This takes elements from both top- In view of this, when deciding on the ambition of the ETS cap, down and bottom-up cap setting. Bottom-up data and it is important to consider the cap in the context of the over- analysis might be used as a basis for the cap, which is then arching, economy-wide ambition. Three options are available adjusted to reflect interaction effects between sectors, and to policy makers (two of which are illustrated in Figure 2.2): the intended contribution of the capped sectors to top- 1. A top-down approach: The government sets the cap down mitigation objectives. Many of the ETSs with a more based on its overall emissions reduction objectives and a limited scope use these hybrid approaches.47 high-level assessment of mitigation potential and costs across capped sectors. This approach makes it simpler to 2.1.3 Share of mitigation effort borne by capped and align the ambition of the ETS with the jurisdiction’s broader uncapped sectors mitigation goals and the contribution from other policies Linked to the discussion above, in cases where an and measures. This approach is, of course, not available economy-wide emissions reduction target exists, determining in cases where an economy-wide ambition has not been the ambition for sectors within an ETS with a limited scope agreed upon. The broader the scope of the ETS is planned, has important consequences for the intended mitigation from the more attractive top-down approaches are. uncapped sectors. The government should consider the equity, 2. A bottom-up approach: The government bases the cap efficiency, and political implications of decisions on the share on a more granular assessment of emissions, mitigation of mitigation responsibility borne by capped and uncapped potential, and costs for each sector, subsector, or partici- sectors. The decision on how much mitigation responsibility to pant, and determines an appropriate emissions reduction assign to capped sectors should take into account the relative potential for each. The overall cap is then determined by capacity of capped and uncapped sectors to reduce emissions. aggregating the emissions reduction potential for those sectors, subsectors, or participants. The benefit of a bot- If marginal abatement costs are relatively low within uncapped tom-up approach is that it takes into account the specific sectors, firms could be permitted to access these lower-cost circumstances of participants and sectors. However, units through domestic offsets. This is discussed further in there are some downsides to the bottom-up approach: Step 4. it requires high-quality, disaggregated data; it may not As a practical example, alongside decisions on the cap for the capture interaction or portfolio effects or broader macro- third phase of the EU ETS (2013–20), policy makers issued economic considerations; and the ambition of the resulting cap may not align with the jurisdiction’s broader mitigation 47 This involves adjusting for the possibility that emission savings in one sector might become easier, or more difficult, if they are also being sought in another sector at the targets. If the scope of the ETS, for whatever reason, is same time. STEP 2: SET THE CAP 49 an Effort Sharing Decision that expressly defined the level the overarching mitigation targets (the cases of the EU and of mitigation responsibility allocated to uncapped sectors California were discussed in section 2.1.3). across member states in order to achieve EU-wide mitigation However, while such alignment may be easier, it is not essen- commitments. To achieve the goal of reducing the region’s tial. In particular, a common misconception is that an absolute emissions to a level of 14 percent below the 2005 emissions cap cannot be used in cases where absolute emissions are level (equivalent to 20 percent below the 1990 level), capped expected to grow, and that an intensity cap should be used sectors needed to achieve a 21 percent reduction with respect instead. However, both intensity and absolute caps can be to the 2005 level, and uncapped sectors needed to achieve a designed to accommodate “growth targets” that allow for 10 percent reduction with respect to the 2005 level. Greater absolute emissions to increase for a period of time while mitigation effort was required from capped sectors because of reducing the rate of increase below BAU, thereby producing the expected lower mitigation costs in power generation (one a global emissions benefit. For example, under a “slow, of the capped sectors)48 and the effects from complementary stop, reverse” trajectory, an absolute cap could allow initial policies to strengthen the use of renewable energy sources growth in absolute emissions (but at a slower rate than under for a fully ETS-regulated electricity sector. The interaction of BAU) and then transition to driving reductions in absolute ETS with other policies is more fully discussed in the chapter 2. CAP emissions.49 “Before You Begin”. Therefore, a jurisdiction’s choice of ETS cap structure is not 2.1.4 Overview of cap setting approaches dictated by that of its broader mitigation targets or growth Table 2.1 provides a more detailed account of the caps chosen potential. Yet the nature of the overarching targets might play by different jurisdictions and how they relate to economy-wide a role in the structural specification of the target. If an ETS targets. will be used to achieve far-reaching decarbonization within a few decades for mature economies with relatively moderate 2.2 Type of cap: absolute or intensity potential for growth, absolute caps will provide a more robust Four important considerations can influence whether a juris- framework than in the context of emerging, fast growing diction may prefer an absolute or intensity-based cap: economies that aim for an emissions trajectory of peak and decline. ▲▲ Alignment between the ETS cap and overarching mitigation target; 2.2.2 Relationship between cap structure and ETS ▲▲ The extent and nature of uncertainty in the input/output ambition under output uncertainty metric that might be used for the intensity cap; Broadly, the stringency of an ETS depends on the ambition of ▲▲ Data considerations; and its cap rather than the structure of its cap. Both absolute and intensity caps can be designed to deliver ambitious mitigation ▲▲ Whether or not the jurisdiction wishes to link with another outcomes. However, when a key driver of emissions deviates ETS and the design of that ETS. significantly from projections, even if set with comparable Each of these considerations is discussed below. intentions, absolute and intensity caps (expressed relative to that driver) could produce very different mitigation and cost 2.2.1 Alignment of cap structure and the structure of outcomes.50 overarching targets If output is higher than projected, then an absolute cap will Alignment between the overall emissions reduction target for achieve more mitigation (and correspondingly higher total the economy and the emissions reduction target for the ETS cost) than an intensity cap, which will allow emissions to rise. is generally preferable—in other words, an absolute emissions As a result, if output grows faster than expected, absolute reduction target for the economy as a whole will correspond caps place the risk on compliance cost while intensity caps more easily with an absolute cap, and an economy-wide emis- place the risk on emissions outcomes. By contrast, if output sions intensity target may do so with an emissions intensity is lower than projected, an intensity cap will force more cap. In particular, structural alignment between caps and tar- mitigation at higher cost than an absolute cap, and an abso- gets will make it much easier to understand and communicate lute cap will be relatively less binding on emissions. Further to stakeholders how the ETS is contributing to attainment of 49 The “slow, stop, reverse” trajectory is discussed in Ellerman and Sue Wing (2003). 50 While, in principle, an intensity-based cap may be set by reference to many intensity metrics (see section 2.2.3), for the sake of simplicity, in this example we assume that 48 EC (2013); EC (2009). the intensity metric is output. 50 EMISSIONS TR ADING IN PR ACTICE TABLE 2.1 Economy-Wide Emission Reduction Targets and ETS Caps in Existing ETSs Economy-wide targets for jurisdiction/ETS coverage of ETS system jurisdiction’s GHG emissions (as of 2015) ETS cap (in millions of allowances) EU ETS a Cap based on aggregation of National Allocation Plans of each EU Member State Phase I (2005–07) Reduce emissions to levels 8% below 1990 levels over 2008–12 Phase II (2008–12) Same as above Phase III (2013–20) Single, EU-wide cap for stationary sources Reduce emissions to levels 20% below 1990 levels by 2020 2013: 2,084, cap for stationary sources, declines 1.74%/year, expanded to cover ETS coverage: 45% CCS installations, production of petrochemicals, ammonia, nonferrous metals, gypsum and aluminum, nitric adipic and glyoxylic acid; aviation sector cap: 210 Phase IV (2021–30) European Commission proposes to decline the cap for stationary sources by 2.2% Reduce emissions to levels 40% below 1990 levels by 2030 annually New Zealand b,c Reduce emissions to 1990 levels over 2008–12 2008–15: operated under the Kyoto cap with no domestic ETS cap Reduce emissions by 5% relative to 1990 levels by 2020 (unconditional), 11% by 2030 (conditional), and 50% by 2050 (unconditional) ETS coverage: 52% RGGI d,e Not applicable 2009: originally stabilized at 149.7 (165 M short tons) ETS coverage: 5.5% of U.S. emissions 2014: 82.6 (91 M short tons), the cap was amended in the 2012 program reform; 45% reduction in CO2 from covered sources below 2005 levels cap declines linearly by 2.5%. To account for banked allowances, RGGI has a total by 2020 interim adjustment for 2014–20 of 139.5 million CO2 allowances. Tokyo f,g 2010–14: cap is set at the facility level and aggregated to a Tokyo-wide cap that Reduce emissions by 25% relative to 2000 levels by 2020, reduces emissions by 6–8%/fiscal year below base year (average of any 3-year 30% reduction relative to 2000 levels by 2030. period from 2002–07) ETS coverage: 20% 2015–19: 15–17% below base year Saitama h 2011–14: cap is set at the facility level and aggregated to a Saitama-wide cap that Reduce emissions by 25% relative to 1990 levels by 2020 reduces emissions 6–8% below base year (average of 3 years from 2002–07) ETS coverage: 18% 2015–19: 15–20% below base year California i, j 2013: 162.8 Reach 1990 level emissions by 2020 2014: 159.7, cap declined linearly approx. 2% ETS coverage: 85% 2015: 394.5, expanded to distributors of transportation, natural gas and other fuels; cap declines linearly approx. 3%/year from 2015 to 2020 Québec l 2013-2014: 23.2 (per year) Reduce emissions by 20% relative to 1990 levels by 2020 2015: 65.3, expanded to distribution and importation of fuels in the transport and ETS coverage: 85% building sectors, cap declines linearly at 3.2% through 2020 Kazakhstan k Reduce emissions by 15% relative to 1990 levels by 2020 and 2013: 147.2, plus a reserve of 20.6 25% relative to 1990 by 2050 2014: 155.4 ETS coverage: 50% 2015: 153 Switzerland m, n Reduce emissions by 20% relative to 1990 levels by 2020, 2013: 5.63, cap declines linearly by 1.74% a year through 2020 35% by 2025, 50% by 2030, and 70-85% by 2050 (targets 2015: 5.44 for 2025 and 2030 are subject to approval by parliament, target for 2050 is an indicative goal) ETS coverage: 11% Republic of Korea Reduce emissions by 30% relative to modeled BAU by 2020 2015: 573, the cap declines by about 2% through 2017 (4% below 2005 levels). Reduce emissions 37% below BAU (22% below 2012 levels) by 2030 ETS coverage: 66% Source: EDF et al. Note: CCS = Carbon Capture and Storage; BAU = Business as Usual; RGGI = Regional Greenhouse Gas Initiative; GHG = Greenhouse Gas. a ICAP, 2016b. g ICAP, 2016d. b New Zealand Emission Unit Register, “About the Kyoto Protocol” (n.d.); retrieved from h ICAP, 2016c. http://www.eur.govt.nz/about-us/about-the-kyoto-protocol. i ICAP, 2015a. c Government of New Zealand, “New Zealand’s Emissions Reduction Targets.” (Last updated j California Air Resources Board, 2010c, and 17 CCR §95841 Table 6-1; available July 7, 2015). Retrieved from http://www.climatechange.govt.nz/reducing-our-emissions/ at http://www.arb.ca.gov/cc/capandtrade/finalregorder.pdf. targets.html. k ICAP, 2015a. d Regional Greenhouse Gas Initiative (RGGI), “The RGGI CO2 Cap,” accessed 29 January 2016. l ICAP, 2016a. e EDF, CDC and IETA, 2015g. m ICAP, 2015b. f Tokyo Bureau of Environment, 2010. n Federal Office for the Environment, Switzerland, 2015. STEP 2: SET THE CAP 51 considerations of the optimal type of cap, whether absolute or intensity, BOX 2.2 TECHNICAL NOTE: Intensity under output and emissions uncertainty, are discussed in Box 2.2. It versus Absolute Caps under shows that intensity caps do not provide a comprehensive solution to Output and Emissions reducing uncertainty regarding the mitigation and cost burden under an Uncertainty ETS, for example:51 In the context of setting national emissions ▲▲ Intensity approaches do not address uncertainty in the rate of emis- targets, Sue Wing et al. (2009) studied the sions per unit of output. The rate of emissions per unit of output can conditions under which absolute and intensity also vary with GDP or in response to other drivers. caps on the basis of emissions per unit of GDP would deliver upon expectations for the level ▲▲ The degree of correlation between emissions and output can vary of the mitigation burden and cost to meet the significantly by country, by sector, and over time, especially during target, and minimize their volatility. Based on an the course of development. assessment of hypothetical targets using histor- ical emissions and GDP, their analysis suggested ▲▲ Intensity approaches also introduce additional technical and admin- that the optimal choice between absolute and istrative challenges. Intensity targets require data collection and intensity approaches for each country would reporting on output as well as emissions, which can introduce further 2. CAP vary according to: complexity, error margins, and time lags in determining emissions ▲▲ The stringency of the target; outcomes. ▲▲ The degree of correlation between emissions and GDP; and 2.2.3 Data considerations when choosing intensity metrics Intensity approaches reduce the need for policy makers to develop out- ▲▲ The extent of volatility in both emissions and put projections in order to predict the cost of compliance with the cap. GDP. However, they impose the need to explicitly select appropriate intensity Their analysis also suggested that the optimal metrics. Intensity metrics can relate to economic and/or commodity cap structure for delivering the anticipated outputs. The appropriate choice of metrics will vary according to sector mitigation effort and cost may differ from that coverage, availability of data, and the objectives of the ETS. If an ETS for reducing the volatility of mitigation burden covers a single sector whose emissions are strongly correlated with and cost. GDP, like power generation, then either a GDP or a commodity metric Jotzo and Pezzey (2007) modeled the impacts could be used. When multiple sectors are covered by an intensity cap, of economy-wide absolute targets, standard then the output metric of GDP may be the easiest to apply universally. intensity targets (with one-to-one indexation), Alternatively, a bottom-up multisector cap could be developed using and “optimal intensity” targets (with variable indexation) on global mitigation and welfare for sector-specific commodity metrics. a range of developed and developing countries Experience with setting emission-intensity reference levels, such as under a hypothetical treaty. They found that the extent to which intensity targets helped average performance standards or best-practice emissions benchmarks, neutralize emissions uncertainty around future in other contexts has highlighted a number of technical challenges that GDP varied by country, with the strongest can be associated with using bottom-up intensity caps in an ETS. While benefits received by countries with a strong defining emission-intensity reference levels may be relatively straight- correlation between emissions and GDP, where forward in sectors like electricity generation, it becomes more difficult uncertainty around GDP is high relative to other in sectors like specialized product manufacture, mining, or chemical uncertainties, or countries that are strongly production. It is also challenging to develop emission-intensity reference risk-averse. Larger countries also benefit more levels for processes like cement, steel, and aluminum production when from reducing risk. Overall, allowing variable target indexation to GDP (at levels greater or regional differences in resource and technology availability, process less than one-to-one, tailored according to methodology, and fuel mix need to be taken into account. national circumstances) produced a more ambi- tious global emissions outcome while increasing If, however, substitution of commodities is seen as a significant source global welfare by reducing perceived emission of emissions abatement (aluminum vs. steel, cement vs. other building risk from changes in GDP. materials, etc.), the use of metrics related to commodities is obviously not suitable as a basis to define the cap for certain sectors to be regu- lated by an ETS. When emissions-intensity reference levels are used as a basis for a cap across a number of sectors rather than for allocation 51 Jotzo and Pezzey (2007); Herzog et al. (2006); Wing et al. (2006); and Pizer (2005). 52 EMISSIONS TR ADING IN PR ACTICE to specific firms or sectors, simpler reference levels could be used, particularly if the output metric is GDP. BOX 2.3 CASE STUDY: Practical Experience with Emissions Trading under Intensity Caps Box 2.3 provides practical examples of how intensity Experience to date with setting intensity caps in an ETS is approaches have been applied in two ETSs. limited. Examples from the United Kingdom and the United States are discussed below. 2.2.4 Linking UK ETS: The UK ETS predated the EU ETS and operated If a jurisdiction has intentions to link its ETS to the ETS in one with an absolute cap from 2001 to 2006. Alongside its or more other jurisdictions, then this will be made consider- ETS, the UK government imposed a Climate Change Levy ably easier if the linked ETSs have the same cap structure. on energy use. Energy-intensive industrial firms could Moreover, trading between jurisdictions with absolute and negotiate a Climate Change Agreement (CCA) under which they committed to either an energy or emissions target in intensity caps may result in an increase in overall emissions, return for a partial exemption from the Levy. Both energy relative to the case where no linking is allowed. For this and emission targets could be expressed on an intensity or reason, jurisdictions with absolute caps may decline to link absolute basis. Most CCA firms chose intensity approaches. with jurisdictions with intensity caps. Indeed, in the example These intensity targets implicitly created an intensity cap on of the U.S. Clean Power Plan (see Box 2.3), trading between the firms as a group. The government allowed CCA firms to participants in rate-based states (which choose intensity achieve their target through an emissions trading linkage to targets) and participants in mass-based states (which choose the UK ETS. The government imposed a “gateway” mecha- absolute targets) will not be permitted. Linking is more fully nism that allowed CCA firms to purchase units from the UK ETS, but not to sell units into the UK ETS in order to ensure discussed in Step 9. the stringency of the UK ETS cap. Units were traded across the gateway to help CCA participants meet their targets.a 3. Data Requirements U.S. Clean Power Plan: In the United States, the Obama Administration’s Clean Power Plan was introduced in 2015 A range of data can help policy makers make informed to impose nationwide emissions limits on the power sector. decisions on the type and ambition of the cap. These are Each state was offered the choice between different kinds discussed in this subsection as follows: of emissions reduction targets: rate-based (lbs CO2/MWh) and mass-based, either with or without a new-source 1. Historical emissions data; complement (short tons of CO2 per year). States were given 2. Projections for emissions under a baseline; flexibility as to how to meet their targets. Emissions trading was provided as an option for both rate-based and mass- 3. Technical and economic potential to reduce emissions in based approaches, with the former using Emission Rate capped sectors; and Credits (ERCs) and the latter using allowances. However, 4. Role of existing policies and barriers to mitigation. trading was not permitted between rate-based and mass-based participants. To set the target for each state, policy makers identified a target emissions rate for 2030 3.1 Historical emissions data based on the Best System of Emissions Reduction (BSER) Historical emissions data play an important role in cap derived from each state’s potential for generation efficiency setting as they provide an informed basis from which to improvements and fuel switching from coal to natural gas or renewables. This was then offered as the state’s project future emissions (in the absence of a cap). Data emission-rate target, or converted to a mass-based target at a national level may already be available from national by applying state-specific projections for electricity output. emissions inventories or can be obtained from international Under the mass-based approach, reductions from energy organizations. Examples of the latter include the International efficiency improvements would automatically be recognized Energy Agency (IEA),52 the Emissions Database for Global within the cap. Under the rate-based approach, additional Atmospheric Research (EDGAR, a joint project of the ERCs could be generated through energy efficiency proj- European Commission Joint Research Centre (JRC) and the ects. The mass-based approach would be suitable for linking Netherlands Environmental Assessment Agency (PBL)),53 trading activity under the Clean Power Plan with established ETSs such as RGGI, which use absolute targets.b the Carbon Dioxide Information Analysis Center (CDIAC),54 and the Climate Analysis Indicators Tool developed by the a Herzog et al. (2006); Dahan et al. (2015b). 52 For data collected by the International Energy Agency on energy-related CO2 b The full text of the regulation, as well as fact sheets on the Clean Power Plan, emissions, refer to IEA (2016a). are available from EPA’s website (see, for example, U.S. EPA, 2015). 53 For EDGAR data on national greenhouse gas emissions, see EDGAR (2016). 54 For CDIAC data on national carbon dioxide emissions, see CDIAC (2015). STEP 2: SET THE CAP 53 World Resources Institute (WRI).55 Methodological differences BOX 2.4 CASE STUDY: Accounting for Uncertainty between data sets should be taken into consideration. of Emissions Projections in Cap Setting for Phase I of the EU ETS (2005–07) When gathering firm-level data on historical and anticipated emissions to establish and project trends, policy makers can The availability of historical emissions data is critical when consider the following: determining the ETS cap based on projections or growth rate. For example, because the EU lacked reliable data on ▲▲ Existing firm-level environmental and production reporting industry-wide and company-specific emissions of instal- systems may offer a useful starting point for emissions lations under the ETS prior to 2005, the cap was instead data needed to set a cap, but the methodologies applied based on a bottom-up estimate of the allowances required or the level of quality control or enforcement may not be by each installation. These estimates were based on partly consistent with what is needed for an ETS; incomplete data, partly inconsistent emissions calculation methodologies, and the data collection allowed partly ▲▲ If adequate data for cap setting are not available from for the opt-out of certain years without considering this existing reporting systems, prospective ETS participants carefully enough for the calculation of totals. As a result, could be required to report emissions early so that authori- in mid-2006, after reports for actual emissions in 2005 2. CAP ties have those data available when determining the cap; were published, it became obvious that most member states had set too generous caps and allocated too many ▲▲ The data used to set the cap should predate serious allowances—almost 4 percent more than BAU emissions, consideration of an ETS; otherwise, firms may have an by some estimates.a When entities found that they could incentive to exaggerate their emissions, or emit more, in comply fully with the pilot phase obligations without using the hope of a looser cap, particularly if they anticipate that all their allowances, the price of the remaining allowances allocation will be through grandfathering; and fell to zero. This led to important accounting and allocation reforms for Phases II and III of the trading system involving ▲▲ When using firm-level historical or projected emissions, steady moves to a more centralized cap and allocation policy makers should seek an independent assessment of process based on actual historical emissions data, which the firm’s information and assess it against international were generated by the MRV obligations under the ETS. comparators; Given that banking was not possible between Phase I and ▲▲ As most of the relevant emissions data will be calculated Phase II, any Phase I overallocation was not carried into future phases. from energy data, the methodological consistency (includ- ing the relevant emissions factors) between data calcula- Grubb and Ferrario (2006) examined four lines of evidence tions for cap setting and other steps in the ETS chain is of on emissions forecasting in the context of cap setting in Phase I of the EU ETS: scenario projections, statistical anal- crucial importance. yses of past forecasts, the process for official emissions When historical emissions data are not available or incomplete, forecasts, and the history of allocation negotiations in the EU ETS. They recommend that future ETSs be designed it may still be possible to proceed with the setting of a cap with full recognition of “irreducible uncertainty and projec- but the specific challenges arising from gap filling need to be tion inflation” and that priority be given to improving the addressed carefully. However, the experience of Phase I of reliability and accessibility of the data used for setting ETS the EU ETS, as explored in Box 2.4, illustrates some of the caps. Such issues have been addressed for future phases problems that can arise. of the EU ETS, with more recent research concluding that the National Allocation Plans have resulted in a more efficient cap setting process compared to a single, EU-wide 3.2 Projections for emissions under a cap.b baseline The second type of useful information when setting the cap a Egenhofer (2007); U.S. GAO (2008). is information on expected emissions without the ETS. This b See Fallmann et al. (2015). can inform the potential emissions and cost impacts of an ETS under different emissions caps. 55 For the Climate Analysis Indicators Tool from WRI, see WRI (n.d.). 54 EMISSIONS TR ADING IN PR ACTICE The type of economic and emissions forecasting used for key sectors have been produced by the IPCC,59 the IEA,60 the setting jurisdiction-wide mitigation targets can also be useful Deep Decarbonization Pathways Project led by the Sustainable for these purposes. Four key options are:56 Development Solutions Network (SDSN), and the Institute for Sustainable Development and International Relations (IDDRI). ▲▲ Trend extrapolation: Observed historical trends in output However, it is always important to adapt the findings of such (e.g., GDP) and emissions intensity as a function of output studies to local conditions. are extended into the future to define an emissions pathway. Economic mitigation potential can be defined as “the potential ▲▲ Extended extrapolation: The extrapolation of historical for cost-effective GHG mitigation when nonmarket social costs trends is refined by accounting for potential changes in and benefits are included with market costs and benefits in output and/or emissions intensity. assessing the options for particular levels of carbon prices and when using social discount rates instead of private ones.”61 ▲▲ Decomposition projection: Trends in a small number of Developing marginal abatement cost (MAC) curves for key key emissions drivers (for example, population, economic sectors, both covered and uncovered, can help in the under- growth, energy intensity, and structural change) are standing of the economic costs of meeting mitigation targets. assessed to define an emissions pathway. However, developing accurate MAC curves can be challenging ▲▲ Detailed bottom-up analysis: Drivers of production and and may be easier in sectors that are already regulated or emissions intensity are analyzed in detail at the sector or where technical mitigation options are common across coun- subsector level in the context of broader economic pro- tries so it is possible to draw on others’ experiences. jections and the results aggregated to define an emissions pathway. Importantly, while information on MAC curves is useful, it is not essential to have comprehensive information on MAC curves Because emissions and economic projections involve a high before setting an ETS cap. The point of an ETS is to create degree of uncertainty associated with emissions drivers incentives for market participants (consumers and producers), operating independently of the ETS (e.g., volatility in inter- not regulators, to discover the most cost-effective mitigation national energy prices, commodity demand, and currency options across covered sectors. Raising cap ambition gradually exchange rates), it is useful to develop a range of emissions and reviewing the cap periodically may be sufficient to mod- and economic projections that can be used for assessing the erate price risk and enable the cap to be adjusted as better potential impacts of an ETS. When using company or industrial information on MAC curves becomes available. association data for projections, it is important to remember that these projections regularly tend to be overoptimistic about growth assumption and emissions trends.57 3.4 Relationship with other policies In many jurisdictions, a new ETS will interact with other policies to drive change. Estimates of MACs, and projections 3.3 Technical and economic potential to for relative emissions and price responses under different cap reduce emissions settings might vary significantly, depending on the existence The magnitude and cost of mitigation opportunities across and workings of these policies, and result in enhancing, dupli- covered and uncovered sectors constitute a third key category cating, or negating the impact of an ETS. It will therefore be of information. The cap should incentivize technical innovation important to document these policies carefully as a first step to mitigate and maximize economic mitigation potential to to exploring these interaction effects and hence determining produce cost-effective abatement. the appropriate type and ambition of the cap. In existing ETSs (e.g., EU ETS, RGGI, and California’s cap-and-trade program), Technical mitigation potential can be defined as “the amount significant interactions have been observed in particular by which it is possible to reduce GHG emissions or improve between ETSs and policies to promote renewable energy and energy efficiency by implementing a technology or practice energy efficiency. that has already been demonstrated”.58 Information on technical mitigation potential in key sectors is widely available For Phases II and III of the EU ETS, these interactions with from international research organizations. For example, studies complementary goals and policies in the framework of the synthesizing information on technical mitigation potential in EU’s 20-20-20 targets (20 percent emissions reduction, 20 56 PMR (2015a). 59 IPCC (2014). 57 Matthes and Schafhausen (2007). 60 For information on IEA’s low-carbon energy technology roadmaps, see IEA (2016b). 58 IPCC (2014). 61 IPCC (2007). STEP 2: SET THE CAP 55 percent of energy from renewable energy sources, and 20 was required to take the Authority’s advice and recom- percent of energy-efficiency improvements) were subject to mendations into account when setting caps and announce broad modeling exercises that built a robust reference for a these five years in advance. The Clean Energy Act provided cap that considered the additional emissions mitigation from a default cap in the event that a cap had not been set. the complementary policies.62 ▲▲ In the Republic of Korea, the ETS cap was set outside of legislation to enable greater flexibility and efficiency. The legal basis for implementation of an ETS was first estab- 4. Administrative/Legal lished in the 2010 Framework Act on Low Carbon, Green Options Growth, followed by the Emissions Trading Act. Secondary legislation, an Allocation Plan completed by the Ministry of An appropriate authority should be given the responsibility Environment in September 2014, defined the ETS cap and for setting the ETS cap. The relevant authority may be a reg- allocation provisions in alignment with the Act. ulatory, legislative, or administrative body, depending on the structures already in place in the specific jurisdiction. A jurisdiction may also wish to consider the merits of estab- lishing an independent body to provide advice on setting or 2. CAP The cap could be legislated for, or the legislation could estab- updating the cap. For example, the body could include tech- lish the process for setting the cap. The latter method leaves nical experts, sector stakeholders, and representatives of civil more time for data collection and analysis, and can facilitate society. This could help enhance the objectivity, transparency, later adjustment of the cap. It could also defer technical cap and credibility of the cap setting process. This approach was setting discussions until later—and less political—stages of ETS proposed by Australia for cap setting under its Carbon Pricing development. Mechanism (see Box 2.8). The approach taken in a range of jurisdictions includes the following: ▲▲ For the Phases I and II of the EU ETS, the governance 5. Setting the Cap approach for cap setting was left to the member states. In Once the fundamental design decisions have been made, some jurisdictions (e.g., Germany) cap setting was under a informed by the collection of relevant data, and the formal full legislative process; in other jurisdictions (e.g., France), legal and administrative arrangements have been agreed it was by administrative orders. Member state caps were upon, it is possible to set the initial cap. As discussed in this subject to approval by the European Commission, as the section, this requires: administrative body of the EU, acting within the legislative 1. Designating allowances to be allocated under the cap; and framework that defined principles rather than quantitative 2. Choosing time periods for setting the cap. specifications. From Phase III onward the cap was set by a full European legislative process. The role of administrative bodies at the national and EU levels was and is strictly 5.1 Designating domestic allowances limited to technical adjustments. Every ETS currently in operation issues its own domestic allowances in units of tonnes of GHG, either CO2 or CO2e. All ▲▲ In the case of the California ETS, state legislation (AB existing ETSs use tonnes, with the exception of RGGI, which 32) set the requirement that California return to 1990 uses U.S. short tons. In addition, policy makers also need to emissions levels by 2020 and charged the California Air decide whether to recognize external units for compliance. Resources Board (ARB) with developing a Scoping Plan for Such external units may derive from offset mechanisms (see meeting the 2020 target. The initial Scoping Plan, approved Step 4) or the ability to buy and sell through linking (see Step by ARB in 2008, provided for development of an ETS. The 9). The EU ETS, for example, recognizes four different types of cap was set through regulation under a process managed units (see Box 2.5). by ARB as the primary implementing agency.63 ▲▲ In Australia, the Carbon Pricing Mechanism (now repealed) Not all allowances issued by the government may be subject required the Climate Change Authority, an independent to the ETS cap. For example, the government may choose to statutory agency, to make an annual recommendation on issue allowances for removals by sinks. Removals are environ- what the cap should be in five years’ time. The legislator mentally equivalent to lower emissions from mitigation so units are often issued in addition to the cap. In this case, removal 62 See Capros et al. (2008) for further details. allowances would increase unit supply in the market. Policy 63 ARB (2008). 56 EMISSIONS TR ADING IN PR ACTICE makers may choose to place quantity limits on the issuance or a central registry. For example, New Zealand’s government use of removal allowances. As noted above, the government chose to create a single allowance, the New Zealand Unit may also choose to operate market stability mechanisms that (NZU), which applied equally to emissions by all sectors and issue units beyond the cap in order to provide price protection removals by the forestry and industrial sectors. Some market or hold back allowances for specific purposes (e.g., new buyers (domestic and international) were willing to pay a entrant allocation in the course of a trading phase or allocation price premium for NZUs associated with forest conservation for market stability purposes). These may or may not be made and afforestation, especially for land under long-term forest available to the market if not used for the purpose for which covenants. By assigning a unique serial number to each they were originally held back. For the latter case, the cap allowance issued into the registry and enabling allowance would be implicitly tightened, which is another way to gradu- tracking, sellers could market the attributes of their NZUs to ally adjust a cap for real emissions trends (see Step 6). gain a price premium and buyers could verify the sources. By contrast, California and Québec deliberately chose not to The activities associated with specific domestic allowances can publish identifying numbers that would distinguish allowances be differentiated and tracked if desired by assigning a unique from the two systems for fear that this would undermine the serial number to each allowance at the time of issuance into fungibility of allowances. BOX 2.5 CASE STUDY: Eligible Units in the EU ETS 5.2 Choosing time periods for cap setting The EU ETS allows multiple unit types for compliance. At the start of an ETS, the government needs to decide European Union Allowances (EUAs) and European Union whether to define caps on an annual or multiple-year basis, Aviation Allowances (EUAAs) are domestic units. Certified and how far into the future caps will be set in advance. The Emission Reductions (CERs) are Kyoto Protocol units, term “cap period” is used to refer to the number of years for issued to offset projects in developing countries under the which the cap is fixed in advance under a given set of param- Clean Development Mechanism (CDM). Emission Reduction eters. This will usually correspond to a commitment period or Units (ERUs) are also Kyoto Protocol units, originating from ETS phase under which other program design features are also other Annex B countries with their own climate mitigation specified. The length of cap periods can change over time. commitment. Each of these units represents 1 tonne of CO2 equivalent. Decisions on cap periods should be coordinated with other Although each unit represents the same amount of aspects of climate change policy and ETS design. For example, emissions, the prices for EUAs in the EU ETS are generally changes in the jurisdiction’s international climate change higher than those for international credits. In large part, contributions and emissions reduction targets will have impli- this is due to the quantity limits applied to CERs and ERUs cations for cap setting. Transitions between cap periods can under the EU ETS, which lower their value. In order to maintain an incentive for innovation at home and guard be scheduled to accommodate milestones like the entrance against the possibility of low-quality credits from outside of new sectors or new participants, or the commencement of the jurisdiction, the EU has imposed a limit mandating linking. that no more than 50 percent of abatement may be achieved with international credits across Phases II and Some systems have developed cap time periods as follows: III. Differentiated limits apply to existing operators, new ▲▲ In RGGI, caps were initially set upfront for two periods entrants, operators with significant capacity expansions (2009–14 and 2015–20), with a cap review and adjustment or covering new gases/sectors, and aircraft operators. In in 2012. Phase III (2013–20), the EU ETS accepts newly generated CERs only from Least-Developed Countries and does not ▲▲ In California and Québec, annual caps were set upfront accept any credits from industrial gas destruction projects for a series of multiple-year compliance periods covering (e.g., HFC-23 and N2O). The combination of changes over 2013–14, 2015–17, and 2018–20. time in the supply of international credits and regulatory limits on the use of international credits, along with the ▲▲ The EU ETS set a new cap prior to each multiyear phase: uncertainty in the long-term value of international credits 2005–07, 2008–12, 2013–20, 2021–30, etc. A unique under the EU ETS, have contributed to fluctuations in the feature of the EU ETS is that the caps from 2013 onward observed price spread in the EU ETS between international include a automatic linear reduction factor that defines the credits and EUAs.a annual contraction of the cap. ▲▲ The Tokyo ETS also set a new cap prior to each multiyear a EDF et al. (2015b). phase: FY2010–14 and FY2015–19. STEP 2: SET THE CAP 57 ▲▲ The Waxman-Markey Bill, which was passed by the U.S. House of Representatives in 2009 but not by the Senate, 6. Common Challenges would have established annual caps from 2012 through There are at least three challenges that policy makers must 2050. consider when setting the cap: ▲▲ Most Chinese pilots combined an initial cap on an intensity ▲▲ Accommodating changes during the cap period; basis with annual ex post adjustment based on the actual ▲▲ Ensuring allocation methodologies are consistent with the outputs/business volumes of the enterprises. cap; and ▲▲ The Australian ETS proposed to set five years of caps ini- ▲▲ Providing a long-term price signal. tially and to set the next annual cap on a rolling basis each year so that caps were always set five years in advance. 6.1 Accommodating changes during the Scheduling formal cap reviews on a periodic basis can enable cap period systematic adjustment of the cap to ensure it remains During the cap period, policy makers must accommodate appropriate while providing certainty about cap settings changes in response to system shocks and changes to sectoral composition and participation. 2. CAP between reviews. Cap reviews may be conducted as part of a comprehensive ETS review, or as a stand-alone exercise. When conducting a formal cap review, the government may wish to 6.1.1 Adjusting the cap in response to system shocks evaluate: Under normal operation, an ETS market responds to fluctua- tions in unit supply and demand through changes in allowance ▲▲ Changes in the broader context of the ETS, such as the prices, demand for offsets, or banking. When system shocks jurisdiction’s overarching mitigation targets, economic (such as major changes in fuel prices or economic activity, development trends, the availability of new technologies, or force majeure events) drive changes in allowance supply and the relative ambition of carbon pricing or alternative or prices that cannot be managed within existing flexibility mitigation policies in other jurisdictions. mechanisms and could destabilize the market, policy makers ▲▲ How the ETS has performed relative to expectations for may need to consider whether to adjust the cap temporarily allowance prices, compliance costs, and potential for or permanently. This decision requires a trade-off between the leakage and competitiveness impacts. following considerations: ▲▲ How much the carbon price has influenced behavior and ▲▲ Adjusting the allowance supply can help preserve prices investment to reduce emissions, particularly relative to at a level considered “appropriate” by stakeholders but other drivers such as international energy prices, commod- will also affect the local and/or global emissions outcomes ity demand, and other policies and regulations. of the ETS. If the ETS is operating under a binding juris- dictional mitigation commitment, then the jurisdiction will Reviews of ETS operation are discussed in more detail in have to compensate for any mitigation shortfall under the Step 10. ETS, which could represent a fiscal risk to the government A relatively simple approach to cap setting applied by many and may have implications for the mitigation burden shifted systems to date is to define annual caps that start at a to uncapped sectors. If the ETS is not operating under a designated point and decline at a (possibly linear) rate that binding commitment, then increasing or overriding the cap is fixed for each cap period. The benchmark for defining the could raise global emissions. cap’s starting point typically is actual emissions in a recent ▲▲ Providing certainty on overall allowance supply shifts the year, average annual emissions over a recent period, or pro- focus to other price-containment mechanisms (e.g., oper- jected emissions in the starting year, even though projected ation of a reserve within the cap, banking, and/or access emissions are inherently uncertain and subject to pressure for to offsets and linking) that do not alter the system’s net revision. The cap ending point is defined in alignment with the contribution to global emissions reductions. However, these jurisdiction’s mitigation and cost objectives for capped sectors mechanisms may not be able to accommodate very sig- (which will require projections to be made). A straight line is nificant system shocks or may have political ramifications then often drawn between the starting and ending points, (e.g., increasing wealth transfers to other countries in the which sets the cap level in each year in-between. In other case of offsets or linking). cases, the annual cap may stay constant across individual years within a cap period but decline in a stepwise fashion If policy makers do decide to alter supply, then increases in over the cap periods. supply can be achieved by issuing more allowances—either 58 EMISSIONS TR ADING IN PR ACTICE from a reserve within the cap or through a price safety valve BOX 2.6 CASE STUDY: Reconstructing mechanism that supersedes the cap—or by allowing more Historical Emissions Trends in China offset units into the market. Allowance reserves, in particular, have been employed by a variety of systems, including the In 2015, an international research team reported that EU ETS, Switzerland, Tokyo, Saitama, California, Québec, the China’s historical emissions from energy and cement production had been overestimated in earlier assessments Republic of Korea, Kazakhstan, and several of the Chinese due to the use of incorrect data and default emissions ETS pilots. Options to reduce supply include temporarily with- factors. According to the researchers, over the period from holding or permanently canceling allowances, and restricting 2000 to 2012, actual energy consumption had been 10 the import of units from offsets or linking.64 Temporarily percent higher than reported, but emissions factors for withholding allowances essentially shifts the banking power Chinese coal were 40 percent lower on average than the from participants to the government (See Step 6). defaults applied. China’s cement emissions were found to be 32–45 percent less than earlier estimates, once default Another system shock could arise with improved data collec- clinker-to-cement ratios were revised based on actual tion that reveals emissions factors need to be recalculated. production data. As a result of the recalculation, China’s The Chinese experience shows how important this could be in 2013 fossil fuel and cement emissions were found to be 12 countries new to climate policy and emissions reporting (see percent less than in the inventory reported by China to the UNFCCC, and 14 percent less than in the data reported by Box 2.6). In this context, an appropriate balance needs to EDGAR. This difference is material enough to alter assess- be struck between allowing cap adjustments to reflect data ments of the global carbon budget.a improvements and providing certainty to ETS participants Later in 2015, Chinese energy statistics based on a 2013 during each period for which the cap is set in advance. economic survey were released that suggested China’s To improve policy certainty and retain the confidence of annual coal consumption had been underestimated since 2000 and may have been up to 17 percent higher than market participants, policy makers should define clear triggers previously reported.b and/or procedures for unscheduled cap adjustments as part of initial ETS design, and set parameters around the type of These studies highlight the potential challenges for ETS cap setting in countries where historical emissions data are adjustments that could be made. Cap adjustment triggers less readily available and where improved data collection could be defined on the basis of unit supply or unit price.65 results in the recalculation of fuel consumption and emis- Step 6 provides more information about market stability sions factors. mechanisms. Alternatives to rule-based cap adjustments would be procedural mechanisms that could rely on decisions a Liu et al. (2015). of specific bodies appointed for these purposes. Such proce- b Buckley (2015). dural arrangements have been subject to the conceptual and theoretical debate but have not been used for unscheduled but aviation entered the system mid-stream during the Phase cap adjustments for the existing ETSs. II cap period. After the further enlargement of the EU in 2007 (when Romania and Bulgaria joined), the cap was adjusted for 6.1.2 Sectoral coverage changes the ETS-regulated sectors in the new member states in the As sectors enter or exit an ETS, or as participation thresholds course of Phase I of the EU ETS. In the case of RGGI, the cap change, an ETS cap will need to be adjusted accordingly. An was revised downward when one of the participating states— operational ETS with phased sectoral entry under an absolute New Jersey—withdrew. In most cases, these kinds of cap cap (e.g., EU ETS, California, Québec) may explicitly provide for changes can be planned in advance and integrated smoothly step-changes in the cap as new sectors enter. In the California into cap setting arrangements. and Québec systems, breaks between cap periods aligned with Besides sectoral coverage changes, individual entities within the entry of new sectors. In the EU ETS, some sectoral scope covered sectors can either enter or exit the market during a changes were made at the transitions between cap periods commitment period. Further information on accommodating 64 The “minimum auction price” in the WCI ETS design is a mechanism imbedded in new entrants and closures during the cap period may be the regulation that allows, in case of oversupply, the temporary removal from the found in Step 3. market of any excess allowances that would result in the market price falling below the minimum auction price. The removed allowances would slowly be reintroduced in the market only once two consecutive auctions close above the minimum price. Therefore, applying a minimum price at auction may be one option to reduce the risk of oversupply. Allowances dedicated to auction will be retained if the market price is under that price. This feature is applied in the Québec/California ETS. 65 Gilbert et al. (2014b). STEP 2: SET THE CAP 59 6.2 Ensuring allocation methodologies are two allowances for each unit of emissions from electricity compatible with the cap generation: one upstream and one downstream. Decisions on the cap will have central implications for decisions on allocation. It is generally preferable for discussions on 6.3 Providing a long-term price signal allocation to take place after the cap has been defined in As described in section 5.2, it is typical for the period over order to separate discussions on overall system ambition from which a cap is set in advance to be between two and ten discussions on the distribution of costs. This can also help years. At the transition points between cap periods, policy avoid the problems seen, for instance, in Phase I of the EU ETS makers have an opportunity to review and make adjustments where the decision on how many allowances to provide for to the cap as more information on abatement costs, macro- free became determinative in setting the overall cap, resulting economic fluctuations, and actions by international trading in a total cap that was above BAU emissions and hence the partners becomes available. price falling to zero. However, enabling periodic cap adjustments can create However, given political and administrative pressures, uncertainty among market participants as to the possible long- decisions on caps and allocation may become interlinked and term trajectory of the cap and the resulting price signal. This 2. CAP iterative, especially in systems that allocate most or all of their threatens to undermine one of the main benefits of an ETS, allowances for free. In these cases, policy makers will need namely to provide a price signal that will incentivize low-car- to ensure that the level of free allocation they plan to supply bon investments. A recent study, based on a survey of EU ETS under a given methodology (e.g., on the basis of facilities’ participants, found companies perceive policy risks—caused historical emissions or emissions benchmarks per unit of pro- by changes to the EU ETS and other policies and measures duction) can be accommodated by the cap they have set.66 related to renewables and fuel taxes—as more challenging to manage in their investment decisions than market risks.68 From a procedural perspective, however, the lesson to be learned is that a deep integration of cap setting and allocation In this context, ETS participants might benefit from having procedures tends to inflate the caps as a result of distribu- some additional policy certainty. One option is to define a tional conflicts about (free) allocation. A clear separation of long-term trajectory for the cap. The trajectory could signal the cap setting and allocation processes should be seen as a direction of change and/or rate of change over time with the preferable target model for the procedural arrangements regard to emissions levels and/or carbon prices in alignment around the cap setting. with broader long-term mitigation, technology, or economic transformation targets. Options include setting an indicative In systems that combine free allocation with auctioning, as cap range or a default pathway to guide future decision long as the cap can safely accommodate committed levels making while building in flexibility for decision making by future of free allocation, the issue is in principle less significant, as governments. This was the approach taken by the European the amount of auctioning within the cap can be adjusted to Commission (see Box 2.7). Achieving cross-party support accommodate fluctuations in free allocation. Further details on for a long-term cap trajectory would help further improve the trade-offs between allocation methods are given in Step 3. policy certainty. Box 2.8 describes the proposed rolling cap Special considerations arise for cap setting when the point of mechanism that was discussed in the development of the obligation for surrendering units in regard to one emissions Australian Carbon Pricing Mechanism (CPM), the cap design in source is applied at more than one point in the supply chain. the California ETS, and the model of the LRF in the EU ETS. For example, in the case of emissions from electricity gen- Box 2.9 provides an account of how the policy makers eration in the Korean ETS, policy makers have assigned unit managed this challenge when setting the cap for the California surrender obligations for both direct emissions at the point ETS. By identifying clear rules and parameters upfront for of electricity generation and indirect emissions at the point of adjusting caps over time, and signaling future changes well electricity consumption.67 A key consideration is the potential in advance where possible, governing authorities can change for government regulation of energy prices to prevent carbon the cap over time while still maintaining market confidence prices from being passed through the supply chain. The cap and providing a clear price signal to market participants. in such a system has to accommodate the need to surrender The balance between predictability and flexibility is relevant 66 In some of the Chinese ETS pilots, the caps are actually determined by the allocation throughout the development of an ETS, and detailed further in approaches, as caps have not been announced and the actual total number of allow- Step 10. ances in the market constitutes the actual caps. 67 Kim and Lim (2014) 68 Gilbert et al. (2014b). 60 EMISSIONS TR ADING IN PR ACTICE BOX 2.7 CASE STUDY: The Linear Reduction BOX 2.8 CASE STUDY: Australia’s Rolling Cap Factor for the EU ETS Mechanism From 2013 onward, the cap for the EU ETS is defined by The Australian ETS applied the concept of a rolling cap the so-called Linear Reduction Factor (LRF). The LRF is a mechanism. Under the government’s Carbon Pricing percentage of the emissions that were regulated by the EU Mechanism (CPM), which started operation in 2012 ETS in 2010 (which are adjusted for later scope changes, but was repealed in 2014, the initial 3-year fixed-price etc.) and marks the annual contraction of the cap following phase was to be followed by a flexible trading phase that a linear trajectory. For Phase III of the EU ETS, the cap is provided for fixed 5-year caps that were to be extended calculated as the average of the annual cap levels between annually by one year by the government, with advice from 2013 and 2020 on this linear trend. The LRF was initially an independent Climate Change Authority. In the event no defined at 1.74 percent, will explicitly not expire by the decision could be reached, a default cap would align with end of the recent phase, and is part of the binding ETS the government’s national emissions reduction target for legislation for the periods beyond 2020. In the context of 2020.a Under the government’s precursor proposal for the the structural reform of the EU ETS, the LRF is planned Carbon Pollution Reduction Scheme (CPRS), the cap setting to be increased to 2.2 percent from 2021 onward, again process included the same design of a 5-year fixed cap explicitly without a date for expiration. Hence, the original with rolling annual updates plus the definition of a “gate- concept of the LRF at 1.74 percent implied a legally binding way” consisting of a band (upper and lower cap limit) that emissions reduction for the capped entities of 70 percent would guide cap setting for the 10-year period beyond below the 2010 levels by 2050. The adjustment of the LRF each 5-year cap. This approach was intended to provide to 2.2 percent from 2021 onward leads to a legally binding some certainty over cap setting for a period of 15 years.b emissions reduction of approximately 83 percent below the 2010 levels by mid-century. This robust long-term emissions reduction commitment is one of the factors explaining the fact that prices did not fall to zero during a Government of Australia (2011). the deep surplus crisis of the EU ETS from 2010 onward. b Government of Australia (2008). STEP 2: SET THE CAP 61 BOX 2.9 CASE STUDY: Ambition and Cap Design in the California ETS The California ETS was designed to help the state achieve its auctions, with a price floor that increased over time. The 2020 target to reduce GHG emissions to 1990 levels by 2020 cap extended across three compliance periods (2013–14, and by 80 percent below 1990 levels by 2050. Strategically, 2015–17, and 2018–20). The state’s initial projection for start- it was intended as a backstop to reinforce outcomes from year emissions had to be adjusted downward after officials a large portfolio of mitigation policies and ensure that miti- received improved facility-level data under a mandatory gation incentives penetrated into the parts of the economy reporting regime for industrial sources, fuel suppliers, and that were not covered by targeted policies. Drawing from electricity importers starting in 2008. For further supply assessment of mitigation potential and modelling of economic and price flexibility beyond the cap, participants could use costs, the state allocated a share of the state-wide emissions approved offsets to meet up to 8 percent of their obligation reduction responsibility to covered ETS sectors, which and access unlimited units from linked ETS. The cap was account for 85 percent of the state’s emissions. adjusted upward in 2015 to accommodate the entry of new sectors, which were subject to a faster annual rate of decline 500 than earlier entrants. -70.9 MtCO2e 450 2. CAP When setting the cap and price expectations, officials 400 evaluated the system ambition and costs in other systems, 350 particularly RGGI and the EU ETS, and concluded that their 300 approach compared favorably while supporting the state’s MtCO2e 250 emissions reduction goals. Cap setting and allocations 200 based on historical, verified emissions has contributed to 150 establishing a stable and active market. For example, in the 100 three California-only auctions held in 2014, the price for 2014 50 vintage allowances stayed extremely steady throughout 0 2015 2016 2017 2018 2019 2020 the three auctions, only fluctuating by two cents (US$11.48 to US$11.50) and staying 15 cents above the floor price on California Québec average. Between the state-run auctions, daily trade activity on the secondary market has been characterized by stable Author: ICAP. allowance prices and increased trading volumes. These results indicate California companies have faith in the integrity and Officials defined an absolute cap to start from a projection strength of the current program and are using the auctions to for actual emissions in 2013 and to decline on a linear basis buy the allowances they need to comply with the regulation.a to meet the designated 2020 endpoint for total emissions from covered sectors, which was more than 16 percent below starting levels. The program design included quarterly a Center for Climate and Energy Solutions (2014) and ARB (2010c). QUICK QUIZ Conceptual Questions ▲▲ What is the role of the cap in an ETS? ▲▲ What background information is helpful to set the ETS cap? ▲▲ What is the difference between an absolute cap and an intensity cap? Application Questions ▲▲ In your jurisdiction, how much should the ETS contribute toward meeting economy-wide emissions reduction targets? ▲▲ Will your jurisdiction need to design a cap that supports linking to another ETS in the near or longer term? 62 EMISSIONS TR ADING IN PR ACTICE This page intentionally left blank. STEP 3: DISTRIBUTE ALLOWANCES 63 STEP 3: DISTRIBUTE ALLOWANCES At a Glance___________________________________________________________________________ 64 1. Objectives When Allocating Allowances________________________________________________ 65 1.1 Managing the transition to an ETS_______________________________________________ 65 1.2 Reducing risk of carbon leakage or loss of competitiveness_________________________ 66 1.3 Raising revenue_______________________________________________________________ 66 1.4 Preserving incentives for cost-effective abatement________________________________ 67 2. Methods of Allocation_______________________________________________________________ 67 2.1 Auctioning___________________________________________________________________ 67 2.2 Free allocation using grandparenting____________________________________________ 72 2.3 Free allocation using fixed sector benchmarking__________________________________ 73 3. ALLOCATION 2.4 Free allocation using Output Based Allocation (OBA)_______________________________ 74 3. Identifying Sectors to Protect Against Leakage__________________________________________ 76 4. Other Issues________________________________________________________________________ 76 4.1 New entrants and closures_____________________________________________________ 76 4.2 Allocation of allowances for removals____________________________________________ 78 Quick Quiz____________________________________________________________________________ 78 64 EMISSIONS TR ADING IN PR ACTICE AT A GLANCE ✓✓ Match allocation methods to policy objectives ✓✓ Define eligibility and method for free allocation and balance with auctions over time ✓✓ Define treatment of entrants, closures, and removals When policy makers place a cap on emissions, they create ▲▲ Preserving incentives for cost-effective abatement: In scarcity that, in turn, generates a “climate rent.” This scarcity attempting to achieve any or all of the above objectives, leads to higher consumer prices for emissions-intensive policy makers must ensure that the overall objective of the goods and services, reduces some asset values, and can ETS is maintained: ensuring covered firms are incentivized adversely affect workers. The method of allowance allocation to abate emissions in a cost-effective manner and as far as helps determine how this climate rent and these costs are possible through the value chain. distributed across society. Even if the total costs of an ETS to In many cases, the total value of the allowances will be consid- the economy are small, there can be big winners and losers. erably higher than mitigation costs.69 Distribution of allowances Who the winners and losers are will depend on, and can be will be a contentious issue and finding a solution that is strategically influenced by, how allowances are distributed. acceptable to government, stakeholders, and the general The choice of allocation methods is also key to how companies public is critical to getting started. It will be time-consuming to react to the ETS. For example, allocation can be pivotal to get the relevant parties to agree. companies’ decisions on production volumes, location of new There are two fundamental approaches to allocation. The investments, and how much of carbon prices they pass on to government can sell allowances through an auction, or it can consumers. In these ways, it can therefore also affect the total give allowances away for free—either to ETS participants or cost to the economy of the ETS. to other affected parties. As free allowances can be allocated When distributing allowances, policy makers will seek to through three main methods, there are four allocation meth- achieve some or all of the following objectives (which are not ods in total (auctioning plus three free allocation approaches). always mutually compatible): Each of the following methods involves trade-offs against ▲▲ Managing the transition to an ETS: There are numerous achieving one or more of the objectives mentioned above: issues involved in transitioning to an ETS that a policy ▲▲ Selling allowances in an auction: Policy makers create maker may wish to manage through the approach to a source of public revenue using a method with little allowance allocation. Some issues relate to the distribution of costs and value, including possible loss of asset value chance of market distortion or political input. Auctioning is a simple and efficient way to get allowances to those (“stranded assets”), undesirable impacts on consumers and who value them most. It can provide flexibility in managing communities, and a desire to recognize those who have distributional issues for consumers and communities. It taken early reduction actions. Others relate to risks such as also rewards early action. However, auctioning offers weak the fact that participants may have a low capacity to trade protection against leakage and does not compensate for initially or that, where institutional capability is weak, some losses from stranded assets. companies may resist participation. ▲▲ Free allocation using a grandparenting approach:70 ▲▲ Reducing the risk of carbon leakage or loss of competi- This can provide compensation for stranded assets. In a tiveness: These risks present a combination of undesirable downstream system, this can be a simple method that can environmental, economic, and political outcomes for policy be attractive when managing a transition. As long as the makers. Avoiding these factors is always one of the most level of allocation is not updated based on the company’s controversial and important aspects when considering the emissions, it provides strong incentives for cost-effective design of an ETS. reductions. By providing compensation for the risk of ▲▲ Raising revenue: The allowances created when an ETS is established are valuable. By selling allowances, often 69 Consider an example where baseline emissions are 100 tonnes, the cap is set at 80 through auctioning, policy makers thus have the potential to tonnes, and the price is $10 per unit. The cost of abatement is always less than $200 (20 units times $10) and may even be well below that, while the value of allowances generate sometimes significant amounts of public funding. is $800. 70 Grandparenting is often referred to as grandfathering in the literature. STEP 3: DISTRIBUTE ALLOWANCES 65 stranded assets, it can also ease the transition to an ETS but, as a corollary, it also raises the possibility of windfall 1. Objectives When Allocating profits. It provides only weak protection against leakage, Allowances can significantly distort the price signal if applied in combi- When distributing allowances, policy makers will likely seek to nation with updating provisions, and does not reward early achieve some or all of the following objectives: action. ▲▲ Managing the transition to an ETS; ▲▲ Fixed sector benchmarking with infrequent updating: ▲▲ Reducing the risk of carbon leakage or loss of The use of sectoral benchmarks can, if designed consis- competitiveness; tently and carefully, safeguard incentives for cost-effective emissions reductions (including through demand-side ▲▲ Raising revenue; and abatement). It also rewards early action. However, these ▲▲ Preserving incentives for cost-effective abatement. benefits can be lost if the benchmarks are not designed carefully, and this process can be time-consuming and This section discusses each of these objectives and highlights data-intensive. It may have mixed results in protecting some of the important trade-offs that policy makers will need against leakage, and can still result in windfall profits. The to consider. If it is possible, policy makers should first have output used to determine the free allowances to covered clear discussions on competing objectives and agree to a entities could be either historical or real data, and updating balance among them, then choose the type of mechanism(s) is necessary in the latter case. to use and design the specific allocation methodologies based 3. ALLOCATION on information and data available in the jurisdiction. ▲▲ Free allocation using output-based allocation (OBA) with annual updating: Company-level allocations can be based either on their own pre-ETS emissions intensities or 1.1 Managing the transition to an ETS on sector benchmarks. As in the fixed sector benchmarking Policy makers may wish to address three key distributional approach, either historical or output data can be used to impacts involved in transitioning to an ETS: calculate the free allowances for companies and updating 1. Stranded assets: Stranded assets are assets (such as coal is necessary in the latter case. This option strongly protects mines, inefficient generation capacity, coal-fired boilers) against leakage and rewards early action. However, it can acquired in the past that generated profits before regula- be administratively complex if sector benchmarks are used, tion but that now leave their owners with high emissions safeguarding the incentives for cost-effective reductions that are hard to reduce. They fall in value with the intro- require consistent and careful benchmark designs, incen- duction of an ETS. Their operating costs rise and they may tives for demand-side abatement need to be protected, become obsolete earlier than anticipated. These losses can and care may be required to keep allocations within the be compensated through free allocation. cap if levels of free allocation are high overall. 2. Recognize early reductions: An ETS takes time to create. Rather than allocating all emissions by auctioning or giving During that process, it is valuable to reward, or at least them away for free, many systems have elected a hybrid not penalize, those who reduce emissions. The process approach where entities in some sectors receive some free by which allowances are allocated can influence this. allowances, but not all. Often this is a way to ensure that Auctioning rewards early action. If allowances are allocated those sectors considered to be at genuine risk of emissions for free, then either using an early date for measuring leakage can receive the benefits of protection through appro- historical emissions under a grandparenting approach, or priate free allocation approaches. Such sectors are usually the use of benchmarking approaches from the beginning identified using two main indicators—emissions intensity and can help reward early action or prevent delays in emissions trade exposure. reductions. This chapter first examines the four policy objectives consid- 3. Undesired impacts on consumers and communities: ered when allocating allowances. The next section looks at the Emissions costs passed through to consumer prices will four methods of allocation—one selling through an auction and have welfare impacts on households. Some value from three methods of distributing them for free. Hybrid methods of allowances can be used to protect households’ wellbeing, allocation are discussed in section 3 as well as how to identify particularly that of poorer households. California used which sectors may be chosen for assistance. The concluding free allocation (with conditions) to protect electricity section discusses new entrants and closures, and removals. consumers; Australia recycled auction revenue to protect low-income households. 66 EMISSIONS TR ADING IN PR ACTICE Two risks could arise early in ETS implementation: The risk of leakage presents a combination of undesirable outcomes for policy makers: ▲▲ Companies may have a low capacity to trade initially: A further transitional concern could be that companies, espe- ▲▲ Environmental: Leakage undermines a carbon pricing cially small companies, may have a low capacity to trade. policy’s environmental objective by causing carbon to rise Concerns about not being able to access allowances on in jurisdictions beyond the reach of the policy. the market or of making costly mistakes (for example, by ▲▲ Economic: The decline in domestic production can affect failing to be compliant with obligations, resulting in fines) the balance of trade and lead to structural change with are common before an ETS is implemented. Again, this strategic economic implications. Reduced production may lead to a preference to provide firms with allowances is likely to be associated with job losses and stranded for free, such that they may not need to substantively assets in the affected sectors. It also reduces the participate in auctions and trading in order to meet their cost-effectiveness of the ETS in achieving global emissions compliance obligations, at least in the early phases of the reductions. ETS. ▲▲ Political: The risk of loss of jobs and asset values can ▲▲ Resistance to participation: If institutional capability is create significant political challenges. weak early in the ETS, it can make identifying participants and collecting data from them difficult. If allowances are This confluence of potentially undesirable environmental, eco- given for free, this resistance may be reduced. nomic, and political outcomes means that the issue of leakage is always one of the most controversial and important aspects 1.2 Reducing risk of carbon leakage or loss when considering the design of an ETS. Different forms of free of competitiveness allowance allocation are among the most frequently deployed tools to reduce the actual or perceived risk of leakage. While Carbon leakage (also known as emissions leakage) occurs different mechanisms for free allocation can be effective in when a mitigation policy, such as an ETS, causes a reduction in addressing carbon leakage, in doing so they often dampen the emissions in the jurisdiction where it is implemented but inad- carbon price signal and hence the incentives for abatement. vertently leads to an increase in emissions in other jurisdictions This trade-off must be managed and is discussed in the meth- that do not have equivalent policies in place. This increase in ods for free allocation below. emissions in other jurisdictions arises because the differences in policy can cause shifts in production, through relocation of existing production or new investments, in response to the 1.3 Raising revenue difference in policy settings. The allowances created when an ETS is established have value. By selling allowances, usually through auctioning, policy Products that are “trade-exposed” because the companies makers have the potential to generate sometimes significant that produce them compete directly with foreign producers in amounts of public funding. either export or import markets are most vulnerable. Higher production costs because of the ETS cannot be fully passed These new resources can be used to either cut (distortionary) on to consumers and production may no longer be profitable. taxes elsewhere in the economy; support other public Where factors such as trade barriers or transport costs make spending needs, for instance, other policies to decarbonize trade unlikely to occur, covered firms are insulated from com- the domestic economy or to support international action on petition from uncovered competitors and the risk of carbon health, education, or infrastructure; or to reduce government leakage should be small. deficits and/or debts. It can also play a valuable role in com- pensating disadvantaged households who might otherwise be Empirical ex post estimates on the level of leakage are limited adversely affected by an ETS. but tend to find little evidence of carbon leakage. It is also possible to use economic models to generate ex ante leakage However, raising revenue through the sale of allowances may estimates: general equilibrium estimates (economic models be in conflict with some of the objectives addressed above; for that look at impacts across the whole economy) of leakage example, it means that fewer allowances can be given away rates range from 5 to 15 percent while partial equilibrium esti- for free to protect against leakage. mates (sector-specific economic models) project wide ranges, from 0 to 100 percent. 71 71 PMR (2015g). STEP 3: DISTRIBUTE ALLOWANCES 67 1.4 Preserving incentives for cost-effective to use a mixture of auctions and free allocation: any of the abatement free allocation methods could allocate only a share of the allowances. In attempting to achieve any or all of the above objectives, policy makers must ensure that the overall objective of the ETS Table 3.1 summarizes allocation methods used in each ETS to is maintained: ensuring firms and individuals are incentivized date while Table 3.2 summarizes allocation methods against to abate emissions in a cost-effective manner. There are three objectives identified in section 1. This table shows that none of types of abatement incentives that policy makers will want to the free allowance allocation approaches score a “yes” against preserve when allocating allowances: maintaining the incentives for cost-effective abatement. This 1. Encouraging substitution from high-carbon to partly relates to the approach that they take to updating low-carbon producers: Where the cost of emissions is allowance allocation over time, as further discussed in Box 3.1 internalized in an ETS, it is an intended effect that carbon- (a recurrent theme throughout the following sections). In addi- efficient producers (those with a lower carbon intensity) will tion, Table 3.3 provides an overview of the data requirements benefit over less efficient ones; for the different allocation methods. 2. Incentivizing firms to reduce their emissions intensity: Because lower-emitting firms gain a competitive advantage 2.1 Auctioning over higher-emitting ones, this should encourage firms to Auctioning involves the allocation of allowances through a reduce their emissions intensity. market mechanism, ensuring efficient functioning of the trad- 3. ALLOCATION 3. Promoting demand-side abatement: The method of allo- ing market and strong incentives for carbon abatement. It also cation should allow the price of emissions-intensive goods creates a source of public revenue that can then be distributed and services to increase, so that end users are discouraged to a wide range of potential beneficiaries. from buying polluting goods and encouraged to switch Existing ETSs vary substantially in the extent to which they use toward cleaner ones. auctioning. At one extreme, RGGI started with high levels of The simplest way to ensure that all of these incentives for auctioning—about 90 percent of allowances—and individual abatement are preserved would be to sell allowances through states could choose how to spend the revenue. Some systems auctioning,72 but this may not be the best way to achieve (e.g., California and Québec) have framed ETS in part as a other objectives such as managing the transition to an ETS or revenue-raising instrument from the beginning. In other cases addressing carbon leakage. (e.g., EU ETS), the use of auctioning has gradually expanded over time, primarily to the power sector, and it is estimated that up to half of the allowances may be auctioned over Phase 2. Methods of Allocation III of the EU ETS. By contrast, in some jurisdictions (e.g., most Chinese pilots and the Republic of Korea) virtually no allow- There are two fundamental approaches to allocation. The ances are currently allocated through auctioning, although the government can give allowances away for free, using a variety Republic of Korea and China’s national ETS do foresee a rising of methods, or it can sell them in an auction. This section share of auctioning in the future. considers the following four options: If auctioning is pursued, conducting relatively frequent 1. Selling allowances in an auction auctions will help provide transparency and a steady price 2. Free allocation using a grandparenting approach signal to participants and consumers, and could reduce carbon 3. Free allocation using fixed sector benchmarking with price volatility. Frequent auctions mean that the value for sale infrequent output-based updating at each individual auction is reduced, decreasing the risk of manipulation of the auction itself and making it more difficult 4. Free allocation using OBA with annual updating for any one participant to gain too much market power in the It can be helpful to break this down first into a decision as secondary market. RGGI and California-Québec both have joint to whether to sell allowances through auction (option 1) or quarterly auctions. The large-scale EU ETS auctions are held provide them for free (options 2–4). 
As a number of systems several times a week at different trading platforms. The single- demonstrate, it is possible to use different approaches for round, sealed-bid, uniform-price auction design is the most different sectors or firms covered by the ETS. It is common 72 This could even be combined with cash-based, rather than allowance-based assis- tance, to deal with leakage and/or transitional concerns. 68 EMISSIONS TR ADING IN PR ACTICE TABLE 3.1 Allocation Methods in Existing ETSs ETS Free Allocation vs. Auction Free Allocation Recipients Free Allocation Type EU (phase I Mixed, minor share auctioned Power generators, manufacturing industry Mixed, large share of grandparenting, increasing share of benchmarking and II) EU (phase III Mixed, large and increasing Manufacturing Industry and aviation Fixed sector benchmarking and beyond) percentage auctioned New Zealand Mixed, few freely allocated. No Emissions-intensive trade exposed (EITE) Output-based; some grandparenting, now ended auctioning has yet taken place activities Switzerland Mixed Manufacturing Industry Fixed sector benchmarking RGGI 100% auction None N/A Tokyo 100% free allocation All Grandparenting based on entity-specific baseline set on any consecutive three years in the period 2002–07. Saitama 100% free allocation All Grandparenting based on entity-specific baseline set on any consecutive three years in the period 2002–07 California Mixed, increasing percentage Electric distribution utilities and natural gas OBA—with output and sector-specific emissions-intensity benchmarks, auctioned suppliers on behalf of ratepayers; emissions- some grandparenting, very few sectors (industry); based on long-term intensive and trade-exposed industrial activities procurement plans (electricity); historical data (natural gas) Québec Mixed, most auctioned— Emissions-intensive trade exposed (EITE) Output-based benchmarking increasing with time activities Kazakhstan 100% free allocation All Grandparenting Republic 100% free allocation All Grandparenting (for most sectors), benchmarking (for cement, refinery, of Korea domestic aviation). TABLE 3.2 Summary of Methods of Allocation TABLE 3.3 Summary of Data Requirements for against Objectives Different Methods of Allocation Objective Method of Historical Historical Emissions Actual Allocation emissions output benchmark output Reducing Preserving Managing risk of incentives for Auctioning No No No No Method of transition carbon Raising cost-effective allocation to ETS leakage revenue abatement Grandparenting Yes Maybe No No Auctioning No No Yes Yes Fixed Sector Maybe Yes Yes No Benchmarking OBA Maybe Maybe Yes Yes Grandparenting Partial Partial No Partial Source: Maosheng, 2015. Fixed sector Partial Partial No Partial benchmarking Output-based Partial Yes No Partial allocation (OBA) STEP 3: DISTRIBUTE ALLOWANCES 69 commonly used in carbon markets around the world today.73 BOX 3.1 TECHNICAL NOTE: Updating Box 3.2 discusses ETS auction design issues in more detail. As Table 3.1 illustrates, if allowances are allocated for free, the price signal of the ETS can be distorted and the incen- 2.1.1 Advantages tives for cost-effective abatement may not be preserved. Auctions have several advantages: A key determinant for the degree of these distortions ▲▲ Revenue: Governments can use income raised in an auc- will be the interaction between allocation and different tion to support several objectives: updating provisions, that is, whether and how the allocation of allowances responds to changes in ▲▲ Support other climate policies: The government circumstances after the initial allocation is made. If entities may, for example, wish to invest in low-emissions know or can predict that a change in circumstances will infrastructure, incentivize industry to invest in energy lead to a change in the allocation approach then this may efficiency and clean energy technology, or reduce distort their behavior. In particular: emissions in uncovered sectors (see Box 3.3 on ▲▲ Only few ETSs (e.g., the repealed Australian Carbon auctioning use in California and Québec). Pricing Mechanism) foresee a pure lump sum allocation. This provides an undistorted price signal comparable to ▲▲ Improve overall economic efficiency: Revenues an auction and does not distort abatement incentives. could support fiscal reform such as reducing other distortionary taxes in order to improve overall ▲▲ Most of the existing ETSs update the free allocation. This may be done between trading phases (the fixed efficiency or they could be used to lower government 3. ALLOCATION sector benchmark approaches described in section 2.3) debt. or within a trading phase (the OBA described in section ▲▲ Address distributional concerns and generate 2.4). This updating can reduce leakage. However it can public support for the ETS: The government could also create significant price distortions. use revenue from the sale of allowances to make ▲▲ Many ETSs also have updating provisions for new offsetting adjustments to the tax and benefit system entrants and plant closures. These likewise require to ensure distributional impacts are minimized and carefully and consistently designed allocation build public support for the ETS. (benchmarking) features. ▲▲ Less political input: Auctions can be administratively sim- Due to the possible distortions of price signals, the pler than alternative free allocation approaches. They also allowances allocation not only needs to be reflected as a reduce the opportunity for industry lobbying in support pure distributional issue but also considered an important design feature with regard to the cost effectiveness of of specific firms or sectors (although there may still be emissions abatement. lobbying for the auction proceeds). ▲▲ Price discovery and market liquidity: Auctions provide a minimum amount of market liquidity and can facilitate price discovery, especially in cases where liquidity is otherwise limited by significant amounts of banking of allowances (see step 5) by those who receive free allowances. ▲▲ Reduced risk of distortions: As described further below, different forms of free allowance allocation may distort incentives to undertake cost-effective abatement and may lead to windfall profits. In an auction, all entities pay the full cost of allowances, which should lead to cost-effective abatement, including demand-side abatement, as costs are passed through to consumers and significantly reduce the risk of windfall profits. The auction results in an efficient allocation of emissions rights and a price reflective of the true value of allowances in the market. ▲▲ Rewarding early action: Early actions and early movers do not face disadvantages and are fully incentivized. 73 Cramton and Kerr (2002) and Betz et al. (2009) discuss detailed choice of auction mechanisms for GHG markets. 70 EMISSIONS TR ADING IN PR ACTICE BOX 3.2 TECHNICAL NOTE: Auction Design for ETSs The issuance of emissions allowances against payment is usu- Today, most ETSs favor a sealed bid, uniform price auction ally conducted by government through multi-unit auctions, format for its price discovery, openness, simplicity and which are, in essence, similar to those conducted in other nondiscrimination of participants, and prevention against markets such as stock, bonds, and commodities (e.g., energy, collusive behaviors. However, some scholars have also noted flowers, and fish). In order to ensure efficient allowance allo- the benefits of enhanced price discovery that clock auctions cation, key elements of auction design and implementation— offer.b In determining the frequency of auctions and the auc- including auction format, schedule and frequency, available tion schedule, the regulator must strike a balance to ensure volumes, access to auctions, access to information, and open access and participation on the one hand and minimize management of auctions—are to be considered in light of the the impact of the auction on the secondary market on the impact of auctions on the secondary market; the possibility other hand. Frequent auctions may indeed be desirable to of market manipulations; and openness and operational costs ensure a steady flow of allowances into the secondary market for all participants, especially small- and medium-compliance at a rate that does not jeopardize market instability. Yet mul- participants.a tiple auctions can also increase transaction costs and the risk of low participation. Several auctions are held for EU allow- Multi-unit auctions can be either dynamic, involving several ances every week at different trading platforms, whereas bidding rounds between which participants are informed of Québec and California hold four joint auctions a year. the demand of others, or sealed, where participants simulta- neously submit a single bid without knowing what others are Another critical guiding principle for auction design is to pre- willing to pay. Winners of a multi-unit auction either pay what vent against fraud and market manipulation. Some jurisdic- they are willing to pay (pay as bid) or the auction clearing tions have commissioned (independent) market monitors to price (uniform price). Following Lopomo et al. (2011), these oversee the conduct of the auction participants, and identify various combinations are laid out in the table below. indications of market manipulation and collusion.c To ensure transparency, some ETSs require that winning bidders as well Bidding as the total allowances bid for are made public. Maximum and Pricing Dynamic Sealed minimum bids are also reported, but individual bids are not Pay as bid “Descending Clock” “Discriminatory Sealed Bid” published (e.g., California).d Other ETSs sell the allowances via ▲▲ Dutch Tulips ▲▲ U.S. Sulfur dioxide established exchanges that publish aggregate results of the ▲▲ Sydney Fish Market ▲▲ U.S. Treasury bonds (pre-1992) auctions without disclosing the winning bidders. Reporting Uniform “Ascending Clock” “Uniform Price, Sealed Bid” to market oversight authorities is, however, mandated (e.g., price ▲▲ Virginia Nitrogen Oxide ▲▲ RGGI EU ETS).e ▲▲ EU ETS ▲▲ California and Québec Cap-and- Trade Programs a For more information on ETS auction design and implementation see Charpin (2009) which reflects the recommendations made by France’s public-private work- Source: Adapted from Lopomo et al., 2011. group on the format, operational implementation modalities, and access to the EU ETS phase III auction process. b Cramton and Kerr (2002); Evans & Peck (2007); Betz et al. (2009). See Kachi and Frerk (2013) for a summary. c Kachi and Frerk (2013). d See California’s auction summary, ARB (2015h). e For an example, see EEX (2016). STEP 3: DISTRIBUTE ALLOWANCES 71 2.1.2 Disadvantages BOX 3.3 CASE STUDY: Auction Revenue Use in Auctions also have disadvantages: California and Québec ▲▲ No direct protection against leakage or compensation California and Québec linked their systems on January 1, for stranded assets.74 The key disadvantage of auctions on 2014. By November 2015, they had held five joint auctions. In total, California’s auctions raised approximately US$3.5 their own is that they provide no direct protection against billion in revenue for the state through 2015 (ARB 2015). carbon leakage and do not compensate firms for losses Total auction revenue for California is expected to be from stranded assets. Firms will face the full financial cost about US$15bn by 2020.a associated with their emissions liability. These costs can be Québec has raised revenues of approximately Cad$967 passed on to consumers in sectors that face limited inter- million (about US$700 million). Despite their linked systems national competition, like (often) electricity. But for sectors and joint auctions, California and Québec have their own exposed to carbon leakage, this could imply significant approaches and restrictions on what to do with their financial challenges and strong incentives for output (and auction proceeds. emissions) to relocate to a jurisdiction where carbon pricing California has strict statutory requirements regarding how is not as stringent. Measures other than free allocation auction revenues must be spent. Specifically, three laws to counteract this, such as border carbon adjustments, passed in 2012 set parameters for the kinds of investments are hotly discussed but may entail significant political and the funds can be used for: practical barriers to implement—and have not yet been ▲▲ One law created the Greenhouse Gas Reduction Fund used for any ETS. 3. ALLOCATION and required that all auction revenue be placed in this fund.b When a department is allocated moneys from ▲▲ Concerns over impacts on small firms. There will also this fund through the state budget process, it must often be concerns that small firms will not be able to easily state how the money will be used, how that use will participate in an auction process, further raising costs. further the goals of the Global Warming Solutions Act However, an enabling framework for liquid secondary mar- of 2006,c which established the system, reduce GHG kets could avoid this and the acquisition of smaller numbers emissions, and work toward non-GHG-related goals. of allowances from intermediaries might even entail lower ▲▲ A second law requires that auction revenue be spent transaction costs than allocation in some cases. on reducing GHG emissions and, where possible, cre- ating jobs, improving air quality, and improving public There is an important political dimension to these consid- health. erations. The introduction of carbon pricing is usually a ▲▲ A third law requires 25 percent of auction revenue politically contentious process with significant vested interests to be used to benefit disadvantaged communities, often opposed to policy reform (although this is increasingly with 10 percent of revenue to be invested in those balanced by a constituency of business interests and other communities.d stakeholder groups calling for carbon pricing). In this context, Through the budget process, the California Governor and one of the practical attractions of emissions trading is that the Legislature have directed funds to various state agencies free distribution of allowances can reduce the distributional and diverse programs, including high speed rail, affordable impacts of carbon pricing on some of those who might be housing in sustainable communities, weatherization, and most opposed to its introduction, while still providing policy water energy efficiency. makers with an assurance that a particular emissions reduction As to Québec, all auction revenues go to the Québec target, as reflected in the cap, will be met. Green Fund and are dedicated to the fight against climate change by funding measures in Québec’s 2013–20 Climate As a result, many ETSs initially started with a large majority Action Plan. of allowances being allocated for free, using different approaches, yet are often looking to gradually increase the proportion of auctioning over time. a Estimate from ARB as quoted in Reuters story, October 2015. By way of comparison, Quebec’s five auctions to November 2015 raised around Cad$967 million. b California Senate Bill (SB) 1018, see Government of California (2005). c Assembly Bill (AB) 32, see Government of California (2006). d The second law is AB 1532 (Government of California, 2012a) and the third is SB 535 (government of California, 2012b). 74 This assumes that the revenue raised from the sale of allowances is not used to address these issues. 72 EMISSIONS TR ADING IN PR ACTICE 2.2 Free allocation using grandparenting ▲▲ Relative simplicity in “downstream” systems: In a down- stream system, grandparenting means that the amount There are two key characteristics of allocating allowances for of free allocation is based entirely on a firm’s historical free through grandparenting. emissions. Early MRV will provide these data. Despite the ▲▲ First, firms receive assistance directly related to their challenges identified above, compared to other methods historical emissions (often reduced by some percentage). of free allowances allocation, this is a relatively straightfor- Allocation could be based on the entity’s emissions directly, ward approach to undertake allocation. This has made it a or on past production or fuel input multiplied by a standard popular method in the initial stages of many carbon pricing emissions factor. schemes. Prominent examples include the first two phases ▲▲ Second, the amount received remains independent of of the EU ETS, the first phase of the Republic of Korea ETS future output decisions or decisions to reduce carbon (for most sectors) and various Chinese ETS pilots. intensity. Prominent examples include the first two phases ▲▲ Maintains abatement incentives: It does this in two ways: of the EU ETS, the first phase of the Republic of Korea ETS ▲▲ Firms that reduce emissions can sell their surplus (for most sectors), and various Chinese ETS pilots. allowances, those firms that increase emissions pay However, while these characteristics define the pure form of the full cost. grandparenting, in relation to the second aspect, many grand- ▲▲ As with auctioning, grandparenting should, in the parenting schemes make periodic adjustments or updates absence of any updating provisions (direct updating, to take account of changes in circumstances from when the plant closure provisions, new entrant allocation, etc.), initial allocation was made (also see Box 3.1). result in an efficient allocation of emissions rights and a price reflective of the true value of allowances in It is critical to set the date for data used for grandparenting the market. One of the features of grandparenting is for all facilities early (the base year upon which allocation that it is a lump-sum financial allocation to firms—the is determined) to avoid incentives to drive up emissions to amount that the firm receives is not a function of its increase allocation, to ensure equitable treatment of facilities, current or future output. This should mean that firms and to minimize lobbying by firms to maximize the benefit to will respond to the carbon price in the same way as if their facilities. Two challenges in this context are: they had not received the free allowance allocation. ▲▲ Data availability: The data may need to be collected Firms that are not fully trade-exposed will tend to and audited specifically for this process and may not be increase their product prices to reflect their higher available for earlier years; and costs, stimulating demand-side abatement. However, ▲▲ Perceived inequity as a result of rapid changes within as discussed below, if the ETS includes updating sectors: Firms that have contracted since that date may provisions these advantages will diminish (depending receive more allowances than their current emissions. on the frequency of updating). Firms that have expanded will receive relatively few allow- ▲▲ Reduces firms’ need to trade in the early years: Unless ances—but also probably have fewer “stranded assets” firms are changing rapidly, their free allocation will be close because their investments were made more recently, when to their level of emissions. the regulation may have been anticipated. 2.2.1 Advantages 2.2.2 Disadvantages However, grandparenting is also associated with several The key advantages of grandparenting are: disadvantages: ▲▲ Attractive method of compensating affected industry: ▲▲ Repeated grandparenting reduces incentives to abate: One-off grandparenting may be a particularly attractive While grandparenting should maintain incentives to abate, approach where there is a desire to provide transitional this can be significantly diluted if applied in combination support for industries that might otherwise lose significant with updating provisions (as widely implemented for Phase value from stranded assets. For example, the now repealed I and II of the EU ETS). In these cases, future allowance Australian carbon pricing mechanism included a one-off, allocation will be based on updated emissions levels. This nonupdating allocation of allowances to electricity gener- means that firms that reduce emissions (either by reducing ators to reduce the financial impact that they otherwise output or emissions- intensity) could receive lower support would have faced. Firms are also less likely to resist partici- in the future, significantly decreasing the incentive to pation if they receive free allowances. STEP 3: DISTRIBUTE ALLOWANCES 73 abate. This is a major distortion of the carbon price signal extent feasible. Free allowances received by firms/installations and leads to less cost-effective emissions abatement from in the sector are in principle calculated by multiplying the production and investment decisions. It is only likely to be installations’ historical output level by the benchmark. Once addressed if it is signaled at an early stage that subsequent the level of free allowances is set, future changes in installation allocations will not be based on grandparenting, as indeed output have limited impact on the allowances received by each has been the case in a number of systems. installation (only if capacity is added). ▲▲ Weak impact on leakage prevention: Providing assistance through grandparenting should not affect the incentives 2.3.1 Advantages that firms face under a carbon price. This means that There are two main advantages to this approach: higher costs brought about by the introduction of a carbon ▲▲ Severing the link between firms’ emissions intensity and price could lead to a reduction in firm output (and a trans- allowances received: Firms that have taken actions before fer of this output to competitors outside of the jurisdiction). the ETS to reduce their emissions intensity will benefit ▲▲ Windfall profits: With grandparenting, firms are incen- relative to those with high emissions intensity; early actions tivized to reduce emissions to minimize their carbon cost are rewarded. In addition, as explained above, under a liability. This reduction in emissions may lead to a fall in grandparenting approach with periodic updating, firms may output and thus an increase in prices. However, this has be reluctant to reduce their emissions intensity as it will no impact on the free allowances an entity receives. In reduce the free allowances the firm is entitled to receive in the future. This challenge is largely eliminated by this 3. ALLOCATION other words, firms may benefit from both higher prices and free allowances.75 This was seen, for instance, for some approach: it is the industry-wide benchmark, rather than a electricity generators in Phase I and II of the EU ETS.76 firm’s specific emissions, which determines the amount of Windfall profits under grandparenting may be highest for free allowances received in the future. Firms will therefore the historically high emitters within a sector who have not profit even in the medium to long run from production taken early action; they receive high free allocations and efficiency improvements that reduce their emissions may still have low-cost abatement opportunities. Windfall intensity. profits may undermine public confidence in the system, ▲▲ Demand-side abatement incentives are preserved for particularly if they persist. nontrade-exposed products: As with grandparenting, ▲▲ Penalizing early action: Early actions and early movers changes in output do not immediately lead to changes in may face disadvantages if they implemented abatement allowances under a fixed sector benchmarking approach. measures before the period that was selected as the base This means firms may have an incentive to reduce output period for grandparenting. in order to reduce emissions liabilities, and those not com- peting in international markets can raise prices (with less risk of perceptions of windfall profits) and hence stimulate 2.3 Free allocation using fixed sector some demand-side abatement. benchmarking Fixed sector benchmarking combines two features. Firstly, in 2.3.2 Disadvantages contrast to grandparenting, the level of assistance is deter- The disadvantages of this method are: mined by reference to a product or sector level benchmark ▲▲ Calculation of sector benchmarks: This is data-intensive emissions intensity rather than by reference to the current or and creates potential for lobbying around the allocation historical emissions intensity of each individual firm. Thus, it methodology. Complications arise through issues such as depends on the firm’s historical output level but not its emis- the existence of similar products with different production sions. Secondly, there is only infrequent updating of assistance processes, and through multi-output production processes. levels in response to changes in firm output. However, the successful development of benchmarking This is the approach adopted in Phase III of the EU ETS for the approaches in the EU indicates that these technical manufacturing industry (see Box 3.4). A series of benchmarks challenges can be overcome. Existing principles and meth- were created for different products under the cap, to the odologies to set benchmarks, for instance, from the EU or from California, could also be used by other systems as a 75 CE Delft and Öko-Institut (2015) present empirical evidence suggesting cost pass- basis for developing their own. through despite the provision of free allowances in both phases II (grandparenting) and phase III (fixed sector benchmarking) of the EU ETS, for certain industrial sectors. 76 See Sijm et al. (2006). 74 EMISSIONS TR ADING IN PR ACTICE ▲▲ Risk of windfall profits: As the level of allocation is not BOX 3.4 CASE STUDY: Fixed Sector dependent on current output levels, firms that are not Benchmarking in Phase III of the EU ETS exposed to international competition may raise prices in response to a significant emissions cost. While this increase The fixed sector benchmarking allocation approach in prices might stimulate some demand-side abatement, as under the EU ETS Phase III does not regularly update the discussed above, it can also lead to firms earning windfall output basis for allocation. To improve its effectiveness profits from free allowance allocations. in preventing leakage, the policy has been designed to create a stronger link between allocations and output, ▲▲ Mixed results in mitigating leakage risk: Fixed sector which in turn facilitates stronger protection against benchmarking has a dynamic similar to grandparenting; leakage. Specifically, a historical output level is set, sectors genuinely exposed to international competition could based either on output in 2005–08 or 2009–10 (Decision still cut back on production and lose market share to those 2011/278/EU). not facing carbon prices. In other words, it may not be partic- Firms producing: ularly effective at reducing carbon leakage risk. Accordingly, ▲▲ Less than 10 percent of their historical level in any policy makers may adjust the approach to provide stronger one year receive no allocations in the subsequent incentives for leakage protection, as described in the chapter year, effectively acting as a closure threshold; "Before You Begin." ▲▲ Between 10 and 25 percent of the historical level ▲▲ Potential for distortions of the price signal: If benchmarks activity receive allocations with a 25 percent weight- are not strictly based on sector or product outputs but ing in the next year; instead reflect process, fuel, or other input specifics, price ▲▲ Between 25 and 50 percent of their historical level signal distortions may arise that are comparable to those receive 50 percent of their full allocation in the next observed with grandparenting in combination with updating year; and provisions. ▲▲ More than 50 per cent of their historical level receive their full allocation, even if their output exceeds their ▲▲ Increases high emissions-intensive firms’ need to trade historical activity level. from beginning of the program: This factor can make the transition into the ETS more difficult. In a comparison of production decisions in the EU cement sector between 2011 and 2012, one study indi- cates that firms might have increased their output levels 2.4 Free allocation using Output Based in 2012 in order to ensure higher allowance allocations in Allocation (OBA) 2013, the first year of Phase III.a If cement is considered OBA has two key properties. Firstly, assistance is allocated at risk of carbon leakage, this suggests that the thresh- according to a predetermined emissions intensity. Secondly, olds and allocations are having some effect in terms of when firms increase or decrease their output, the amount preserving output and hence addressing leakage. of assistance that they receive correspondingly rises or falls, However, there are two disadvantages to this approach: according to the predefined level of intensity. The predefined ▲▲ Because allocations are not directly in proportion to intensities can be fixed by sector or be based on the firm’s own output, there is a possibility for gaming: by setting historical emissions intensity. production at a level just above a threshold, firms can receive allocations that exceed the emissions This model is similar to the fixed sector benchmarking approach costs they face—at an output level of 51 per cent of if the allowance allocation is determined by a sector benchmark their historical activity level, firms would be entitled (which could be calculated in exactly the same way as the fixed to receive 100 percent of their allocation. sector benchmarking approach) multiplied by the firm’s output ▲▲ The market can be distorted as firms are incentivized level. However, in contrast to the fixed sector benchmarking to produce above activity level thresholds. Such approach, if there are subsequent changes in firm output, then, perverse incentives could lead to production at an with just a small lag, there is an adjustment in the allowances inefficient level.b that the firm receives. A simple worked example is provided in Box 3.5. Variants on this basic model are used in California, Québec, New Zealand, the former system in Australia, some a Branger et al. (2014). sectors in the Republic of Korea, and some sectors in most of the b Neuhoff et al. (2015) Chinese pilots. STEP 3: DISTRIBUTE ALLOWANCES 75 2.4.1 Advantages BOX 3.5 TECHNICAL NOTE: Impacts of OBA on The advantages of OBA are: Incentives to Produce ▲▲ Maintains incentives to abate emissions intensity: Consider a carbon price of $100. As a high-emissions- OBA preserves incentives to reduce emissions intensity. A intensity firm (A) increases output from 1 to 2, its emissions also rise by 1 tCO2e. With no free allocation, reduction in emissions intensity reduces emissions liability this increase in production would cost $100 in terms of but has no effect on free allocation. This incentive will be liability on top of the direct cost of production. That could stronger when OBA is used with fixed sector benchmarks leave firm A vulnerable to international competition. With rather than with firm-specific benchmarks (where the benchmarked OBA, as output rises, allocation also there may be an implicit or explicit possibility that the rises, from 0.7 tCO2e to 1.4 tCO2e. Firm A’s extra emissions firm-specific benchmark will be updated). Sector-specific liability from increasing production from 1 to 2 units is now benchmarks reward early mitigation action and also allow only $30. less carbon-intensive firms to gain a competitive advantage By contrast, when low-emissions-intensity firm (B) through lower carbon costs. Again, these advantages will increases output, the extra free allocation it receives materialize only if the benchmark design is strictly based on (also 0.7 tCO2e more) is greater than its extra emissions a sector or product output approach, and process, fuel, or (0.5 tCO2e) and it actually receives a production subsidy of $20 per unit. This illustrates the way benchmarks give other input shifts are fully rewarded. low-emissions-intensive firms a competitive advantage but ▲▲ Targets leakage risk strongly: Under OBA, an extra unit of also illustrates the risks of setting sectoral benchmarks 3. ALLOCATION output (or production by a new entrant) will directly result that are too high. If the emissions rate is set above the in additional allocations, as opposed to grandparenting and level of actual emissions per unit of output, perverse fixed sector benchmarking schemes, where extra output incentives to increase output can be created. This is an issue of particular concern in a heterogeneous sector does not usually lead to additional assistance. This works to where one rate may be applied to a set of different activi- maintain or increase output levels despite the pressure of ties and outputs. competition from firms that do not face the carbon price. As such, it offers strong leakage protection. The volume Unit Firm Output preservation feature of OBA is even more attractive if there 1 unit 2 units are opportunities to reduce the carbon intensity of produc- Firm’s emissions tCO2e/unit of A: High 1 tion, which firms will only pursue if they are confident that intensity output B: Low 0.5 they will retain high levels of output in the future. Benchmark Allowances/unit 0.7 of output 2.4.2 Disadvantages Allocation tCO2e Both 0.7 1.4 The disadvantages of this method are: Emissions tCO2e A: High 1 2 B: Low 0.5 1 ▲▲ Demand-side abatement incentives may be lessened: OBA provides a strong incentive to maintain or even Net liability tCO2e A: High 0.3 0.6 (emissions less increase production levels. In sectors not exposed to $ 30 60 allocation) and cost international competition, higher levels of output mean (price = $100) tCO2e B: Low -0.2 -0.4 that end user prices are lower than they would be under $ -20 -40 alternative forms of allocation. This can mean that OBA dents incentives for demand-side abatement. The latter will often be a relatively low-cost form of abatement (e.g., using steel, aluminum, and concrete more efficiently in construction) and hence means that the cost of meeting a given emissions reduction target may be unnecessarily high. In sectors exposed to leakage, this may not have material effects on demand-side efficiency as international competition would serve to limit price increases in any case. ▲▲ Calculation of benchmarks and measurement of output: Benchmarks based on firms’ historical emissions intensity require much the same data as grandparenting, although 76 EMISSIONS TR ADING IN PR ACTICE “output” must also be defined. The establishment of carbon price on sectors or firms, the greater the risk of sectoral benchmarks is data-intensive and creates potential leakage, all other things being equal. for lobbying around the methodology. ▲▲ Trade exposure can be thought of as a proxy for the ability ▲▲ Possible interaction challenges with the overall cap: In of a firm or sector to pass on costs without significant loss all forms of free allowance allocation, there is a need to of market share and hence its exposure to carbon prices. ensure that the number of allowances allocated for free Trade, or the potential to trade, is what allows competition does remain within the cap (e.g., in Phase III of the EU between producers in different jurisdictions. Therefore, ETS, a cross-sectoral adjustment factor was applied to the trade is critical to allowing firms that face different carbon initial free allowance allocation of all sectors). This may be prices to compete. Where factors such as trade barriers or more difficult to manage under OBA if overall levels of free transport costs make trade unlikely to occur, covered firms allocation are high. If increases in OBA allocation cannot are insulated from competition from uncovered competi- be absorbed within the pool of allowances that would tors and the risk of leakage should be small. otherwise be auctioned, the overall level of assistance firms The two indicators can also be used to separate assistance are entitled to receive may not be known when a particular categories into tiers. Table 3.4 shows the different factors that phase of the scheme starts. Alternatively, the overall cap ETSs have used to identify which sectors might be exposed to on emissions could change, rendering the domestic envi- the risk of leakage and Box 3.6 provides more information on ronmental outcome of the ETS less certain. the approach taken in Australia. While these criteria have typically been used in determining 3. Identifying Sectors to sectors exposed to carbon leakage, there are a number of Protect Against Leakage important considerations: Rather than allocating all emissions by auctioning or all allow- ▲▲ First, in the academic literature, a number of authors ances for free, most systems have elected a hybrid approach have argued that trade intensity, while relevant, is not a whereby some sectors receive free allowances, but not all. standalone driver of carbon leakage and only has an effect This approach is particularly common when free allowance when a sector or firm is also carbon-intensive. The same is allocation is being used to protect against carbon leakage, but also true for carbon intensity in cases where trade intensity otherwise policy makers want to auction allowances. In this is not high. case, there is a need to identify the sectors most likely to be ▲▲ Second, when considering carbon intensity, it is important at genuine risk of carbon leakage. Even where sectors are not to take into account the carbon emissions costs passed trade-exposed, and hence less likely to be at risk of leakage, through from the supplying sectors, particularly electricity, if they have high emissions intensity, they may experience as well as the direct carbon emissions costs incurred in significant stranded assets, which can also be a justification production. for assistance during the transition to the ETS. This argument becomes more difficult to sustain when an ETS has been operating for a significant period of time. 4. Other Issues Policy makers have generally used two main indicators— carbon intensity and trade exposure, either in isolation or 4.1 New entrants and closures combination—to determine exposure to carbon leakage risk When deciding on allocation methods, it is important to con- and hence eligibility for free allocation: sider how the system will deal with both new entrants to, and exits from, the market. As noted in "Before You Begin," these ▲▲ Carbon intensity captures the impact that carbon pricing can be thought of as special forms of updating provisions. has on a particular firm or sector. It can be thought of, for these purposes, as the volume of emissions created Under an auction system and with allocations based on per unit of output, revenue, value added, profit, or similar benchmarks, both entry and exit may be accommodated in a economic metric (the term emissions intensity can be used relatively straightforward manner. An auction system automat- interchangeably). As carbon leakage is driven by carbon ically accommodates new entrants and exits—allowances are emissions cost differentials between jurisdictions with and readily available for purchase. In current OBA systems, new without carbon prices, the larger the impact of a given entrants are treated in broadly the same way as an existing STEP 3: DISTRIBUTE ALLOWANCES 77 TABLE 3.4 Trade Exposure and Emissions Intensity in Different ETSs Scheme Applied at firm or (Period) Criteria Definitions sectoral level? Cost increase >30%; or Cost increase: [(assumed carbon price (€30) × emissions) + EU ETS Trade intensity >30% or (electricity consumption × emissions intensity of production × Cost increase >5% and trade intensity >10% carbon price (€30))]/GVA) Sectoral Phase III Qualitative assessment for borderline sectors Trade intensity: (imports + exports)/(imports + production) Highly exposed if carbon intensity >1,600 tCO2e per million Carbon intensity is calculated as tonnes of CO2e per million New Zealand dollars of revenue and trade exposed dollars of revenue metric New Zealand Moderately exposed if carbon intensity >800 tCO2e per million Trade exposure is qualitative and based on the existence of Sectoral New Zealand dollars of revenue and trade exposed trans-oceanic trade in the good in question. Electricity is explicitly excluded Variously split into high, medium, and low exposure. This was based on a combination of tiers of emissions intensity and trade intensity. Emissions intensity tiers are: High: >5,000 tCO2e per million dollars of value added; Emissions intensity calculated as tonnes of CO2e per million Medium: 1,000–4,999 tCO2e per million dollars of value added; dollars of value added metric California Sectoral Low: 100-999 tCO2e per million dollars of value added; Very low: <100 tCO2e per million dollars of value added. Trade intensity: (imports + exports)/(shipments + imports) Trade intensity tiers are: 3. ALLOCATION High: >19%; Medium: 10–19%; Low: <10%. Highly exposed if trade exposed and one of the following applies: carbon intensity >2,000 tCO2e per million Australian dollars of Carbon intensity is calculated as tonnes of CO2e per million revenue, or >6,000 tCO2e per million Australian dollars of GVA dollars of revenue metric or, alternatively, tonnes of CO2e per million dollars of gross value added Australia Moderately exposed if trade exposed and one of the following Sectoral (repealed ETS) applies: carbon intensity >1,000 tCO2e per million Australian dollars of revenue, or >3,000 tCO2e per million Australian dollars Trade exposure based on either a quantitative test: (imports + of GVA exports)/production; or a qualitative assessment Trade exposed >10% Author: Vivid Economics. source that expands production. When a new entrant reports BOX 3.6 CASE STUDY: Approach to Identifying output, it will receive allowances just like existing firms. The Activities at Risk of Leakage in Australia only complication may relate to the calculation of the bench- mark intensity metric, unless this is set at a sector-wide level. Australia used an administrative process to determine Similarly, if any firm closes, it produces no output and receives eligibility of activities. Activity definitions were simple and measurable. Activities needed to pass both an emissions no allowances. intensity and a trade-exposure test. Firms volunteered Under grandparenting (and fixed sector benchmarking), these activities to be assessed for eligibility. The level of free allocation varied by degree of emissions intensity. issues are more complex. In terms of closure, while it might be Emissions intensity was calculated on the basis of value considered fair that once a facility closes down, it should no added.a The list of eligible activities was shortb and total longer receive free allowances, this may not be consistent with levels of free allocation were low as a percentage of total the intention to provide allowances as compensation for the allowance value.c loss of stranded assets. It may also create an artificial incentive to preserve production.77 Nonetheless, in most ETSs with a New Zealand copied the Australian system, including the latter’s much higher grandparenting, closure is normally associated with the loss of electricity emissions factor—in order to harmonize and facilitate future link- rights to free allowances. age. New Zealand used revenue rather than value added to define emissions intensity. In terms of new entrants, the typical approach in systems with b In New Zealand, in 2014, only 24 activities received industrial allocations (New Zealand Government, 2015). grandparenting involves a new entrants’ reserve, which is set c New Zealand, under similar rules, in 2013 allocated 4.8 out of 37 megatonnes aside within the cap to provide free allocation to eligible new of allowances surrendered freely to industrials. New Zealand Environmental Protection Agency (2014). 77 Ellerman (2008) discusses these issues in the context of Phase I of the EU ETS. 78 EMISSIONS TR ADING IN PR ACTICE entrants to the market. In the EU, member states included new entry provisions primarily to avoid leakage of new QUICK QUIZ entrants. Conceptual Questions ▲▲ What are the key options for distributing allowances? 4.2 Allocation of allowances for removals ▲▲ What objectives can each distribution option help achieve? As is discussed in Step 2, a jurisdiction may wish to have arrangements for allocating allowances to sources that might Application Questions facilitate the removal of emissions from the atmosphere. your jurisdiction, what activities are both strongly trade- ▲▲ In Potential activities include capture and destruction of industrial exposed (to jurisdictions with no or weak carbon pricing) gas, carbon capture and storage (CCS), and reforestation. and emissions-intensive? There is a whole range of ways to treat these potential remov- ▲▲ Would your jurisdiction want an ETS to generate additional als but there is a need to align allocation for these activities government revenue that could be used strategically? with the accounting treatment of the related emissions source. Given the local confidence in markets, how willing would firms and regulators be to rely on auctions vs. free alloca- tion for distributing allowances? STEP 4: CREATE OFFSETS 79 STEP 4: CONSIDER THE USE OF OFFSETS At a Glance___________________________________________________________________________ 80 1. What Are Offsets?__________________________________________________________________ 81 2. Using Offsets: Benefits and Challenges_________________________________________________ 84 2.1 Advantages of using offsets____________________________________________________ 84 2.2 Challenges of using offsets_____________________________________________________ 84 3. Designing an Offset Program_________________________________________________________ 85 3.1 Choosing geographic coverage_________________________________________________ 85 3.2 Choosing gases, sectors, and activities to cover___________________________________ 86 3.3 Quantitative limitations on offset use____________________________________________ 86 3.4 Determining appropriate offset methodologies____________________________________ 89 4. Implementing and Governing an Offset Program________________________________________ 91 4.1 Project registration and offset credit issuance_____________________________________ 91 4. OFFSETS 4.2 Seller vs. buyer liability________________________________________________________ 91 4.3 Liability for reversals__________________________________________________________ 92 Quick Quiz____________________________________________________________________________ 93 80 EMISSIONS TR ADING IN PR ACTICE AT A GLANCE ✓✓ Decide whether to accept offsets from uncovered sources and sectors within and/or outside the jurisdiction ✓✓ Choose eligible sectors, gases, and activities ✓✓ Weigh costs of establishing an own offset program vs. making use of an existing program ✓✓ Decide on limits on the use of offsets ✓✓ Establish a system for monitoring, reporting, verification, and governance Offsets provide credit for emissions reductions and/or removal activities to render eligible for offset generation. Qualitative by sources not covered by an ETS. Once accepted, offsets are limits on offset use may, for example, be based on criteria treated as equivalent, for compliance purposes, to allowances of environmental integrity or the region of origin. For offsets within the ETS. that are classified as eligible, quantitative limits may also be used to control the inflow of low-cost offset credits and the Opening up an ETS to offsets expands the amount of abate- relocation of mitigation co-benefits. It is important to ensure ment options in the market, as it renders new regions, sectors, that all offsets are generated following sound methodologies, and activities eligible to sell emissions reductions. These either using an existing offset program for sourcing reductions options may be available at lower cost than abatement oppor- domestically or internationally, or by creating a new offset tunities under the cap; allowing the use of offsets for com- program to achieve a set of specific policy objectives. pliance can thus reduce entities’ costs of compliance, which can potentially enable greater mitigation ambition for an ETS. Once any qualitative and quantitative limits have been set and Allowing offsets often has economic, social, and environmental acceptable methodologies identified, the offsets can be inte- co-benefits and can also support low-carbon investment, grated in the ETS. This involves adopting a process for project learning, and engagement among uncovered sources. registration and credit issuance, and determining liability in case of reversal of emissions reductions. At the same time, the acceptance of offsets in an ETS may have several disadvantages. While it will provide greater com- This step elaborates the role that offsets might play in an ETS. pliance flexibility for covered sectors, likely lowering allowance Section 1 explains what offsets are, how they may be sourced, prices, it could also reduce low carbon investment in those and how they affect emissions in an ETS. Section 2 elaborates sectors, at least for some time.78 Offset approaches should some of the advantages of using offsets and potential chal- be designed and implemented in a manner that ensures the lenges. Section 3 discusses more in-depth how to design an environmental integrity of units. Among some types of offsets, offset program that can address the potential disadvantages. it is also necessary to manage the risk of a reversal of emis- It sets out an approach to applying qualitative limits to the sions reductions, for example, if forests or other carbon sinks use of offsets—that is, the geographic origin, types of gases, are established but the sequestered carbon is later released sectors, time periods, and types of activities eligible for offset back into the atmosphere. The use of offsets may also bring generation; and quantitative limitations that might, in particu- distributional concerns, as finance flows to other sectors or lar, guard against the potential for overly depressing allowance jurisdictions for investment in low-carbon technology and prices. The section further discusses the methodologies activities, along with the associated co-benefits of emissions underlying offsets, whether applied as part of an existing or reductions. a new offset program. Section 4, finally, sets out some of the key elements of effective governance and implementation of These concerns mean that much care is required when offset programs. considering which geographic regions, gases, sectors, and 78 See, for example, Szolgayová et al. (2014); Koch et al. (2016). STEP 4: CREATE OFFSETS 81 1. What Are Offsets? BOX 4.1 TECHNICAL NOTE: Achieving a Net Offsets represent emissions reductions resulting from actions Decrease of Emissions through the Use of Offsets taken to reduce emissions by sources that are not covered by an ETS, or to increase carbon sequestration. The use of The example in Table 4.1 shows a stylized case where the offsets allows for aggregate emissions from covered sources actual reductions from within the offset program exactly to exceed the cap, but the overall emissions outcome is cover the increased emissions in the covered sectors on a unchanged as the excess emissions are offset by the emissions 1-for-1 basis. Traditionally, offset mechanisms such as the CDM have been designed in this manner. Because such reduction credited by the offset. Subject to conditions set out offsets achieve a zero net gain for the atmosphere, they in protocols for crediting such reductions, ETSs may allow the are typically seen as a means to control costs and provide use of offsets for compliance in place of allowances. benefits to uncovered sectors, rather than as a tool to drive mitigation across the economy. Table 4.1 provides a simplified illustration of how an ETS with an offset program functions. Without offsets, entities covered Furthermore, there are also potential issues with the environmental integrity of offsets, meaning that less than by an ETS cap can emit 100 MtCO2e. The regulator has cre- one tonne of emissions could actually be reduced via off- ated an offset program in which uncovered sources currently sets for each tonne of emissions increased in the covered emitting about 20 MtCO2e can obtain credit for emissions sectors. This could erode the overall level of emissions reductions. Sources under the offset program choose to reductions or potentially shift greater cost to the covered implement practices to reduce their emissions by half and sell sectors if policy makers adjust the cap on the covered these reductions, totaling 10 MtCO2e, to covered sources. In sectors to make up for the lower-quality offsets. this example, typical of how most offset programs to date Offset programs can also be designed such that more have been designed to operate, each offset credit represents than one tonne of emissions reduction must be achieved an emissions reduction equivalent to exactly one allowance.79 for each tonne that can be credited. In particular, the 4. OFFSETS Covered sources can then increase their emissions by 10 new mechanism established under the Paris Agreement MtCO2e and still comply with the ETS cap. Total emissions of December 2015 must “deliver an overall mitigation in global emissions” as well as foster sustainable development remain unchanged through the addition of the offset program, (see Box 0.2 in "Before You Begin"). Some proposed but overall costs have fallen if the abatement costs of sources sector-wide or jurisdictional crediting programs would under the offset program are lower than the abatement require emissions to first fall below a “crediting baseline” costs of sources covered by the ETS. Box 4.1 discusses offset lying below historical emissions (or a conservative estimate approaches that would achieve a net decrease of emissions. of BAU), before any reductions could be credited via offsets.a a ARB (2015f). TABLE 4.1 A Simple Illustration of Offsetting in an ETS No offset program With offset program Sources (MtCO2e) Before trading (MtCO2e) After trading (MtCO2e) Covered emissions 100 100 110 10 Uncovered emissions within offset program 200 20 10 (with no offset program there is no Other uncovered emissions distinction between these categories) 180 180 Total emissions 300 300 300 79 Some Parties, however, including France, decided to deliver only 90 percent of the emissions reductions achieved in their territory as carbon credits to the project participants, creating a net benefit for the compliance of the host Party with its international commitments. 82 EMISSIONS TR ADING IN PR ACTICE An offset program issues carbon credits according FIGURE 4.1 Sources of Offsets for an ETS to an accounting protocol and has a registry to track and trade the credits.80 Depending on the ETS, an offset can originate from either within or outside the International or Foreign ETS Jurisdiction ETS jurisdiction. Offset Crediting Program ▲▲ An international offset program is a program that is run by an institution recognized by multiple countries (e.g., a body within an international ETS Covered Sectors organization or a non-profit organization). The rules are clearly defined for all participating coun- tries, and the credits are sourced from multiple countries and sold on the international market. The Kyoto Protocol’s project-based mecha- Offsets nisms—the Clean Development Mechanism (CDM) is an example of an international offset program (see box 4.2). Article 6 of the Paris Agreement introduces future mechanisms for which rules and guidelines have to be developed. Offsets ▲▲ A domestic offset program is a program that is run at the national or subnational level by a domestic body. The rules are specific to the juris- Non-Covered Sectors diction and developed by the relevant domestic authority, potentially informed by international guidelines. The credits are sourced from projects developed domestically or internationally. Programs in other jurisdictions or countries might link to this ETS and/or its offset program, enabling sales of credits outside the jurisdiction. Author: Mehling. 80 See two PMR reports and a USAID report for Kazakhstan for a compre- hensive overview on key aspects of offset program design (PMR 2015d; 2015f; and USAID 2014). For an earlier discussion of offset policy issues, also see Olander (2008). STEP 4: CREATE OFFSETS 83 BOX 4.2 CASE STUDY: The Kyoto Flexibility Mechanisms Under the Kyoto Protocol, actions to reduce emissions by by the cancellation of the corresponding number of AAUs Annex I countries can be supplemented by three flexibility from within the selling country’s emissions budget. Under mechanisms. These were designed to create an interlinked JI there are two “tracks” by which projects can apply for system of tradable units among nations and facilitate trans- approval: party verification and international independent action of emissions units at the entity level. The three flexible body verification. The mechanism is overseen by the JI mechanisms are: Supervisory Committee, which answers ultimately to the countries that have ratified the Kyoto Protocol (Article 6 of ▲▲ International emissions trading. Countries with commit- the Kyoto Protocol). ments under the Kyoto Protocol can acquire emissions units called Assigned Amount Units (AAUs) from other The CDM was the first, and remains the largest international countries with commitments under the Protocol and use offset market. Overall, it has fostered US$130 billion of them to meet a part of their targets (Article 17 of the investment in GHG reducing activities in developing countries. Kyoto Protocol). Entities under the EU ETS were able to save up to US$20 ▲▲ The Clean Development Mechanism (CDM). The CDM billion by buying CERs to meet compliance obligations. A total allows emissions reduction (or emissions removal) projects of 200 GW of renewable energy capacity has been installed in developing countries to earn certified emission reduc- through CDM projects. tion (CER) credits, each equivalent to one tonne of CO2. The size, scope, and operation of the CDM have drawn some These CERs can be traded and used by Annex I countries criticism. In particular, various parties have questioned the to meet part of their emissions reduction targets under environmental integrity of some CDM projects, such as those the Kyoto Protocol. The mechanism stimulates emissions generating CERs from the destruction of industrial gases reductions, while giving Annex I countries some flexibility like HFC, which accounted for approximately 70 percent of in how they comply with their emissions reduction CERs issued in 2009 and 2010. One important issue has been targets. The projects must qualify through a public that CER revenue may have created perverse incentives to 4. OFFSETS registration and issuance process designed to ensure increase production of the underlying product to profit from real, measurable, and verifiable emissions reductions that the CERs awarded for its destruction (in the case of HFCs). are additional to what would have occurred without the Motivated by that concern, the EU and New Zealand decided project. The mechanism is overseen by the CDM Executive to ban the use of such CERs in their ETS. Board, answerable ultimately to the countries that have ratified the Kyoto Protocol (Article 12 of the Kyoto Prices on the CDM market have dropped dramatically in Protocol). recent years, from over US$20 per unit before the 2008 recession to less than US$0.20 per unit in 2014, before recov- ▲▲ Joint Implementation (JI). A country with an emissions ering to US$0.50/unit in December 2015. The price decline is reduction or limitation commitment under the Kyoto likely driven by a number of factors, including: Protocol may participate in an emissions reduction (or emissions removal) project in any other country with a ▲▲ The drop in demand caused by the financial crisis; commitment under the Protocol, and count the resulting ▲▲ Overallocation of allowances in the EU ETS, which would emissions units toward meeting its Kyoto target. As otherwise have been a greater source of demand for with the CDM, all emissions reductions must be real, CERs; measurable, verifiable, and additional to what would ▲▲ Japan and New Zealand declining to participate in the have occurred without the project. This project-based second commitment period of the Kyoto Protocol; mechanism is similar to the CDM, but only involves parties with commitments under the Kyoto Protocol, so ▲▲ Preannounced limits by some ETSs on the types of CDM strictly speaking the credits are not offsets, because they projects they will accept credits from, which accelerated are nested under an overall economy-wide emissions the generation of offsets so that they might continue to limitation commitment. The credits generated by these JI be eligible; and projects, each equivalent to one tonne of CO2, are denom- ▲▲ Uncertainty about the future eligibility of credits. inated Emission Reduction Units (ERUs) and are created 84 EMISSIONS TR ADING IN PR ACTICE 2. Using Offsets: Benefits and outside covered sectors and prepare uncovered entities to enter the ETS. Challenges 2.2 Challenges of using offsets 2.1 Advantages of using offsets A number of potential issues must be addressed when consid- There may be several advantages to using offsets: ering the use of offsets to ensure environmental integrity and ▲▲ Cost containment: Offsets allow covered entities access avoid undesirable impacts: to a greater set of cost-effective mitigation opportunities. ▲▲ Pressure on allowance prices: The corollary of cost con- For example, the forestry, agriculture, transport, housing tainment is that offset credits will reduce prices and incen- and waste sectors fall outside of the cap in the cases of tives to reduce emissions in the covered sectors (see Step most existing ETSs (see Step 1). Nonetheless, these sectors 6 for a discussion of the problems associated with volatile still offer a range of opportunities to reduce emissions or and low prices). In the EU ETS, the availability of low-cost increase carbon sequestration at relatively low costs.81 By offsets from the CDM has contributed to low prices and the lowering compliance costs and creating a new, supportive accumulation of an oversupply of allowances, which policy political constituency for the ETS in the form of offset makers have sought to reduce in an effort to exacerbate project developers, offsets may allow policy makers to set a scarcity in the system. A typical way to introduce scarcity more ambitious cap and may support policy stability. and ensure that a minimum level of reductions occurs ▲▲ Generate an abatement incentive in uncovered sectors: in covered sectors is the imposition of quantitative limits If it is considered infeasible to include certain sectors on offsets use although this often involves a trade-off within an ETS, then an offset mechanism may create an against improved cost effectiveness (see section 4.3). In abatement incentive and support investment flows within addition, costs and supply of offsets may be challenging to these sectors. anticipate and, once information has been collected, any quantitative limits may have to be reviewed. ▲▲ Generate co-benefits in uncovered sectors: Allowing offsets often has economic, social, and environmental ▲▲ Establishing additionality: Offsets involve assessing co-benefits, including better air quality, restoration of whether the emissions reductions are additional to those degraded land, and better watershed management. When that would have materialized without the incentive of being this aligns with policy priorities, for instance, in relation to able to sell the credit. This requires the estimation of a international cooperation or improving livelihoods in rural, baseline or counterfactual scenario. Because regulators agricultural areas, this will be an advantage. cannot accurately estimate baseline emissions of a project, there is a risk that the offsets generated may not represent ▲▲ Increase capacity for implementing a market-based genuine emissions savings.83 Various ways to address addi- mechanism in uncovered sectors and other countries: tionality have been developed in different offset method- An offset program can engage new sectors and countries ologies, including aggregating reductions across a broader in climate mitigation and lead to innovation and learning set of actors in a jurisdiction to reduce the self-selective about market-based mechanisms. Sectors that would nature of the voluntary program.84 otherwise have struggled to attract financing for mitigation action are provided with a financial incentive to invest ▲▲ High transaction costs: The transactions costs associated in mitigation. When offsets are generated abroad, this with the administration of offset programs may be high: learning process can support the adoption of market-based often the reason policy makers leave sources uncovered measures in the host countries. Over two-thirds of offsets in the first place is that they are small and numerous, or generated by the CDM to date originate from China— otherwise costly or difficult to administer (see discussion of reviews suggest this extensive experience is likely to have emissions thresholds and scope considerations for different played a role in China’s decision to implement an ETS.82 sectors in Step 1). Similarly, a domestic offset program can develop capacities ▲▲ Reversals: Some types of offsets generate credits from carbon sequestration projects and programs, helping 81 The U.S. Environmental Protection Agency’s economic analysis of the most recent to establish carbon stocks. However, there is a risk that national cap-and-trade proposal in the U.S. Senate provides a case in point. It esti- mated that including domestic and international offsets (mostly from forestry and 83 A similar “baseline” issue may arise when setting the cap (see Step 2). If this is set agriculture mitigation) would cut allowance prices by more than 50 percent and have up above BAU then any emission reductions would have occurred anyway and the a larger effect on compliance costs than the deployment of key technologies such as associated allowances do not correspond to emission reductions resulting from the carbon capture and storage or nuclear power (see U.S. EPA, 2010). regulation (typically referred to as “hot air”). 82 CDM Policy Dialogue (2012). 84 Van Benthem and Kerr (2013). STEP 4: CREATE OFFSETS 85 reductions achieved from these activities at one point in time could later be unintentionally or intentionally reversed 3. Designing an Offset and provide only temporary (“nonpermanent”) climate Program benefits. For example, a field that has been converted When designing an approach to using offsets in an ETS, policy to no-till cropping may be turned back into conventional makers need to decide the following aspects: the geographic tillage, releasing soil carbon. Similarly, a forest planted scope of an offset program (see section 3.1); the gases, to sequester carbon may be harvested prematurely or sectors, and activities to cover (see section 3.2); whether to burned, releasing the credited carbon. An offset program limit offset use (see section 3.3); and further methodological needs to address liability for reversals to guarantee that the requirements (see section 3.4). reductions in emissions for the program persist at least as long as the reductions achieved under the emissions cap In deciding the scope of, and any limitations to, the offset (see section 4.2.1). Often, imposition of liability is the best program, four goals are likely to be important:85 way to align incentives to prevent reversals, but if this is 1. Avoiding double counting of emissions reductions and impossible, one option to manage reversal risk is to estab- helping ensure additionality by covering only emissions lish a buffer pool of credits that acts as a general insurance that are not regulated under a cap or reductions that are against reversals as well as to pool risks by aggregating already being achieved by other mitigation policies; activities across a larger region. 2. Matching potential supply to expected offset demand; ▲▲ Leakage and leakage protection: On the one hand, 3. Ensuring compatibility with international systems, particu- providing incentives for sources outside the cap to mitigate larly those of potential future linking partners if linking is a emissions can reduce leakage (shifts of emissions to consideration (see Step 9); and uncovered sources if demand for those emissions is not met) by bringing more sectors under a carbon price. At the 4. Supporting policy priorities (e.g., cost containment, 4. OFFSETS same time, offsets can generate leakage through shifting rewarding early action, and promoting co-benefits and activities, market leakage, and investment leakage. Shifting emissions reductions in specific sectors or regions). activities may occur, for example, in avoided deforestation and forest degradation projects—in a large forest area, 3.1 Choosing geographic coverage paying to protect the forest in one part does not protect An ETS may accept offset credits from within the jurisdiction’s other areas, and communities may simply deforest unpro- boundaries, outside the jurisdiction’s borders, or both: tected areas. Leakage through market and investment channels seem less likely to occur. One solution that has ▲▲ Local: Accepting offsets only from within the jurisdiction, been proposed to some of these challenges in the context but outside of covered sectors, may be preferable if of international offsets is to scale up the accounting across domestic emissions reductions are a key priority, and may an entire sector or jurisdiction. Such larger-scale account- also ease compliance, monitoring and enforcement con- ing may account for all the emissions—and thus implicitly cerns. Additionally, any co-benefits of mitigation are kept capture leakage within that sector or jurisdiction. within the jurisdiction. In the Korean ETS, for example, only domestic offset credits are used. Eligible activities include ▲▲ Distributional issues: Offset programs may give rise to those eligible under the CDM and carbon capture and distributional concerns over resource transfers to uncov- storage (CCS) implemented after April 14, 2010. ered sectors, whether domestic or international. As noted above, this transfer of resources and potential co-benefits ▲▲ Outside jurisdiction: Accepting offsets from outside the may align with other policy objectives, but it can be a jurisdiction expands potential sources of supply and offers disadvantage in cases where there is misalignment. There more low-cost abatement opportunities. Domestic offset may also be concerns over transferring resources abroad programs that allow credits from outside the jurisdiction and compromising international competitiveness. of an ETS have been integrated in subnational ETSs in California and Québec, RGGI, and Saitama. International ▲▲ Subsidy lock-ins: If an ETS intends to expand its coverage programs are used by a wide range of ETSs. They may over time, allowing the generation of offsets before sectors target a wide range of countries (e.g., CDM or the envis- are covered can make it more difficult to subsequently aged international sectoral offsets in California), certain extend the cap. These sectors may resist the change from regions (e.g., North America, including the Mexico forestry recieving revenue from abatement activities to incurring a liability for emitting. 85 Adopted from Climate Action Reserve et al. (2014), which has wider applicability outside of California. 86 EMISSIONS TR ADING IN PR ACTICE protocol within the Climate Action Reserve (CAR)), or Qualitative limits can also be seen as a positive incentive for specific sectors and projects based on bilateral agreements the types of projects that are accepted. Projects deemed likely (e.g., Japan’s Joint Crediting Mechanism). The decision to lead to learning and transformation could be bolstered by regarding the scope of outside jurisdiction coverage will becoming eligible offset categories. For example, Shenzhen largely depend on how policy makers assess the trade-off targets particular clean energy and transport projects as well between enhanced cost effectiveness (which favors a as ocean carbon sequestration. The EU ETS, since 2013, only broad geographic scope) and attainment of other policy accepts new projects from Least Developed Countries, as objectives (which may favor a narrower scope, to direct access to mitigation finance is most restricted there. the subsequent financial flows toward certain recipients), Some systems have also chosen to use offsets to recognize taking into account the environmental integrity of offsets early action taken before the ETS is implemented, given the from a particular location (see Step 9). learning benefits and reduced risk of lock-in to high-emission technologies that such early action provides. The Chinese 3.2 Choosing gases, sectors, and activities pilots designed a new system to take advantage of the early to cover action that some participants have had with the CDM. Other It will generally be preferable to include particular industries, goals included ensuring environmental quality, reducing sectors, gases, or activities when they have: programmatic compliance costs, and producing co-benefits ▲▲ Mitigation potential (to ensure that the inclusion of offsets (see Box 4.3).86 has an impact); ▲▲ Low mitigation costs (to promote cost effectiveness and 3.3 Quantitative limitations on offset use cost containment); A regulator may wish to limit the use of offsets in an ETS if it has policy goals other than increasing the supply of low-cost ▲▲ Low transaction costs (to promote cost containment); abatement options. Objectives that warrant quantitative limits ▲▲ Low potential for nonadditionality and leakage (to ensure may include incentivizing investment in low-carbon technology environmental integrity); in covered sectors (which may be undermined if offsets result ▲▲ Environmental and social co-benefits in uncovered sectors in too low a price) and realizing mitigation and co-benefits in (to allow these opportunities to be realized); and its own jurisdiction. There may also be concerns over envi- ronmental integrity of offsets relative to reductions achieved ▲▲ Potential to encourage investment in new technologies (so under an ETS. Relaxing or removing quantitative limits on that the purchase of offsets can provide an appropriate offsets can also be used as a cost-containment tool (see Step incentive). 6). Approaches to limiting units from linked systems, including To give effect to these considerations, many ETSs place offset generating systems, are further discussed in Step 9. qualitative limits on the type of credits they accept, either by Table 4.2 summarizes the quantitative and qualitative limits setting specific criteria to ensure environmental integrity and across different ETSs. The most straightforward and commonly other goals, or by using lists of eligible and noneligible offset used quantitative limit is to restrict the share of entities’ com- types, or both. These typically reflect assessments of co-bene- pliance obligation that can be met with offsets. In the Republic fits, distributional implications, as well as additionality, leakage, of Korea, for example, each covered entity can only use offset and reversal risk. Both Europe and New Zealand blocked the credits to cover up to 10 percent of its compliance obligation. use of offsets from nuclear power and large hydroprojects (for If the cap is relatively nonstringent, allowing a relatively small political and environmental sustainability reasons) and from percentage of the compliance obligation to be satisfied with industrial gas destruction (because of additionality concerns). offsets could still represent a high percentage of total reduc- Further, the EU has not accepted temporary credits (tCERs) tions achieved. An alternative approach, as used in phase III of issued under the CDM, thereby excluding credits from projects the EU ETS, limits use of international offsets to 50 percent of for afforestation and reforestation, which the CDM treats as estimated aggregate emissions reductions (1.6 billion tonnes only temporary. Although New Zealand has a domestic pro- of CO2e). This limit applies to the market as a whole and is not gram to reward forestry sequestration, it also did not accept differentiated. Saitama also uses a limit relative to emissions temporary CERs arguing that it could not control the risk of reductions and further differentiates limits by entity, allowing reversals outside its borders. factories to use more offsets for compliance than offices. 86 Margolis et al. (2015). STEP 4: CREATE OFFSETS 87 BOX 4.3 CASE STUDY: Offset Use in the Chinese ETS Pilots China was a major provider of offsets under the CDM. This A majority of the methodologies eligible under the CCER experience helped develop local expertise in carbon markets, program are directly derived from the CDM, although some which was later valuable in the establishment of the seven new methodologies have been approved by the NDRC. CCER Chinese ETS Pilot programs.a All seven pilots allow for the use projects encompass a wide range of activities with large of Chinese Certified Emission Reductions (CCERs), which are numbers for wind, solar, hydro, and some large projects domestic units generated under a national offset program aimed at afforestation/reforestation and addressing fugitive administrated by the National Development and Reform emissions. To be eligible for generating CCERs, a project must Commission (NDRC). have started implementation after February 16, 2005, and meet a number of other requirements.b The so called “pre- All Chinese ETS pilots set restrictions on the types, origination CDM” projects, which are those projects being granted CCERs date, geography, and quantity of offsets that can be used for for emissions reductions produced before their registration compliance. These reflect a number of concerns, including under the CDM, currently dominate, but the share of such those related to preventing double counting and ensuring projects is expected to decline.c that CCERs do not flood the market. The table below sum- marizes the ways in which offsets can be used across the Chinese ETS pilots. Pilot Type of Offset Credit Rules of Use Geographic Restriction Temporal Restriction Shenzhen CCER No more than 10 percent CCERs from projects in the covered entity CCERs must come from existing or planned of allocated allowances boundary cannot be used. renewable and new energy projects, clean transport projects, marine carbon sequestration projects, forestry carbon sequestration projects, or agricultural emissions reduction projects Shanghai CCER No more than 5 percent CCERs from projects in the covered entity CCERs generated after January 1, 2013 4. OFFSETS of allocated allowances boundary cannot be used Beijing CCER; validated No more than 5 percent Up to 50 percent of the annual CCER quota CCERs must come from projects that began oper- emission reductions of allocated allowances may come from projects located outside of ation after January 1, 2013; excluding CCERs from from energy Beijing, with priority to projects located in HFCs, PFCs, N2O, SF6, and hydropower projects conservation projects cooperation areas, including Hebei Province and and forestry carbon Tianjin City sequestration projects Guangdong CCER No more than 10 At least 70 percent of CCERs should come from At least 50 percent of the reductions from a percent of annual verified projects located in Guangdong Province particular project must be in CO2 and CH4 emissions; emissions excludes CCERs from hydropower, fossil fuel (coal, oil, and gas) power generation, heating, and waste energy projects; excludes CCERs from pre-CDM projects Tianjin CCER No more than 10 CCERs from Beijing, Tianjin, and Hebei should CCERs must be generated after January 1, 2013, percent of annual verified be given priority. CCERs from projects located and only from CO2 projects; hydropower projects are emissions in the covered entity boundary of Tianjin and not allowed other province and city pilots cannot be used Hubei CCER No more than 10 percent 100 percent of CCERs should come from CCERs can only be from small hydropower projects of allocated allowances projects located in Hubei Province Chongqing CCER No more than 8 percent N/A CCERs must be sourced from projects operational of annual emissions after December 31, 2010 (except forestry carbon projects); excludes hydropower projects a CDM Policy Dialogue (2012). b According to the Administrative Measures for the Operation and Management of CCER projects, all projects that were developed after February 16, 2005 and belong to any of the following categories are eligible to apply for registration: Type I: Voluntary emissions reduction projects that were developed using methodologies approved by the national authority; Type II: Projects that were approved as CDM projects by the NDRC but not registered at the UN CDM Executive Board; Type III: Projects that were approved as CDM projects by the NDRC and produced emissions reductions before being registered at the UN CDM Executive Board; and Type IV: Projects that were registered at the UN CDM Executive Board but whose emissions reductions have not been issued. c PMR (2015b). 88 EMISSIONS TR ADING IN PR ACTICE TABLE 4.2 Offset Use in Existing ETSs ETS Type of Offset Limits California ▲▲ Compliance Offsets Credits issued by California Air Offsets limited overall to 8 percent of an entity’s compliance. Sector-Based Offset Resources Board (ARB) from a project in the United States Credits are subject to a sublimit of 2 percent of compliance obligations through or its Territories, Canada, or Mexico, and developed accord- 2017, and up to 4 percent between 2018 and 2020. ing to a compliance offset protocol approved by ARB. ▲▲ Compliance Offset Credits issued by linked regulatory programs (i.e., Québec) ▲▲ Sector-Based Offset Credits from crediting programs (including REDD) in an eligible developing country or some of its jurisdictions. This will, however, be subject to further regulation. EU Phase I (2005–07) No offset eligible N/A Phase II (2008–12) JI (ERUs) and CDM projects (CERs) Qualitative limits vary across member states. No credits from land use, land use change and forestry, and nuclear power sectors. Restrictions on hydroprojects > 20 MW. Credits can account for a certain percentage of each country’s allocations. Unused credits transferred to Phase III. Phase III (2013–20) JI (ERUs) and CDM projects (CERs) Qualitative restrictions from Phase II apply. Post-2012 credits restricted to those originating in Least Developed Countries. Credits from industrial gas projects not allowed. Credits issued for emissions reductions in 1st commitment period of Kyoto Protocol only accepted until March 2015. Use of credits in Phase II and III is restricted to 50 percent of overall emissions reductions from 2008—20 (1.6 billion tonnes of CO2e). Phase IV (2021–28) TBD Proposal to exclude all international credits is under consideration. Kazakhstan Domestic offsets No offset program established to date. New Zealand JI (ERUs), Kyoto Removal Unit (RMUs), CDM (CERs), domestic Not allowed: CERs and ERUs from nuclear projects; long-term CERs; temporary removal units CERs; CERs and ERUs from HFC-23 and N20 destruction; CERs and ERUs from large-scale hydroelectricity (if in compliance with the World Dam Commission guidelines); Post 31 May 2015: Only Primary CER units from second ERUs, RMUs, CERs from 1st commitment period only accepted until 31 May commitment period 2015. Québec Domestic (North American: Canada and United States) Offsets (domestic and international) limited to 8 percent of entity’s compliance. RGGI Domestic (projects located in RGGI states and select others) Up to 3.3 percent of each entity’s compliance obligation, although no offsets have been generated by this program to date. Saitama (Japan) Domestic and national Unlimited use of offset credits in general. Credits from projects outside Saitama can be used for up to one third (offices) or one half (factories) of a facility’s reduction target. Republic of Korea Phase I–II (2015–20) Domestic (including domestic CERs) Limited to activities implemented after April 14, 2010. Limited to 10 percent of each entity’s compliance obligation. Phase III (2021–25) Domestic and International Up to 50 percent of offsets in the ETS can be international. Switzerland International, from CDM (CERs) and JI (ERUs) Limited to credits originating in Least Developed Countries or other countries if CDM projects were registered before January 1, 2013, or credits from JI projects for emissions reductions achieved before January 1, 2013. In addition to these criteria, only projects in the following sectors/activities are eligible: use of renewable energy (for hydropower plants only those with an installed production capacity of no more than 20 MW), end user’s improved energy efficiency, methane flaring and avoidance of methane emissions at landfills, municipal waste recycling or waste incineration plants, recycling of agricultural waste, waste water treatment or through composting. Installations that already participated in voluntary phase (2008–12): Offsets in 2013–20 limited to 11 percent of five times the average allocated allowances in 2008–12 minus credits used during that period. Installations that entered in mandatory phase as of 2013 as well as newly covered emission sources: 4.5 percent of actual emissions in 2013–20. Tokyo (Japan) Domestic and national Unlimited use of offset credits in general. Credits from projects outside Tokyo can be used for up to one third of a facility’s reduction obligations. STEP 4: CREATE OFFSETS 89 3.4 Determining appropriate offset This leads to a number of questions that may help policy mak- methodologies ers decide on the role that international programs could play: Regulators also need to determine how offsets are developed ▲▲ What are the short-term objectives of the offset program and the way in which environmental integrity is safeguarded. (cost containment versus preparation for international This is provided for by the methodologies and MRV require- carbon market)? What are its long-term objectives? Should ments of different offset programs, which include processes the offset program attract both domestic and foreign to assess additionality of projects and baselines against which investment? If the policy objective is to maximize low-cost reductions are credited. Another consideration for regulators is abatement options, it may be preferable to link to a wide- the time frame during which eligible offsets can be generated, scoping offset mechanism; other policy objectives may especially if the offset program starts before generating warrant qualitative restrictions. sectors are covered by an ETS (see Box 4.3). ▲▲ What is the current situation in terms of institutions, regu- lations, and technical and operational capacity? The greater Regulators first need to decide whether to make use of the concern over domestic capacity, the more reliance international offset programs (such as the CDM and any other might be placed on international offset programs. future UNFCCC crediting mechanisms, offsets from other ETSs, and/or voluntary market protocols) and, if so, how ▲▲ How aligned are the existing international offset programs and how much (section 3.4.1). If these deliberations lead to with domestic priorities? The greater this alignment, the the decision to set up a domestic offset program, a host of more attractive options that make greater use of interna- further decisions will need to be made (section 3.4.2). In either tional programs will be. case, credited emissions reductions could be sourced from ▲▲ How much alignment is desired between the domestic activities within and/or outside the jurisdiction in which the program and international practices? A desire for closer ETS operates. alignment would place a premium on greater integration 4. OFFSETS with international offset programs. 3.4.1 Using existing international offset programs ▲▲ What level of control is expected over the approval of There are four main scenarios by which an ETS may draw on projects and the issuance of credits? If a strong level of international offset programs:87 control is desired, this may suggest the establishment of a ▲▲ Full reliance. International offset programs are responsible new offset mechanism. for offset generation, oversight and enforcement of ▲▲ How important is the quick delivery of offsets? Making process, and review of projects. The ETS regulator chooses use of established international offset programs is likely to which international offset programs to include, and over- facilitate the generation of offsets more quickly than if a sees retirement of international units for ETS compliance. domestic offset program has to be established. ▲▲ Gatekeeping. As with full reliance, except that the ETS ▲▲ How important is it to develop domestic capacities around regulator places qualitative and/or quantitative restrictions offsetting (including institutional structure, technical skills on the activities generating credits in international offset in general and MRV skills in particular, and establishing a programs that can be used for domestic compliance. registry)? If this is a priority, a domestic offset program ▲▲ Outsourcing. Under this approach, responsibility for might be preferred. developing and approving methodologies, or for validation, ▲▲ What financial resources are available for the planning, verification, and accreditation is outsourced to international design, and implementation phases of the offset program? offset programs. However, projects are reviewed and The development of a domestic offset program will be approved domestically and domestic institutions are more expensive than options that make greater use of responsible for oversight and enforcement of the program, international programs. including issuance of credits. ▲▲ Indirect reliance. International offset programs provide examples that inform development of a domestic offset program (see section 3.4.2). 87 PMR (2015f). 90 EMISSIONS TR ADING IN PR ACTICE 3.4.2 Creating a new offset program subjectivity in the approval process, it may allow for subjectiv- In the event that the considerations described above lead to ity in the design of standards. In addition, the upfront cost of the decision to create a new, domestic offset program, further designing standards and the cost of updating those standards issues need to be addressed. One of the most important is as needed, may be large. the design and development of the specific methodologies to Table 4.3 lists different elements of methodologies that could credit offset activities, building on more general overall criteria be standardized. Elements that are commonly standardized and guidelines that are usually established by the ETS. These include default parameters to measure emissions reductions can be defined along two dimensions: standardized versus and the use of sector-wide performance standards to assess project-by-project assessments, and if some standardization additionality and set the baseline. is sought, whether standards are developed as bottom-up or top-down standards. Bottom-up vs. top-down. Methodologies may be developed via a top-down or bottom-up process, even if the method- Standardized vs. project-by-project methodologies. A pro- ologies are later standardized. In a bottom-up approach, ject-by-project-based approach to developing methodologies individual project developers propose a methodology for their allows for the conditions of each individual project to be taken project. If approved, that methodology can then also be used into account, and may allow for more precise determination of as the basis for a standardized approach to assess emissions emissions reductions and additionality. This, however, can be reductions from other projects in the same category. A top- costly, as each project must be evaluated separately and the down approach leaves the development of methodologies to approval process may rely on subjective assessments, which the offset program. Project developers who want to provide will reduce the certainty project developers have as to whether offsets under the program must comply with the standards set their proposed project will be accepted. in the relevant methodology for their project type. Between By contrast, with standardized methodologies, the approval the bottom-up and top-down extremes, there is a set of process for projects is easier, more transparent, and stream- intermediate options that combine elements of each. Table lined—evaluators only have to check whether the project 4.4 gives an overview of differences, examples, and advan- meets the defined standards, rather than individually assess tages and drawbacks of both approaches. Not all of these additionality, for example. Although this approach induces less approaches are currently used in an ETS context. TABLE 4.3 Aspects of Standardization of Methodologies Standardized Approach Definition Examples Common criteria Terms or conditions applied across multiple methodologies “Not mandatory by law” “Does not generate non-carbon related revenue” (As part of additionality language) Common methods, factors, and Emissions factors, default value, and estimation methods used Avoided electricity emissions module used across CDM equations to address common circumstances in a consistent fashion across methodologies multiple project types Denitrification-Decomposition model used to estimate methane emissions from rice cultivation projects Project-specific default values Used to calculate baseline/project emissions; only applicable to a 90 percent N2O destruction as baseline for adipic acid JI projects specific project type Performance standard: Baseline emissions rate (emissions per unit of output, input, or Emissions rate: X tonnes of CO2 per tonne of cement emissions intensity benchmark throughput) Average of top 20 percent (often used in CDM) (Applied to baseline/additionality determination) Performance standard: market Market share of current production sales or cumulative market Market share: < X percent of current sales penetration rate penetration rate (of existing stock) of a technology or practice Cumulative penetration rate: technology in use at < X percent of all (Applied to additionality determination) installations Positive lists Technology-specific list that deems all projects of that technology Specific project types (eg., agricultural methane destruction, solar additional PV) might be automatically eligible—no additionality assessment required Standardized monitoring Standardization of requirements for baseline and project monitoring Prescription of minimum accuracy of measurement equipment across project types Tools for determination of boiler efficiency Source: PMR, 2015d. STEP 4: CREATE OFFSETS 91 TABLE 4.4 Bottom-Up vs. Top-Down Approaches to Developing 4. Implementing Offset Methodologies and Governing an Offset Program Bottom-up Top-down Typical qualities Offset program has broader coverage Offset program has more selective coverage The operationalization of an offset program Examples Clean Development Mechanism California Compliance Offset Program involves creating a process for project Joint Implementation Québec Compliance Offset Program registration and offset credit issuance (sec- Verified Carbon Standard Climate Action Reserve Voluntary tion 4.1), handling seller and buyer liability Program Gold Standard (section 4.2), and determining liability for Pros Allows for quick start Provides more certainty to project reversals (section 4.3). developers Once developed, may be used by others Cons Potentially costly for project developers Requires more upfront time and public and administrators resources to develop 4.1 Project registration and Source: Adapted from PMR, 2015d. offset credit issuance Figure 4.2 depicts a generic process for project registration and offset credit issuance. Dashed lines refer to actions that FIGURE 4.2 General Process for Project Registration and Offset Credit Issuance are included in some, but not all programs. Final project eligibility can be awarded if the Project Registration Offset Credit Issuance project developer has filed a project design that has been through a cycle of validation Project design Monitoring and checks by third-party auditors and 4. OFFSETS (project developer) (project developer) the program administrator. Credit issuance follows once monitoring, verification, and reviews have been completed. Once offsets Stakeholder consultation Verification (project developer) (third-party auditor) are created, there will likely also be a process of continued monitoring to identify and address potential invalidation and any Validation Review of verification (program reversals (see section 4.2). (third-party auditor) administrator/executive body) 4.2 Seller vs. buyer liability Completeness/consistency check Final approval/rejection If the MRV process uncovers that, (program administrator) (program administrator/executive body) retrospectively, offset credits have not met the required quality standards or that Review (program administrator/ fraudulent acts have been committed, then executive body) Credit issuance there are a number of possible responses. There may be no liability assigned (in which Final approval (program case, the environmental outcome suffers) administrator/executive body) or, in some cases, a legal procedure may be followed to assign liability. However, often systems establish rules that assign respon- Projects are eligible to sibility either to the seller or the buyer: generate offsets under the program they were approved under ▲▲ With seller liability, offset project developers are required to reimburse the regulator if credits submitted for Source: Adapted from PMR, 2015d. compliance are later found to fall short Note: Dashed lines indicate steps that are skipped by some of the examined offset programs. of quality standards or other mandatory conditions. 92 EMISSIONS TR ADING IN PR ACTICE ▲▲ With buyer liability, it is the responsibility of the purchaser BOX 4.4 CASE STUDY: New Zealand Reforestation to ensure that the credits meet quality standards. In Offset Protocols this case, covered entities in possession of invalid offset credits would have to buy new credits or allowances as a In New Zealand, owners of forest (native or exotic) are replacement. eligible to receive units if the land was afforested from January 1, 1990. Participation is voluntary, and once a Buyer liability may be acceptable if there is reason to believe landowner joins the system, their land is registered and that the buyer is more capable than the seller to manage mapped geospatially. Landowners can only deregister if and insure against associated risks—among other things, by they surrender all units received. Participants must submit selecting less-risky project types, diversifying offset purchases, regular emissions returns. The registration of the land is or buying third-party insurance. For instance, in the California noted on the land title so future purchasers understand the potential liability associated with the land. system there are rules by which the regulator can invalidate an offset up to eight years after it is generated and the liability for To reflect Kyoto Protocol rules, a compulsory liability to replacing this offset is placed on the buyer. This strengthens surrender allowances for emissions from deforestation of pre-1990 plantation forest was created—as well as other ARB’s ability to ensure environmental integrity and promote controls that limit deforestation of native forest. due diligence under the program. However, the invalidation period can be shortened from eight to three years if the Once land is registered, the participant can receive units for carbon sequestrated in each emissions period. On project and documentation submitted to claim the emissions harvest, emission units must be surrendered to match the reduction/sequestration is reverified within three years. carbon lost (accounting assumes instant release to the atmosphere of all above-ground biomass), capped at the If buyer liability is not considered appropriate (i.e., the reasons number of credits the participant has received. Below- stated above do not apply), it can be better for the regulator ground biomass is assumed to be released linearly over 10 to impose liability on sellers and seek redress in the event of years. reversals or if sellers are later found to have violated manda- Monitoring is achieved through a combination of generic tory standards. This places an additional burden on regulators, look-up tables (by species, region, and age) and a field however, and can be especially challenging for offsets measurement approach used to create participant-specific generated outside the jurisdiction of the ETS. This is why some tables (for areas of 100 hectares or larger). A self-reporting programs favor buyer liability. approach is used—with the possibility of audit. This self-reporting approach is supported by strict legislated Even where buyers are liable for replacing emissions units in enforcement powers, including financial penalties, make- case of invalidation or reversals, buyers can shift liability to good provisions, and civil and criminal actions. sellers on a private contractual basis, with commensurate If carbon in the forest is lost due to natural disturbance increases in transaction costs. Regulators can also create a (wind, fire, flood), the landowner must surrender emissions tiered system of liability where sellers are primarily liable but, units to match the loss. Commercial carbon insurance is ultimately, if the seller’s liability cannot be enforced, buyers available to protect landowners, but is not required. become liable. 4.3 Liability for reversals Questions about liability also arise in the event of reversals. the buffer pool cannot be traded. The amount set aside Seller liability may be preferable, particularly if the offset can be based on a project-specific assessment (e.g., 10 to provider can be made a legal participant in the ETS with 60 percent under the Verified Carbon Standard (VCS)), or obligations to monitor and report on their level of carbon can be common for all projects.89 storage (see the case of New Zealand in Box 4.4). However, this may be difficult to enforce, particularly in an international ▲▲ Reserve accounts: A portion of the credits issued by context, and may not be appropriate if sellers are not able to a given project is put in an account to compensate for readily pool their risks or otherwise manage their liability. Other possible reversal of that particular project. available options include:88 ▲▲ Commercial insurance or host country guarantee: ▲▲ Buffer approach: A portion of the credits issued by every Participants may secure additional private insurance project is deposited in a common pool, which acts as a general insurance against natural reversals. The credits in 89 For example, the former Australia Carbon Framing Initiative applied a 5 percent auto- matic deduction for sequestration activities. The Gold Standard applied a 20 percent 88 See PMR (2015f) as well as Murray et al. (2012). deduction. STEP 4: CREATE OFFSETS 93 or public guarantees (e.g., from a host country seeking to support BOX 4.5 TECHNICAL NOTE: Offsets mitigation). Such insurance could serve in place of a buffer or reserve and ETS account, or provide additional insurance in the event other mechanisms Consider these questions when determining are insufficient. whether, how, when, and from whom to allow ▲▲ Compensatory activities by project developer: The project developer offsets. (in the case of seller liability) compensates for the carbon that is ▲▲ Which sectors are likely to not be covered released back into the atmosphere by implementing extra activities, for by the cap? example, replanting areas where reversals occurred or planting new Is there potential to manage the sectors through offsets? areas. ▲▲ Is the recognition of offsets from outside the jurisdiction consistent with the goals of ETS? QUICK QUIZ ▲▲ How can it be ensured that offsets do not undermine the environmental integrity of Conceptual Questions the cap? ▲▲ What are the benefits of allowing offsets into your ETS? ▲▲ What might be the administrative ▲▲ What are the risks from including offsets? challenges to having eligibility rules? What might be the challenges to having additionality and leakage tests? Application Questions ▲▲ Will buyer liability, seller liability, or a ▲▲ What are the primary motivations for including offsets in your system, combination of both be most feasible for and how might those affect the type of offsets you accept? ensuring the quality of offsets? ▲▲ Does your jurisdiction want to absorb existing CDM units or reward 4. OFFSETS ▲▲ Will offsets be unlimited or will they have early action by sources that will be covered in your ETS? restrictions? ▲▲ How could your jurisdiction manage the risks of allowing offsets? ▲▲ Do you have the administrative capability and mitigation potential among uncovered emissions sources to make it worthwhile to create your own offset program? 94 EMISSIONS TR ADING IN PR ACTICE This page intentionally left blank. STEP 5: DECIDE ON TEMPOR AL FLEXIBILITY 95 STEP 5: DECIDE ON TEMPORAL FLEXIBILITY At a Glance___________________________________________________________________________ 96 1. Benefits from Temporal Flexibility_____________________________________________________ 97 1.1 Cost optimization over time____________________________________________________ 97 1.2 Reducing price volatility________________________________________________________ 97 1.3 Long- versus short-term impact of GHGs_________________________________________ 98 2. Types of Temporal Flexibility__________________________________________________________ 98 2.1 Borrowing between compliance periods__________________________________________ 98 2.2 Banking between compliance periods___________________________________________ 100 2.3 Length of compliance periods_________________________________________________ 102 3. Financial Instruments_______________________________________________________________ 103 Quick Quiz___________________________________________________________________________ 104 5. TIMEFRAMES 96 EMISSIONS TR ADING IN PR ACTICE AT A GLANCE ✓✓ Set rules for banking allowances ✓✓ Set rules for borrowing allowances and early allocation ✓✓ Set the length of reporting and compliance periods The ability to incentivize cost-effective emissions reductions it more likely that short-term targets will be met. It also is one of the most important advantages of an ETS. One key creates a constituency with a vested interest in the success design aspect is providing entities with temporal flexibility as of the ETS and in one with more stringent caps, as this will to when emissions reductions are achieved (“when flexibility”). increase the value of their banked allowances. For these rea- Temporal flexibility can also reduce price volatility. Moreover, sons, banking rules are generally more liberal than borrowing these advantages can be realized, in many cases, without hav- rules. Under certain circumstances, banking can reduce price ing any significant detrimental effect on the ability to reduce volatility, but in situations where the cap is relatively loose or the risks of climate change. uncertain, it can actually exacerbate volatility. Restrictions on banking may be most sensible when there is a desire to isolate There are three main decision points where policy makers can a pilot phase from subsequent phases, or in the context of choose to provide more temporal flexibility: reducing the risk of market power in the allowance market. ▲▲ By allowing borrowing of allowances from future Within a compliance period, banking and borrowing are gener- compliance periods to the current period; ally unlimited, making the length of the compliance period an ▲▲ By allowing banking of allowances from the current important determinant of temporal flexibility. Longer periods compliance period for use in future periods; and provide the same opportunities and the same risks as greater ▲▲ By deciding on the length of a compliance period. banking and borrowing do between periods. Many existing ETSs have opted for 1-year compliance periods, or at least Borrowing provides entities with flexibility in determining their some annual compliance requirements; multiyear compliance compliance strategy. In particular, it allows those who cannot periods are sometimes accompanied by a requirement for easily abate immediately the opportunity to make investments partial or “rolling” 1-year compliance obligations to balance that will provide greater abatement in the future. It can also flexibility and risk. help provide market liquidity in times when allowances might be scarce and prices high. However, allowing borrowing A number of design features determine the extent to which can make it harder to meet short-term targets. In addition, an ETS allows for flexibility over when emissions reductions regulators might find it difficult to monitor the creditworthiness are realized. This temporal flexibility—sometimes also termed of the borrowers—particularly because it is likely that those “when flexibility”—is detailed in this step. Section 1 explores who will be most eager to borrow will also be the least the rationale for providing temporal flexibility. Section 2 creditworthy. Critically, allowing borrowing also creates a discusses three determinants of the extent to which an ETS constituency with an interest in diluting or even removing the provides temporal flexibility: (i) rules on borrowing, (ii) rules on ETS in the future. For these reasons, most ETSs have entirely banking, and (iii) the length of the compliance period. Finally, prevented borrowing, only allow it to a limited extent, or have section 3 summarizes a range of financial instruments that imposed stringent borrowing terms. can be facilitated by the provision of temporal flexibility and that can help provide market liquidity, and make it easier for Banking also provides temporal flexibility. It can help boost entities to manage risks associated with fluctuating allowance low prices as well as create a buffer against future high prices. prices. Crucially, banking brings forward emissions reductions, making STEP 5: DECIDE ON TEMPOR AL FLEXIBILITY 97 1. Benefits from Temporal 1.2 Reducing price volatility Flexibility Temporal flexibility can also reduce price volatility, potentially encouraging low-carbon investment (see Step 6).91 If The two main reasons policy makers may wish to provide allowance prices are low, entities may choose to buy or hold temporal flexibility are: allowances and save them for later, when prices might be ▲▲ It allows for lowering costs through optimization of higher. This will increase demand for allowances and hence investments over time; and increase prices. Similarly, if prices are high, entities may choose to either profit by selling allowances or defer the purchase ▲▲ It may reduce price volatility. of allowances, if they are allowed to fulfill any compliance At the same time, temporal flexibility by itself is unlikely to shortfall at a later point in time. This will reduce allowance have a significant detrimental effect on the environment due demand, causing allowance prices to fall. The net result of to the long timelines of many underlying chemical and physical these self-correcting dynamics is that the trajectory of carbon processes that link GHG emissions to climate change. This prices over time is smoother than it otherwise would be (see section discusses each of these issues in more detail. Figure 5.1). Under certain circumstances, however, allowing temporal 1.1 Cost optimization over time flexibility will be insufficient to address volatility and may even Allowing entities to choose when they reduce emissions exacerbate it if entities are simultaneously allowed banking facilitates cost-effective action on climate change. It does so in or borrowing across the system. Other market management two ways: interventions may be needed to ensure price predictability ▲▲ By allowing individual entities to abate in the most cost-effective way: The regulator’s timing of emissions FIGURE 5.1 Stylized Model of Banking in an ETS over limits and associated allowance allocations over time Time may not match the most cost-effective path for individ- ual regulated entities. The optimal timing for undertak- t CO2 ing abatement and installing new equipment will vary Excess reductions = banked allowances 5. TIMEFRAMES with the age of the existing capital stock or plans for expanding/contracting facilities. Allowing flexibility over Excess emissions = use of time allows heterogeneous firms to determine the most banked allowances cost-effective trajectory for new investments and to balance these with the optimal management of existing assets and infrastructure.90 ▲▲ By facilitating sectoral and firm-level investment in new technology: Fully addressing the challenge Volume of of climate change over the long term will also require banked allowances technologies that may not yet exist, so time is needed for new investments in research, development, and time Commitment period/ Commitment period/ demonstration to pay off. Permitting flexibility over Phase I Phase II when emissions reductions are achieved can provide sectors and individual firms with the necessary time to Cap trajectory Actual emissions invest in new technology and R&D. Author: ICAP. 91 Fell, MacKenzie, and Pizer (2012). Conversely, temporal flexibility in the form of bank- ing helps smooth the transition to stricter caps. When long-term targets are credible and anticipated, regulated entities may find it in their best interest to overcomply 90 Kling and Rubin (1997) state that banking will lead to cost reduction and, while and save allowances for later use, when caps will be stricter and probably higher (Di- discounting the value of banked units, will lead to a convergence of socially optimal nan and Orszag, 2008; Murray et al., 2009). Fell et al. (2012) also find that allowing and firm optimal costs. Fell, MacKenzie, and Pizer (2012) compare ETS with and temporal flexibility in the form of banking could entail significant cost savings, by without banking. Their analysis shows that allowing participants to bank allowances incorporating some of the benefits of tax policy—allowing quantity to adjust on a significantly lowers expected costs. short-term basis. 98 EMISSIONS TR ADING IN PR ACTICE and provide cost containment in the context of longer-term, with assets that have a similar risk profile.94 In the case of system-wide market conditions (see Step 6). declining caps, this should produce a more gradually rising price path, compared to a situation with no banking or bor- 1.3 Long- versus short-term impact of rowing. In theory, this provides a clear investment framework GHGs where emissions reductions are met at least cost. A further benefit of allowing for some extent of temporal flex- However, despite the theoretical attractions of temporal ibility is that, in many cases, this comes without a significant flexibility, for each of these mechanisms, providing complete detrimental effect on environmental performance. In particular, flexibility also has important disadvantages. In particular, pri- the long-term warming impact of CO2 (the most important vate actors will perceive policy uncertainty and risks as higher, GHG) is primarily determined by the cumulative amount and face a higher cost of capital than society as whole. This emitted; it is relatively insensitive to the emissions pathway in will shorten private planning horizons and create incentives the short term.92 While delaying abatement by decades would to delay abatement more than is desirable from a social increase temperatures and hence increase climate damages, perspective. This makes borrowing particularly problematic. an increase in emissions now in exchange for fewer emissions This section discusses both the advantages and drawbacks in the next few years (or vice versa) will have a negligible of temporal flexibility in relation to each of the three options impact on the resulting level of climate change. noted above. The approach taken by existing ETSs to each of these issues is shown in Table 5.1. This is not true for all GHGs, however. Whereas the damage done by CO2 emissions is determined by their cumulative concentration, annual emissions of shorter-lived GHGs, such 2.1 Borrowing between compliance periods as methane and aerosols, do have an impact on the speed Borrowing allows entities to use allowances they will receive of warming.93 Thus, the timing of these emissions even in in future compliance periods within the current compliance the short term can be important in determining temperature period. Entities are allowed to emit more today while prom- changes and climate impacts. ising to surrender an equal or greater number of allowances later. 2. Types of Temporal Flexibility Consistent with the general discussion on providing temporal flexibility identified in section 1, borrowing, in principle, offers Given these advantages, almost all ETSs provide some forms a number of advantages. It provides firms with flexibility to of temporal flexibility. Three main mechanisms are available to meet targets. For instance, it allows those that cannot easily policy makers: abate immediately the opportunity to make investments that ▲▲ Whether to allow entities to explicitly (or implicitly) will provide greater abatement in the future. It can also reduce “borrow” allowances from future compliance periods for short-term price volatility; in particular, it helps provide market surrender within the current compliance period, allowing liquidity in times when allowances might be scarce and prices them to postpone emissions abatement; high. ▲▲ Whether to allow entities to “bank” allowances issued in However, borrowing, in particular, illustrates some of the one compliance period for use in a subsequent compliance challenges associated with providing temporal flexibility. As period; and noted above, in the real world, private actors are likely to face Choosing the length of the compliance period (as within a incentives to delay costs and behave in a more short-sighted compliance period there is, ordinarily, considerable flexibility manner relative to the social optimum. In addition, four chal- regarding when emissions and abatement activity take lenges associated with allowing entities to borrow allowances place). 
In theory, with complete banking and borrowing, and are: 95 perfect information over long-term emissions limits, a cost-ef- ▲▲ Governments may not be able to assess creditworthi- fective abatement pathway emerges where carbon prices ness: The government may not be well-equipped to assess increase at a rate of return (e.g., the interest rate) associated 94 If allowances were expected to appreciate faster than other comparable investments, this would create an investment or “arbitrage” opportunity that rational market ac- tors would presumably want to take advantage of by buying and banking allowances for the future. Conversely, if emissions allowances were expected to appreciate more slowly than comparable investments, there should be an incentive to use more of 92 Allen et al. (2009); Matthews et al. (2009); Zickfeld et al. (2009). those allowances now rather than holding on to them for later use. 93 Shindell et al. (2012); Shoemaker et al. (2013). 95 Fankhauser and Hepburn (2010); Vivid Economics (2009). STEP 5: DECIDE ON TEMPOR AL FLEXIBILITY 99 TABLE 5.1 Temporal Flexibility Provisions in Existing ETSs Length of commitment Compliance ETS period/ Phases periods Banking Borrowing EU ETS 2005–07 Annual Unlimited banking No (beyond partial 1-year early access)a 2008–12 since 2008 2013–20 2021–30 New Zealand 1-year period Annualb Unlimitedc No RGGI 2009–11 Three years, aligns Unlimitedd No 2012–14 with phases 2015–17 Tokyo (Japan) 2010–14 Five years, aligns Unlimited across No 2015–19 with phases two phases but not multiple phasese Waxman-Markey 1-year period Annual Unlimited Unlimited one year; limited up to five years, with interestg (proposed U.S. Federal) f California 2013–14 Aligns with phases Unlimited, with Limited: 2015–17 + 30 percent emitter subject to a ▲▲ In the case of true-up of product-based allocation to match actual annual surrenderh general holding limit 2018–20 production from the previous year ▲▲ In the case of an entity that is new to the program within a compliance period In the case of untimely surrender at a compliance period compliance event, allowed at a 4:1 ratioi Kazakhstan 2013 Annual Unlimited, beginning Currently not addressed in the regulation. 2014–15 in phase 2 2016–20 Québec 2013–14 Two to three years, Unlimited, with No 2015–17 aligns with phases emitter subject to a 5. TIMEFRAMES general holding limit 2018–20 Australia j 1-year period Annual Unlimited < 5 percent of compliance obligation Republic of Korea 2015–17 Annual Unlimited < 10 percent within phasesk 2018–20 2021–25 Source: EDF et al. (2015e); EDF and IETA (2015a); MDDELCC (2014); ICAP (2016e); RGGI (2013); TMG (2012). Note: EU = European Union; RGGI = Regional Greenhouse Gas Initiative. a It is also technically possible to effectively borrow allowances from a future allocation for one year, in order to meet compliance obligations for the current year. This is because the allocation of allowances takes place in February each year, but the surrender of allowances for the previous year takes place after this date, by the end of April. However, such early access is only permitted within but not across trading periods (i.e., access to phase III allowances for compliance in phase II is not allowed) (EC, 2015b). b Sector-specific true-up dates in early implementation. c The NZ ETS allows unlimited banking, except for allowances bought at the price ceiling. d RGGI states’ number of allowances offered at respective auction accounts is lowered if the number of banked allowances rises. e For example, banking from first to second compliance period is allowed but from first to third it is not. f The Waxman-Markey Bill proposed a national ETS in the United States. It passed the House of Representatives in 2009 as the American Clean Energy and Security Act of 2009 (H.R. 2454), but never went to a vote in the Senate (U.S. Congress, 2009). g Unlimited from one year ahead (without interest), up to five years further into the future; is limited to 15 percent of the compliance obligation, and subject to an 8 percent interest rate. h Every year, units corresponding to at least 30 percent of former year’s emissions must be surrendered. i Borrowing is not allowed except under limited supply scenarios. j The Australian CPM was repealed in 2014 after a change in government. k Only within phases, borrowing up to 10 percent of compliance obligation. 100 EMISSIONS TR ADING IN PR ACTICE the creditworthiness and solvency of firms that borrow BOX 5.1 TECHNICAL NOTE: Vintaged Allowances allowances. The usual mechanisms, such as the provision and Advance Auctions of collateral, may be deployed to mitigate this risk, but this adds transaction costs and complexity. In some systems, issued allowances are tagged with vintages (dates), before which they cannot be used for ▲▲ Adverse selection of debtor emitters: The first problem compliance; they can only be banked or traded. For is exacerbated by the fact that the firms that are least example, California and Québec sell a limited number of solvent are likely to want to borrow more than the firms allowances from vintages up to three years ahead during that are most solvent. Requiring firms to report net com- annual “advance auctions.” pliance assets and liabilities on their balance sheets is one While putting a vintage on allowances prevents some possible way to promote transparency and oversight by of the implicit forms of borrowing discussed above, the shareholders. trading of these allowances provides a forward price signal, revealing market expectations of future prices. This ▲▲ Increases political pressure to delay action: Borrowing can make it easier for participants in financial markets to allows firms to delay abatement, thus potentially creating design derivatives such as futures and options, which can an active interest to lobby for weaker targets, or even for make it easier for market participants to hedge price risk scrapping emissions trading altogether, so that their debts (as discussed in section 3). are reduced or cancelled.96 ▲▲ Uncertainty over targets: Depending on the length of the borrowing period, there will be less certainty over whether 2.2 Banking between compliance periods domestic or international emissions reduction targets will be reached. Banking explicitly allows covered entities to save unused allow- ances for use across compliance periods. It enables reductions In view of these disadvantages, most ETSs have either in emissions today in exchange for increased emissions later. prevented explicit borrowing, limited it quantitatively (e.g., to 10 percent of compliance within phases in the Republic of In line with the general discussion of providing temporal Korea), or discouraged it by imposing an exchange rate. The flexibility, allowing banking has a number of advantages. It can proposed Waxman-Markey bill in the United States had a more facilitate cost-effective abatement by allowing those that wish sophisticated formulation that established exchange rates for to abate early the flexibility to do so in preparation for stricter the use of allowances from current versus future compliance caps later. Moreover, it can reduce price volatility by creating periods allocations, depending on how many years into the additional demand for allowances when prices are low and, future allowance vintages were being borrowed from. once a bank is established, providing an additional supply of allowances when prices are high. Further, if banking is under- In some ETSs, a degree of short-term, implicit borrowing taken with respect to GHGs that have shorter-lived warming is facilitated by offering early access to future allowance potential, it can reduce short-term warming pressures, even if allocations, prior to the deadline for compliance in the current longer-term levels of average warming remain unchanged. period. For example, in the EU, entities receive allowances for the current compliance year by February 28, two months However, importantly, and in contrast to borrowing, banking ahead of the end of the previous compliance period (April 30). also creates a private sector group with a vested interest in Because there is no vintage associated with the allocation the success of the system, including an incentive to ensure (in other words, there is no “activation” date on which an rigorous monitoring and enforcement, as well as tight future allowance becomes valid for compliance, see Box 5.1), these targets, to protect and maximize the value of their carbon allowances can be used for current compliance and implicitly assets.97 “borrowed” without any limitation or penalty from the next Given the generally benign effects of banking, the associated year’s allocation, except in the last year of the commitment rules tend to be more liberal than for borrowing. Policy period. While such mechanisms provide firms with additional makers have usually allowed full flexibility on banking across flexibility, there is also a risk of a systematic shortfall in abate- compliance periods within the same commitment period (see ment if all emitters borrow in this way. Box 5.4 for a recap on the difference between compliance and commitment periods). Across commitment periods, banking has been unlimited in the EU ETS since 2008, and is also 96 Kling and Rubin (1997) found that when firms are given complete freedom to bank and borrow, they produce (and emit) more than is socially optimal in early periods. 97 Fankhauser and Hepburn (2010). STEP 5: DECIDE ON TEMPOR AL FLEXIBILITY 101 unlimited in the ETS in New Zealand, the Republic of Korea, serve to reduce volatility, it can also increase volatility. In par- Québec, California, as well as RGGI, although in some cases it ticular, banking means that changes in expectations of future is subject to a general holding limit at the entity level. market conditions can feed back to today’s prices, by altering the value of banked allowances. This is desirable if future caps However, there can also be disadvantages to banking. For are credible and policy signals are clear, but can generate one, unlimited banking can enable excess supply of allowances volatility in cases where there is a lack of certainty over future in one compliance period to be carried over into future compli- policies. This volatility is most likely to emerge in cases where ance periods, potentially perpetuating an underlying imbalance there is an oversupply of allowances in the present and so the between demand and supply (see also Step 6). Without bank- primary driver of allowance demand is for future compliance. ing, such an imbalance would be contained within the current Box 5.2 describes how this problem arose in the EU ETS. compliance period. Also, while allowing banking can often BOX 5.2 CASE STUDY: Banking in Phase II of the EU ETS During Phase II of the EU ETS, a “surplus” of allowances relative to emissions projections developed (see the figure below). Prices reflected continued market demand for allowances that could be banked, in the expectation that they would be valuable in the future. However, this resulted in speculation over future policies becoming the principal driver of changes in the ETS price during Phase III.a 3000 2500 5. TIMEFRAMES 2000 Mio. emission units / Mt CO2eq 1500 1000 500 0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Scope correction EUAs allocated for free EUAs sold & auctioned by government Surrendered CERs Surrendered ERUs Verified emissions & scope corrections Source: European Environment Agency (2015). Note: EUA = EU Allowance; ERU = Emission Reduction Unit; CER = Certified Emission Reduction This experience has emphasized the importance of ensuring market signals are maintained over the longer term. European policy makers have responded by introducing a market stability reserve that aims to maintain a demand-supply balance in order to ensure prices are driven by market fundamentals (See "Step 6"). a Koch et al. (2014); Koch et al. (2015). 102 EMISSIONS TR ADING IN PR ACTICE In practical terms, there are a number of cases where policy BOX 5.3 CASE STUDY: Holding and Purchase makers have chosen to impose limits on banking: Limits in California ▲▲ Banking from trial phases: Prohibiting or limiting banking The regulations for California’s cap-and-trade system is a way to isolate a trial phase from the subsequent impose holding limits and auction purchase limits to phase. This creates potential for greater experimentation prevent participants from acquiring market power. in the trial phase without necessarily requiring that the The regulation limits the number of allowances a market allowances from the first phase be recognized as valid participant can hold at any one time. All covered entities in subsequent phases (see Step 10). This approach was are subject to a purchase limit of 25 percent of allowances adopted in relation to Phase I of the EU ETS. The Chinese sold at auction while for noncovered entities the limit is pilots have also been designed as experimental markets, 4 percent. with no guarantee that those allowances will have any The California regulator, ARB, will treat a group of associ- value once the pilot phases are complete. However, as the ated entities as a single entity for determining compliance EU ETS Phase I experience shows, if there is excess alloca- with the purchase and holding limits. tion of allowances in the trial phase, prices can quickly fall Holding limits are vintage-specific and are set with refer- to zero, as there will be no demand to buy allowances to ence to a “Base” (25MMt CO2e) and the “Annual Allowance bank for later use. Budget,” which is equal to the number of allowances issued for the current budget year, as shown in the ▲▲ Delinking from other markets: Limits on banking may be equation: imposed when an ETS delinks from another or changes its policy on offsets (see Step 4 and Step 9). In 2013 the 0.1*Base + 0.025* HL(current year) =  (Annual Allowance Budget – Base) New Zealand ETS announced that, as of May 31, 2015, international Kyoto units would no longer be accepted for compliance. After this date, firms could no longer use the Kyoto units they had banked. 2.3 Length of compliance periods ▲▲ To smooth the transition across commitment periods during which rules for eligibility of allowances may Another way to provide temporal flexibility is through the change: Proposed approaches include limiting the number choice of length of the compliance period; in other words, of banked allowances, requiring banked allowances to be over what period of time emissions are calculated and the used before a certain time, or establishing a trading ratio surrender obligation is established. Rules for banking and that governs how early vintage allowances can be used for borrowing establish the flexibility to trade allowances between compliance in later periods. Establishing an orderly process compliance periods and in some cases commitment periods. such that firms do not unexpectedly lose the value of However, within a given compliance period, firms can effec- banked allowances if rules change is important to maintain tively bank or borrow, since they have temporal flexibility for belief in regulators’ willingness and ability to ensure a sta- managing emissions and compliance efforts. ble framework for investment and trading (see Step 10).98 Longer compliance periods reduce administrative burdens ▲▲ To control the ability of individual entities to acquire on regulated entities and also provide the same advantages market power: If individual institutions can acquire large as those described generally for temporal flexibility. They numbers of allowances, there may be a concern that this generate greater opportunities for cost-effective timing of could be used to distort the market. This may provide a abatement and greater flexibility to respond to unplanned rationale for limiting the amount of allowances that entities events. For example, in California, the regulator notes that the can hold, including for banking, as the case of California 3-year compliance period helps firms respond to low-water illustrates (see Box 5.3). years that might affect the generation of hydroelectric power. Longer compliance periods may be particularly valuable when it is known that abatement investments requiring long lead times may be necessary for some emitters. At the same time, longer compliance periods—and the associ- ated implicit banking and borrowing that they allow—raise the same challenges as banking and borrowing more generally. 98 The challenges of addressing market transitions in the U.S. SO2 trading program, one of the earliest and most successful examples of the ETS approach, illustrates the importance of this issue for ETS in other contexts (Fraas and Richardson, 2012). STEP 5: DECIDE ON TEMPOR AL FLEXIBILITY 103 Systems with longer compliance periods may also require BOX 5.4 TECHNICAL NOTE: Compliance, reporting and some “partial” compliance on a more frequent Reporting, and Commitment Periods basis, while still maintaining some of the flexibility from a longer period. This helps ensure covered entities are making The length of the compliance period establishes the basic progress toward meeting their obligations. time limit for compliance, with longer periods providing greater temporal flexibility for managing emissions and Partial or full compliance on an annual basis could also help compliance efforts. At the end of each compliance period, align ETS compliance requirements with other normal financial covered entities need to surrender the allowances neces- sary to cover their emissions from that time frame. disclosure, tax, and regulatory compliance requirements. Most existing and proposed ETSs do have some annual compliance The length of the reporting period determines at what requirements. However, except for Kazakhstan, New Zealand, point entities need to provide information on emissions over a given time frame. This time frame may be shorter and the Republic of Korea, systems provide flexibility to only than the compliance period. comply partially in a given year. ETSs with longer compliance periods include RGGI, California, and Québec, all at three The compliance period may fall within a longer commit- ment period (called a “phase” or “trading period” in the EU years, and Tokyo, at five years. In addition, in California there ETS), which is a period that may have its own emissions is a requirement of partial yearly compliance of at least 30 target, potentially tied to an international commitment or percent of annual emissions.99 The EU effectively has a rolling other contribution, and during which allowance allocation compliance deadline as allowances from the next compliance and other program features are comparatively fixed. period can be used to cover emissions during the current Separate rules may exist for banking and borrowing across period, up to the end of each phase (see Table 5.1). compliance versus commitment periods. 3. Financial Instruments Because allowances have a financial value, they can constitute an investment opportunity. As such, in many cases, market participants are not limited to compliance entities, but may 5. TIMEFRAMES also include financial intermediaries in secondary markets. By providing temporal flexibility and holding advance auctions (see Box 5.3), policy makers can facilitate the creation of financial instruments by financial intermediaries that allow entities to better manage the risks associated with fluctuating allowance prices (see Step 6). This can, in turn, improve their ability to take advantage of the flexibility allowed via banking and borrowing. Four financial instruments (derivatives) that can often be important in carbon markets are detailed in Box 5.5. 99 From ARB’s Initial Statement of Reasons, justifying the 3-year compliance period: “A three-year compliance period provides some temporal flexibility by allowing covered entities to manage planned or emergency changes in operations over the short term, as well as to deal with low water years that might affect the generation of hydroelectric power” (ARB, 2010, II-17). And ARB’s justification for partial annual compliance, to address potential adverse selection: “Staff also recognizes that there is a need to require covered entities to submit a portion of its compliance obligation more frequently to ensure they are making progress toward their obligations. Covered entities could emit GHGs and then declare bankruptcy or otherwise cease operation before fulfilling their compliance obligations at the end of the three-year compliance period” (ARB, 2010:II-22). 104 EMISSIONS TR ADING IN PR ACTICE BOX 5.5 TECHNICAL NOTE: Financial Products in QUICK QUIZ Secondary Carbon Markets a Conceptual Questions Derivatives are financial products that derive their value ▲▲ Whatare reasons for providing flexibility in the timing of from changes in the price of an underlying asset or com- modity. There are four main types of derivatives. These compliance? are described below, along with their application to carbon ▲▲ What are the key policy tools for providing temporal markets: flexibility over short, medium, and longer terms? ▲▲ Future contracts are standardized agreements to buy ▲▲ What are the main advantages and disadvantages of or sell allowances or offsets in the future at a certain banking and borrowing respectively? price. A future contract does not necessarily result in physical delivery, but could be satisfied by a payment Application Questions based on the current market price at the agreed time ▲▲ What potential is there to align timeframes for compliance of maturity. with other administrative processes in your jurisdiction? ▲▲ Forward contracts are similar to futures, but are non- ▲▲ How confident are market actors likely to be in the future standardized agreements to buy allowances or offsets of an ETS in your jurisdiction and how can policy design in the future for a certain amount. A forward contract help provide stable signals for investment? usually results in physical delivery or settlement of the underlying asset. There may be details in the forward contract that fit the exact needs of the buyer or seller. As these personalized clauses are not going to be common in the market, these kinds of contracts are comparatively less commonly traded. ▲▲ Options entail the right, but not the obligation, to buy (“call option”) or sell (“put option”) a certain quantity of allowances at a particular price at a future date, regardless of the current (“spot”) market price at that time. ▲▲ Swaps are a nonstandardized exchange or series of exchanges (allowances, offsets, cash flows) at a given time or for a set period of time. Common examples are allowance-offset swaps. For example, in some trading systems, a limit has been set on the amount of offsets installations can use for compliance. Since there is often a difference in the price between offsets and allowances themselves, companies that have not yet reached their quota of allowed offsets may sell their allowances and buy offsets, thereby taking advantage of the price difference vis-à-vis companies that may have more offsets than allowances and are already over their quota. a Kachi and Frerk (2013); Monast et al. (2009); Pew Center on Global Climate Change (2010). STEP 6: ADDRESS PRICE PREDICTABILITY AND COST CONTAINMENT 105 STEP 6: ADDRESS PRICE PREDICTABILITY AND COST CONTAINMENT At a Glance__________________________________________________________________________ 106 1. Price Formation in ETS______________________________________________________________ 107 1.1 Supply and demand__________________________________________________________ 107 1.2 Market balancing and the variation of prices over time____________________________ 107 1.3 Price volatility and price variability_____________________________________________ 108 2. Market Intervention: Rationale and Risks______________________________________________ 109 2.1 Common objectives of an ETS_________________________________________________ 109 2.2 Risks of market interference___________________________________________________ 110 3. Managing the Allowance Market_____________________________________________________ 110 3.1 Responding to low prices_______________________________________________________111 3.2 Responding to high prices______________________________________________________113 3.3 Price corridor_________________________________________________________________114 3.4 Quantity-based mechanism____________________________________________________115 3.5 Delegation___________________________________________________________________117 3.6 Summary of options___________________________________________________________118 Quick Quiz____________________________________________________________________________118 6. PRICE STABILITY 106 EMISSIONS TR ADING IN PR ACTICE AT A GLANCE ✓✓ Establish the rationale for, and risks associated with, market intervention ✓✓ Choose whether or not to intervene to address low prices, high prices, or both ✓✓ Choose the appropriate instrument for market intervention ✓✓ Decide on governance framework Allowance prices can be volatile as they balance supply, which been implemented and proposed can be characterized in is largely controlled by policy makers, and demand, which is terms of the extent to which they increase price certainty (as driven by a complex interaction of economic and firm-level opposed to the quantity certainty that ETSs normally provide) factors. and the extent to which interventions are governed by prede- termined rules or are at the discretion of regulatory bodies. Price fluctuations are often desirable as they represent the transmission of price signals about abatement costs to market Within this governance framework, policy makers can choose participants. However, what might be considered excessive from a menu of interventions that each have their pros and price variability can occur as a result of exogenous shocks, cons, and each likely to be suitable for a particular set of policy regulatory uncertainty, and market imperfections. Whether objectives and economic context. For any intervention, there is this warrants market intervention by policy makers depends always a risk that it may increase regulatory uncertainty rather on the objectives of the ETS and whether the benefits of inter- than reduce it. This means that any intervention warrants vention are judged to exceed its risks. If the sole objective of careful design and management to ensure it does not have a an ETS is the reduction of emissions at least cost in the short counterproductive effect. term, price variability may not be of concern. If, however, the This chapter is structured as follows. Section 1 discusses the objective is to realize an efficient abatement pathway over the mechanism of price formation in an ETS. Section 2 sets out the long term with high levels of innovation, unlimited variability rationale for market intervention and the risks associated with may be undesirable as it may deter investment. Policy makers this. Section 3 introduces a series of approaches to managing may also wish to contain costs for market participants to the allowance market, each along a continuum of the degree ensure political support. to which intervention is based on predetermined rules set Price variability can be curtailed over the medium-term by the regulator, and the degree to which the government through a wide variety of market management mechanisms. delegates market oversight to independent institutions. The governance models for market management that have STEP 6: ADDRESS PRICE PREDICTABILITY AND COST CONTAINMENT 107 1. Price Formation in ETS by factors such as weather, economic conditions, capital stock, and existing technologies); This section explains the ways in which prices are formed in an ▲▲ The outcomes of complementary policies (such as ETS. Section 1.1 elaborates the key drivers of allowance supply renewable energy mandates or fuel economy standards) and demand in an ETS. Section 1.2 explains the dynamics that reduce emissions within covered sectors; of supply-demand balancing in the market and how these dynamics may lead to excessive medium-term price variability, ▲▲ Expectations regarding future allowance prices, which which might run counter to some ETS policy objectives. determine the demand for banking emissions units for use Section 1.3 introduces the concepts of price volatility (short- in future compliance; run variations in allowance prices) and distinguishes it from ▲▲ Technological change, including that driven by the price variability (systemic mid- to long-term price movements). expectation of future stringency of the program and future demand for permits; and 1.1 Supply and demand ▲▲ Any external demand for emissions units from linked Various factors affect the supply and demand of emissions systems. units in an ETS (see Figure 6.1) and, hence, determine allow- ance prices and how they evolve over time. 1.2 Market balancing and the variation of prices over time 1.1.1 Supply The market will set the price that balances supply and demand The total supply of emissions units depends on: at any one point in time. When the economy is strong and 1. The level of the cap and the associated amount of allow- businesses are expanding operations, demand for products will ances (allocated freely, through auctions, or through unit be higher and thus associated emissions will also be higher. reserves) as well as any conditions for the prices at which This will raise BAU emissions and increase the total amount of these are allocated (see Step 2); abatement necessary to meet a given cap. For a particular set 2. The availability and cost of offsets (see Step 4); of abatement technologies, holding all else equal, the larger the gap between BAU emissions and the level of the cap, the 3. Any supply of allowances and emissions units carried over higher the prices. When the level of BAU emissions is closer (“banked”) from previous periods or drawn from future to or below the cap, due to a recession or the impact of other periods (“borrowed”) (see Step 5); and 4. The availability of units from linked systems (see Step 9). 6. PRICE STABILITY To a large extent, therefore, supply depends FIGURE 6.1 ETS Allowance Price Formation on parameters set by policy makers, be it Allowance directly by the level at which the cap is set, Supply or indirectly through the rules set relating to Allowance Drivers of allowances demand offsets, banking and borrowing, or linking. Demand • BAU emissions • Marginal abatement costs Allowance • Future price expectations 1.1.2 Demand Price • Weather patterns By contrast, the total demand for emissions • Related commodity markets • Demand from linked systems units in an ETS depends largely on the behav- ior and characteristics of market participants, and on exogenous shocks unrelated to ETS design features, including: ▲▲ The level of emissions under BAU (i.e., no carbon price) relative to the cap; ▲▲ The costs of abating emissions within Allowance the covered sectors (which are driven Author: ICAP. Note: BAU = Business As Usual. 108 EMISSIONS TR ADING IN PR ACTICE policies, prices will be low and, in principle, could even reach self-correcting. However, if market participants have sys- zero (particularly if banking is not permitted, see Step 5). tematically higher discount rates than socially optimum or lack the strategic insight or information to value allowances Expectations about the allowance market are also key drivers properly beyond the short term, this self-correction may of price formation. For example, a low interest rate environ- not take place and prices will remain low. These problems ment will reduce the cost of investing in allowances for the will be aggravated in the event of significant regulatory future and increase banking demand; by contrast, regulatory uncertainty, which could mean market participants are uncertainty over the future of the ETS will temper such legitimately uncertain about the long-term value of demand. Expectations can mean that even if, in the short run, allowances. the total demand for emissions units associated with current production falls below the number of allowances available Regulated entities can manage price volatility in various ways. in the marketplace (supply), emissions unit prices may still Temporal flexibility, regular auctions, offsets and linkage, be above zero if there is demand for banking allowances. and derivative trading provide them with ways to smoothen Expectations of economic and policy conditions also matter price fluctuations, to the extent that they are part of the ETS because they affect the expected profitability of investments in design. Opening trade in emissions units to entities that are capital assets and technology R&D that generate returns over not obliged to surrender units is important for creating the a period of time. possibility to manage volatility, as it gives rise to a secondary market with the necessary financial instruments for entities to While price movements driven by these dynamics reflect the manage price volatility. functioning of a market that allows for achieving an efficient abatement pathway, a number of factors can lead to what policy makers may consider “too much” price variability, or 1.3 Price volatility and price variability otherwise to a need to provide a justification for intervention. In some cases, the factors described above will create short- Three factors, in particular, may be important: run variation in allowance prices, referred to as price volatility. Some of the features embedded in the overall market design— ▲▲ Exogenous shocks: Significant changes in economic out- temporal flexibility, regular auctions, broader scope, including put, and the associated level of emissions, can lead to large offsets and linkage—provide regulated entities with a way to and lasting changes in prices. For instance, the financial smoothen short-run price fluctuations. In general, any remain- crisis and subsequent recession was one of the key drivers ing price volatility is unlikely to be a serious concern for policy explaining why allowance prices in the EU ETS fell from makers. If the regulatory environment allows for it, market more than €20 in 2008 to less than €5 in 2013. actors have tools to effectively manage volatility in allowance ▲▲ Regulatory uncertainty: Governments will always retain prices via private financial market instruments—options, the legitimate ability to change certain key parameters of futures, and other derivatives (see Box 5.5 in Step 5)—just an ETS or adjust the policy mix that the ETS is a part of. as these tools are used to hedge risks and handle volatility in These changes, or anticipation of these changes, can also oil and other commodity markets. Managing the exposure of lead to considerable price changes, as well as uncertainty, market actors to price volatility is also one of the key rationales which increase the risks of investments in abatement. For for opening the allowance market to entities other than example, policy deliberations over postponing (“backload- regulated entities, and creating an enabling framework for a ing”) the auction of allowances to temporarily tighten the secondary allowance market that can provide the necessary EU ETS’s cap led to considerable price movements during financial instruments. the third phase of the program and may have increased the perceived risk from banking allowances.100 In other cases, impacts are more persistent and have systemic effects on the market over the medium and longer ▲▲ Market imperfections:101 A variety of market imperfections terms. This is captured by the concept of price variability: may lead to prices being “too” high or “too” low, or other- a divergence between expected and actual prices that wise not reflecting all relevant considerations. For instance, persists over the medium to long term. For example, a rapid ordinarily a low allowance price would be expected to lead expansion of economic growth and emissions could cause to an increase in demand as participants seek to bank prices to remain unexpectedly high for a decade. On the other allowances now, which they could use for compliance hand, a recession, or a faster-than-expected deployment of purposes at a later date. This would lead to prices partly renewable energy, could lead to relatively low prices for a prolonged period. It is unlikely that market actors would be 100 Koch et al. (2015). 101 Based on a discussion in Neuhoff et al. (2015). able to completely buffer such medium-term price changes STEP 6: ADDRESS PRICE PREDICTABILITY AND COST CONTAINMENT 109 with derivative instruments, which are typically expensive—or However, policy makers may have other objectives that could not even available—much longer than a year ahead. Similarly, justify intervention to limit price variability. Two of the most banking of allowances or purchases of future vintages may important are: not be sufficient to buffer a large and persistent unanticipated ▲▲ Providing a predictable climate for investment. If the price rise—and could potentially exacerbate a sustained price objective is to achieve long-term decarbonization at least decline. cost and drive structural transformation (see the chapter “Before You Begin”) price variability may lead to socially suboptimal investments.103 Uncertainty generally leads 2. Market Intervention: firms to take a “wait and see” approach and delay any Rationale and Risks long-term investments in low-carbon technology (see also the related discussion on time frames for compliance in The three factors discussed in section 1.2 above—exogenous Step 5).104 This provides a rationale for price stabilization shocks, regulatory uncertainty, and market imperfections— measures such as a price floor. may provide a justification for market intervention to address relatively persistent, medium- and longer-term price variability. ▲▲ Containing costs. Prices that are too high can undermine In making this assessment, policy makers will need to take into the political viability of an ETS, providing a rationale for account what the objectives of the ETS are (see section 2.1) setting an upper bound on prices. This can help reassure as well as whether the benefits of intervention exceed its risks market participants that the ETS is not going to impose (see section 2.2). costs perceived as excessive. These goals have been prominent around the implementation 2.1 Common objectives of an ETS of ETS across jurisdictions. Prior to ETS implementation, The objectives of an ETS will have a significant bearing on concerns have typically focused on the possibility of high whether or not market intervention should be considered. For prices and the options to contain costs. For the ETSs already example, while low prices are sometimes seen as a reason in operation, however, low prices have turned out to be a for concern, they need not be if the objective of an ETS is to bigger concern: it is hard to know in advance how difficult it attain emissions targets at least cost; in that case, low prices will be to achieve a specific cap. Persistently low prices may may simply reflect that it is easier than expected to achieve reveal that actual mitigation is much less costly than expected. the goal.102 Low prices may also provide an opportunity and As a result, policy makers may want some mechanism to a rationale to increase ambition and make the cap more increase the ambition of their program over the medium-term, stringent in the future, as discussed below. Too high prices, by especially if they determine that a high price is desirable to 6. PRICE STABILITY contrast, may be reason for concern, as these may jeopardize create greater incentives for the adoption of low-carbon the political viability of the ETS. technologies, to better reflect and internalize an estimated social cost of carbon,105 or to meet political objectives. More generally, the responsiveness of allowance prices to economic conditions may be considered an advantage of an Over the longer term, policy makers can directly adjust the ETS. Because underlying economic activity is a main driver of level of the cap. Questions about the right long-term level of energy demand and thus emissions, allowance prices tend the cap, how often and in what way this should be revisited, to be lower during economic recessions and higher during and whether this should be made contingent on changing periods of economic growth; this feature may help stimulate economic conditions, are covered in Step 2 and Step 10. economic recovery and maintain political support for an ETS during downturns, while spurring greater emissions reductions during periods of robust growth. 103 See Wood and Jotzo (2011). Dixit and Pindyck (1994) lay the framework to under- stand how the combination of uncertainty and irreversible investments make firms more cautious in their investment decisions. 104 Martin et al. (2011) find a correlation between the expectation firms hold about the future stringency of the cap and low-carbon innovation, which is robust when includ- ing a broad range of control variables. 102 Stavins (2012) discusses the meaning of low prices in an ETS. He argues that low 105 See Grosjean et al. (2014). If the policy maker’s primary objective is to establish a prices do not necessarily reflect a failure within the system. In the case of RGGI, specific price (such as an estimated social cost of carbon), a carbon tax may be a observed low prices are due to the economic downturn combined with the recent more suitable policy instrument (see the discussion of prices vs. quantities in "Before developments in the gas sector. You Begin"). 110 EMISSIONS TR ADING IN PR ACTICE 2.2 Risks of market interference away from quantity certainty, adjustment rules are introduced. Such rule-based mechanisms are typically While the discussion above may provide a rationale for predetermined allowance supply adjustments that intervention to constrain price variability, this needs to be provide transparency to market participants with respect balanced against the possibility that interference in the market to potential intervention. The rules can be based on may create distortions. The self-regulating responsiveness of specific triggers (e.g., a minimum price at auction) or a the market enables cost-effective abatement to be allocated mathematical formula (e.g., linked to trend deviations of across the economy and over time. This mechanism may be economic variables or deployment of renewable energy) to jeopardized by distortions as a result of unintended effects of adjust the allowance supply. The rules can be managed by policy intervention. the jurisdictional government or by an independent agency In particular, there is a risk that a further layer of policy inter- with a predefined mandate. Finally, at the end of the vention and the associated regulatory uncertainty as to how delegation continuum, the government relinquishes most the policy may operate or how the rules might change in the governance decisions to an independent body managing future, could exacerbate rather than alleviate price volatility.106 the ETS market. This may imply transferring the control over the cap and/or price to this independent institution. The extent to which price stabilization measures compound Its legislative basis would clarify its objectives, such as regulatory uncertainty may be limited if the measures are well minimizing the cost of achieving a specific emissions designed and operate in a predictable manner. At a minimum, reduction target. However, this independent institution they should be transparent, have a long time horizon, and would have discretionary power to choose instruments and have a clear and targeted remit. To the extent that they timing for intervention. This institutional setup is derived obviate the need for additional future regulatory changes to from the classical mandate of independent central banks, achieve policy objectives, they may reduce regulatory uncer- which enjoy significant discretion over money supply while tainty compared to a counterfactual scenario. they are guided by core targets such as price stability, set by government. Historically, this setup was implemented to constrain policy makers and strengthen the long-term 3. Managing the Allowance credibility of monetary policy. Market Examples of interventions in this governance space are Several policy options are available for managing the allow- discussed below. The interventions are: ance market to reduce price variability. These options can be ▲▲ Seeking to maintain or increase prices when they reach mapped onto the two-dimensional ETS governance space a low threshold by setting a reserve price at auction (see depicted in Figure 6.2, following Grosjean et al. (2014):107 section 3.1.1), committing to purchase an unlimited or ▲▲ The horizontal dimension represents the extent to which limited number of permits from the market to support an option leads to more price certainty as compared to the prices (hard or soft price floor, section 3.1.2), or imposing a classic ETS that provides quantity certainty (see Box 6.1 top-up fee or surrender charge (see section 3.1.3); for a recap of price and quantity certainty in ETS). At either ▲▲ Seeking to maintain or lower prices when they reach a high end of the price versus quantity certainty spectrum lie a threshold by adjusting limits on use of offsets (see section pure cap-and-trade system (left) and a carbon tax (right). 3.2.1), selling a limited number of allowances at preset In-between these two extremes, there is a wide range of prices from an allowance reserve (see section 3.2.2), or a hybrid schemes such as “hard” and “soft‘’ price collars. hard price cap (see section 3.2.3); ▲▲ The vertical dimension represents the extent to which ▲▲ Setting a price corridor as a combination of interventions governance of the ETS is delegated away from the when prices are both low and high (see section 3.3); jurisdictional government. In a classic ETS, there is no delegation of governance: the government (legislator) ▲▲ Deploying a quantity-based mechanism such as a reserve implements changes directly through a normal legislative that retains and releases allowances but does not target a act. Moving down on the continuum of delegation and specific price range (see section 3.4); and ▲▲ Delegating market oversight to a an independent entity (see section 3.5). 106 For a discussion of this issue with regard to recent experience in the EU, see Koch et al. (2015). 107 The ETS governance space is an adaptation of the EU ETS Reform Space in Grosjean et al. (2014). STEP 6: ADDRESS PRICE PREDICTABILITY AND COST CONTAINMENT 111 3.1 Responding to low prices FIGURE 6.2 Different Types of Price Predictability and Cost Containment Measures Policy makers can choose between a variety of interven- tions to address low prices. Three of the main options are: Quantity Price certainty certainty seeking to maintain or increase prices when they reach a low threshold by setting a reserve price at auction (see Classic Offsets ETS Classic tax section 3.1.1); committing to purchase an unlimited or limited number of permits from the market to support Hard price Rules Quantity- Auction reserve price; Cost floor and cap; prices (hard or soft price floor, section 3.1.2); or imposing based Price collar; based containment mechanism reserve Surrender a top-up fee or surrender charge (see section 3.1.3). charge Allocation committee 3.1.1 Reserve price at allowance auctions Carbon central Carbon central One option for market intervention is to set a minimum Discretion bank (quantity bank (price mandate) mandate) reserve price at allowance auctions. While this sets a minimum price for allowances purchased at auction, it Degree of does not necessarily establish a hard, or absolute, floor delegation on the market price. Prices in the secondary market could temporarily fall below the auction reserve price. It there- Source: Based on Grosjean et al., 2014. Note: A circle with a solid line denotes a governance model that has already been fore sits to the left of hard price floors in the governance implemented. A dashed circle denotes a governance model that has been proposed but space in Figure 6.2. not yet been implemented. A price floor at auction is a rule-based delegation, as rules are required to set the reserve price and to reintroduce BOX 6.1 TECHNICAL NOTE: Recap of Price and allowances that are not initially sold. If allowances are Quantity Control simply placed in a reserve and are to be auctioned in Price and quantity in an ETS are intimately connected. By future periods, the mechanism is cap-neutral. However, if setting a certain quantity reduction, some certainty about how unsold allowances are at some point permanently retired, much that reduction will cost is sacrificed. This is illustrated in the figure below. Under a quantity restriction (a cap), if mar- then the instrument can play a role in tightening the cap. ginal savings from emissions (i.e., avoided abatement costs) are higher than expected, the market price for GHGs will be higher In the California auctions, any allowances that are not sold than expected. at auction are returned to the Auction Holding Account. 6. PRICE STABILITY These unsold allowances are not reintroduced to auction Cap and Trade (Quantity set) unless prices are above the floor for two consecutive Cost per Expected Marginal Savings from Emissions auctions. At the same time, California requires that the unit of (Expected avoided abatement costs) volume of these reintroduced allowances not exceed 25 reduction percent of the total volume offered in a given auction. This is an approach to temporarily tighten the cap in response to an early period of low prices. It has a similar Actual Marginal impact as if the market banked the units directly. P* Savings (actual) P 3.1.2 Hard or soft price floor for allowances (expected) Establishing a hard price floor, another example of rule-based delegation, requires additional mechanisms to ensure that prices in the market cannot drop below a certain level. To this end, the government may Q* (set) commit to buy back as many allowances as needed at a Quantity of Emissions predetermined price. This provides more price certainty By contrast (but not shown), in a situation in which there are than a reserve price at auction and the intervention is higher-than-expected marginal savings from emissions (i.e., therefore located further to the right in the governance higher avoided abatement costs) when a carbon tax is set, the space. However, market forces will determine the level of adjustment will be in the form of fewer emissions reductions than expected. the price when it moves above the price floor, so as an intervention it is to the left of a carbon tax. 112 EMISSIONS TR ADING IN PR ACTICE This approach could potentially be quite costly to the BOX 6.2 CASE STUDY: Carbon Price Floor to government and is therefore not a common feature of ETSs Foster Investment in the UK established to date. Under the Beijing pilot program, if the price is lower than 20 yuan per tonne for 10 consecutive days, On April 1, 2013, the UK unilaterally introduced a carbon the government will buy from the market at a fixed price. price floor (CPF).a The CPF is an attempt to “reduce revenue uncertainty and improve the economics for Shenzhen, Shanghai, Tianjin, Hubei, and Guangdong have investment in low-carbon generation.”b The price floor is similar policies, but without specific operational guidelines. achieved by the implementation of Carbon Price Support (CPS), a tax levied on all entities that generate electricity 3.1.3 Top-up fee or surrender charge using gas (supplied by a gas utility), liquid petroleum gas, A top-up fee or surrender charge on allowances is one way of or coal and other solid fossil fuels. Rather than being increasing the cost of emissions in an ETS domestically within an auction price floor, CPS is charged on top of EU ETS a linked or multijurisdictional system, and could also be used to allowance prices to ensure that the price of carbon meets ensure a minimum cost for emissions in a stand-alone system. a minimum national target. The CPS is paid by entities for each unit of emissions and is additional to any cost of It could also be used as a way to raise the cost of using offsets allowances. The obligation to pay the CPS applies when in cases where these are available at prices below the price allowances are surrendered. Policy makers intend for the floor set for allowances. price floor to encourage investment in low-carbon tech- nology by sending a more certain price signal to investors. Under a surrender charge, emitters are required to pay the Entities are regulated at the point where gas passes government a top-up fee that reflects (either exactly or through the meter or, in the case of LPG, coal, and other approximately) the difference between the market price and a solid fossil fuels, at the point of delivery at generating given set price. This approach does not affect the quantity of stations. allowances in the ETS, but rather combines a fee with an ETS The CPF is made up of the price of EUAs from the EU ETS such that a minimum combined cost per tonne of emissions and the CPS rate per tCO2e, which is the UK-only additional is maintained for ETS participants. In this way, it can deliver a tCO2 emitted in the power sector. The CPS rates are fixed high degree of price certainty, which is reflected by its position annually, with the original CPF trajectory to reach £30/ on the right-hand side of the governance space. However, the tCO2 in 2009 prices by 2020. HM Revenue and Customs exact degree of price certainty depends on how frequently expected that the CPF would support £30–40 billion of new investment in low-carbon technology. the top-up fee changes in response to changes in the market prices of allowances. Frequent updating increases price The CPS was designed to start at £4.94 per tonne and certainty but can be technically challenging to implement (as expected to increase to £7.28 per tonne in 2014–15 and to £9.86 per tonne in 2015–16. The actual value of the CPS discussed below). would depend on the gaps between the “target price’’ in This mechanism has been implemented in the UK power sector each year and the price of allowances in the EU ETS in the recent past, with a target price in 2020 of £30 per tonne, (see Box 6.2), a subset of the entities covered in the EU ETS. in 2009 prices. HM Revenue and Customs expected that The policy is designed to increase certainty to generators and this would support £30–40 billion of new in investment encourage investment in low-carbon power generation. in low-carbon technology. On March 19, 2014, however, it was announced that the CPS (the UK-only element of Australia’s ETS was designed to include a price floor, as part of the CPF) rate would not exceed £18 per tonne of carbon a gradually widening price collar. To implement the price floor, dioxide from 2016–17 to 2019–20, even if that means fall- the ETS included a minimum auction price domestically and ing short of a target price of £30 per tonne by 2020. The a surrender charge on imports of foreign offset credits that freeze in CPS rates was a result of lower than expected EU would have presumably entered the market at an even lower ETS allowance prices in the time after the price floor was price. How to implement this surrender charge raised a num- introduced, resulting in a wider gap between the prices for ber of technical challenges, given the expectation that it would emissions units for other states in the EU ETS and those in the UK. This led to a concern that the CPS might be respond quickly to changes in the CER price.108 When Australia damaging the competitiveness of UK industry and leading entered into linking negotiations with the EU ETS, it agreed to undue increases in household energy bills. to abandon its price floor as part of the EU’s conditions, as this would have decreased its demand for EU allowances (see Step 9). a Brauneis et al. (2013); HM Revenue & Customs (2015); HM Revenue & Customs (2014a); HM Treasury and HM Customs (2011). 108 See Australia Department of Climate Change and Energy Efficiency (2011) and b HM Treasury and HM Customs (2011)). Hepburn et al. (2012). STEP 6: ADDRESS PRICE PREDICTABILITY AND COST CONTAINMENT 113 3.2 Responding to high prices up for auction but remain unsold (e.g., because the auction reserve price is not met). These allowances are part of the To tackle undesirably high prices, policy makers can seek to overall cap, but are only offered for sale when prices exceed a maintain or lower prices when they reach a high threshold certain level, as a means of helping to contain costs. In order by adjusting limits on the use of offsets (see section 3.2.1), to keep the level constant in real terms over time and to avoid selling a limited number of allowances at preset prices from an creating unintended speculative opportunities to profit from allowance reserve (see section 3.2.2), or setting a hard price simply holding allowances, the threshold price level is usually cap (see section 3.2.3). set to rise over time at a rate comparable with the market rate of return for other investments with similar risk profiles (e.g., a 3.2.1 Cost management through limits on offsets 5 percent interest rate plus inflation). The relaxation of offset limits (by quantity or category of offsets) or the introduction of additional offset volumes held An allowance reserve provides a soft ceiling since there is only in reserve can increase the supply of units to help contain a fixed amount of allowances the government is prepared to costs in response to high prices (see Step 4). As such, in the sell at a given price. This provides some assurance to the mar- governance space in Figure 6.2, it sits slightly to the right ket, but not a guarantee, that the price will not rise above that of the classic ETS. An advantage of this approach is that, as level. In this way, it provides more certainty over the quantity long as offsets represent real reductions, it can contain costs of allowances auctioned than it does over the maximum price, without increasing emissions, as would be the case when and is therefore located further to the left-hand side of the policy makers simply release additional allowances into the ETS governance space. Probabilistic modeling can help con- market. Certain types of offsets may also provide important duct stress tests and estimate the required size of a reserve co-benefits, as discussed in Step 4. Offset limits could also to keep prices within certain bounds with a particular level of be tightened as a way to bolster low prices. However, under confidence, given best available information.109 certain conditions, adjustments to offset limits may have little impact on prices. For example, increasing the offset limits will In the case of California, a percentage of allowances from have no impact on price if offset supply is not sufficient to the cap is set aside each year in order to stock an Allowance meet current potential demand. Price Containment Reserve (APCR) (see Box 6.3). So far, market prices in California’s ETS have remained below the level The option to relax offset limits to contain prices has been at which an allowance release from the APCR is triggered. instituted in the Republic of Korea ETS and RGGI. Under the In Québec, a similar system is in place, and the auction former, the Allocation Committee can change the offset limits reserve price and allowance reserve prices are harmonized at its discretion (see Box 6.6). During the first and second with California. In both jurisdictions, a staggered approach 6. PRICE STABILITY control periods, RGGI had a provision that if average allowance is used, with different quantities of allowances available for prices over the first 14 months rose to $7 or $10/ton, the sale at different prices. The RGGI system also implemented a limit on offset use would be relaxed from 3.3 percent to 5 CCR, which establishes a soft price cap, in 2014. In contrast percent and 10 percent respectively. In addition, if average to California and Québec, this has a single price at which prices rose to $10, entities were allowed to use international intervention is triggered and allowances from the CCR are offset units, including from the CDM. In the first and second automatically offered as part of regular auctions if the trigger control periods, RGGI prices never reached these levels, so level is reached. these provisions were never activated and, more generally, there was never any demand for offsets. After the revisions to While these allowance reserves provide cost containment for the RGGI system and the introduction of the Cost Containment the entire market, researchers have suggested that regulators Reserve (CCR), the RGGI eliminated the previous provisions for could also (or instead) provide limited and targeted assurance expanded use of offsets. The proposed U.S. Waxman-Markey to regulated entities that prices would not exceed a certain bill also had a provision to relax the limits on international level.110 Borrowing a tool from the finance world, regulators offsets in the event that prices reached the levels of the allow- could provide “Allowance Reserve Coupons” to regulated ance reserve, and allowing these units to be tendered through entities, granting the right but not the obligation to buy reserve auctions. allowances from a reserve at predetermined prices (i.e., a “call” option; see Box 5.5 in Step 5) and such coupons could 3.2.2 Cost containment with an allowance reserve be tradable.111 These coupons could be allocated selectively In this approach, an allowance reserve is created from allow- 109 Golub and Keohane (2012). ances that are initially withheld from distribution and/or put 110 Grüll and Taschini (2011). 111 Anda et al. (2009). 114 EMISSIONS TR ADING IN PR ACTICE or auctioned (as with the “put” options discussed in section BOX 6.3 CASE STUDY: California’s Allowance 3.1.2) to generate government revenue. Price Containment Reserve The Californian APCR is an example of a rule-based mech- 3.2.3 Hard price cap anism that allows for access to higher-priced allowances. A hard price ceiling sets an absolute limit on the price that These allowances are available for purchase at quarterly entities pay to buy allowances.112 This requires the regulator sales, but likely would not be accessed unless auction or to commit to selling as many units as the market will demand secondary market prices exceeded the price at which the APCR allowances were available.a at the ceiling price. Such a safety valve or hard price cap approach has the downside that, like a tax, it allows emissions The APCR is made up of a percentage of the total cap to rise above the level of the cap as long as emissions through 2020. Specifically, 1 percent of the first compli- ance period’s budget, 4 percent of the second compliance abatement is costlier than the ceiling price. While it ensures period’s budget, and 7 percent of the third compliance a very high degree of price certainty, total emissions cannot period’s budget were allocated to the APCR. Allowances be known ex ante. Therefore, the instrument is located to the placed in the APCR “lose their vintage,” meaning that if right of the ETS governance space. In some cases, including the APCR were triggered, all of these allowances would be Alberta’s Specified Gas Emitters Regulation, entities can pay a available to contain costs regardless of which budget they penalty or other fee to the government instead of submitting originated from. allowances. This is an effective price ceiling, which directly Allowances from the APCR may be offered for sale, substitutes a set tax for an ETS when prices hit certain levels. depending on demand, four times a year, six weeks after Similarly, if the ETS enforcement arrangements do not include each quarterly auction. Allowances in the reserve are a penalty set with reference to the price or make good provi- divided equally into three price tiers. Price levels at each sion (see step 7), the penalty will also act as a price ceiling. tier increase by 5 percent plus inflation annually. Prices started in 2013 at $40, $45, and $50 respectively. In 2015 the tiers had increased to $45.20, $50.86, and $56.51. To 3.3 Price corridor date, however, these prices have not been reached and so Any of the mechanisms that seek to raise prices when they are the reserve has not been accessed. low (see section 3.1.1) and that seek to cap prices when they In 2015, in response to stakeholder concerns about are high (see section 3.2.2) can, in principle, be combined to the potential exhaustion of the APCR, the regulation create a hard or soft price corridor or collar. was amended so that 10 percent of all remaining past unallocated allowances from each vintage year are eligible Australia’s system started with a 3-year fixed price period to be sold through the APCR sales; and 10 percent of followed by three years with a price floor and ceiling (cor- all remaining allowances from each future vintage year ridor). The price ceiling was to start at AUD$20 above the are also eligible to be sold during an APCR sale. These allowances will only be made available at the highest-price international price expected at the beginning of the fixed price tier level. period (1 July 2015) and would have risen at 5 percent in real terms annually. The price floor was set at AUD $15, rising at 4 Filling the reserve requires removing allowances from the overall allocated budget. To negate the implied increased percent in real terms annually. The higher growth rate of the stringency of the cap, California simultaneously increased ceiling (5 percent) compared to the floor (4 percent) implied the quantity of offsets that could be used for compliance that the corridor was set to widen over time. However, as by 4 percent—to a total of 8 percent of each entity’s part of the discussions on linking the Australian CPM with the compliance obligation. EU ETS, the decision was made to abandon the floor price, although this became moot when the CPM was abolished following a change of government in Australia. a ARB (2013); ARB (2010a). 112 The idea of a price ceiling was originally developed by Roberts and Spence (1974) and applied to the case of climate policy by Pizer (2002).The latter estimates that with a $50 “trigger” price per tonne of carbon (a hard price ceiling of $50), the expected $3 trillion loss associated with reaching the 1990 level of emissions becomes a $150 billion gain. STEP 6: ADDRESS PRICE PREDICTABILITY AND COST CONTAINMENT 115 BOX 6.4 TECHNICAL NOTE: Price Ranges Under a Price Collar Versus Allowance Reserve The Figure below illustrates the allowance supply curve with curve) to maintain that market price. This results in a fixed a price collar, as compared to a situation where there is no price range. Similarly, an allowance reserve can restrict supply price control and there is an allowance reserve (discussed in to guarantee Pmin. However, a reserve by design only has a 3.2.2). Without price controls, allowance supply is perfectly limited number of allowances and if demand exceeds the size inelastic and fixed at Qo. With a price collar, supply is of the reserve (at Qo) after it starts releasing allowances in perfectly elastic at the minimum price (Pmin), up to point Qo, the market at the trigger price, supply is perfectly inelastic as the regulator commits to restricting supply at levels that again. As such, it cannot guarantee a maximum price, which guarantee Pmin. At Pmax, the regulator commits to supply is the key difference between a price collar and an allowance sufficient allowances (as shown by the perfectly elastic supply reserve. No Price Price Collar Allowance Controls Reserve Allowance Allowance Allowance Allowance Allowance Price Supply Price Price Allowance Supply Reserve Allowance Supply Pmax Trigger Fixed Price price Range Pmin PMin Qo Allowances Allowances Qo - R Qo Allowances Qo Note: For another helpful iteration of this illustration see Murray et al. (2009). 3.4 Quantity-based mechanism on the quantity of allowances. The MSR is designed to adjust the annual number of allowances auctioned in the market in Quantity collars aim to restrict the number of allowances 6. PRICE STABILITY certain years, based on predefined rules regarding the level that are in circulation. Given a fixed cap, a quantity-triggered of the allowance surplus (see Box 6.5). The MSR aims to reserve can respond to external shocks by adding or subtract- maintain a certain supply-demand balance to keep the carbon ing allowances from a reserve and releasing them into the price signal at levels necessary to achieve the long-term market, based on predefined triggers, including the quantity of decarbonization target in a cost-effective manner (European surplus or banked allowances.113 As such, this type of mech- Commission, 2014). The MSR will be implemented in 2018 and anism is positioned on the left-hand side of the governance be operational from January 1st 2019. space. The Market Stability Reserve (MSR) under the EU ETS can be characterized as a rule-based approach that is triggered based 113 Analysts have suggested a variety of potential triggers for regulating allowance volumes offered at auction, including allowance volumes in circulation, as well as changes in production and other economic conditions. These approaches vary in their ability to provide price predictability, respond to shocks, provide certainty of adjustment, reduce oversupply, and prevent potential manipulation (see Gilbert et al. (2014a) for a review). 116 EMISSIONS TR ADING IN PR ACTICE BOX 6.5 CASE STUDY: The EU ETS Market Stability Reserve 5,000 4,500 4,000 In the purple zone, the reserve absorbs the 3,500 equivalent of 12% of 3,000 allowances in circulation from Mt 2,500 auctions, each year. 2,000 1,500 1,000 833 Mt No intervention 500 400 Mt In the green zone, the 0 reserve reinjects 100Mt each year through auctions 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 Allowances in circulation Possible evolution up to 2021 Source: Trotignon et al. (2014). In 2015, EU policy makers adopted the Market Stability the MSR and added to current auction volumes if the surplus Reserve (MSR), which will be established in 2018 and operate is lower than a predefined threshold. Additionally, if the allow- from January 1, 2019. The MSR aims to “address the current ance price is over three times the average price of allowances surplus of allowances,” and “improve the system’s resilience during the two preceding years for six consecutive months, to major shocks by adjusting the supply of allowances to be 100 million allowances will be released from the reserve. auctioned.”a The MSR is intended to address the imbalance between The MSR would function by triggering adjustments to annual allowance supply, which is currently fixed, and demand, which auction volumes in situations where the total number of changes with a number of economic and other drivers.c allowances in circulation is outside a certain predefined range (see Figure above).b Allowances may be removed from auction volumes and added to the MSR if the surplus in the a EC (2015d). b EC (2014) market is larger than a predefined threshold, or removed from c Ibid. STEP 6: ADDRESS PRICE PREDICTABILITY AND COST CONTAINMENT 117 3.5 Delegation BOX 6.6 CASE STUDY: Price Predictability in the Finally, there have been proposals for delegating the man- Republic of Korea ETS agement of the allowance market to an independent carbon The provisions for price predictability in the Republic authority or a carbon central bank; these proposals are posi- of Korea ETS combine automatic and discretionary tioned on the lower half of the governance space. Examples of approaches.a this type of delegation and proposed delegation include: There is an allowance reserve, which serves as a ▲▲ The United States Congress Lieberman-Warner legislative mechanism to manage price variability but also provides proposal (S. 2191) suggested the creation of a Carbon allowances to new entrants, as well as to firms that have Market Efficiency Board. The Board’s proposed mandate earned early action credits. was to achieve some price level that balanced emissions In a number of predetermined situations, the Allocation reductions and economic growth (Manson, 2009). Committee is authorized, but not required, to intervene in the market. ▲▲ The Republic of Korea ETS operates with an Allocation Committee that is guided by rules on when to intervene in The conditions under which the Committee may intervene in the market include: the market, but also operates with a degree of discretion (see Box 6.6). In a number of predetermined situations, the ▲▲ The market price for allowances has been at least three Allocation Committee is authorized, but not required, to times the 2-year average, for at least six consecutive months;b intervene in the market. Similarly, in any of these situations, the Allowance Committee may take a number of actions ▲▲ The market price for allowances has been at least two including but not limited to releasing allowances from a times the 2-year average, for at least one month, and the average trading volume for the current month is at reserve. least twice that of the same calendar month in the two ▲▲ A number of Chinese Pilots have established allocation previous years; or committees that can directly intervene in the market under ▲▲ The average market price for allowances for the last certain circumstances. month is less than 40 percent of the 2-year average. ▲▲ Researchers have proposed various models for delegation The actions the Committee may take in response to these to independent bodies akin to central banks that would aim conditions include: to adjust auctions to ensure proper market functioning and ▲▲ Allocate up to 25 percent more allowances from the liquidity in the short term and, over the medium to long reserve; term, potentially change the allowance cap. ▲▲ Set a limit on allowance retention (between 70 and 150 6. PRICE STABILITY percent of the compliance year’s allowances); ▲▲ Increase or decrease the limit on borrowing; ▲▲ Increase or decrease the limit on offsets; or ▲▲ Temporarily set a price ceiling or floor. a ICAP (2016f). b This trigger is effectively the same as that used in the EU ETS, as stated in Article 29a of the EU ETS Directive. Specifically, if the allowance price is more than three times the average price of allowances during the two preceding years on the European carbon market, then either member states will be allowed to bring forward auctions or up to 25 percent of the remaining allow- ances in the New Entrants Reserve can be auctioned. 118 EMISSIONS TR ADING IN PR ACTICE 3.6 Summary of options Table 6.1 presents a summary of the pros and cons of the various interventions. TABLE 6.1 Pros and Cons of Approaches to Market Management Approach to manage market Pros Cons Offset limit relaxation/ Relatively simple to implement, no financial burden for regulator; Price bounds not guaranteed; affects emissions limit within capped tightening does not compromise environmental integrity globally (assuming sector or system (in case of international units); can lead to abrupt high-quality offsets). price changes if not anticipated. Auction floor price (“reserve Relatively simple to implement; reduces investment uncertainty; Does not guarantee minimum price in market if there is no demand price”) ensures positive price and government revenue even if emissions for auctions. demand below cap; can tighten cap depending on reintroduction of unsold volumes. Government purchases units Relatively simple to implement; can tighten cap if volumes not Financial burden to regulator; budget may be insufficient to from market to maintain floor reintroduced. guarantee price ceiling. Top-up fees Simple to implement if fee does not fluctuate with price; provides hard Difficult to implement if fee adjusts with price; inhibits efficiency of floor on carbon price faced by entities subject to fee. system as a whole if implemented only partially. Allowance reserve (soft price Provides greater certainty on prices while limiting uncertainty on Price ceiling only partially guaranteed; potential incentives for cap through limited supply emissions (since emissions cannot increase by more than limited market manipulation. from unit reserve) amount of units released from reserve); release can fail to increase in emissions if reserve is filled with offsets or external units. Hard price cap through Guarantees price ceiling for market participants; relatively simple to Environmental target can be compromised without limit; potential unlimited supply at fixed price implement. incentives for market manipulation. Regulator offers call/put No financial burden for regulator if options fairly auctioned; emissions Price bounds only partially guaranteed; could introduce added options with fixed cap limit maintained (or cap tightened) if units sold from limited reserve. complexity and administrative burden for regulator. Price corridor Relatively simple to implement; guaranteed price floor and ceiling. Combined cons of price ceiling and floor. Quantity-based mechanism Avoids political debates on where the price should be set. May increase policy complexity and uncertainty. Delegation Could enhance compatibility of ETS with other energy and climate May be politically challenging to implement and lack democratic policies, monitor the interactions with international markets, and allow legitimacy. flexibility to balance ensuring target quantities with allowance prices. Source: Table adapted from Grüll and Taschini, 2011, and Gilbert et al., 2014a. QUICK QUIZ Conceptual Questions ▲▲ What factors determine the supply of and demand for emissions units and corresponding prices? ▲▲ What causes uncertainty over prices and what are the consequences? ▲▲ What are the rationales for managing low prices, high prices, and other market indicators, and what are some approaches for doing each of these? Application Questions are your priorities for ensuring price predictability on the low and/or high ends, and for other goals of market ▲▲ What management? ▲▲ What approaches might provide sufficient certainty over prices, emissions, and other market indicators? ▲▲ Are you considering linking your system in the future, and how might this affect your preferred approaches? STEP 7: ENSURE COMPLIANCE AND OVERSIGHT 119 STEP 7: ENSURE COMPLIANCE AND OVERSIGHT At a Glance__________________________________________________________________________ 120 1. Identifying and Managing Legal Entities_______________________________________________ 121 1.1 Identifying the regulated legal entities__________________________________________ 121 1.2 Leveraging existing relationships with regulated entities__________________________ 121 1.3 Managing regulated entities over time__________________________________________ 121 2. Managing the Reporting Cycle_______________________________________________________ 121 2.1 Establishing monitoring requirements___________________________________________ 123 2.2 Establishing reporting requirements____________________________________________ 125 2.3 Establishing verification requirements__________________________________________ 127 2.4 Procedural considerations_____________________________________________________ 128 3. Managing the Performance of Verifiers_______________________________________________ 128 3.1 Accrediting third-party verifiers________________________________________________ 128 3.2 Balancing risks and costs in the verification process______________________________ 129 4. Developing an ETS Registry__________________________________________________________ 129 4.1 Setting up a registry__________________________________________________________ 129 4.2 Preventing fraud_____________________________________________________________ 130 4.3 Providing market information__________________________________________________ 130 5. Designing an Enforcement Approach_________________________________________________ 131 6. Oversight of the market for ETS units_________________________________________________ 133 Quick Quiz___________________________________________________________________________ 134 7. COMPLIANCE 120 EMISSIONS TR ADING IN PR ACTICE AT A GLANCE ✓✓ Identify the regulated entities ✓✓ Manage emissions reporting by regulated entities ✓✓ Approve and manage the performance of verifiers ✓✓ Establish and oversee the ETS registry ✓✓ Design and implement the penalty and enforcement approach ✓✓ Regulate and oversee the market for ETS emissions units An ETS must be governed by a rigorous system for market the verification process may depend on the existing regulatory oversight and enforcement. A lack of compliance and oversight culture, although most jurisdictions have favored a more may threaten the environmental integrity of the system and stringent regime, sometimes with a commitment that the the basic functionality of the market, with high economic government itself covers the verification costs of entities. stakes for all participants. The compliance and oversight Registries—databases that record and monitor the creation, system ensures emissions covered by the ETS are measured trading, and surrender of all units within a system—need to be accurately and reported consistently. Effective market over- developed. This requires an assessment of the legal and insti- sight can enable the market to run efficiently and promote tutional framework in which the registry will be situated as well trust between market participants. as the definition of its functional and technical requirements. A prerequisite for effective compliance is the identification Registry data can be made available to market participants of all entities regulated by the system, compiled by the and the public to allow interested parties to form views on regulator based on firms’ self-nomination or through its own the balance of demand and supply. This is a precondition for assessment. This can be made easier by leveraging existing the emergence of liquid primary and secondary markets for regulatory relationships, but governments will probably also emissions units with robust price information. To this end, the need to develop a specific process to identify new regulated registry may provide sufficiently granular data on emissions, entities, as the population of firms changes over time. allowance allocation and surrender, and compliance while ensuring that appropriate standards of confidentiality and Effective systems for monitoring, reporting and verification security are maintained. (MRV) of emissions and other necessary data (e.g., in the context of allocation approaches such as benchmarking or Full compliance must be assured through a credible enforce- output-based allocation) are at the heart of ensuring the ment regime with appropriate penalties. Systems typically environmental integrity of an ETS. Different protocols for rely on a combination of naming and shaming, fines, and monitoring emissions have been used in different systems, make-good requirements to provide this enforcement. While but default emissions factors are often used to keep costs low the reputational implications of noncompliance have proven while generating an unbiased emissions estimate. Reporting to be a strong deterrent that can be reinforced by public arrangements need to be transparent and can build on disclosure of ETS performance, a binding system of penalties is existing data collected on energy production, fuel character- still needed. istics, energy use patterns, industrial output, and transport. Finally, regulators also need to provide oversight of both the Independent verification of emissions reports is often consid- primary and secondary markets for units. Market regulation ered essential to the credibility of an ETS. Further collection, determines who can participate, what is traded, where trans- monitoring, reporting, and verification of activity data (e.g., actions take place, as well as other rules relating to market tonnes of clinker or steel produced) allow for cross-checks and integrity, volatility, and prevention of fraud or manipulation. provide flexibility to adopt different approaches to allowance Instruments for market regulation include clearing and margin allocation. The (typical) importance of independent verification requirements, requirements for reporting and disclosure of demands that the process for accrediting independent verifiers trading positions, position limits and participation, registry also be robust. While international standards for accrediting accounts, and licensing requirements. verifiers can be leveraged, governments may sometimes need to supplement these with additional checks on verifier capacity, especially in the early stage of an ETS. The rigor of STEP 7: ENSURE COMPLIANCE AND OVERSIGHT 121 This step considers the requirements and options for regula- 1.2 Leveraging existing relationships with tors to oversee and enforce compliance of regulated entities regulated entities with ETS requirements. While different options are available Regulators often have existing relationships with entities newly depending on the design of the ETS and the specific jurisdic- regulated under an ETS, which they can build on when setting tional context, compliance—and sufficient trust that there is up the ETS compliance cycle. For example, fossil fuel power compliance—is essential for the integrity and functioning of stations may have reporting obligations on emissions from the entire ETS. The chapter is structured around six important sulphur dioxide, nitrous oxide, and other pollutants. These elements of designing and implementing an approach to (legal) arrangements may provide a base from which permit- compliance and oversight in an ETS, each elaborated in the ting arrangements can be developed as they provide clarity on following sections: which legal entity is regulated, and support the establishment 1. Identifying and Managing Legal; of regular reporting cycles and penalty systems. Similarly, large 2. Managing the Reporting Cycle; industrial installations may already be subject to a compliance cycle associated with maintaining and enforcing permits to 3. Managing the Performance of Verifiers; operate. Other helpful relationships may exist between govern- 4. Developing an ETS Registry. ment statistics services and regulated entities, and/or between 5. Designing an enforcement approach; and government departments and industry associations. But where existing relationships with regulated entities are insufficient to 6. Oversight of the market for ETS ensure compliance with the ETS, new or expanded rules will become necessary. Depending on the jurisdictional context, such rules may be based on existing powers granted to the 1. Identifying and Managing ETS regulator, or may necessitate new legislation. Legal Entities As discussed in Step 1, a wide range of options is available for 1.3 Managing regulated entities over time determining the scope of covered sectors and the points of The list of regulated entities changes over time and must be obligation in an ETS. Decisions on these aspects will need to continuously managed and updated. Businesses may open be formalized in a set of rules determining which installations, or close, expand, dispose of or merge their operations, with facilities, or operations are covered by the ETS, and the nature implications for the specific legal entities involved and their of the interactions that are expected between these entities compliance requirements under an ETS. These changes will and the ETS regulator. A regulator will need to keep track of not align with the compliance cycle of the ETS, requiring the these arrangements by identifying legal entities (section 1.1), regulator to determine rules and processes for managing assessing the nature of existing or new regulatory relationships part-year emissions liabilities and compliance requirements. with regulated entities (section 1.2), and updating the list of Most ETS regulators have a regular cycle for updating the regulated entities over time (section 1.3). list of regulated entities and oblige entities to report material changes in their eligibility or the legal ownership of assets. 7. COMPLIANCE 1.1 Identifying the regulated legal entities There are different approaches to identifying the regulated entities within an ETS. It may be an individual company, a 2. Managing the Reporting specific production line or process, or a specific plant site Cycle (housing several processes and/or companies, see Step 1). An ETS requires effective MRV.114 Monitoring involves emissions Once this decision has been made, there are two main quantification through calculation or direct measurement, approaches to identifying the regulated entities within an ETS. which must then be consolidated in an emissions report. They may be identified through self-nomination—consistent Typically, these reports are then verified by independent with the self-reporting of tax liabilities by liable entities in service providers (verifiers). As an illustrative example, Figure many jurisdictions—or alternatively be based on a regulator’s 7.1 details the EU ETS MRV cycle. own research. Once an approach has been decided, an appropriate list of those entities regulated by the ETS will need to be drawn up. 114 For more information on creating programs for the MRV of GHG emissions, please refer to Singh & Bacher (2015). 122 EMISSIONS TR ADING IN PR ACTICE A regulator must provide the following key elements of an system. Compliance can be further enhanced if the regulator MRV system, in line with the relevant legislative regimes in the minimizes the administrative costs for covered entities, for jurisdiction: example, by establishing information technology platforms that allow for efficient transfer of data and compliance reports. ▲▲ Methodologies for accounting and quantification of emis- Regulators may design monitoring guidance in such a way sions and other necessary data (e.g., in the context of allo- that preexisting monitoring systems, such as process control cation approaches such as benchmarking or output-based systems, energy statistics reporting, and financial accounting allocation); systems115 can also be used for the MRV requirements under ▲▲ Guidance on monitoring methodologies; the ETS, lowering compliance costs. ▲▲ Templates for reports; Guidance on establishing monitoring requirements is provided ▲▲ Rules for the use of verifiers; and in section 2.1; on establishing reporting requirements in ▲▲ Details on the exchange and management of data. section 2.2; and on establishing verification requirements in section 2.3. Additional procedural considerations are discussed The provision of detailed methodologies and guidance for reg- in section 2.4. ulated entities is key to enhancing compliance with the MRV FIGURE 7.1 MRV in the EU ETS 1 January Start of monitoring period for year n 28 February 31 December Issuance of End of monitoring allowances for period for year n year n (free allocation) 31 December 31 March Submit changes Verifiction of to monitoring plan emissions report for year n+1 for year n-1 30 June Submit Checking improvement Regulated entity report report for year n-1 Regulator 30 April Enforcement Surrender Verifier (sanctions) allowances for year n-1 Source: ECRAN (2014). 115 Such as SAP (Systems, Applications, and Products in Data Processing). STEP 7: ENSURE COMPLIANCE AND OVERSIGHT 123 2.1 Establishing monitoring requirements although in some cases they will need to be tailored to the specific context of the ETS. Table 7.1 gives a brief overview of The ETS regulator should define the specific monitoring the approach to monitoring (and reporting and verification) in requirements for all emissions sources included in the scope of countries with established ETSs. the system. The variety of approaches to monitoring across countries Monitoring guidelines must be available for each sector cov- illustrates that different monitoring requirements will work ered by the ETS. These can draw on a wide library of detailed best for different sectors and different GHGs. One approach to methodologies, product and activity descriptions, emissions monitoring is to prescribe a conservative default method that factors, calculation models, and relevant assumptions,116 BOX 7.1 TECHNICAL NOTE: Simplified Example of Annual Emissions Monitoring (Calculation) in a Hard Coal Power Plant Emissions = Input x NCV x Emission Factor Carbonate Flue gas cleaning unit Hard Coal Steam boiler 1,500 MW Electricity Grid Hard Coal Power Plant Inputs Heating Value (NVC) Emissions Factor Emissions t Energy GJ/t tCO2/GJ tCO2 1,087,387 25.5 0.095 2,634,195 Hard Coal (truck scale) (sample analysis) (sample analysis) Carbonate 10,321 — 0.44 4,541 (truck scale) (standard factor) Total 2,638,736 7. COMPLIANCE Source: Adapted from BMUB/FutureCamp. This drawing shows a simplified example of the standard methodology to monitor and calculate combustion emissions from a hard coal fired power plant. Here, emissions are calculated by means of activity data for the inputs coal and carbonate multiplied by emissions factors. As the energy content of coal varies, an adjustment must be made for fuel quantity multiplied by the net calorific value (NCV). The amount of hard coal and carbonate is measured via a truck weigh station; for the major emissions source, the steam boiler, the NCV and the emissions factor are determined by sample analysis, while for the minor emissions from the flue gas cleaning unit, a standard emissions factor can be applied. 116 ICAP (2016g) provides links on its website to monitoring approaches used around the world. 124 EMISSIONS TR ADING IN PR ACTICE TABLE 7.1 MRV approaches in existing ETSs Reporting software/ Applicability requirements Monitoring methodologies Verification required for platform EU ETS Threshold: capacity threshold for combustion For CO2: calculation (standard methodology, Emissions Report Excel templates activities: rated thermal input > 20MW. Emissions mass balance), direct measurement, fallback (European Commission); threshold for aviation, excluding air transport approaches, or combinations of approaches others by member states, operators that operate flights with annual can be used. e.g., FMS (Germany) emissions below 10,000 tCO2. For N2O, direct measurement is required. Source categories: Specific source categories A tier system sets requirements for data irrespective of emissions levels (e.g., production quality and accuracy. of aluminum, ammonia, and coke, refining and mineral oil). Production capacity threshold: By industry, e.g., manufacture of glass: melting capacity that exceeds 20 t/day. California Emissions threshold: All facilities with annual Both calculation and measurement may be Monitoring Plan and “Cal e-GGRT” emissions ≥ 25,000 t CO2e. used with specific tier requirements. Emissions Report Source categories: Some source categories irrespec- Continuous Emissions Monitoring (CEM) is tive of emissions levels (e.g., cement production, required for certain activities. lime manufacturing, petroleum refineries). Embedded emissions: Suppliers of petroleum products, natural gas and natural gas liquids, and CO2, if annual emissions that would result from consumption of products produced and sold are ≥ 10,000 t CO2e. Québec Emissions threshold: All facilities with annual Entities can choose their calculation Monitoring Plan and emissions > 10,000 t of CO2e per year. methods among those provided by the Emissions Report (but Ministry for each sector. If entities have only for installations with measurement instruments, they must use emissions > 25,000 metric the method associated with the instrument. tons of CO2e per year) South Korea Emissions threshold: On installation level > 25,000 t Calculation with different uncertainty and Monitoring Plan (annual) National Greenhouse Gas CO2e per year. data requirements. For some installations, and Emissions Report Management System CEM is required. (NGMS) On entity level > 125,000 t CO2e per year. Installations with 15,000–25,000 tCO2e per year remain under Target Management Scheme. New Energy threshold: Methodologies for each sector are provided. Emissions Report, but only Zealand Generally the accounting uses activity data if participants use a unique Liquid fossil fuels: Owning more than 50,000 liters on inputs. Emissions factors are specified emissions factor per year of obligation fuel, to be removed for home by the Ministry but entities can apply for consumption or refinery. unique emissions factor. Stationary energy: Includes importing and mining Majority of activities have to use calculation coal in excess of 2,000 t/year, natural gas in excess as standard methodology. However, use of of 10,000 liters per year, combusting oil, crude oil, CEM is an explicit possibility in the context waste oil, and refining petroleum. of “combustion of used oil, waste oil, used Source categories: Industrial processes, forestry, and tires, or municipal waste.” others. RGGI Capacity threshold: Electricity generators with Operators of coal-fired units and units Emissions Report RGGI uses data reported capacity ≥ 25 MWe combusting any other type of solid fuels (no Monitoring Plan to the U.S. EPA Clean Air have to use CEM. required) Markets Division data- base in accordance with Operators of gas- and oil-fired units state CO2 Budget Trading may use alternative methods, calculating Program regulations. emissions via daily fuel records, periodic fuel sampling to identify carbon content in %. RGGI COATS continued on next page STEP 7: ENSURE COMPLIANCE AND OVERSIGHT 125 TABLE 7.1 MRV approaches in existing ETSs (continued) Reporting software/ Applicability requirements Monitoring methodologies Verification required for platform Tokyo Energy threshold: Primarily, monitoring is based on calculation Emissions Report using direct measurement of activity data or All facilities with fuel/heat/electricity consumption (No Monitoring Plan by using receipts. >1,500 kl (m3)a of crude oil equivalent (COE). required, but reduction plan) Emissions thresholds: For non-energy CO2 as well as other GHGs, all entities with annual emissions ≥ 3,000 tCO2e and the company has at least 21 employees. Transport capacity threshold: Entities with a certain transport capacity (e.g., at least 300 railroad cars or 200 buses). Author: ICAP. a Around 58 TJ or 16 GWh. is relatively easy to apply (and verify), and then require larger ▲▲ How long records should be kept (typically between 3 participants to monitor more accurately (see Box 7.1). This tries and 10 years);118 to seek a balance between a desire to minimize overrewarding ▲▲ Standardizing emissions reports to ensure consistency over those who monitor poorly with a desire not to unnecessarily time and across reporters; penalize small sources that may not be able to afford or ▲▲ Aligning timing of emissions reports with existing business just lack the capability for more accurate methods. Box 7.2 cycles and compliance timeframes; and presents an illustrative example on emissions monitoring requirements for a Lime Kiln included in the EU ETS. ▲▲ Creating electronic reporting formats to cut down on pro- cessing time and transcription errors, e.g., through web- The regulator needs to balance a desire for accurate and based reporting platforms that can reduce time demands, robust data while limiting the potential for gaming. Especially easily manage large volumes of data, automatically check in the early phases of an ETS, when time series of consistently for errors, and bolster security. 119 monitored and reported data are lacking, the uncertainties about site-specific factors can give rise to significant potential When establishing reporting requirements, it is important to for gaming. A stepwise phase-in of more precise monitoring consider the ETS context. Many jurisdictions already collect and reporting approaches, starting with default factors inputs to the calculations used for emissions reporting, such followed by a carefully supervised transition to site-specific as energy production, consumption, transport and distribution sampling and emissions factor calculation, may reduce these statistics, fuel characteristics, industrial output, and transport risks (see Box 7.3). statistics. Synergies with company process control systems and financial accounting systems can help avoid duplication of 7. COMPLIANCE 2.2 Establishing reporting requirements information flows and ensure that the ETS reporting require- ments are practical and effective. Regulated entities need to report their monitoring data to the regulator in a standardized and transparent form. Emissions Allowance allocation may require similar or other data than report timing should be aligned with compliance time frames ETS compliance, depending on the form of allowance alloca- (see Step 5 for more details on the frequency of compliance tion (see Step 3 for information about the types of allocation requirements), typically providing sufficient time after the and associated data requirements). Besides emission data, end of the compliance period for reports to be prepared. The many ETSs require the collection, monitoring, reporting, and regulator can design an efficient reporting process by:117 verification of activity data (e.g., tonnes of clinker or steel pro- ▲▲ Providing regulated entities with clear guidance on report- duced). Even if these are not needed for allowance allocation ing requirements, including: initially (for instance, if allowance allocation is done through grandparenting), the collection of these data from the outset ▲▲ The type of information to report, ▲▲ The frequency of reporting, and 118 Singh & Bacher (2015). 117 Prada (2009). 119 Ibid. 126 EMISSIONS TR ADING IN PR ACTICE BOX 7.2 TECHNICAL NOTE: Monitoring Emissions from a Lime Kiln When Croatia joined the European Union in 2013, GHG was determined using a regularly calibrated weighing belt, emitting installations in the power sector and in industry had while various accessible data sources, including sales invoices, to ascertain whether they would be covered by the EU ETS. inventory data, and financial statements, were then used to A manufacturing plant for dolomitic lime determined that corroborate the results and reduce the risk of errors.  it would be covered because its daily production capacity The vertical annular shaft kiln used in the plant was fueled exceeded 50 t of lime. As one of the obligations resulting with natural gas. The operator had to determine whether the from Croatia’s inclusion in the EU ETS, the operator of the existing gas meter complied with the relevant quality require- lime kiln had to design a monitoring plan outlining how GHG ments, especially regarding the measurement uncertainty. emissions would be monitored, and that plan had to be The operator was able to demonstrate that the requirement approved by the competent authority. At the time, however, for tier 3 (± 2.5% over the reporting period) could be met. the operator of the plant had never been required to monitor Therefore, use of the existing meter was allowed. For the and report on greenhouse gas emissions. combustion emissions, the calculation required establishing For the EU ETS, instructions on how to meet these obliga- the calorific value of the fuel used to fire the kiln, and tions are laid out in the Monitoring and Reporting Regulation multiplying it with the emission factor of the fuel type and associated guidance documents. As the operator learned, and an oxidation factor indicating the amount of unburnt these specify that monitoring parameters such as activity carbon. Due to the medium size of the installation, the use data and calculation factors have to meet certain quality of standard factors as established by the national inventory requirements, so-called “tiers”. For cost effectiveness rea- was allowed, thereby avoiding the costs for sampling and sons, minimum tiers are based on the amount of greenhouse laboratory analyses.   gases emitted, with less rigorous requirements imposed on Although use of default calculation values—meaning a lower smaller emitters. Because the plant emitted between 50,000 tier in terms of data quality—would have been permissible, and 500,000 tCO2 on average each year, it was considered the operator chose to use laboratory analyses for deter- a medium-sized emitter (a “Category B Installation”), which mining the emission and conversion factors for process impacted the chosen monitoring method as described below. emissions. This was easy to implement, as such analyses When producing dolomitic lime, CO2 is emitted during the were already well-established at the plant for the purpose of chemical reaction that converts the raw material—dolomitic product quality control.  limestone, consisting of calcium and magnesium carbonate— into the final product ( process emissions), as well as during Calculating Emissions: An Example the combustion of fuel to heat the kilns in which the Under the Monitoring and Reporting Regulation, process conversion takes place (combustion emissions). Under the emissions are calculated using the following formula: Monitoring and Reporting Regulation, both the process and Em = AD * EF * CFF the combustion emissions have to be monitored and included Where Em stands for emissions (in t CO2), AD for activity in an annual emission report.  data, EF for emission factor and CF for conversion factor. To determine emissions, the regulation describes a “standard Production data showed that the plant had produced calculation method” that builds, to the greatest extent 63,875.25 tonnes of lime in 2013. On average, the emission possible, on data already available to the operator for other factor was determined to be 0.91 t CO2/t and the conversion purposes, such as process control and financial book keeping. factor of dolomitic limestone to dolomitic lime in the plant’s Another option under the regulation is continuous emission kiln was found to be 0.96. Applying the above formula yielded monitoring based on sensor probes that measure CO2 total process emissions of 55,801 tCO2 for 2013. concentrations and volumetric flows in the flue gas stream, For the natural gas used to fire the kiln, the operator was but the required investment was considered too costly for allowed to use the reference values set out in the national the lime manufacturing plant, whose operator opted for the inventory, namely an emission factor of 56.1 t CO2/TJ and a standard calculation method instead. net calorific value of 34 TJ/106m3. Likewise, the rules allowed To determine process emissions, the operator had a choice applying a fixed oxidation factor of 1. of focusing either on the quantity of limestone input or the For combustion emissions, the Monitoring and Reporting amount of lime output, multiplied with their respective emis- Regulation sets out the following formula: sion factors and a conversion factor reflecting the proportion of unconverted limestone in the final product. The operator Em = AD * EF * OF chose the second method—basing the calculation of emis- Where Em stands for emissions (in t CO2), AD for activity sions on the output of lime produced—because appropriate data, EF for emission factor and OF for oxidation factor. metering equipment was already installed. Lime production continued on next page STEP 7: ENSURE COMPLIANCE AND OVERSIGHT 127 can facilitate a shift to alternative allocation approaches such BOX 7.2 TECHNICAL NOTE: Monitoring Emissions from a Lime as benchmarking or output-based allocation in the future. Kiln (continued) Activity data of fuels is expressed with the formula: 2.3 Establishing verification requirements AD = FQ * NCV Regulated entities have an incentive to underreport total Where FQ stands for fuel quantity and NCV for the net calorific value. emissions in order to pay less for compliance, and in some situations also to overreport emissions in order to receive In 2013, the plant had combusted 7,095,379 m3 of natural greater allocation of free allowances. Aside from robust mon- gas. Thus, the emissions stemming from natural gas com- busted in the plant were 13,534 tCO2 in 2013. Adding these itoring and reporting provisions, it is therefore crucial to verify combustion emissions to the process emissions calculated the accuracy and reliability of the information reported by the earlier showed that the plant had altogether emitted regulated entities. 69,335 tCO2 in 2013. Verification occurs when an independent party reviews an emissions report and assesses that the reported information is Authors: Mehling and Fallmann. an appropriate estimate of emissions, based on the available data.120 Quality assurance used by regulators comes in three forms: self-certification, review by program administrators, and BOX 7.3 TECHNICAL NOTE: Default Emissions third-party verification. These different options are highlighted Factors for Balancing Cost with Accuracy in Table 7.2. Default emissions factors can be used to provide an estimate for emissions without having to directly measure emissions factors from a particular source. They allow TABLE 7.2 Quality Assurance Options entities to save costs on detailed monitoring procedures Approach Definition and are feasible where emissions sources are similar. Self-certification Formal assertion by the reporting entity of the In New Zealand, default emissions factors are available accuracy of regulated entity’s emissions report for most emissions sources unless a participant prefers to obtain a “Unique Emissions Factor” through direct Review by program External review undertaken by the program administrators administrator measurement. Another example is Switzerland where mandatory default factors have to be used for various Third-party Reviewed by a qualified third party types of coal. The default factors were assessed in verification corporation with industry to make sure they reflect actual Source: Based on table 13 in Singh and Bacher, 2015. emission values. A default emissions factor should be set to ensure that it provides reasonable accuracy without penalizing sources that may not be able to use more accurate methods (based on costs or capabilities). The use of defaults may 7. COMPLIANCE also be restricted to smaller emitters and avoid the use of uncertainties related to site-specific emissions factors to game the system, especially in the initial and early phases of an ETS. If there is no flexibility to measure emissions other than through the default factor, entities will not have an incen- tive to introduce new and cleaner inputs. Overall accuracy can be improved if flexibility is provided for entities to adopt more accurate approaches than the default, as the information provided by those entities can also be used to improve default factors. 120 IPCC (2000). 128 EMISSIONS TR ADING IN PR ACTICE Whatever approach is chosen for quality assurance, it should ▲▲ Managing disclosure of sensitive data. Much of the take into account the administrative costs for the regulator data monitored and collected during emissions reporting and the regulated entities, the capacity of regulators and ver- is considered confidential and commercially valuable by ifiers, and the context of business compliance with other gov- businesses. It is therefore critical for the ETS regulator to ernment regulations in a jurisdiction, as well as the likelihood guarantee the security of the information provided by the and value of incorrect emissions quantification. In practice, regulated entities so that information flows are not hin- many jurisdictions use more than one or all of these quality dered by these concerns. The benefits of public disclosure assurance approaches. When there is a strong culture of of emissions and broader (market) transparency in the ETS regulatory compliance, it may be possible to rely on self-certi- need to be balanced with the objective to protect com- fication with spot-checking by regulators. However, most ETSs mercially sensitive information.121 It is important to consult require third-party verification, which provides higher levels of regulated entities on what information will be made publicly confidence in reported data. Section 3 discusses the different available before the system starts (see also Step 8). options for regulating such verifiers. Given the complexity and site-specificity of many emissions reports, some jurisdictions (including California, Québec, and 3. Managing the Performance the Republic of Korea) extend the need for verification to the of Verifiers monitoring plans that lay down the site- or company-specific As discussed in section 2, MRV in most ETSs require the use methodologies for measuring, calculating, and reporting data, of third-party verifiers. This section discusses the process of and are subject to approval by the regulatory authority. accrediting third-party verifiers (section 3.1), and balancing risks and costs in the verification process (section 3.2). 2.4 Procedural considerations Procedural considerations in the design and implementation of 3.1 Accrediting third-party verifiers an MRV system include: To ensure the quality of third-party verifiers, the regulator ▲▲ Phased implementation. Establishing and managing should establish a verifier accreditation process—either compliance with MRV systems is a time- and resource- internally or involving a local or accessible international accred- consuming process that requires significant upfront itation body.122 This is useful in providing an independent investments. Regulators can adopt a learning-by-doing assessment of the verifier’s technical competence in emissions approach, for example by implementing MRV systems in accounting and calculation and measurement of emissions stages, starting with major emissions sources or simpler from specific sources and sectors. It may also help ensure methodologies, or incorporating additional components that the verifier can retain impartiality while conducting the over time. Continuous changes in MRV systems may, verification in accordance with program rules. however, be a source of confusion for regulated entities, There are internationally recognized standards that a regulator and should thus be carefully managed by the regulator. can use or adapt for this purpose, such as those set by the To allow covered entities to adapt to the new regulatory International Organization for Standardization (notably ISO requirements, some jurisdictions (including the Republic of 14064-3 and ISO 14065, as well as ISO 17011, which provides Korea) have used mandatory emissions reporting prior to general requirements for accreditation bodies assessing and imposing constraints on emissions. The Republic of Korea accrediting verifiers).123 established its MRV requirements before the formal launch of the ETS, which facilitated the system’s introduction (for Regulators may choose to establish guidelines on verification more details, see Box 10.1 in Step 10). Early collection of for the verifiers to follow. As verifiers need time to form data can also be useful for cap setting and for distributing specialist teams and develop the right tools and methods allowances (see Step 2 and Step 3 respectively). to perform verification tasks, it is important for the ETS ▲▲ Case-by-case technical decisions. Where guidance is 121 Singh et al. (2015) inconclusive, the regulator will need to make decisions on 122 This option is in the European Commission Regulation (EU) nº 600/2012: “A Member a case-by-case basis. This process of interpretation and State that does not consider it economically meaningful or sustainable to establish a national accreditation body or to carry out accreditation activities should have technical decision making can be supported by a technical recourse to the national accreditation body of another Member State. Only national panel or advisory committee. accreditation bodies that have undergone a successful peer evaluation organized by the body recognized under Article 14 of Regulation (EC) No 765/2008 should be permitted to perform the accreditation activities pursuant to this Regulation.” 123 ISO (2006); ISO (2007); ISO (2011). STEP 7: ENSURE COMPLIANCE AND OVERSIGHT 129 regulator to carefully monitor and manage their performance, particularly in early stages of the ETS. In the Chinese pilot ETS, 4. Developing an ETS Registry for instance, some verification reports are double-checked Regulators must ensure that covered entities surrender the by experts or other verifiers appointed by the regulators and, correct amount of eligible units by the relevant compliance in case of poor quality of the verification report, the verifiers date. To keep track of transactions in the market and the units will be asked to revise the report. In addition, regulators may that have been surrendered, an ETS requires a registry where stipulate a period of time after which accreditation must be transfers of units are recorded and monitored. At the end of renewed. each compliance period, regulated entities can then transfer (or surrender) units via the registry to the ETS regulator to meet their emissions liability for the period. Section 4.1 3.2 Balancing risks and costs in the discusses the process of setting up a registry. Section 4.2 verification process discusses prevention of fraud. Typically, verification requires that regulated entities have their reports scrutinized by an accredited verifier who must confirm 4.1 Setting up a registry that the regulated entity is complying with all of the require- Registries are IT databases that assign a unique serial number ments of the reporting system. This normally requires that the to each unit and track those serial numbers from their verifier makes use of detailed guidelines and standards speci- issuance onward. This includes information on who has been fied by the ETS regulator, including checklists and risk registers issued allowances, who holds those allowances as well as to establish the levels of compliance with the requirements. On other units, and when and from where units are surrendered this basis, verifiers must use their own professional judgment or canceled. Market participants sign up to the registry and to understand the regulated entity’s key risks of noncompli- create an account where their units are stored. ance, assess compliance with the program requirements, and conduct sufficient investigations so that they have enough Establishing an ETS registry involves the following steps: confidence to issue their assurance statement. ▲▲ Creating the legal framework for a registry.125 The legal This approach is intended to achieve good risk management. framework for a registry will ideally reflect the nature, However, there are a number of options that a regulator might scope, and scale of the proposed ETS. The regulator must consider if there are concerns that this might create excessive establish timelines for drafting, conducting consultations transaction costs, including: on, and implementing this framework. It must indicate any interactions it may have with other areas of law—such ▲▲ Allowing or requiring regulated entities to provide quality as property, tax and accounting, insolvency, and financial assurance statements or self-certification, for all reports, legislation—and address these with the bodies responsible with legal liability assigned for false reporting; for those laws. If necessary, external expertise and support ▲▲ Assessing only a sample of reports selected by the ETS should be drawn in. The most challenging legal aspects regulator for detailed review and/or third-party verification often relate to the determination of the legal nature of the after they have been submitted; allowances126 and the allocation of responsibilities to all the 7. COMPLIANCE ▲▲ Focusing reviews and audits only on compliance in the bodies involved. These responsibilities should be identified areas of high risk that have been identified by the ETS and addressed at an early stage to avoid later disputes. regulator (for a specific regulated entity); and/or ▲▲ Setting up the institutional framework for administering ▲▲ Reducing the frequency of review or verification. a registry.127 The regulator should list the responsibilities of the registry administrator, and determine the terms of use However, while these approaches may reduce the costs that and fees for registry users as well as the size and structure regulated entities need to incur, they also increase the risk of the budget for registry administration. On this basis, it that entities fail to comply with the ETS requirements, which should decide which entity is best placed to assume this could undermine the credibility of the system. One solution, role. It should establish cooperation procedures between as applied in the Chinese ETS pilots, is to maintain the more rigorous procedures but for the government to fund the 125 For more information on creating the legal framework for registries, please refer to verification process.124 Zaman (2015). 126 It is important to decide on the legal nature of emissions units, for example, whether they are an administrative grant, license, or property. Where this is not stipulated in law, opportunistic speculation may occur. This is further discussed in Zaman (2015). 127 For more information on creating the institutional framework for registries, please 124 SinoCarbon (2014). refer to Dinguirard and Brookfield (2015). 130 EMISSIONS TR ADING IN PR ACTICE the registry administrator and relevant authorities BOX 7.4 CASE STUDY: Fraud and the Evolution of (e.g., market oversight and regulation, justice, etc.) the EU ETS Registry ▲▲ Specifying the functional and technical require- For the first two phases of the EU ETS, each EU member state ments of a registry.128 This includes procurement of had its own registry system, while a Community Independent the relevant IT systems; identifying and addressing Transaction Log (CITL) was used for checking and recording security issues and options; defining the data to be transactions of units between accounts. During Phase II, the managed; estimating the volume of data and number national registries were also connected to the International of transactions to be processed; establishing trace- Transaction Log, which accounts for the credits under the ability procedures including audit logs, notifications, Kyoto Protocol. and messages; formulating the main business rules The EU ETS suffered a number of cases of fraud and cyber- and alerts; specifying the main reports to be produced attacks against the registry accounts: by the registry; and creating the main pages of the ▲▲ Phishing. Phishing refers to fraudsters impersonating a registry website. legitimate and trusted entity to make participants provide access to sensitive data. In January 2010, a handful of account holders in Germany had allowances stolen after 4.2 Preventing fraud responding to a bogus e-mail requesting details to access A key function of an ETS registry is the prevention of their accounts. In November 2010, there was a similar case fraud. Along with the direct losses suffered as a result of involving a cement producer’s account in Romania’s EU fraudulent activity, fraud can compromise the reputation ETS registry. of the system and threaten confidence in the market. In ▲▲ Hacking. Several million EUAs were stolen from national the event that fraud is discovered, quickly reacting to the registries of five member states—Austria, Romania, the events and the appropriate strengthening of systems can Czech Republic, Greece, and Italy—in January 2011. In help minimize long-lasting damage. response, the Commission completely suspended transfers of allowances in all member states until it could verify The incidents in the EU ETS, discussed in Box 7.4, high- and improve registry security. The registries progressively light both the fraud risks that ETSs are exposed to, as well reopened and spot trading started again later in 2011. as the lessons learned from these experiences. Thanks to early allocation, this did not cause problems regarding compliance for emissions in 2010. 4.3 Providing market information In response to these activities, the EU ETS established an EU-wide registry system in 2012, and the European Union Registry data can be made available to market participants Transaction Log replaced the CITL. A unified registry system, and the public to allow interested parties to form views on instead of one registry per member state, has made it easier the balance of demand and supply. This is a precondition to control transactions and prevent fraud. Some of the spe- for the emergence of liquid allowance markets with cific new registry security measures include:a robust price information. To this end, the registry may ▲▲ Enhanced control for account opening. This consists of provide sufficiently granular data on emissions, allowance stronger and harmonized Know-Your-Customer checks; allocation and surrender, and compliance, while ensuring ▲▲ Enhanced transactions security. Consists of a range of that appropriate standards of confidentiality and security security measures including a 26-hour delay at initiation of are maintained. a transfer, a trusted account list, and better authentication methods for carrying out transactions. ▲▲ Strengthened registry oversight. Includes administrator power to suspend registry access and block transfers. ▲▲ Enhanced protection of the good faith acquirer. Includes serial numbers of allowances that are only accessible by administrators and irrevocability of transfers. 128 For more information on creating the technical infrastructure for registries, a Kossoy and Guigon (2012). please refer to Dinguirard (2015). STEP 7: ENSURE COMPLIANCE AND OVERSIGHT 131 5. Designing an Enforcement Penalties, which are often used in combination, may include: “Naming and shaming.” The names of noncompliant Approach ▲▲ entities can be published. This may be particularly useful Effective compliance primarily relies on establishing processes in jurisdictions where a company’s reputation would be that are transparent and well communicated. If information significantly affected by such a statement. about compliance is easy to understand, accurate, complete, ▲▲ Fines. These can either take the form of a fixed amount and accessible, regulated entities will be more likely to comply or be set pro rata to the size of the noncompliance, for on time and without errors. Appropriate capacity-building example, per tonne of missed emissions. The value of measures targeting regulated entities are key in this regard the fine can be set by reference to the observed market (see Step 8). prices for allowances. A fine may be higher for intentional However, while well-designed processes will increase compli- noncompliance than for unintended mistakes. ance rates, full compliance must be assured through a credible ▲▲ “Make-good” requirements. This can help maintain enforcement regime with appropriate penalties. The regulator environmental integrity. Installations may have to comply needs to ensure it has the ability to enforce penalties and within a certain time period, by buying units from the that, if penalties are not paid or met, it can invoke powers to market or borrowing from their future allocation (usually at investigate or prosecute with fines or other civil or criminal an unfavorable exchange rate). sanctions. For example, in New Zealand, the law gives the ▲▲ Further measures. Ongoing or repeated intentional regulator extensive prosecution provisions for noncompliance noncompliance may call for stronger penalties, including that can result in significant financial and criminal sanctions.129 criminal charges. In addition, or alternatively, penalties Penalties should be set at a level that exceeds an entity’s outside of the ETS might be used. For example, some of expected benefits of noncompliance. Typically, there are three the Chinese pilot systems linked ETS performance with new categories of noncompliance that carry penalties: construction project approvals, performance evaluation for state-owned companies, and credit records.131 ▲▲ Emitting in excess of the number of units surrendered; ▲▲ Misreporting or not reporting emissions and other data Table 7.3 shows details of penalties for noncompliance with before specified deadlines; and unit surrender obligations applied across different jurisdictions, including penalties outside of the ETS in the Chinese pilot ▲▲ Failing to provide, or falsifying, information to the regulator, systems. A range of other penalties are applied in most verifiers, or auditors. jurisdictions for other offences relating to MRV requirements, Some ETS pilots in China also penalize verifiers that provide such as not reporting on time or withholding information from fraudulent information or reveal confidential information.130 a verifier. 7. COMPLIANCE 129 New Zealand Environmental Protection Authority (2013). 131 Information about penalties outside the ETS in the Chinese pilots is noted in Zhou 130 SinoCarbon (2014). (2015). 132 EMISSIONS TR ADING IN PR ACTICE TABLE 7.3 Penalties for Noncompliance with Surrender Obligations in Existing ETSs ETS System Jurisdiction European Union A fine per unit of 100 EUR. The name of the non-compliant entity is also published. For the pilot phase from 2005 to 2007, a reduced fine of 40 EUR is applied. New Zealand A fine per unit of 30 NZD (19 EUR) and a make-good requirement (surrender or cancel allowances to make up for shortfall). The fee may be reduced by up to 100 percent if participant states voluntarily that it failed to surrender the required allowances or made a mistake in its emissions return before the administering agency sends a penalty notice or the participant is visited by an enforcement officer. Switzerland A fine per unit of 125 CHF (115 EUR) and a make-good requirement (surrender missing allowances and/or international credits in the following year). RGGI Penalties for noncompliance are set by each state. Tokyo The following measures may be taken in two stages:  First stage: The Governor orders the facility to reduce emissions by the amount of the reduction shortage multiplied by 1.3.  Second stage: Any facility that fails to carry out the order will be publicly named and subject to penalties (up to 500,000 JPY [3,828 EUR and surcharges (1.3 times the shortfall)] California Under the Cap-and-Trade Regulation, if an entity fails to surrender sufficient instruments to meet its obligation, California imposes a non-enforcement incentive requirement that the entity submit four compliance instruments (only one quarter of which can be offsets) for each instrument the entity failed to surrender. Of these four instruments, one is permanently retired, effectively reducing the cap, and three allowances are recirculated through the auction mechanism. If an entity fails to meet this untimely surrender obligation (i.e., 4 times per metric ton missed), California may institute formal enforcement actions, including seeking penalties as defined by statute. This includes statutory penalty provisions setting forth penalty amounts of 1,000-10,000 USD (921-9,204 EUR) per day per violation (i.e., per metric ton that remained unsurrendered) for strict liability, and increasing amounts depending on the level of intent. Kazakhstan A fine per unit of 11,156 KZT (30 EUR). In the first year of the system, 2013, penalties for noncompliance with unit surrender require- ments were waived. Québec Companies failing to surrender enough allowances to match their emissions have to surrender the shortfall plus a 3 for 1 penalty. Furthermore, depending on the infraction, they can face additional charges varying from 3,000–500,000 CAD (1,988-331,250 EUR) and up to 18 months in jail in the case of a natural person, and 10,000–3,000,000 CAD (6,625-1,987,500 EUR) in the case of a legal person. Beijing A fine per unit of three to five times the market average allowance price in the previous six months. Guangdong 10,000 CNY (1,414 EUR) to 50,000 CNY (7,069 EUR). Other sanctions include: two times the shortfall is deducted from next year’s allocation and the breach is recorded in the company’s credit record. Shanghai A fine of between 50,000-100,000 CNY (7,069-14,138 EUR). Other sanctions include: the breach is recorded in the company’s credit record, suspension of ability to access government funds for energy conservation, emissions reduction measures, energy savings assessments and appraisal scheme for one to three years. Shenzhen A fine per unit of three times the market average allowance price in previous six months. Other sanctions include: the shortfall is deducted from allowance allocation, the breach is recorded in their credit information management account, government funds discon- tinued, financial aid is prohibited for five years and the breaches are included in the performance evaluation system for state-owned enterprises. Tianjin No penalties apply. Hubei A fine per unit of one to three the times the market allowance price, with a maximum penalty of 150,000 CNY (21,207 EUR). Other sanctions include: two times the shortfall is deducted from next year’s allocation, the breach is recorded in the company’s credit record, suspend ability to access government funds for energy conservation, emissions reduction measures, and the breach is included in the performance evaluation system for state-owned enterprises. Chongqing A fine per unit of three times of the market average allowance price in the previous month of the allowance shortfall (draft). Other sanctions include: cancellation of all financial funds granted by the government and prohibition of government financial aid for three years; the breach is included in the performance evaluation system for state-owned enterprises and precludes participation in energy saving, environment protection and climate change mitigation evaluation activities for three years. Republic of Korea A fine per unit of up to three times the average market allowance price of the given compliance year or 100,000 KRW/tonne (78 EUR). In 2015 and 2016, there is a price ceiling of 10,000 KRW (8 EUR). Therefore, the maximum penalty in this time period would be 30,000 KRW (23 EUR). Author: ICAP. Note: Information about noncompliance penalties in jurisdictions other than China and New Zealand is from the ICAP website, Introduction to ETS, MRV and Enforcement: https://icapcarbonaction.com/en/about-emissions-trading/mvr-and-enforcement. Information about penalties in China pilots are sourced from Zhou (2015). STEP 7: ENSURE COMPLIANCE AND OVERSIGHT 133 6. Oversight of the market for Exchanges may play a regulatory role with their own procedures in case of violations, such as membership sus- ETS units pension. They may also be useful in providing information In addition to monitoring, reporting, and verification of on prices, volume, open interests, and opening and closing emissions—and the associated surrender of units—the market ranges. for units also requires oversight.132 On the one hand, under- ▲▲ Clearing and margin requirements. While trading on regulation and a lack of oversight risks fraud and manipulation; exchanges is always cleared (i.e., there is a clearing house on the other hand, overregulation may lead to spiraling that becomes the central counterparty to the trade), this transaction costs and stifle innovation. is not necessarily the case with OTC trading. Regulators are increasingly requiring OTC clearing of standardized The scope of ETS market regulation includes: contracts. As clearinghouses require a deposit as collateral ▲▲ Who can participate in the market; to cover the credit risk until a position is closed (also called ▲▲ Who is responsible for overseeing the market; a “margin”), this greatly reduces not only systemic, but also counterparty risk. ▲▲ What exactly can be traded on the market; ▲▲ Reporting and disclosure. In absence of mandatory clear- ▲▲ Where transactions may take place; and ing or exchange trading, trade repositories or a central limit ▲▲ Other rules that affect the market’s safety, volatility, and order book (CLOB) can function as a registry for market vulnerability to fraud, including those related to oversight orders and an archive of trades, to provide regulators with of other financial and commodity markets. information on market movements. These oversight rules need to be set both in the primary mar- ▲▲ Position limits. A position limit imposes a restriction on the ket (i.e., at the point of initial distribution of units) and in the total number of units or derivatives that may be held by a secondary market (i.e., any subsequent transactions of units). market participant or a group of market participants with The secondary market relates to both trades in the actual units (direct “over the counter” (OTC) trades as well as trades through exchanges) and trades in the derivatives of the units BOX 7.5 CASE STUDY: VAT Fraud in the EU ETS a such as contracts for future sales of units.133 The experiences Until 2010, the EU ETS tax regime treated the transfer of a of existing ETSs also show that these oversight rules should be carbon unit as a service that attracted a value added tax, developed from the beginning of any ETS and that compliance with the tax collected by the seller. should be rigorously monitored. The VAT fraud challenges A number of exchanges offered carbon unit spot products experienced in the EU illustrate the risks that need to be (exchange-traded products with physical settlement managed (see Box 7.5). by way of delivery of a carbon unit within 1–3 days of the transaction date). These products, along with the As in the case of markets dealing in commodities and financial “real-time” (i.e., within seconds) transfer and settlement securities, several measures can be taken by regulators at capability of EU Registries, allowed multiple transactions 7. COMPLIANCE various levels to minimize the risk of market misconduct, (involving the same carbon units changing hands) to be prevent systemic risk, and safeguard against manipulation. carried out within a short time span. Criminals exploited These include:134 this to commit VAT carousel fraud: the acquisition of carbon units without paying VAT (because of the cross- ▲▲ OTC vs. exchange trading.135 Transactions on OTC markets border nature of the transactions), which were then sold are less transparent than those on exchanges and thereby in the same country at a price charging VAT, with the lead to a degree of systemic risk. For example, if a single fraudsters then “disappearing” before the tax was handed buyer and counterparty amass a very large share of over to the tax authorities. transactions and either is incapable of fulfilling contractual Europol estimated that approximately €5 billion was lost obligations, the result may be a complete market failure. to VAT carousel fraud between June 2008 and December 2009. 132 See Kachi and Frerk (2013) for a brief summary of key elements of market oversight. 133 Derivatives are financial products that derive their value from an agreement to buy or sell an underlying asset or commodity for a certain price in the future. a Adapted from Zaman (2015). 134 Kachi & Frerk (2013). 135 OTC trades involve a buyer and a seller coming to a negotiated terms of transac- tion which is represented in a contract. Usually, OTC transactions use standardized contracts particular to that ETS or jurisdiction. 134 EMISSIONS TR ADING IN PR ACTICE business relationships to prevent the possibility that they seek to distort the market. Position limits can be enforced QUICK QUIZ through transparency at the registry level, the central Conceptual Questions clearinghouse level, or by an exchange. ▲▲ Why are compliance and market oversight important for ▲▲ Participation, registry accounts, and licensing require- an ETS? ments. Regulators have the option to impose restrictions on who can open an account with the registry and who Application Questions can trade on what markets, and decide whether licenses ▲▲ Inyour jurisdiction, are there existing environmental, tax, for these activities are required. They can also introduce legal, and market administrative or regulatory processes capital requirements to reduce systemic risk and disclosure that could be replicated or used for the ETS? rules covering business relationships with participants ▲▲ What are the benefits of a stand-alone MRV phase ahead registered in the system. Generally, having more market of compliance requirements? participants will create a more liquid market, which is desirable. However, verification of identities and previous records for all market participants is important to reduce the risk of manipulation and fraud. STEP 8 : ENGAGE STAKEHOLDERS, COMMUNICATE, AND BUILD CAPACITIES 135 STEP 8: ENGAGE STAKEHOLDERS, COMMUNICATE, AND BUILD CAPACITY At a Glance__________________________________________________________________________ 136 1. Objectives for Engagement__________________________________________________________ 137 2. Stakeholder Mapping_______________________________________________________________ 137 2.1 Identifying stakeholders______________________________________________________ 137 2.2 Developing stakeholder profiles________________________________________________ 139 2.3 Prioritizing engagement______________________________________________________ 139 3. Designing an Engagement Strategy___________________________________________________ 139 3.1 Guiding principles____________________________________________________________ 139 3.2 Different forms of engagement________________________________________________ 140 3.3 Engagement within government_______________________________________________ 143 3.4 Mobilizing champions outside of government____________________________________ 143 4. Designing a Communications Strategy________________________________________________ 144 4.1 Tailored messages___________________________________________________________ 145 4.2 Sound communication practices and procedures_________________________________ 146 4.3 Media engagement___________________________________________________________ 146 5. Stakeholder Engagement Process Management________________________________________ 147 5.1 Risk management____________________________________________________________ 147 5.2 Transparency of engagement outcomes_________________________________________ 147 5.3 Evaluation and review________________________________________________________ 148 6. Capacity Building__________________________________________________________________ 148 6.1 Identification of capacity-building needs________________________________________ 148 6.2 Methods and tools for capacity building_________________________________________ 149 6.3 Learning-by-doing___________________________________________________________ 149 8. STAKEHOLDERS 6.4 Evaluation and review________________________________________________________ 149 Quick Quiz___________________________________________________________________________ 150 136 EMISSIONS TR ADING IN PR ACTICE AT A GLANCE ✓✓ Map stakeholders and respective positions, interests, and concerns ✓✓ Coordinate across departments for a transparent decision-making process and to avoid policy misalignment ✓✓ Design an engagement strategy for consultation of stakeholder groups specifying format, timeline, and objectives ✓✓ Design a communication strategy that resonates with local and immediate public concerns ✓✓ Identify and address ETS capacity-building needs Implementing an ETS requires both enduring public and will be possible to improve ETS design and help gain trust, political support and practical collaboration across government understanding, and acceptance. and market players, based on shared understanding, trust, A communication strategy can be developed, involving the and capability. ETS impacts can be significant and far-reaching, development of tailored messages for different audiences, as making ETS development and operation politically sensitive well as making use of well-established communication prac- and of interest to a broad array of stakeholders. These include tices, including engagement with the media. Throughout ETS different industries and their trade associations, government development and operation, a government’s communication agencies, and environmental advocacy groups. Some jurisdic- about an ETS should be clear, consistent, and coordinated, and tions have found that it took five to ten years of engagement the government needs to maintain integrity and credibility. and capacity building on climate change market mechanisms to enable informed and broadly accepted policy making on an Developing an ETS also requires strategic capacity building. ETS. Government decision makers, administrators, and ETS par- ticipants need to build the specialized technical expertise and Stakeholder engagement normally begins by clarifying the key administrative capacity to develop and operate an ETS. objectives of the stakeholder engagement process and devel- oping a comprehensive map of relevant stakeholders. This Step 8 guides policy makers through the objectives of engage- mapping exercise can go beyond simply identifying stakehold- ment in section 1. It then presents an approach to mapping ers to also understanding the profiles of these stakeholders relevant stakeholders in section 2. Section 3 elaborates on the and hence why their engagement should be sought, as well as guiding principles and key aspects of engagement strategies. what the priorities for engagement should be. Section 4 looks specifically at the design of a communications strategy. Section 5 outlines the most important aspects of A carefully considered engagement strategy will be of enor- managing the stakeholder engagement process. Section 6 mous value. This chapter will consider the different forms of presents an approach to building the capacity of policy mak- engagement and which forms of engagement may be most ers, regulators, ETS participants, service providers and other important for different stakeholder profiles. By tapping stake- stakeholders. holder expertise—in particular economic and technological—it STEP 8 : ENGAGE STAKEHOLDERS, COMMUNICATE, AND BUILD CAPACITIES 137 1. Objectives for Engagement low-GHG technology (see Step 10 for more on the impor- tance of predictability), so engagement on changes can Before mapping key stakeholders and devising engagement improve acceptability and efficiency. strategies, it is helpful to note the main objectives for engage- ▲▲ Build acceptance and support: A sustainable ETS does ment. These may include: not require universal support, but it does require enduring ▲▲ Meet statutory obligations: Each government is likely to social acceptance.139 This can take the form of a “quiet have statutory requirements and standard practices for majority,” even if it is overshadowed by a vocal opposing public engagement on major policy and legislation, and minority.140 Broad political support will help ensure the there is a lot of available guidance on public engagement in long-term viability of the system through political cycles, policy making.136 Whatever approach is applied to the ETS and also be key to its overall legitimacy as an exercise of should be consistent with local requirements. However, it public authority. Perceived long-term viability and legiti- will be important to consider whether any unique aspects macy of the ETS will probably also have a positive effect on of ETS design require a change to standard approaches.137 investment in abatement technologies (see Step 10). For example, extra time may be needed to allow stakehold- ers to consider complex proposals. Governments may need to make a special effort to reach out to stakeholder groups 2. Stakeholder Mapping that are not often involved in policy making and simplify This section presents an approach to stakeholder mapping. complex technical information. It covers the identification of relevant stakeholders in section ▲▲ Build understanding and expertise at all sides: Stake- 2.1 and the elements to be recorded in stakeholder profiles holders need to learn about an ETS, how it works, and its in section 2.2. These profiles can then be used to prioritize potential impacts, before they can support it and partici- stakeholders for engagement, as described in section 2.3. An pate in it. Potential participants in the system will also have overview is provided in Figure 8.1. access to better information than government about their emissions, mitigation potential and costs, and competitive- 2.1 Identifying stakeholders ness. They may also have valuable institutional knowledge ETS stakeholders include individuals and organizations that that could positively affect program design. Access to affect, are affected by, or have an interest in ETS design and information from multiple, well-informed stakeholders will implementation. Identification of relevant stakeholders will help improve the ETS and is an essential precondition to create the design and implementation of an effective engagement effective regulatory bodies.138 strategy. Relevant stakeholders for an ETS include: ▲▲ Build credibility and trust: Long-term goals need to be ▲▲ Government stakeholders play a key role in ETS design credible, and rules and enforcement should be clear. ETS and implementation. They include departments involved participants and other stakeholders are more likely to have directly in ETS design and implementation, departments confidence in an ETS if they have been provided and been whose operations will be affected by the ETS, departments able to review pertinent information. Conversely, they are whose support is essential, decision makers with legislative more likely to be suspicious of the government’s assess- functions; as well as national and subnational authorities. ments if these are conducted confidentially and without Some of the government departments and agencies that independent review. External, peer-reviewed research will be most heavily involved are those with responsibilities will ensure that information and data are public, and that for environment, energy, economic affairs, treasury, 8. STAKEHOLDERS conclusions are as transparent as possible. Predictability accreditation bodies, and market regulation and oversight. of decision-making processes and ETS operation is equally Depending on the ETS design and jurisdictional context, important. Unexpected changes to ETS design will reduce other departments that may have an interest include trust in the system and could discourage investment in those with responsibility for transport, forestry, agriculture, 136 e.g., OECD (2009). fisheries, waste, social development, foreign affairs, tax, 137 During the development of the EU ETS, the German government identified the need competition and consumer affairs, justice, competition and to create a new institution for more in-depth stakeholder engagement than would be industrial policy, and research and statistics. At the political achieved under standard practice (Matthes, 2013 and Box 8.3). 138 A case in point is the treatment of space heating in Beijing’s ETS. Government level, a broad range of stakeholders are relevant, particu- analysts assumed that boilers would be more efficient in the richer central city and larly if partisan politics are a feature within the jurisdiction; allocated emission allowances based on that assumption. However, extensive stake- holder engagement revealed the opposite: in fact, boilers in the outlying areas were more efficient. The large range in emissions intensity for space heating influenced the 139 Caron-Malenfant and Conraud (2009). eventual choice to forgo a standard benchmark for the entire industry. 140 For a description of a “silent majority,” refer to Government of South Australia (2013). 138 EMISSIONS TR ADING IN PR ACTICE FIGURE 8.1 ETS Stakeholders and Key Considerations in Stakeholder Mapping Civil Society: Government input on stakeholders: understanding key role in ETS design and managing & implementation ETS impacts Media: acceptance and support for ETS, BUILD MEET build credibility and trust UNDERSTANDING STATUTORY & EXPERTISE OBLIGATIONS ETS participants: directly affected & their data provides foundation of ETS STAKEHOLDER MAPPING & OBJECTIVES Academics and researchers: help design options, model ETS impacts, evaluate/improve ETS BUILD BUILD CREDIBILITY ACCEPTANCE & TRUST & SUPPORT Firms not directly regulated: also affected and may serve as information conduit General public: support key for social acceptance & electoral support Market service providers: support effective operation of ETS Other ETS jurisdictions: valuable knowledge or experience & can discuss linking Author: ICAP. ▲▲ Regulated entities are an important group, as they are ▲▲ Civil society organizations, such as environmental, social directly affected and will be fundamental to gaining access justice, health and governance NGOs, labor organizations, to robust information and data on which the operation of and consumer groups have an interest in the ETS and could an ETS is based. Engagement can be targeted both toward provide valuable input on understanding and managing ETS gaining executive commitment to constructive participation impacts; in the ETS and securing involvement of operational staff in ▲▲ The media are crucial to building acceptance and support the design of effective MRV and other systems; for an ETS. Accurate and objective media coverage can ▲▲ Firms affected, but not regulated directly by the ETS, help build broad-based credibility and trust, whereas including manufacturers and suppliers at different points persistent biases and misreporting may yield the opposite in the supply chain, may also have an interest. Trade and effect; industry associations can play an important role in present- ▲▲ Academics and researchers are an important resource for ing aggregate views on business interests and in serving evaluating and improving ETS design, and can help explain as a conduit of information to their membership and to to the public how an ETS works, building credibility and consumers; trust; ▲▲ Market service providers could include banks, exchanges, ▲▲ The support of the general public is key to building the and other financial intermediaries such as brokers and trad- enduring social acceptance and broad political support ing houses, verifiers and auditors, offset project developers, necessary for a sustainable ETS; legal advisors, and verifiers, all offering professional services that can support the effective operation of an ETS; STEP 8 : ENGAGE STAKEHOLDERS, COMMUNICATE, AND BUILD CAPACITIES 139 ▲▲ Other jurisdictions with an ETS may be engaged early in successful design, implementation, and sustainable operation the design process to identify and resolve potential barriers of the ETS. This assessment can be based on the stakeholder to linkage. They may also have valuable experience and profiles drafted in the previous step. Given limited resources, knowledge to share. Engagement with other jurisdictions moreover, outreach activities that can be targeted at multiple can also include participation in international forums such audiences or can be scaled up and replicated without addi- as the World Bank Partnership for Market Readiness (PMR), tional cost—such as a robust online information platform—can International Carbon Action Partnership (ICAP), formal help maximize the impact of engagement efforts. fact-finding missions, and through informal contact; and ▲▲ Trading partners who place a premium on mitigation ambition, or who are considering trade measures such as 3. Designing an Engagement border carbon adjustments, should be consulted to stream- line and integrate future policy making on international Strategy Engagement activities need to be undertaken strategically at mitigation action and trade. each stage of ETS design and implementation. The potential complexity of this effort warrants the development of a 2.2 Developing stakeholder profiles formal strategic engagement plan that involves, and has It can be useful to develop stakeholder profiles to create an buy-in, across government departments. The components effective information base for engaging strategically on an of the engagement plan should be customized to local ETS.141 These profiles can cover groups of stakeholders or circumstances, but some of the main aspects that might be individual stakeholders, as appropriate. They may answer considered are: 142 questions such as: ▲▲ Guiding principles (section 3.1); ▲▲ What role will they play in ETS implementation? ▲▲ Different forms of engagement (section 3.2); ▲▲ How will they be affected by the ETS, and how significant ▲▲ Engagement within government (section 3.3); and will that impact be? ▲▲ Mobilizing champions outside of government (section 3.4). ▲▲ What is their understanding of emissions trading and broader climate change policy? 3.1 Guiding principles ▲▲ What are their priority issues or concerns regarding an An effective engagement plan should be guided by a number ETS? of core principles. These may include the following: ▲▲ What will they expect from the government? For instance, ▲▲ Clearly define the goals, target audience, and timeline for stakeholders might wish to be informed of major decisions each engagement activity. and developments, have an opportunity to influence policy, give feedback on how the ETS is operating, or simply be ▲▲ Engage early, sufficiently often, and in a well-targeted able to understand the rules of the ETS. manner, so that the government can make well-informed decisions at each step of the process. ▲▲ What is the government’s current relationship with them, and how willing are they to engage? ▲▲ Engage broadly, where possible, so that both majority and minority views can be considered. ▲▲ How might they interact with other stakeholders on these issues? ▲▲ Engage in good faith, providing enough time and informa- 8. STAKEHOLDERS tion for stakeholders to evaluate government proposals and 2.3 Prioritizing engagement for the government to incorporate substantive feedback into final decisions. The last step of stakeholder mapping is to prioritize the stakeholders to engage. As human and financial resources for ▲▲ Accommodate the needs and capabilities of the target engagement activities are likely to be limited, it is critical to audience (e.g., inviting written submissions, holding public ensure that engagement is targeted at the most important meetings, using media, etc.). stakeholders. Priority may be assessed, for example, by the extent to which a lack of engagement would pose a risk to the 142 See Krick et al. (2005) as a useful general resource for developing a comprehensive 141 For an example of stakeholder mapping of positions and concerns in the context of engagement plan. For corporate perspectives on engagement with both government the introduction of California’s Global Warming Solutions Act (AB32), see Table 2 in and nongovernment stakeholders during ETS development, refer to PMR (2015e) and PMR (2013). Morris and Baddache (2012). 140 EMISSIONS TR ADING IN PR ACTICE ▲▲ Ensure public accountability by maintaining a public record ▲▲ Providing plain-language summaries of technical of engagement and reporting back what information documents, legislation, and regulations. was received and how the government took it into ▲▲ Consult. Defined as “To obtain public feedback on analy- consideration. ses, alternatives and/or decisions.” This may involve: ▲▲ Coordinate engagement on similar issues across govern- ▲▲ Meeting with staff of companies that are likely to be ment to avoid duplicative efforts and “consultation fatigue.” ETS participants; ▲▲ Evaluate and continually improve the effectiveness of ▲▲ Engaging with consultants and researchers; engagement activities.143 ▲▲ Inviting general public input on government proposals during ETS design; and 3.2 Different forms of engagement ▲▲ Mandating public consultation on legislation, regula- Different forms of engagement are appropriate for different tions, and ETS reviews. stakeholders, and at different stages of ETS development. Box 8.1. details stakeholder engagement methods in the Tokyo ▲▲ Involve. Defined as “To work directly with the public ETS. Box 8.2 provides insight into expert engagement with throughout the process to ensure that public concerns and California's ETS. Box 8.3 outlines Germany’s positive experi- aspirations are consistently understood and considered.” ences with setting up a permanent working group to support This may involve: ETS engagement. ▲▲ Commissioning independent experts to assess ETS design and operation; The International Association for Public Participation (IAP2) has developed a useful framework for considering engagement ▲▲ Enabling substantive dialogue with stakeholders, options in its public participation spectrum (see Figure 8.2).144 formally and informally; and It distinguishes five forms of engagement, ranging from those ▲▲ Holding multistakeholder workshops for the public that are appropriate for a low level of public influence over exchange of views. decision making (“Inform”) to those that involve a high level of ▲▲ Collaborate. Defined as “To partner with the public in each influence (“Empower”). The framework can be applied to ETS aspect of the decision including the development of alter- design and implementation as follows: natives and the identification of the preferred solution.” ▲▲ Inform. Defined as “To provide the public with balanced This may involve: and objective information to assist them in understanding ▲▲ Inviting stakeholders and technical experts to work the problem, alternatives, opportunities and/or solutions.” with the government in modeling ETS impacts by In the ETS context, this may involve: reviewing data, assumptions, and outcomes; and ▲▲ Producing green/white papers145 that explain the ▲▲ Creating joint government/stakeholder working government’s proposals with supporting discussion groups to discuss technical matters, and develop and analysis; related regulations and guidelines for ETS ▲▲ Creating a central website, hotline, or help desk participants. where information can be obtained about the ETS; ▲▲ Empower. Defined as “To place final decision making in the ▲▲ Releasing modeling results and other government hands of the public.” This may involve: analyses; ▲▲ Ensuring that the introduction of an ETS is identified ▲▲ Issuing regular updates on the progress of ETS early and clearly in campaign platforms, political planning; and programs, and legislative dockets to facilitate a robust civil society debate; ▲▲ Where allowed, holding a public referendum on 143 These principles represent a synthesis of concepts from multiple sources. For other examples of principles for effective public engagement for policy making, refer to whether to proceed with an ETS;146 and OECD (2009), Krick et al. (2005), and Government of South Australia (2013). 144 From informing to empowering, including consulting, involving, and collaborating, ▲▲ Delegating authority for technical aspects of the IAP2 Public Participation Spectrum is a useful tool to better understand the role allocation plan development to representative sector stakeholders can be given (IAP2, 2007). experts. 145 In this context, a green paper is a government document presenting preliminary or tentative policy proposals that is circulated among interested parties for consulta- tion. The ensuing government white paper presents firm policy proposals for further 146 For example, holding a public referendum played a key role in the development of the testing and refinement prior to the introduction of legislation. ETS in California. STEP 8 : ENGAGE STAKEHOLDERS, COMMUNICATE, AND BUILD CAPACITIES 141 FIGURE 8.2 Role of Stakeholders in ETS Decision Making Increasing influence on decision-making EMPOWER COLLABORATE INVOLVE CONSULT INFORM Source: ICAP. Adapted from IAP2 (2014). BOX 8.1 CASE STUDY: Designing Engagement Methods in the Tokyo ETS In developing the Tokyo ETS government officials tailored the format of engagement to meet the evolving needs of different stakeholder groups across different phases of work. The outcome is summarized in the table below. ETS phase Stakeholders engaged Format Pre cap-and-trade reporting ▲▲ Facility managers and engineers at regulated ▲▲ Publications companies ▲▲ Report submissions and feedback ▲▲ Seminars Draft program design and ▲▲ Experts ▲▲ Expert panels proposal ▲▲ Facility managers, experts and engineers at regulated ▲▲ Environmental councils companies ▲▲ Questionnaires ▲▲ Local business groups Introduction ▲▲ Business groups (local and national) ▲▲ Stakeholder meetings ▲▲ NGOs ▲▲ Thematic meetings 8. STAKEHOLDERS ▲▲ General public ▲▲ Collection of public comments ▲▲ Forums Detailed program design ▲▲ Local business groups ▲▲ Negotiations ▲▲ Leaders in building sector ▲▲ Discussions (one-to-one, one-to-some) ▲▲ Engineers at regulated companies ▲▲ Seminars and forums ▲▲ Experts (e.g., academia, lawyers) Implementation and ▲▲ Facility managers and engineers at regulated ▲▲ Report submissions and feedback improvement companies ▲▲ Call Center Source: Table adapted from PMR (2013). 142 EMISSIONS TR ADING IN PR ACTICE BOX 8.2 CASE STUDY: California’s Formal Expert BOX 8.3 CASE STUDY: Germany’s Experience with Engagement in ETS Design the “Working Group Emissions Trading” The design process for the California ETS included regular Stakeholder outreach in Germany has a long tradition public meetings from its inception. In total, more than through industry associations. In the context of the EU 40 public meetings were held between 2009 and 2012.a ETS, this took the form of “Working Group Emissions The California Air Resources Board (ARB) also relied on Trading” (AGE), established in 2000. The founding mem- experts and economic analyses from different committees bers were major industrial and energy companies, the to inform the design and implementation of the system. federal government (represented by the Ministry for the These boards brought together experts with different Environment), and environmental NGOs. Including repre- backgrounds to work on specific issues: sentatives of civil society in the process from the start was important in establishing an open and trusted exchange ▲▲ The Market Advisory Committee (MAC) was appointed of views. This was also helped by the fact that the group in 2007 to advise on the creation of a market-based operated under the Chatham House Rule, distinguishing it mechanism for reducing GHGs, and was comprised of from lobbying groups.a experts who had experience in the creation of other ETSs, including the EU ETS and RGGI.b The working group operates with its own budget (financed jointly by the Ministry for the Environment and ▲▲ The Economic and Allocation Advisory Committee the participating companies) and a joint secretariat. The (EAAC) was appointed in May 2009 to provide recom- group is headed by the Ministry for the Environment mendations on the provision of allowance value and and co-chaired by the Ministry for Economic Affairs and allowance distribution. The EAAC was comprised of 16 Energy. It now consists of 75 members engaged in regular, economic, financial, and policy experts, split across subworking and plenary group dialogues on a range of different subcommittees—economic impacts, allocation technical, political, and cross-cutting issues. methods, allowance value provision, legal issues, and constraints.c Early and intense consultations on the risks, benefits, and methodologies of the EU ETS proved to be helpful. The ▲▲ The Emissions Market Assessment Committee (EMAC) timing and sequencing of engagement have also helped was commissioned in order to identify market issues make the group more effective. For example, detailed in the California Cap-and-Trade Program. EMAC held technical discussions only took place after political deci- public meetings with stakeholders and conducted sions on overall targets had been made. confidential meetings with ARB staff. The Committee worked particularly on the price containment reserve, The working group has been established as a permanent information sharing, resource shuffling, and linkage and continuous stakeholder “process” on all matters with Québec.d related to emissions trading and as a platform for exam- ining the interactions of ETS with other climate change ▲▲ The Market Simulation Group (MSG) was established policy instruments and acts. in June 2012 to identify, through simulation analysis, specific concerns with market rules.e Risks of market disruption or potential for market manipulation were a Chatham House (2002). assessed, especially regarding the allowance price containment reserve. The work of the group was publicly presented and stakeholders were able to com- ment on it, and its work led to the report Competitive Supply/Demand Balance and the Potential for Market Manipulation.f a See ARB (2015c) for archived and scheduled meetings. b See California Market Advisory Committee (2007) for a description of the role of MAC and the committee’s findings. c See Economic and Allocation Advisory Committee (2010) for the full report of EAAC’s recommendations to ARB. d See ARB (2014) for a description of the role of EMAC. e ARB (2015b). f Borenstein and al. (2014). STEP 8 : ENGAGE STAKEHOLDERS, COMMUNICATE, AND BUILD CAPACITIES 143 Laying out an engagement schedule in advance, allocating BOX 8.4 CASE STUDY: Government Coordination sufficient time and resources to complete each stage of in New Zealand ETS Design work, and aligning engagement activities with government decision-making deadlines will all help make engagement more An Emissions Trading Group was created to lead the manageable. implementation and design of the New Zealand ETS (NZ ETS). This team included officials seconded from the Ministry for the Environment (MfE), the Treasury, and 3.3 Engagement within government the Ministries of Economic Development, Transport, and The government is an important stakeholder as a range of Agriculture and Forestry. It was based at the Treasury and different ministries, departments, and agencies will be needed led by an MfE manager with joint oversight by the chief executives of both the Treasury and MfE. This allowed a for the design and implementation of an ETS, while several small and nimble group of officials from key departments government functions may be affected by an ETS. to collaborate directly on technical ETS design while helping to secure support from their wider departments. A key question to consider is how the leading policy designers will engage with other departments and with political decision To facilitate cross-departmental coordination and decision makers to garner support and deliver successful outcomes at making, separate groups of departmental executives and senior officials met regularly to review progress and make each stage of the design and implementation process. To this decisions. At the political level, the Cabinet designated a end, each department’s needs, priorities, and concerns must subgroup of ministers to lead ETS design and other climate be taken into account, noting that emissions trading may be policy development; in some cases they were delegated perceived to run counter to some departments’ goals. The decision-making authority, although on all major issues full stakeholder-profiling exercise described above will facilitate this Cabinet agreement was required. process. These arrangements enabled the economy-wide NZ ETS to be developed rapidly with alignment of technical Providing clarity about the range of roles in ETS design and design and political decision making across government; implementation may help in engagement with government the Emissions Trading Group started work in April 2007, departments (see also the experience with the New Zealand and legislation for the NZ ETS was passed in September ETS, Box 8.4). Some principles to consider include: 2008. However, this should be seen in the context of New Zealand having been considering both emissions trading ▲▲ Ensure appropriate leadership. Clear executive and and carbon taxes since the 1990s and having previously ministerial leadership and commitment help in securing begun to develop the institutional capacity to implement a departmental engagement and support; carbon tax, before political support for this earlier initiative ▲▲ Designate decision makers. Assigning a specific depart- receded. ment, team, or manager to lead ETS development and be accountable for delivery, including to other government departments, will help define clear lines of authority and avoid uncertainty; 3.4 Mobilizing champions outside of ▲▲ Establish special working groups. These can facilitate government interdepartmental collaboration at different levels, enabling While the development of an ETS relies heavily on the relation- challenging issues to be raised and discussed; ships between government and external stakeholders, it can also be supported by fostering effective relationships among ▲▲ Develop communication channels. Coordination can also 8. STAKEHOLDERS external stakeholders. Demonstrable peer support for an ETS be supported by establishing regular channels to communi- can be a powerful influence over other stakeholders. cate progress, share information, and document decisions; and To achieve this, it is necessary to find stakeholders who can ▲▲ Document outcomes. Documenting technical and policy put themselves forward as “champions” of the ETS, notably in decisions and their rationales at different levels and stages the private sector. Stakeholders with previous experience, such of the process will facilitate final political decision making as those that have implemented carbon pricing systems within and provide a solid information base for future reviews of, companies or have supported ETS design in other jurisdictions, or legal challenges to, the ETS. may be particularly valuable in this regard. For example, in the 144 EMISSIONS TR ADING IN PR ACTICE BOX 8.5 CASE STUDY: The U.S. Climate Action BOX 8.6 CASE STUDY: Stakeholder Engagement Partnership During the Development of the New Zealand ETS The United States Climate Action Partnership, formed in 2007, was a coalition of 22 major companies and five When designing New Zealand’s ETS, the government NGOs that came together to “recommend the prompt conducted formal consultations on a detailed ETS design enactment of national legislation in the United States to proposal.a It sought active involvement of, and collabora- slow, stop and reverse the growth of GHG emissions over tion with, stakeholders. This included: the shortest period of time reasonably achievable.”a The ▲▲ Inviting external experts—domestic and interna- partnership included, among others, Ford Motor Company, tional—to review its design proposal and subsequently Alstom, General Electric, and PepsiCo, as well as the releasing the results to the public; Environmental Defense Fund and the World Resources Institute. In its Call for Action, one crucial recommendation ▲▲ Requesting influential thought leaders to join a Climate was the implementation of a cap-and-trade system.b Change Leadership Forum, which met regularly with ministers and officials, to both provide input into the In 2009, the coalition produced an extensive Blueprint for design and identify how to generate support for the Legislative Actions.c This developed the outline for an ETS system more broadly;b and in the United States—making recommendations on scope, allocation, cost containment measures, and offsets. The ▲▲ Creating technical advisory groups where stakeholders Partnership stated that they were “ready to work with worked with officials on design elements, such as the Administration, Congress, and other stakeholders to methodological and accounting frameworks for station- develop environmentally protective, economically sustain- ary energy and industrial processes, transport fuels, able, and fair climate change legislation.” agriculture, forestry, and waste.c The U.S. Climate Action Partnership represented a mile- These processes both improved the quality of government stone in the discussions around climate change policies in decision making and broadened the base of credibility and the United States, as it was the first time NGOs and major support for the ETS. companies joined together to call for a price on carbon. The Blueprint served as a basis for the American Clean a New Zealand Ministry for the Environment (2007). Energy and Security Act (referred to as the Waxman- b The Forum consisted of several meetings in 2007–08 with private sector par- Markey Bill, after its legislative sponsors), which intended ticipants and representatives of government. For more details on the process, to establish an ETS in the United States. Although passed see New Zealand Ministry for the Environment (2010). c The composition of the advisory groups is available at New Zealand Ministry by the House of Representatives in June 2009, the bill did for the Environment (2011). not gain sufficient legislative support to reach a vote in the Senate. a Meridian Institute (2006). b United States Climate Action Partnership (2007). 4. Designing a Communications c United States Climate Action Partnership (2009). Strategy Public perception is a key component of the success of an ETS. The way in which policy makers communicate about an ETS development of the American Clean Energy and Security Act plays a crucial role in building understanding and acceptance. (known popularly as the Waxman-Markey Bill), the U.S. Climate Action Partnership brought several leading companies together Communication about an ETS needs to be clear and consis- in a way that allowed them to be important advocates of tent, and the government should maintain integrity and cred- emissions trading (see Box 8.5). Other champions may include ibility throughout the process. This will require communication academics and thought leaders in civil society. These were to start early in the design process, so as to build and maintain actively involved, for instance, through a consultation process, confidence in the system. It will also require working with in the development of New Zealand’s ETS (see Box 8.6). technical and communications experts. The following sections offer guidelines for effective communications. Section 4.1 presents tools for tailoring messages to their audience. Section 4.2 presents sound communication practices and procedures. Section 4.3 discusses the importance of engaging the media. STEP 8 : ENGAGE STAKEHOLDERS, COMMUNICATE, AND BUILD CAPACITIES 145 4.1 Tailored messages to ETS is to do nothing to mitigate climate change, the messaging will be very different than if the alternative is a The categorization of target audiences is important in tailoring command-and-control approach or other environmental the technical content of government communications to meet regulation to achieve an accepted mitigation goal; the needs and capabilities of each audience. It will also help crystallize key messages. Mapping communication needs and ▲▲ Co-benefits can be powerful selling points. These might key messages against stakeholder groups can be a useful include better air and water quality, improved energy extension of the stakeholder mapping exercise described in security and efficiency, and increased investment in section 2. Whereas each stakeholder group’s profile must be new technologies. For example, in California, the role of considered when drafting tailored messages, the following emissions trading in supporting energy security (as a net themes could provide a useful foundation: importer of energy) and industrial strategy (as an exporter of advanced, innovative technologies) was particularly ▲▲ The inherent advantages of emissions trading lend effective; and themselves to a variety of arguments—from its effective contribution toward meeting emissions reduction targets to ▲▲ Correcting misconceptions proactively can help prevent a focus on flexibility, cost effectiveness, and environmental them from spreading and adversely affecting stakeholder and economic co-benefits. These may resonate to a differ- and public perception of an ETS. Table 8.1 presents exam- ent extent with different stakeholders; ples of common misconceptions about emissions trading, taken from past experience in different jurisdictions, and ▲▲ Defining a clear counterfactual scenario (e.g., what hap- how these may be countered. pens if the government does not proceed with an ETS) can help explain the relative merits of an ETS. If the alternative TABLE 8.1 Misconceptions around an ETS and Possible Counterarguments Misconception Response supporting an ETS An ETS imposes additional costs Such a statement is not necessarily true. By providing an increased signal to be more efficient, a carbon price can actually save an on the economy. economy money. RGGI, for example, is thought to have produced significant economic benefits despite long periods of low allowances prices. A well-designed ETS may be able to reduce those emissions more cheaply than other policy options. A carbon tax is better than an A carbon tax and an ETS each have strategic merits and differences that should be considered by each jurisdiction. Both an ETS and a ETS. carbon tax result in a price on emissions that can change behavior. Under an ETS, the government constrains emissions quantity and the market sets the price, whereas under a carbon tax the government sets the price to provide a constant signal and the emissions quantity is not constrained. Both can involve policy uncertainty regarding future ambition and both can provide special measures for managing leakage and competitiveness impacts. When an ETS includes auctioning, it can generate revenue that can be reinvested or returned to the economy, as does a carbon tax. An ETS adapts more readily to changing market conditions than a carbon tax, and allows international cooperation. Emissions trading allows polluters An ETS limits the system’s total contribution to net global emissions, and then offers flexibility as to whether participants invest in to avoid responsibility for reducing their own emissions or help reduce someone else’s emissions. Participants that choose not to reduce their own emissions bear reducing their emissions. the full costs of that decision. An ETS will place businesses’ Through mechanisms such as incremental changes in the stringency of the cap, free allocation, and price stability mechanisms, an ETS competitiveness at risk and send can avoid or mitigate adverse and disproportionate impacts on emissions-intensive and trade-exposed industry during the transitional production overseas. period before carbon pricing is more widespread among trade competitors. Importantly, an ETS provides financial advantages to firms that improve their emissions intensity and innovate, which can help improve their competitiveness in the longer term, especially as carbon regulations develop around the world. 8. STAKEHOLDERS Free allocation is a subsidy from Free allocation, whether permanent or temporary, can help businesses and other affected entities to adapt more smoothly and gradually the government to polluters. to carbon pricing, and can reduce perverse leakage effects that raise global emissions and cause job losses. Free allocation under an ETS is not considered a subsidy under international trade rules. Participants who receive free Free allocation helps recipients manage the costs of ETS obligations, while they still retain the economic incentive to reduce their allocation have no incentive to emissions, given the price on GHGs and the possibility of selling excess allowances. reduce their emissions. Market mechanisms cannot be An ETS helps remedy the market’s failure to price the environmental impacts from emissions when participants make investment trusted to solve the problems decisions. While carbon pricing in an ETS may not solve the whole problem alone, it is a critical component of the solution. As with all created by market failures. forms of regulation, an ETS requires strict monitoring and enforcement to maintain environmental integrity. 146 EMISSIONS TR ADING IN PR ACTICE 4.2 Sound communication practices and demand will be affected by government decisions on key procedures issues like the overall cap, allowance allocation plans, rules for new entrants, and access to units from linking and Previous experience with ETS development indicates that offsets.149 The way in which these decisions are commu- sound communication practices and procedures are key to nicated is therefore important. The government needs to ensure cross-stakeholder understanding and support. These consider: include: ▲▲ How and when it will communicate information ▲▲ Coordinate government communication. The govern- that will affect market prices can have an impact on ment’s communications around an ETS need to be clear market confidence, induce gaming of the system, or and consistent across departments and political leaders. interact with other corporate reporting requirements. The content of key messages should be developed with In particular, there is a need to manage tensions input from the relevant departments and approved by between the public benefits of information disclosure, the appropriate authorities. As discussed in section 4.1, the commercial interests of ETS participants, and the interdepartmental nature and political complexity of the effective operation of the carbon market. For ETS design make effective coordination and alignment of example, in the case of the EU ETS, researchers communications particularly challenging and important. found that the release of National Allocation Plans ▲▲ Address questions proactively. One practical communica- and information on emissions verification affected tions tool is an evolving Frequently Asked Questions (FAQ) spot and future prices for Phases I and II. Studies document designed to meet the information needs of suggested that information was systematically leaked different types of stakeholders. This can begin with general in advance of official announcements, affecting how information about the need for climate change mitigation the market responded.150 policy and progressively focus on more detailed aspects ▲▲ How it weighs the merits of publicly disclosing infor- of ETS design. A FAQ document can be a living document mation specific to individual regulated entities, given that is updated more frequently than a formal progress any competitiveness issues that may arise as a result report.147 of disclosure. ▲▲ Provide regular progress reports. Providing regular ▲▲ How it will manage the release of market-sensitive progress reports (e.g., on a quarterly or annual basis) information held by government regulators, company can be a useful tool for keeping stakeholders both inside auditors, and ETS participants. Like other markets, and outside of government informed. Such reports can carbon markets can be vulnerable to insider trading. provide an update on the operation of the ETS, enhancing transparency and credibility, and providing information of value to policy makers, market participants, researchers, 4.3 Media engagement and the media. They also impose a discipline of regularly Building the capacity of the media to understand ETS design documenting and publicly reporting key statistics about ETS and operation, and the confidence of the media in the credi- operation.148 Step 10 provides more information on system bility of government communications about the ETS, will help evaluation. ensure that accurate information about the system reaches ▲▲ Communicate market-sensitive information appropri- the general public. It will therefore have a major impact on ately. As with any financial market, carbon markets and public acceptance of the system and its long-term viability. price formation are highly sensitive to information regard- The guidelines for tailoring messages (discussed above) as well ing supply and demand. In the case of an ETS, supply and as generally sound communication practices and procedures can help generate this acceptance. 149 Market factors that impact prices, as well as policy tools to limit those impacts, are 147 For two good examples see the EC (2008b; 2013) and Gouvernement du Québec covered in detail in Step 6. For more on the impact of policy changes and related (2014). uncertainty on market operation, see Step 10. 148 For an example of a progress report on the EU ETS, see EC (2015). 150 Lepone et al. (2011). STEP 8 : ENGAGE STAKEHOLDERS, COMMUNICATE, AND BUILD CAPACITIES 147 5. Stakeholder Engagement BOX 8.7 CASE STUDY: Overcoming Legal Process Management Challenges: the Case of the Californian ETS Once the stakeholder engagement process is underway, sound In California, political disputes led to lawsuits chal- management must keep the activities on course. Aside from lenging the Cap-and-Trade Program as well as one coordinating the process in line with the engagement strategy, political referendum. However, the strong record that policy makers may specifically consider their approach to risk California created over years of planning, learning, and management (section 5.1), ensuring transparency of engagement outreach, which carefully identified each decision and outcomes (section 5.2), and evaluation and review (section 5.3). why it was reached, provided a strong foundation for defending these challenges. California has ultimately prevailed in every legal challenge brought to date, 5.1 Risk management although some cases remain pending. Two of the key Stakeholder engagement can give rise to risks. Proactively identi- legal challenges include: fying potential risks and responding rapidly to actual risks can help ▲▲ Initial Cap-and-Trade Challenge: In 2009, a ensure the effectiveness of engagement activities. Type of risks coalition of environmental justice groups, which that must be managed include: favored a carbon tax over cap and trade, brought a lawsuit challenging whether California’s proposed ▲▲ Procedural risks. Some stakeholders may feel overlooked or approach laid out in the Scoping Plan would ade- marginalized, statutory obligations may not be adhered to, or quately protect low-income, pollution-burdened formal processes may be disrupted by opposing entities. communities, as required by Assembly Bill (AB) ▲▲ Political risks. Formal engagement activities can raise the pub- 32.a After first requiring further analysis under lic profile of issues and create focal points for public opposition the California Environmental Quality Act (CEQA), the court ultimately declared the authority of the and demonstrations. California Air Resources Board (ARB)’s authority ▲▲ Communication risks. Misinformation can be disseminated under AB 32 as broad and sufficient to encompass through inaccurate media or stakeholder reporting. the cap-and-trade approach. While many envi- ronmental justice groups retain concerns, equity ▲▲ Legal challenges. Stakeholders whose concerns are not fully issues have been further addressed by ensuring addressed may choose to challenge the government on legal that at least 25 percent of all revenue from the grounds. Litigation can block or delay ETS implementation. The Cap-and-Trade Program will benefit low-income, government should thoroughly assess the legal context in which pollution-burdened communities (see Box 3.3 in it is operating, and any potential for legal challenges regarding Step 3 on auction revenue use in California). the ETS. Box 8.7 discusses the experiences of California in ▲▲ Offsets Challenge: In 2012, the Citizens Climate relation to legal disputes. Lobby and Our Children’s Earth challenged the use of offsets under California’s Cap-and-Trade Program, claiming that ARB had not demonstrated 5.2 Transparency of engagement outcomes that California offsets protocols represent GHG Transparency is an important component of stakeholder engage- emissions reductions that would not have occurred ment. It helps ensure that stakeholders have confidence that their in the absence of the offsets credit, as required by concerns are considered in the design of the ETS. The creation of AB 32. In 2013, the state trial court ruled in favor a platform for discussion is not sufficient: for engagement to be of California, offering unequivocal support for the credible, the information obtained from the engagement should legality of the offsets program. After an appeal 8. STAKEHOLDERS by Our Children’s Earth, the state appellate court be documented clearly and transparently by policy makers. The upheld the trial court’s ruling. government should ensure that it is accountable to stakeholders and the general public for its response to this information. For example, the extensive and transparent engagement program as part of the design of Tokyo’s ETS contributed to the system’s broad a The environmental justice movement started in the United States in the 1980s and is a social movement that focuses on the fair distribution of acceptance (see Box 8.8). environmental benefits and burdens recognizing that low-income and minority communities have traditionally born disproportionate pollution burdens. 148 EMISSIONS TR ADING IN PR ACTICE 5.3 Evaluation and review BOX 8.8 CASE STUDY: The Engagement Process As Part of Design and Implementation of the Stakeholder engagement requires evaluation and review. This Tokyo ETS can follow standard guidelines of evaluation and review of government activities. Good practice includes that facilitators The Tokyo ETS emerged after two prior stages of work involving progressive engagement: mandatory reporting seek immediate feedback after meetings with stakeholders, and revised reporting.a The mandatory reporting program, and that they organize surveys among ETS participants to started in 2002, provided the backbone of data needed for solicit feedback on the stakeholder engagement process. the later stages. Under the revised reporting program, staff from the Tokyo Metropolitan government visited almost all of the facilities to discuss emissions reduction opportunities. As a result, there was a foundation of strong relationships 6. Capacity Building and understanding from which to engage on emissions Design and implementation of an ETS will require capacity trading. building. The following sections cover key capacity-building In designing its ETS, the Tokyo Metropolitan government needs (section 6.1), possible approaches to meeting these held stakeholder meetings between July 2007 and January (section 6.2), the possibility of introducing pilot or voluntary 2008. Business groups, companies with interests in climate systems first (section 6.3), and the necessity to evaluate and change, environmental NGOs, and the Tokyo Metropolitan review capacity-building activities (section 6.4). government acted as participants, and the meetings were open to the public. Each meeting attracted over 200 attendees.b Stakeholder meetings were held after the 6.1 Identification of capacity-building initial design of the ETS, but before the detailed program needs design had been drafted. Through these meetings, the “Capacity” can be defined as the specialized understanding, Tokyo Metropolitan government was able to respond to the skills, institutions, processes, and resources required to design concerns of the public, and enrich the design of the ETS. and implement an ETS. All stakeholders will need the capacity The Tokyo Metropolitan government’s stakeholder meetings to make informed judgments about the acceptability of an demonstrated how stakeholder engagement can directly ETS and the degree to which they will be involved or affected. inform the design of an ETS. Companies that had already This requires familiarization with the objectives of an ETS, its made reduction efforts were concerned that allowance allocation would not reflect their past efforts.c As a result, design features, and potential impacts.151 A deeper level of Top-Level Facility Certification was designed, allowing facil- understanding will be required for those more closely involved ities with the greatest progress in energy saving to apply to in design, decision making, implementation, and technical be a “top-level facility,” resulting in a less onerous obligation advice. For example: under the ETS.d Similarly, property owners were concerned ▲▲ Government departments involved in ETS design and about their ability to control the emissions from tenants. In response, a system was developed that obliged tenants implementation will need the capacity to fulfill new func- of large floor areas or high electricity use to cooperate in tions, such as: mitigation efforts, including the requirement to submit their ▲▲ Identifying and evaluating ETS design options; own reduction plans. ▲▲ Drafting ETS legislation, regulations, and technical In addition to gaining new design elements through guidelines; stakeholder engagement, the meetings built trust with stakeholders. The timing of the meetings contributed to ▲▲ Administering core ETS functions: cap setting, their success. For example, the government organized allocation, MRV, enforcement, verifier accreditation, meetings after collecting data on CO2 emissions from registry, and record keeping; 1,300 facilities. This gave it insight into the extent to which reduction efforts had been made before the ETS in the final ▲▲ Designing and administering offset mechanisms, if ETS allocation.e applicable; ▲▲ Managing ETS fiscal implications and impacts on a See Kimura (2014; 2015) for accounts of stakeholder meetings in the design of other government policies, measures, and adminis- the Tokyo Cap-and-Trade Program. For a discussion of Tokyo’s larger approach to stakeholder engagement, see PMR (2013). Also of interest is EDF and IETA trative systems; and (2015h). b Kimura (2015). ▲▲ Negotiating linking agreements. c Kimura (2015). d EDF and IETA (2015d). e Kimura (2015). 151 Hausotter & Mehling (2012). STEP 8 : ENGAGE STAKEHOLDERS, COMMUNICATE, AND BUILD CAPACITIES 149 ▲▲ Regulated entities will need the capacity to fulfill their BOX 8.9 TECHNICAL NOTE: ETS Simulations for obligations under the ETS for emissions monitoring, report- Capacity Building ing, verification, and unit surrender. They will also need to develop new skills and processes for factoring carbon A number of jurisdictions have used emissions trading prices into business decisions, developing overall mitigation simulations as a tool to engage, train, research, test designs, and experiment. Some ETS simulations have been and investment strategies, applying for free allocation, designed as “games” where participants assume specified operating a registry account, acquiring and trading units, roles and enact a trading market or policy negotiation, managing the accounting and tax implications of ETS obli- whereas other simulations operate as models for testing gations, and hedging against new risks and uncertainties.152 different (policy) scenarios. While some simulations have ▲▲ Other market participants will need the capacity to targeted specific sectors, others have operated within a national or global scope. Many have been focused analyze the implications of government decisions for the on capacity building for companies, while others have marketplace, design facilitative services, and engage in the included regulators, researchers, NGOs, or other types of development of supporting processes and institutions such participants. as offset mechanisms, trading exchanges, and third-party Some simulations prepared in a general training context verification of ETS reports. are available online. For example, the U.S. Environmental Protection Agency has an extensive ETS simulation 6.2 Methods and tools for capacity building allowing participants to experience an ETS in the role of a manager of an electricity-generating facility.a CarbonLab Following an assessment of the current capacity of relevant at the University of Queensland, Australia, has developed stakeholders, the gaps that need to be filled can be identified. an emissions management simulation called CarbonGame.b A program for ETS capacity building can be designed on the Motu Economic and Public Policy Research in New Zealand basis of this gap analysis. have developed a trading game that can be applied to Key elements of an ETS capacity-building program may emissions or agricultural nutrients.c include: ▲▲ Providing basic educational materials with plain-language a U.S.EPA (2016). b University of Queensland (2016). information about ETS design, impacts, and obligations;153 c Motu (2012). ▲▲ Developing guidelines and technical documentation through a process of participant input and review, to ensure they are comprehensible and practical; ▲▲ Encouraging learning from other systems by engaging ▲▲ Running ETS simulations to provide experience with those with prior experience in ETS design. Study tours trading and compliance in a controlled setting that tries to and inviting outside experts to present can be helpful in be as realistic as possible (see Box 8.9); showing stakeholders how other ETSs are operating. The PMR, ICAP, and other organizations as well as donor coun- ▲▲ Holding workshops that create an opportunity for infor- tries can assist with capacity building through information mation sharing; resources, technical training, and country-to-country ▲▲ Providing training to staff who will be involved in ETS- exchanges. related activities; ▲▲ Engaging researchers to help develop an ETS design 6.3 Learning-by-doing 8. STAKEHOLDERS tailored to the local context, based on experiences gained There may be a place for learning-by-doing through a pilot elsewhere; and or voluntary system, while regular reviews and independent evaluation of an ETS will also support learning. These are discussed in Step 10. 6.4 Evaluation and review Evaluation and review of capacity-building programs can be a 152 For case studies on companies’ practical experience in preparing for emissions valuable exercise. Capacity-building needs will evolve as ETS trading, see PMR (2015e). 153 See, for instance, the ICAP ETS Briefs, short leaflets which are available in several development moves from scoping to design, authorization, languages from the ICAP website at www.icapcarbonaction.com, which provide a operation, review, and amendment. Collecting information general overview of the basics of ETS design, arguments for emissions trading, and information about the systems in operation and under planning worldwide. within and outside of government on the effectiveness of 150 EMISSIONS TR ADING IN PR ACTICE capacity-building activities and materials as well as remaining gaps in capacity can assist in the process of continuous QUICK QUIZ improvement. In the longer term, standardized ETS capacity- Conceptual Questions building activities can become part of the routine training for ▲▲ Why is it important to engage with external stakeholders new staff in both government departments administering the throughout development of an ETS? system and entities fulfilling ETS obligations. ▲▲ What are different methods of engagement that could be used during development of an ETS? Application Questions your jurisdiction, what statutory obligations for public ▲▲ In engagement and consultation would apply to ETS devel- opment at each stage: design, legal or regulatory process, and implementation? ▲▲ What type of capacity building would be needed to build sufficient understanding and acceptance of climate change market mechanisms for decision making on an ETS by key government and external stakeholders? ▲▲ Who might be potential “champions” of an ETS, both within and outside of government? STEP 9: LINK 151 STEP 9: CONSIDER LINKING At a Glance__________________________________________________________________________ 152 1. Different Types of Linking___________________________________________________________ 153 2. Advantages of Linking______________________________________________________________ 154 2.1 Lowering aggregate compliance costs__________________________________________ 154 2.2 Increasing market liquidity and depth___________________________________________ 155 2.3 Improving price predictability__________________________________________________ 156 2.4 Reducing leakage concerns____________________________________________________ 156 2.5 Increasing administrative efficiencies___________________________________________ 156 3. Disadvantages of Linking____________________________________________________________ 156 3.1 Challenges from price convergence_____________________________________________ 156 3.2 Imported risks_______________________________________________________________ 157 3.3 Compromises on ETS design features___________________________________________ 158 4. Managing the Advantages and Disadvantages of Linking________________________________ 159 4.1 Choosing linking partners_____________________________________________________ 159 4.2 Restricted linking____________________________________________________________ 159 5. Aligning Program Design____________________________________________________________ 160 5.1 Aligning key design elements__________________________________________________ 160 5.2 Aligning non-essential design features__________________________________________ 165 6. Formation and Governance of the Link________________________________________________ 166 6.1 Timing of the link____________________________________________________________ 166 6.2 Choosing the linking instrument________________________________________________ 166 6.3 Establishing institutions to govern a link________________________________________ 167 6.4 Preparing a contingency plan for delinking______________________________________ 167 Quick Quiz___________________________________________________________________________ 168 9. LINKING 152 EMISSIONS TR ADING IN PR ACTICE AT A GLANCE ✓✓ Determine linking objectives and strategy ✓✓ Identify linkage partners ✓✓ Determine the type of link ✓✓ Align key program design features ✓✓ Form and govern the link Linking occurs when an ETS allows regulated entities to use terms of a linking partner, if there is a concern about the disad- units (allowances or credits) issued in one or more other vantages of price convergence, and if linking is also regarded as systems for compliance purposes. Such links can be one-way, a way to increase liquidity and depth, or reduce leakage, then that is, where entities in one ETS can buy units issued from linking with economically similar jurisdictions may be preferable. one or more other systems, but not vice versa, or two-way, If the focus is more on lowering aggregate compliance costs where both systems recognize the units of the other system. and encouraging cooperation to promote greater mitigation, If two or more systems recognize credits from the same offset dissimilar linking partners will be preferred. To date, most mechanism, this gives rise to an indirect link. links have been between systems in socioeconomically similar jurisdictions, with relatively similar prelinkage allowance prices. Linking can be attractive for a number of reasons. It reduces Some small jurisdictions’ ETSs were designed from the outset aggregate compliance costs. Allowing two systems to trade to link with a larger market or operate as a multijurisdictional emissions allowances increases efficiency in the same way as system. Placing restrictions on the extent of linkage will reduce trade between two companies. The larger the difference in its cost effectiveness, but may be useful if there is a need to equilibrium allowance prices between the linked systems, the trade off some of the advantages of linking against some of greater the gains from trade. Linking also increases market its disadvantages, especially around the desire to preserve liquidity and depth. It may also promote price stability, allowing incentives for domestic emissions reductions and also ensure shocks to one part of the ETS to spread across a larger num- that linkage supports overall mitigation ambition. ber of participants. If linking partners are also trade partners, the equalization of carbon costs can also reduce the risk of When a decision has been made as to whom to link with and emissions leakage. Finally, linked systems can share some of on what terms, in-depth review of respective programs may the responsibility for governing the market and thereby reduce help further assess alignment of design elements. Linking the costs associated with administrative functions. typically requires clear agreement on acceptable levels of ambition in each jurisdiction, including on the stringency of However, for linkages to work, jurisdictions need to find com- the cap and certain key design features, such as the nature promises to align design elements—in particular to guarantee of the cap or the length of commitment periods. Some other comparable levels of environmental integrity for emissions design elements must be aligned to allow effective linkage, units; this may require adjustment of certain ETS design including the robustness of MRV and criteria for offset use. features. While linking allows for aggregate gains from trade, if Aligning other design elements such as a system’s scope and prices significantly differ between jurisdictions, the associated allowance allocation methods may improve the functioning of price convergence process can be challenging—either because a link or address political considerations, but this is not strictly high price jurisdictions will be concerned that their climate necessary. Linking partners may also wish to consider aligning ambition is being diluted, or because low price jurisdictions are design features that will transmit market signals across links, concerned by the higher prices they will see. The associated such as banking, borrowing, and allowance reserves. financial flows may also be politically challenging. In addition, although price stability will be greater on average, there is When the terms of linkage have been set, jurisdictions can a risk that links transmit large shocks from one system to form and govern the link. Whether linkage occurs alongside the another, with undesirable effects. launch of an ETS or afterwards may depend on the objectives for linking. Jurisdictions need to choose the legal instrument for To address these potential disadvantages, jurisdictions may governing the link depending on their legal context, as well as want to carefully choose linking partners, consider potential the institutions responsible for market oversight and processes safeguards such as restricting the extent to which they link, for implementing any changes to the link. Further, arrange- or define conditions under which the link will be terminated. In ments should include a contingency plan for delinking. STEP 9: LINK 153 Linking occurs when an ETS allows regulated entities to use units (allowances or across multiple systems, is currently credits) issued in a different system for compliance purposes. Section 1 explains being considered in the context of the the different types of linking. Sections 2 and 3 consider the advantages and dis- Western Climate Initiative (WCI). advantages of linking. Section 4 examines how jurisdictions might look to balance ▲▲ One-way, or unilateral, linkages let the advantages and disadvantages of linking through both their choice of linking emissions units flow only in one direc- partner and the possibility of limiting the degree of linking. Section 5 considers the tion. One system accepts units from extent of design and regulatory alignment required by linking. Section 6 concludes one or more other systems, but not vice with a discussion on the formation and governance of the link. versa. Most ETSs have accepted some kind of offsets from outside the system through a one-way link, as discussed 1. Different Types of Linking in Box 9.4. Direct one-way linkages A jurisdiction can consider a number of different types of linking, as shown in may also represent the starting point Figure 9.1, with some examples of linking ventures to date further summarized in for any ETS that considers linking to Table 9.1. In principle, three types of linking exist: another system. Norway first entered into a one-way link with the EU (where ▲▲ Two-way, also termed bilateral, and multilateral linkages effectively create Norwegian entities could buy EUAs but a unified market for allowances if there are no quantitative limits or other not vice versa) as a first step to a two- restrictions in place. Allowances originating in one or more markets are eligible way link. A similar staged accession was for use in the others, and vice versa. An example of two-way linkage is that planned for the linkage between the EU between California and Québec, which includes joint auctions as an additional and Australia.154 layer of integrated operations. RGGI launched as a multilateral linked system of almost identical ETSs, each enacted at the state level, but operating from the ▲▲ Indirect linkages occur when two beginning as a single, unified system. A multilateral two-way link, that is, links unlinked systems (A and B) each link to a common, third system (C). Although not formally linked, activity in system A could affect the market in system B FIGURE 9.1 Types of Linkage and vice versa, through their impacts on prices of a common shared partner sys- Direct Linking tem, C. Linkages to C could be one- or Unilateral Multilateral two-way. An example is New Zealand’s ETS, which has been linked indirectly to Units Units the EU ETS through their mutual accep- System A System B System A System B tance of CERs from developing countries generated under the CDM. Bi-lateral Units Units Units System C System A System B Indirect Linking 9. LINKING Units Units System A System C System B Source: Jaffe et al. (2009). 154 In this case, the link was intended to be an indirect one in practice, involving shadow units representing EUAs in the Australian system. 154 EMISSIONS TR ADING IN PR ACTICE TABLE 9.1 Linkages (and intended Linkages) between ETSs to date Systems involved Type of link Degree of linkage California and Québec Two-way ▲▲ Separate caps (Ontario and Manitoba intend to join the system) ▲▲ Similar design features ▲▲ Joint auction and registry system RGGI Multilateral link among participating states ▲▲ Common cap ▲▲ Similar design features ▲▲ Joint auctions ▲▲ Same registry systems Tokyo and Saitama Two-way ▲▲ Separate caps ▲▲ Similar design features ▲▲ Separate allocation mechanisms and registry system EU and Norway Two-way (began with one-way link with Norway as ▲▲ Common cap buyer) ▲▲ Similar design features ▲▲ Separate auctions and registry systems Intended link between Australia and EU Intended to be one-way (with Australia as buyer) ▲▲ Separate caps during first phase, evolving to a two-way link ▲▲ Some design features were in process of alignment EU and Switzerland Two-way ▲▲ Separate caps (not entered into force yet) ▲▲ Similar design features In addition, while not a formal link, collaboration among allowances. Thus, linkage can reduce costs while keeping total systems may be an important step along the way to full emissions equal, assuming caps in both systems are robust linkage or be considered desirable in itself. By aligning program and compliance obligations are enforced (see Box 9.1). targets, enforcement mechanisms, or other features, systems Linkage between ETSs may also be seen as a strategic step can share information and best practice, increase comparabil- toward a more integrated global carbon market and the cost ity of effort, provide political support, reduce competitiveness savings that this would bring. As a case in point, the European and leakage concerns, and simplify administrative procedures Commission cites supporting global cooperation through for companies operating across the systems. It can also be an bottom-up creation of a better functioning and more cost-ef- opportunity for an established ETS to share information with a fective network of markets as one of the major reasons to new system, streamlining technical, legal, and administrative consider linkage of its system (see Box 9.2).156 Similarly, one of burdens, and lowering costs while also smoothing the potential the goals of the WCI is to foster greater market development path toward eventual full linkage.155 for reducing GHG emissions through regional collaboration, including linkage, of subnational jurisdictions in the United 2. Advantages of Linking States and Canada. Finally, both ICAP and the World Bank are conducting work to enhance linking readiness.157 Linkage can provide a number of advantages that help support the objectives of an ETS. This section identifies five of the most Lowering aggregate compliance costs may also help with important advantages. the political sustainability of an ETS and hence create greater confidence in the durability of the system. These consider- 2.1 Lowering aggregate compliance costs ations will depend on the particular political circumstances but, for example, participation in a linked market with California Allowing two systems to trade emissions allowances enables appears to have helped build support for the carbon market in efficiency gains in a similar way that trade between two com- Québec, and this dynamic seems to be extending to Ontario, panies does (as described in the chapter “Before You Begin”). Manitoba, and potentially other states in North America. The system with higher prices overall will be able to buy allow- ances from the system with (on net) lower prices, reducing the cost of achieving its cap, while net sellers will be able to emit less but benefit from the increased revenues from exporting 156 EC (2015c). 155 Burtraw et al. (2013). 157 ICAP (2016h) and World Bank (2016). STEP 9: LINK 155 2.2 Increasing market BOX 9.1 TECHNICAL NOTE: Gains from Trade via Linkage liquidity and depth The greater the differences in marginal abatement costs are across jurisdictions, Linkage can positively affect the the greater the potential gains from trade. Take a simple example of two functioning of the market by increasing jurisdictions: one with relatively high abatement costs (MACH), and another with the number and diversity of market significantly lower costs (MACL). Total avoided abatement costs from emissions in each jurisdiction without linking are represented by the solid areas in the figure participants, improving market below. liquidity—how easy it is to buy or sell allowances—and market depth, that Each jurisdiction has 100 units of emissions in a BAU scenario and caps emissions at 50 units. For the high-cost jurisdiction, the price is PH0 before linking; for the is, the number and volume of buy- low-cost jurisdiction, the price is PL0. After linking, the price stabilizes at P1. Total and-sell orders at each price. Greater emissions are constant but distributed differently across both jurisdictions before liquidity and depth can improve market and after linking. By allowing for trading across jurisdictions—and keeping total functioning in several ways, among emissions the same—the low-cost jurisdiction will now emit less, while the high- others by: cost jurisdiction will emit more, up to the point where marginal abatement costs ▲▲ Improvingthe ability of the market to are equal. The shaded area shows the joint reductions in abatement costs. form prices; Effects of Linking on Prices and Abatement in High (MACH) and the potential for market ▲▲ Restricting Low-Abatement Cost Jurisdictions (MACL) manipulation as a result of buyer or seller power; and Distribution of emissions ▲▲ Making it easier to trade in a timely after link and low-cost manner through Avoided Each jurisdiction has MACH electronic exchanges, greater access Cost per unit of tCO2 equivalent 100 units of emissions in BAU and caps emissions to financial and risk-management PHO at 50 units. For the high- instruments (such as futures and cost jurisdiction, the Cost savings price is PHO before options), as well as easier negotiation linking; for the low-cost with linkage jurisdiction, the price of trades. is PLO. After linking, their price is P1. Similarly, linking provides smaller P1 Avoided MACL Total emissions are economies that may not in themselves constant but spread PLO differently across both be diverse enough to create a well- jurisdictions before functioning ETS with an opportunity to and after linking. join an ETS. Examples include Cyprus, Liechtenstein, and Malta joining the EU ETS; Québec with California; and the states in RGGI. 0 50 70 100 Emissions from High-Cost Jurisdiction 100 50 30 0 Emissions from Low-Cost Jurisdiction This suggests that aggregate cost savings from linkage will be higher: ▲▲ The greater the differential of allowance prices in the absence of a link, ▲▲ The greater the size of the linking partners, and 9. LINKING ▲▲ The greater the general differences of the two economies.a a Doda and Taschini (2015). 156 EMISSIONS TR ADING IN PR ACTICE 2.3 Improving price predictability BOX 9.2 CASE STUDY: EU ETS – Leading with Linking Another advantage of linking is that a larger, deeper market with more diverse participants through linkage can reduce price volatility, as shocks The member states of the European Union to any one system are spread across the broader linked network. Larger, were the first to implement an international ETS for GHGs operating at the level of private more diverse systems can better absorb day-to-day, company- or indus- entities, and the EU ETS remains the largest try-specific shocks, as it is unlikely that all actors in the market will be hit to date.a It was also a pioneer in developing simultaneously with the same economic shock. international linkages. In Phase I of the EU ETS (2005–07), the 2.4 Reducing leakage concerns Norwegian ETS included a one-way linkage Linkage can help reduce concerns about leakage and competitiveness, with the EU ETS; Norwegian installations could particularly among close trading partners. When two systems link bilat- purchase EU allowances for compliance, but not the other way around. That link was ter- erally without any restrictions, prices will converge. As long as vulnerable minated in 2009, when the EU ETS expanded sectors are covered in both jurisdictions, there should thus be little incen- its geographical coverage to include Norway, tive for shifts in production/emissions (unless covered entities benefits, along with Iceland and Liechtenstein. such as free allocation). The EU has also concluded negotiations to link with Switzerland (date of signature and entry 2.5 Increasing administrative efficiencies into force of the agreement are open) and had Linkage could bring efficiencies and cost savings from joint market reached an agreement to link with Australia’s CPM before the latter system was repealed. operations. This might be particularly relevant for subnational jurisdictions or small countries with greater resource constraints for developing and The Directive establishing the EU ETS clarifies operating an ETS. For example, California and Québec are conducting some conditions for linkage between the EU ETS and other systems. These include that joint auctions to reduce program costs and streamline operations. Linkage the other system must be compatible with would also simplify ETS operations and administrative procedures for mandatory enforcement and an absolute multinationals and other companies operating across systems if each emissions cap.b In order to be linked to the ETS recognizes the same emissions units and uses similar reporting EU ETS, the other system must meet such procedures. requirements or be revised accordingly. For example, in 2013, in preparation for linkage, Switzerland made significant changes to the design of its ETS to harmonize with the 3. Disadvantages of Linking EU system, moving from a voluntary, “opt-in” Linking does not only have advantages. This section discusses three key system that existed as an alternative to paying disadvantages of linking that policy makers need to consider. a carbon tax with about 400 participants to a mandatory ETS system for about 50 larger 3.1 Challenges from price convergence installations. Full linking will lead to price convergence between the linked systems, with the higher costs/higher allowance price jurisdiction seeing a decrease in price and the system with the lower costs/lower allowance prices see- ing an increase in prices (see Figure 9.2). Although this reflects the gains a In Phase I, the EU ETS had features of national systems linked from trade generated by linking, it can also cause challenges for both under a common framework and forming a common market, although the term “linking” was not used. Since Phase III, it jurisdictions and, most importantly, undermine environmental integrity. has become a harmonized system with a common cap and EU-wide allocation rules. For jurisdictions in which linking leads to lower prices, the link may b European Council (2009), see paragraphs 40–43 of the Preamble and Article 25 paragraph 1a. conflict with the objective of stimulating domestic innovation and/or the deployment of newer and higher-cost technologies and the delivery of co-benefits associated with domestic emissions reductions (see “Before You Begin”). Concerns about the impact of low prices on domestic mitigation incentives have been one of the main reasons for placing limits on the amount of international offsets that can be used for domestic compliance purposes. STEP 9: LINK 157 FIGURE 9.2 Effect of Linking on Allowance Prices System 1: High Cost System 2: Low Cost Price Price Allowances p1 Funds pLink p2 Cap eLink eLink Cap Emissions Emissions Source: Zetterberg (2012). At the same time, the increase in price in the other jurisdiction In view of these financial flows, while linkage can enable may create political challenges for the ETS, although, as greater ambition by lowering overall costs, it may also create noted above, this will be at least partly compensated by the an incentive for some countries or subnational jurisdictions increased revenues that some entities in that jurisdiction will who expect to be net sellers to create looser caps (or base- acquire from selling permits. On aggregate, there will be net lines, in the case of emissions reduction crediting systems), so gains from trade for the selling jurisdiction, but there could as to sell more allowances internationally. Some buying juris- still be large distributional and competitiveness implications dictions could be tempted to support this so they will be able for companies and individuals in the jurisdiction facing the to purchase low-cost units and/or may not tighten their caps increase in price, for instance, impacts on low-income house- in light of available cost savings.158 Conditioning the choice of holds from rising energy costs. Such implications may need to linkage partners on willingness to take on acceptable levels of be addressed with additional policy measures. program ambition, as discussed below, is thus an important way for both systems to take advantage of potential gains In addition, price convergence is caused by financial flows from linkage while guarding against negative environmental between jurisdictions: entities in high-cost/high price juris- impacts. dictions buy allowances from low-cost/low price jurisdictions. If these financial flows are significant, this could also cause political challenges. In particular, the recipients of the financial 3.2 Imported risks flows will be those in jurisdictions with lower costs/prices; in While linking can improve price predictability, it also means cases where these low costs/prices are the result of lower that price shocks from one system may be imported into any policy ambition, this could be seen as rewarding low ambition system with which it is linked. In other words, while prices may jurisdictions. A related distributional challenge is that auction be more stable on average, it is also possible that prices will revenues in high-cost/high revenue jurisdictions will fall, move dramatically due to external factors. Shocks originating 9. LINKING potentially jeopardizing initiatives expected to be funded in one system—such as boom-and-bust cycles or ETS policy through those revenues. There may also be legal challenges if changes—will affect the linked system. Smaller systems are the financial flows that the low ambition jurisdiction receives particularly vulnerable to such “imported risks,” as the impact are perceived as a form of “disguised subsidy.” of activity in the larger, linked system will be relatively more significant. 158 Green et al. (2014). 158 EMISSIONS TR ADING IN PR ACTICE This suggests that although linking might result in prices BOX 9.3 CASE STUDY: New Zealand and Imported Risk being more stable on average, they might also change New Zealand’s ETS (NZ ETS) was designed to link with the Kyoto substantially because of external factors, potentially into Protocol, and introduced an unlimited unilateral link to allow ranges that clash with other policy priorities (see Box purchase of international units. After starting with an allowance 9.3). price above NZ$20, once CER prices (units from the CDM) began to fall in 2011, the New Zealand Unit (NZU) price matched the In addition, perceptions of asymmetric market oversight CER price and hence fell dramatically. This resulted in negligible may be a major concern from the perspective of financial incentives for domestic mitigation. regulators, especially in cases where the respective regu- New Zealand regained control of its price only when it lations and institutions of a linking partner are considered announced in 2013 its intention to take a target under the significantly less robust than the domestic context. UNFCCC rather than the second Commitment Period of the Kyoto Protocol, restricting the use of international Kyoto units, including CERs, in the NZ ETS as of June 1, 2015. 3.3 Compromises on ETS design features While the low price may have protected the NZ ETS from polit- ical pressure, it also shook investor confidence in future carbon While an ETS is developed in light of national circum- prices and public confidence in the system. stances, linking requires a significant degree of alignment of design features to ensure compatibility, especially in cases where a full two-way link is being established. 30.00 NZ announces withdrawal from CP2 Importantly, each party to the link will need to be satisfied as to the environmental credibility of the units Price (in real 2015 NZD) used in the other system, as, after linking, it will also be 20.00 possible to use these same units for compliance within their respective systems. Jurisdictions may be reluctant to revise ETS design elements to increase compatibility 10.00 at the expense of domestic circumstances. This aspect is explored in greater detail in section 5. Box 9.4 discusses the concept of networking, which seeks to enable coop- eration of carbon markets without requiring alignment of 0.00 design features. 1/1/10 1/1/11 1/1/12 1/1/13 1/1/14 1/1/15 Date NZU CER Source: OM Financial (2016). BOX 9.4 TECHNICAL NOTE: Networking Carbon Markets Recognizing that aligning policies can be a lengthy and costly process, especially once an ETS is already in place, the Units concept of “networking” carbon markets has recently been System A System B met with increasing interest. Rather than seeking to align systems, “networking” is about facilitating trade of carbon assets by recognizing differences and placing a value on these differences, called the "mitigation value". This would Source: NCM. allow more systems to participate in linked carbon markets, Note: Rather than linking schemes that are the same (e.g., linking two squares), even those that are less advanced or less "aligned," while still networking seeks to link schemes that are different (e.g., linking squares and circles). preserving the environmental integrity of trade. At the core of the networking idea is the need for a reliable analytical framework to better understand the differences between systems, in order compare the relative “mitigation value” of a For more information, see the Networked Carbon Markets initiative on the World carbon units and facilitate their trade.a Bank website: http://www.worldbank.org/en/topic/climatechange/brief/globally- networked-carbon-markets STEP 9: LINK 159 4. Managing the Advantages and On the one hand, economic similarities and geographic proximity often imply close political and trade ties. These Disadvantages of Linking will provide preexisting working relationships that may The discussion above highlighted a series of advantages and facilitate a link, including agreement on acceptable levels disadvantages associated with (different forms of) linking. These of program ambition.159 Linking between trade partners are summarized in Table 9.2. will also be more effective at addressing leakage concerns. This section discusses two issues that will be important to policy On the other hand, if the economic attributes of a makers in trying to maximize the benefits from linking while prospective linking partner are different, and these are avoiding the disadvantages. Specifically, section 4.1 discusses the reflected in an abatement cost differential, the opportunity choice of linking partner, while section 4.2 discusses the options to realize gains from trade and achieve lower aggregate for restricted linking. compliance costs will be greater. Such differences are more likely to prevail between developed and developing country systems, or between economies that have dif- 4.1 Choosing linking partners ferent sectoral structures and hence different abatement While a primary goal will be to ensure environmental integrity opportunities. is maintained, in choosing linking partners, jurisdictions need to manage a tension between linking with jurisdictions with similar This suggests that the choice of linking partners depends economic characteristics (that will often be geographically proxi- on how much weight jurisdictions place on different mate), something that may be politically and institutionally easier, advantages and disadvantages. If the primary purpose and linking with jurisdictions that have very different economic of linking is to increase market liquidity and depth, and if characteristics, which may be more economically advantageous. there is also a concern about the accompanying effects of How jurisdictions choose to trade off this tension will depend, at price convergence, linking with economically similar (and least in part, on the objectives they have for linking. geographically proximate) jurisdictions may be preferred. If the focus is more on lowering aggregate compliance costs or addressing leakage risk, dissimilar linking partners may be preferred. The EU ETS linkages with other systems TABLE 9.2 Advantages and Disadvantages of Linking in Europe as well as the Tokyo-Saitama link suggest that, Advantages Disadvantages to date, most jurisdictions have opted for linking with Economic Lowers aggregate compliance +  an increase domestic emis- -C systems that have some degree of geographic proximity, costs across systems sions and reduce environmental and social co-benefits existing economic and political ties, and relatively similar Increases market liquidity and + depth economic and abatement cost profiles.160 Can reduce leakage and + competitiveness concerns 4.2 Restricted linking Can attract external resources + for reducing emissions A further way to manage or trade off the advantages and ± Can promote price stability, although it can also import disadvantages of linking is to allow linking, but to restrict price volatility from abroad or limit the extent of linkage. This will reduce cost effec- Can prompt significant financial transfers ± tiveness compared to full fungibility, but may be useful May create administrative efficiencies: prelinkage ± if there is a need to trade off some of the advantages negotiations and possible program modifications can be costly, while linked systems may lower administrative of linking against some of the disadvantages, especially costs through pooled resources around the desire to preserve incentives for domestic Political May strengthen domestic +  ay create domestic political -M emissions reductions. It may also make it easier to exit ETS legitimacy and durability concerns over distributional through reduced costs and impacts and resource transfers from a linking agreement if conditions change and the international collaboration abroad linkage is no longer beneficial (e.g. NZ restricted its link to 9. LINKING May increase potential for + the CDM in 2015, see Box 9.3). raising ambition Can help shape and build momentum on global climate ± action, but also decreases independent control over program design and ambition 159 This can be seen in the linkages of Norway, Liechtenstein and Iceland with the EU under the European Economic Area; the link of Tokyo and Saitama subna- tional governments in Japan; and the linkage of California and Québec (and the announced planned link of Ontario) under the WCI. 160 Ranson and Stavins (2015). 160 EMISSIONS TR ADING IN PR ACTICE There are three types of quantitative limits that can be 5.1 Aligning key design elements applied:161 There are four key design elements that need to be aligned to ▲▲ Quotas. Limiting use of external units to a certain enable linking. These cover ETS ambition and goals as well as percentage of an entity’s compliance obligation, or to a the enabling infrastructure. certain system-wide aggregate number of units per year, which can then be applied as an entity-level percentage The four key design features of the ETS that need to be limit. While they would have featured in the proposed aligned are the following: Australia-EU link (see Box 9.5), quotas have not been ▲▲ Cap stringency. The cap of a linking partner’s ETS must applied to date in the context of linking across ETSs, be acceptable to both parties. While there may be greater although they have often been included in links to offset gains from trade when there are differing degrees of strin- programs, such as the CDM (see Step 4). gency, significant political difficulties are likely to arise from ▲▲ Trading ratios (“discounting”). Implementing a conversion extensive asymmetries. In particular, the country with the factor that dictates the quantity of different types of units higher ambition cap may be concerned about the impact that must be surrendered to replace one domestic allow- that the resulting fall in price will have on domestic abate- ance for compliance purposes. This would discount foreign ment incentives, while the country with the lower ambition allowances or offset credits. Trading ratios have not yet cap may be concerned about the increases in allowance been applied in practice by any ETS, although provisions prices and hence costs from the link. Moreover, in the were made for the mechanism in the Waxman-Markey extreme case that one ETS has a cap that requires no program. abatement effort because it is higher than BAU emissions, emissions across the linked systems could be higher than ▲▲ Exchange rates. A special case of trading ratios where without the link. Emissions in the system with a binding cap these operate symmetrically across systems, akin to an would then rise as that system buys emissions units from exchange rate for currencies. Thus, if X number of System the other, without a commensurate decline in emissions in B’s units are needed to substitute for one domestic allow- the system with the nonbinding cap. ance in System A, then 1/ X number of System A’s units will be needed for compliance purposes in the place of one ▲▲ Mandatory versus voluntary participation. Bilateral linking domestic unit within System B. requires systems to align on whether participation is volun- tary or mandatory. For example, Switzerland redesigned its ETS from a voluntary opt-in system (coupled with a carbon 5. Aligning Program Design tax) as part of preparations to link with the EU (see Box 9.2). A voluntary system might, however, seek a buy-only One of the key aspects of formal linking is that it requires a link. degree of consistency between different program features in order to ensure equivalent environmental integrity of units ▲▲ Quantity and quality of offsets. The robustness of rules and a well-functioning emissions market. This section provides for offsets must be aligned to harmonize the environmental guidance on harmonization of design elements to allow for integrity of units. While different offset types need not be linking. Table 9.3 summarizes the design features that need an intrinsic problem (and could potentially even improve to be aligned. Some design elements absolutely have to be cost effectiveness and liquidity), understanding a potential aligned to make linkage work (see section 5.1); alignment of linking partner’s offset rules on quality is important. As for other design elements is optional in principle (see section 5.2), quantitative limits on offset use, alignment may benefit although it may be necessary politically or because linking market functioning as offset limits in one system can be will in any case lead to the effective transmission of design effectively undermined by more lenient offset limits in the features across the linked system.162 other system. 161 Lazarus et al. (2015). 162 See Kachi et al. (2015) for a typology of program elements that are (i) barriers to linking such that harmonization is important; (ii) not necessarily a barrier to linking, but harmonization may improve market operations, and (iii) not necessarily a barrier to linking. STEP 9: LINK 161 TABLE 9.3 Importance of Alignment of Different Design Features Alignment could be desirable to address environmental integrity, Importance of market operations, or political and competitiveness issues aligning (+ and ++ reflect Competitiveness/ level of emphasis Environmental Perception of Step Feature among analysts) integrity Market operations fairness 1. Scope Sector and gas coverage (including opt-in/ ✔ opt-out provisions) Point of regulation 2. Cap Nature of cap (absolute/intensity, mandatory/ ++ ✔ ✔ voluntary) Acceptable stringency of cap ++ ✔ ✔ 3. Allocation Auctioning vs. free allocation ✔ Allocations rules (including for new entrants ✔ and closures and for trade-exposed industries) 4. Offsets Offset provisions (quantity and quality) ++ ✔ ✔ ✔ 5. Timeframe Commitment periods + ✔ ✔ ✔ Compliance periods ✔ Banking and borrowing + ✔ ✔ ✔ 6. Market Stability Stability mechanisms (e.g., price floors/ceilings, + ✔ ✔ ✔ reserves) 7. Oversight and Market oversight (including public disclosure of + ✔ compliance information) Robustness of MRV ++ ✔ Stringency of enforcement + ✔ ✔ ✔ Registry design and allowance tracking ✔ ✔ Source: Based on material from PMR’s Lessons Learned from Linking Emissions Trading Systems: General Principles and Applications; ICAP’s Linking Emissions Trading Systems: A Summary of Current Research; EBRD’s Carbon Limits; and Thomson Reuters Point Carbon’s The Domestic Trading Scheme in Kazakhstan: Phase II, Task 2: Road Maps for Linking Cap and Trade Systems with External Emissions Trading Systems. 9. LINKING 162 EMISSIONS TR ADING IN PR ACTICE ▲▲ Cap type. Linking a system with an absolute cap to a BOX 9.5 CASE STUDY: Linkage between Australia system with an intensity-based cap (indexed to output or and the EU GDP, for example) is theoretically possible, but practically very challenging. In particular, intensity targets are often ▲▲ In August 2012, Australia and the EU agreed to perceived as less stringent than those under an absolute negotiate and finalize a full two-way link. In contrast to the California/Québec case, the EU and Australia ETSs cap (though this technically depends on relative economic had not been mutually designed with an expectation growth rates). This may lead to challenges in reaching of linkage to each other. As a result, at the point of agreement over whether the ambition in the two systems announcing the plans to link, it remained to be seen is sufficiently similar, a factor that, as discussed in 3.1, can if many design features had to be harmonized fully. often hold back linking.163 The linkage agreement was to be implemented in two stages, in order to analyze, negotiate, and implement Boxes 9.5 and 9.6 provide more detail on the discussions any changes to either system that would need to occur surrounding consistency and convergence of the design of ETS in order to facilitate linking. These changes related, in in the case of the link between the Californian and Québec particular, to the removal of the Australian carbon price systems as well as the proposed link between the Australian floor and the reduced use of Kyoto units. CPM and the EU ETS. They illustrate, in particular, that linking ▲▲ In the first stage, Australia and the EU announced a may be easier in cases where it is planned from the outset. one-way link, through which Australian entities would have been able to use EU allowances for compliance at the end of Australia’s fixed-price period ending on July 1, 2015. As part of this negotiation, Australia agreed on a further sublimit of 12.5 percent on the use of Kyoto offsets (CERs and ERUs) and land use-related Kyoto units (RMUs). Australia also agreed to drop its price floor. ▲▲ The second stage, a bilateral link, was planned to commence on July 1, 2018. This would have made EU and Australian allowances interchangeable, subject to a total limit of 50 percent of Australian companies’ compliance obligations being met using international units. ▲▲ The change in government in Australia led to the repeal of its Carbon Pricing Mechanism and thus the link with the EU, so it is unknown what further changes to either system might have been required and what design differences might have been allowed.a ▲▲ For a discussion of the proposed linking of registries, see Box 9.7. a World Bank (2014). 163 PMR (2014). STEP 9: LINK 163 BOX 9.6 CASE STUDY: Linkage between California and Québec Both California and Québec have committed to reduce their voluntary coalition in which participants drew up plans for a GHG gas emissions by 2020, in part through implementation nonbinding, voluntary agreement to reduce their collective of an ETS. California has committed to reduce its emissions to regional emissions to a level 15 percent below 2005 levels by 1990 levels, while Québec intends to reduce emissions by 20 2020. This collective goal lent itself to linkages among partner percent below 1990 levels. From an early stage in the devel- states and provinces—through collaboration, policy harmoni- opment of their respective ETSs, both jurisdictions intended zation, or, in the case of California and Québec, full linkage.a to eventually link their systems. The two systems officially The WCI recommendations were designed to be “integrated linked on January 1, 2014. into, or work in conjunction with any future U.S. or Canadian emissions-reduction programs.”b Both jurisdictions built their climate policies on the design recommendations of the Western Climate Initiative (WCI), a 2007 2008 2010 2011 2012 2013 2014 WCI is set up 2nd WCI Work on administrative Official link by 5 states, incl. CA recommendations issued aspects began QE and other states join, CA & QE adopted CA & QE both start WCI issued 1st recommendations WCI recommendations operating ETS and sign on regional ETS linking agreement Source: ICAP. California and Québec aligned most of their design elements. in demand for California-held allowances, leading to greater Before the link was official, they closely compared their in-state reductions.c, d In practice, all of Québec’s auctions regulations, identifying which provisions needed to be exactly before linking cleared at the floor price, while the price the same (or have the same effect) and which could differ. cleared above the floor price at the first joint auction held In the end, they decided the provisions that had to be com- in November 2014.e It is too soon to be definitive about the pletely harmonized included coverage and arrangements for reasons for these price movements. auctions, floor price, an allowance price containment reserve, banking (with enforced holding limits), and multiyear compli- ance periods. Issues on which they decided they could differ include offset protocols and recognition of early emissions reductions. Allowance prices responded promptly but partly in unex- a Purdon et al. (2014). b WCI (2015). pected ways to the establishment of a full link. Québec had c Purdon et al. (2014). been expected to benefit from cheaper allowances, while d Hsia-Kiung et al. (2014). California had been expected to benefit from a slight increase e MDDELCC (2016). 9. LINKING 164 EMISSIONS TR ADING IN PR ACTICE Three design elements related to enabling infrastructure BOX 9.7 CASE STUDY: Intended Australia-EU require alignment: Linkage – the Role of Registries a ▲▲ Robustness of MRV systems. Confidence that monitoring, Although Australia’s CPM was repealed before it ever linked reporting and verification should be equally robust in both with the EU (see Box 9.5), the two jurisdictions had already systems is critical to assuring comparability in terms of the begun analyzing many of the implementation details of environmental integrity of units. the proposed link, including the linking of their respective ▲▲ Stringency of enforcement. Authorities that exert compa- registry systems. The Australian government and the European Commission proposed six principles that any link rable levels of enforcement are required to ensure smooth between their registries should abide by: operation of the emissions market. If systems are not able to effectively enforce regulation at a comparable level, the ▲▲ Ensures the fungibility of allowances; environmental integrity of both linked systems will suffer. ▲▲ Ensures environmental integrity; Penalties for noncompliance should also be consistent, ▲▲ Ensures ease of use; otherwise noncompliance will happen mainly in the system ▲▲ Is complementary to the efficient operation of both with less stringent penalties. Market oversight, including registries for domestic purposes; the content and timing of public disclosure of information, ▲▲ Provides protected access to allowances; and could also be important to align. The EU and Australia identified oversight provisions as one of the issues to be ▲▲ Supports the development of international carbon markets. negotiated (see Box 9.7). ▲▲ Registry and tracking units. While systems can be For the first stage of the link (in which Australian entities theoretically linked without a direct registry connection, could use EU units for compliance, but entities in the EU would not be able to use Australian units), the negotiators ensuring compatible registry systems can greatly facilitate proposed an indirect registry link. Under this approach, creation of a linked market. The proposed link between no units would be directly transferred between registries. Australia and the EU raised issues that systems will have to Instead, when an EU entity sold to an Australian entity, address when linking registries (see Box 9.7). An example that unit would be held in an Australian government of successful linkage between registries is the Kyoto account in the EU registry and, in parallel an Australian- Protocol’s International Transaction Log (ITL). In order to issued international unit (AIIU) unit would be issued in trade Kyoto Protocol units (such as CERs) with one another, the Australian registry system to the purchaser. This AIIU jurisdictions (and the CDM registry) must go through the would shadow the unit held in the EU, but could be traded or surrendered for compliance in the Australian system. ITL. The ITL verifies the trades in real time, checking that When surrendered, an EU allowance held by the Australian national registries are recording unit holdings correctly government in the EU registry would then be canceled to and making sure transactions are in alignment with Kyoto avoid double counting. In addition, the AIIU could also be Protocol rules.164 traded back to the EU registry, in which case the relevant AIIU would be canceled and an EU allowance, held in the Australian government’s EU account, would be moved to the EU purchaser’s registry account. This was expected to help drive price convergence. a This case study was based on a report by the Commonwealth of Australia and EC (2013). 164 For more information on the ITL, see the UNFCCC’s webpage on the subject (UN- FCCC, 2014) as well as Wabi et al. (2013), which details the more technical aspects and requirements of the ITL. STEP 9: LINK 165 5.2 Aligning non-essential design features can change the distribution of auction revenues across systems, creating a potential need for agreement on the There is another set of program features that do not necessar- division of auction proceeds. ily need to be aligned for effective linking, but where alignment could help further address environmental and competitiveness ▲▲ Commitment periods. Alignment of time horizons across concerns, and help the market operate more efficiently.165 In systems may play a role in reaching agreement on pro- these cases, there may be a trade-off between alignment and grams’ ambition as well as to improve market functioning. efficiency, as maintaining diversity in program elements could Different commitment periods could produce market insta- improve liquidity and be beneficial to market operations. Five bility as a result of uncertainty over the future reduction elements where alignment could be considered but is not targets of the system with the shorter compliance time necessary, include: horizon. For example, the linked ETS programs of California and Québec currently run through 2020 but they are ▲▲ Scope. Two linked systems need not have exactly the same considering extension to 2030 or beyond (see Box 9.6). scope and, in fact, linking systems that contain different sources of emissions reductions can be a key economic ▲▲ Compliance periods. Equivalent compliance periods rationale for linking. On the other hand, linking two for entities could facilitate joint program administration. systems that cover the same sectors that compete with However, different compliance periods could also be bene- each other internationally can help address competition ficial, as they would improve liquidity. and potential leakage issues. For example, the European Some design features that do not strictly require alignment Commission deemed expanding the coverage of the Swiss might be transmitted across a linked system and therefore ETS to aviation essential for its link with the EU ETS in order need to be considered carefully by policy makers. This trans- to address potential carbon leakage issues. mission occurs in three main areas: ▲▲ Point of obligation (or “regulation”). While different ▲▲ Borrowing. If one system allows borrowing to a greater points of obligation are not necessarily barriers to linking, degree than the other, and if prices rise upon linking, they will require careful accounting adjustments. For entities in the former system may be incentivized to borrow example, if one system regulates emissions at the point more. They could then sell those borrowed units (or the of electricity generation and another system at the point present-day vintage units they replace) to the second sys- of electricity consumption (e.g., industrial facilities or tem, even though entities in that system may not borrow residential buildings), accounting adjustments would need for themselves. to be made where electricity is traded across the borders of linkage partners to ensure coverage and avoid double ▲▲ Banking. Similarly to borrowing, if a system that restricts counting of emissions. banking sells units to another system where greater bank- ing is possible, this will erode the effects of the restriction. ▲▲ Allocation methods. Different allocation methods do not affect environmental integrity, as long as the cap is fixed. ▲▲ Price predictability and cost containment mechanisms. However, they could present political, competitive, and Linking effectively provides all market actors with access distributional challenges for linking. If a system with free to the most favorable price and quantity management allocation links with one that auctions allowances, indus- mechanisms anywhere within the system. For example, a tries might view their competitors’ allocations as unfair. The price floor in one system will no longer be effective if there EU and Australia identified provisions to preserve competi- are enough allowances below that price in the other sys- tiveness in sectors subject to carbon leakage as one of the tem. Similarly, a hard price ceiling in one jurisdiction could issues to be negotiated (see Box 9.7). In addition, linking compromise the cap for both jurisdictions.166 9. LINKING 166 For example, Australia dropped its price floor as part of its buy-link agreement with the EU, given that EU prices were significantly below the floor and thus would have undermined or complicated the maintenance of the floor. Similarly, Australia set its 165 The list of design features to harmonize in order to maintain environmental integrity price ceiling equal to the allowance price in the EU, rendering the role of the ceiling was adapted from Sammut et al. (2014). moot. 166 EMISSIONS TR ADING IN PR ACTICE 6. Formation and Governance 6.2 Choosing the linking instrument of the Link Bilateral linking instruments may include formal treaties, nonbinding agreements, and MOUs, while unilateral links will If the issues raised in the preceding sections are addressed, only require action by one government, as long as the seller it is possible to proceed to formal linking, which will include authorizes the sale of units. Important questions to ask about establishing the required governance arrangements. This a linking instrument include: involves considering the timing of the link (section 6.1), choos- ▲▲ Should the instrument be legally binding or not? ing the linking instrument (section 6.2), identifying institutions to govern the link (section 6.3), and preparing a contingency ▲▲ If a linking instrument is nonbinding, how can it be assured plan for delinking (section 6.4). that the regulator of each linking partner has sufficient enforcement scope to address all of the potential issues associated with the linked program? 6.1 Timing of the link Several elements need to be considered in relation to the ▲▲ How will the instrument be designed to provide sufficient timing of a link: certainty about the link’s longevity? ▲▲ Early changes. The history of ETS, notably the EU ETS, ▲▲ How will the instrument address the process for suggests that various design features tend to evolve in the collaboration? early years of a system. This is consistent with the discus- ▲▲ How will design changes, including revisions to the cap and sion in Step 10 regarding pilots. In cases where there is a the potential to delink, be addressed in future? reasonable probability that design features may be subject ▲▲ Which institutions should be established or designated by to change or evolution, it may be better to delay a formal the instrument to govern the link? link, as it is much more difficult to refine the design of an ETS once it has been linked with another. The answers to these questions will depend on the particular ▲▲ Prealignment. Timing the implementation of a link depends legal context in the respective linking jurisdictions. To date, on the extent to which systems are prealigned. California linking via formal treaty has not been implemented, although and Québec engaged in a multiyear collaborative process the EU-Australia link would have been formalized in a treaty under the WCI before formally linking, in one step, in 2014. and the EU-Switzerland link will use this mechanism. Joining By contrast, the proposed EU and Australia link would have the EU ETS has primarily been accomplished automatically by occurred between ETSs that had formed independently, either joining the EU itself (in the case of Cyprus and Malta) without an initial intent to link; in this case, a two-step or, in the case of Norway, Liechtenstein, and Iceland, via a approach was proposed, with a unilateral and then bilateral decision at the level of the European Economic Area (EEA) to linkage in order to provide sufficient time for the alignment adopt the EU ETS Directive. In the California-Québec linkage, process. each partners’ ability to create a binding linking agreement was limited by their subnational status, notably that of the ▲▲ Objectives for linking. Whether linkage occurs alongside United States, where treaty making and the ability to create the launch of an ETS or afterwards may depend on the binding agreements between sovereign states is solely objectives for linking. Where linking is sought mainly to reserved to the federal government. Thus, both California provide depth and liquidity, early linking may be desirable and the RGGI states have resorted to nonbinding agreements to promote the viability of trading within the ETS. By that nevertheless provide a transparent approach to linkage. contrast, if linking is pursued to contain costs, immediate California has also entered into a number of MOUs with other linkage may not be as critical as the level of ambition, and governments that are considering or are in the process of other features in the early stages of the ETS will tend to developing an ETS (e.g., China and Mexico), as well as with keep costs low to smooth the transition into the system. the states of Chiapas (Mexico) and Acre (Brazil) regarding development of REDD+ crediting systems.167 The process of developing the MOU allows all parties to discuss and lay out transparently what they would like to achieve through a col- laborative information-sharing process and gives participants a baseline against which to measure progress. 167 Hsia-Kung and Morehouse (2014). STEP 9: LINK 167 6.3 Establishing institutions to govern a BOX 9.8 CASE STUDY: Delinking in RGGI link The Regional Greenhouse Gas Initiative (RGGI) was origi- Institutions to govern a link may include a provider of market nally made up of 10 Northeastern and Mid-Atlantic states services and a transparent system for design changes: in the United States that joined together to collectively ▲▲ A single provider for market services and oversight. Both reduce GHG emissions in their electricity sectors. The RGGI California and Québec (and the RGGI states) have set up a Memorandum of Understanding (MOU) set the overall not-for-profit entity that provides program administration cap and each state’s share of the cap for each 3-year compliance period. In May 2011, Governor Chris Christie services. These services include administering an allowance announced that New Jersey would withdraw from RGGI tracking system, administering auctions, and monitoring ahead of the Second Commitment Period (2012–14). The the market for fraud or manipulation. By using a single MOU stated that a state “may, upon 30 days of written provider for these services, linked systems are able to notice, withdraw its agreement to [the] MOU and become create administrative efficiencies and reduce costs.168 Joint a Non-Signatory State.”a auctions can also facilitate harmonization of the carbon The RGGI cap had to be modified to take into account the price across linked markets. fact that 40 previously regulated emitters from New Jersey ▲▲ A transparent system for ETS design changes. New would be leaving the system. The only guidance given in the MOU was that, in the event of a state’s withdrawal design features that need to be harmonized across linked from the system, “the remaining Signatory States would systems require a transparent process. This is especially execute measures to appropriately adjust allowance usage important for linked systems with nonbinding linking to account for the corresponding subtraction of units from instruments that retain complete sovereignty for each par- the Program.” New Jersey’s withdrawal from the system ticipant, such as the link between California and Québec. reduced the cap from 188 million to 165 million short ton For example, California and Québec both have regulatory of CO2 for the second compliance period.b New Jersey processes that require notice and opportunity for public completed the first compliance period before officially comments before changes are implemented. They spe- withdrawing. cifically recognize the need to continue harmonizing their When New Jersey left, it had already sold approximately ETS design and provide adequate notice of any changes.169 300,000 CO2 allowances for 2014 and as RGGI allows RGGI, working with a larger collaborative of nine states, unlimited banking and was significantly overallocated for the first compliance period, some of New Jersey’s relies on a Model Rule that is reviewed every three years.170 allowances remained in circulation and available for use. States adopted individual regulations based on the original Consistent with RGGI’s commitment to allow unlimited Model Rule and can update their regulation as the over- banking of allowances by market participants, the other arching Model Rule changes. RGGI member states decided to recognize all outstanding New Jersey allowances for compliance purposes.c While 6.4 Preparing a contingency plan for the cap was adjusted to compensate for the withdrawal, other states may have lost some revenue as a result of delinking
 New Jersey’s action. Three issues have to be considered when structuring a linking In this case, delinking was actually part of a complete agreement with an eye to potential delinking in the future: dismantling of the cap-and-trade system in New Jersey. ▲▲ Adjustment of the cap. If one system delinks from the Notably, the impacts on the broader RGGI program were other, this will affect prices in both systems. Policy makers minor, and the experience established a method by which may wish to consider in advance whether such a develop- an orderly withdrawal of a linked state could occur at the end of a compliance period. ment would require a change in the cap or other market features (see Step 10 for a more elaborate discussion on responding to evolving circumstances). 9. LINKING ▲▲ Treatment of allowances from another system.171 If permits from another system can be identified as such and are no longer valid after delinking, any speculation about 168 Kachi et al. (2015). a RGGI (2005). 169 ARB and Government of Québec (2013). b RGGI (2016). 170 RGGI (2014). c RGGI (2011). 171 See Comendant and Taschini (forthcoming), which includes a discussion of how to deal with such “contaminated” allowances. 168 EMISSIONS TR ADING IN PR ACTICE delinkage will cause prices of permits in the linked systems to diverge. The cheaper units will be used as much as pos- QUICK QUIZ sible before delinking and valuable units will be banked.172 Conceptual Questions ▲▲ Process for delinking. Delinking may occur due to a ▲▲ What are the main advantages of linking and what risks or build-up of issues over time or a sudden (political) event. downsides could this bring, taking into account economic For example, political changes in New Jersey led the state as well as political and strategic factors? to withdraw from RGGI (see Box 9.8). Under some circum- ▲▲ What are different ways to link ETS? stances (e.g., a temporary enforcement issue), a temporary ▲▲ What program design features are likely to require harmo- suspension of a link rather than a complete delink might nization under a link? be desirable. A clear exit strategy will make negotiation on the inevitable changes to adapt to new conditions easier Application Questions and minimize problems if delinking is necessary. This is ▲▲ How important may linking be for your jurisdiction’s ETS? especially critical for links between jurisdictions that do not ▲▲ What goals might different approaches to linking achieve have a close history of interaction on other issues. for your ETS? ▲▲ Whowould be your preferred linking partners, and why, when, and how might you pursue linking discussions? 172 See Pizer and Yates (2015) for an analysis of the impact of different treatments of banked allowances under delinkage. STEP 10: IMPLEMENT, EVALUATE AND IMPROVE 169 STEP 10: IMPLEMENT, EVALUATE AND IMPROVE At a Glance__________________________________________________________________________ 170 1. Timing and Process of ETS Implementation____________________________________________ 171 1.1 Before implementation_______________________________________________________ 171 1.2 Starting with a pilot__________________________________________________________ 171 1.3 Gradual implementation_______________________________________________________174 2. ETS Reviews and Evaluations________________________________________________________ 177 2.1 Rationale for reviews_________________________________________________________ 177 2.2 Types of reviews_____________________________________________________________ 177 2.3 Gathering data for reviews and evaluations______________________________________ 180 2.4 Processes for responding to a review___________________________________________ 181 Quick Quiz___________________________________________________________________________ 182 10. EVALUATION 170 EMISSIONS TR ADING IN PR ACTICE AT A GLANCE ✓✓ Decide on the timing and process of ETS implementation ✓✓ Decide on the process and scope for reviews ✓✓ Evaluate the ETS to support review Moving from design to operation of an ETS requires govern- ▲▲ Price controls: The government may wish to provide a ment regulators and market participants to assume new roles higher degree of price control at the outset of an ETS, and responsibilities, embed new systems and institutions, and when the public and financial institutions needed for launch a functional trading market. trading are still at a nascent stage; and ▲▲ Linking: Linking may be planned for a later stage in ETS Every ETS has required an extensive preparatory phase to development once an ETS is more established. collect data and develop technical regulations, guidelines, and institutions. In addition, some jurisdictions have used explicit Circumstances will change and experience will generate pilot periods. These allow all parties to test policies, systems, learning about the ETS. Reviews of ETS performance—both and institutions; build capacity; and demonstrate effectiveness. frequent regular reviews and less frequent systematic This may be particularly valuable if the jurisdiction faces inter- reviews—will enable continual improvement and adaptation. nationally distinctive conditions. However, if the pilot reveals These should be complemented by rigorous independent challenges, it runs the risk of undermining public confidence evaluation, and both reviews and evaluations should be facili- in the ETS before it fully commences. If a pilot is considered tated by starting data collection before commencement of the desirable, policy makers will need to judge the scope and system (as existing data sets and systems are unlikely to be length carefully to obtain a sufficiently representative under- sufficient) and making entities’ data public where possible. standing of the market and policy, while still incurring and imposing costs consistent with a pilot phase. Any possible changes resulting from these reviews need to be balanced against the risks of policy uncertainty. The latter can An alternative or addition is to gradually phase-in some design be mitigated by establishing transparent, predictable processes features of the ETS. This will allow learning-by-doing, easing by which ETS changes are communicated and implemented. the burden on institutions and sectors. Some of the key design features that may be phased in include: This chapter looks at the process of implementation, evalu- ation, and review. Section 1 considers how a full-scale ETS ▲▲ Coverage: An ETS might start with a limited number of can be gradually “rolled out” and how program features can sectors and thresholds that target the most significant be designed to evolve over time in a predetermined manner. mitigation opportunities, before expanding over time; Section 2 examines how implementation can be evaluated and ▲▲ Cap stringency: Gradual introduction can allow ambition, reviewed so the necessary adjustments to the system can be and associated costs to participants, to grow more slowly; made, while also balancing the need for predictability. ▲▲ Free allocation: Often the proportion of allowances allo- cated for free starts high and falls over time; STEP 10: IMPLEMENT, EVALUATE AND IMPROVE 171 1. Timing and Process of ETS In particular, before compliance or trading begins, it is neces- sary to ensure there are adequate MRV measures in place. As Implementation discussed in Step 8, pre-ETS MRV measures can: The implementation of an ETS requires a large number of ▲▲ Improve the quality of data for setting the cap and making timing and process decisions. Policy makers often choose choices about distribution of allowances; to commence an ETS with a trial or pilot period to test and ▲▲ Support capacity building by both participants and regula- confirm the appropriateness of some of these key decisions. tors as well as legislators; and For instance, Phase I of the EU ETS served as a sort of trial for this system. China is conducting seven regional pilots that are ▲▲ Test government administrative and compliance mecha- helping inform the future national system. Kazakhstan similarly nisms before units must be surrendered. had a formal, one-year trial phase.173 By contrast, California Both Australia and New Zealand had mandatory reporting in launched its full ETS with no formal pilot or testing phase place before ETS obligations. New Zealand phased sectors into except for a practice auction, although it too phased in some the ETS by having one year of voluntary or, for most sectors, elements such as coverage of certain sectors and the share of mandatory reporting prior to the introduction of the ETS unit allowances auctioned.174 surrender obligation. The political and economic feasibility of Pre-implementation phases that set out measures to collect introducing mandatory reporting before deciding to introduce data, establish MRV procedures, or create the necessary insti- an ETS will vary by country. In the Republic of Korea, the tutional arrangements can also serve as partial pilots on the Target Management System has formed the basis for its ETS, way toward ETS implementation without being perceived as a as discussed in Box 10.1. formal ETS pilot. However, incentive structures are important However, while mandatory reporting and related initiatives can and even highly technical elements of an ETS need to be road- yield important insights, in many cases, experience and capac- tested. Pretested methodologies and procedures will require ity can be derived only from pilots or (phased) implementation further testing in the framework of a fully operational ETS. of an ETS itself, including the respective incentive structures. This section discusses measures required before implementa- These are discussed in the following two sections. tion; the objectives of and design choices to be made when starting with an ETS pilot; and the objectives and elements of BOX 10.1 CASE STUDY: Korea’s Target gradual implementation. Management System Korea’s Target Management System (TMS) was introduced 1.1 Before implementation in 2012. It involved both mandatory reporting and As discussed in Step 8, it is crucial to allocate sufficient time firm-specific emissions reduction targets, applied to the before implementation for: same parties that were expected to be regulated by the Republic of Korea ETS. The TMS smoothed the transition ▲▲ Expert advice; into the ETS by developing the necessary MRV processes. ▲▲ Data collection; It also helped define the scope and points of obligation, while the data collected provided the government with a ▲▲ Development of ETS regulations and guidelines; basis for determining free allocation and the total cap for ▲▲ Designation or establishment of supporting institutions; the ETS. For companies, the TMS yielded insights into how emissions/abatement costs could be reduced, further facil- ▲▲ Establishment of registry and trading platforms; itating the implementation of the Republic of Korea ETS. ▲▲ Capacity building among regulators, ETS participants, trad- ing entities, and other service providers or stakeholders; and ▲▲ Public education about the system, possibly including a 1.2 Starting with a pilot voluntary trading system and/or ETS simulations for stake- A pilot is a mandatory program that is explicitly framed as a holder engagement and training. testing or learning period with a specific end date, and for which the regulator clearly signals that the system could 10. EVALUATION significantly change after the pilot ends. This section outlines the objectives of a pilot before discussing their implications for 173 See Sergazina and Khakimzhanova (2013). appropriate design. 174 See ARB (2014). 172 EMISSIONS TR ADING IN PR ACTICE 1.2.1 Objectives of pilots of the EU ETS, while not officially framed as a pilot phase, Pilots have three main objectives: followed this model. Alternatively, the pilot might cover fewer sectors or, as in China, have a more limited geo- ▲▲ To test policy, methodologies, systems, and institutions: graphic scope (see Box 10.2). A narrower scope allows key Pilots can help identify problems related to, for example, policies and institutions to be tested without imposing the data collection, data reporting, database management, same costs (on both the government and covered entities) conflicts with existing legislation, the need for new legis- as a broader pilot would. However, the pilot may not be lation, or the need for improved market oversight. They representative if it does not cover all market participants. can highlight current policies and systems that should be adjusted to effectively implement an ETS; ▲▲ Cap stringency: Some jurisdictions have decided to impose a less stringent cap in the pilot period, since this will not ▲▲ To build capacity in advance of full ETS implementation: directly influence the functioning of the market in the long Pilots, in contrast to ETS simulations or voluntary trading term. However, the benefits gained from experimentation (see Step 8), require actual implementation of ETS legisla- must be balanced against the downsides of lower incen- tion, systems, and the institutions that will support the ETS. tives, a slower start to full market operation, and lower If the pilot is successful, the institutions and infrastructure initial ambition. Lower stringency in a pilot period may also built for the pilot can usually be used in the full ETS. In create a path dependency and generate expectations, addition, pilots can help build regulatory and advisory making it more difficult to transition to a significantly more capacity through training of ETS consultants, verifiers, and ambitious ETS once the pilot ends. intermediaries, as well as the capacity of regulated entities; and ▲▲ Carryover of units: A decision also needs to be made whether units from the pilot may be carried over into the ▲▲ To demonstrate effectiveness: Pilots may be particularly full-fledged ETS. However, as discussed in Step 5, restrict- valuable if the jurisdiction has characteristics that differ ing banking from a pilot to later phases reduces the risk from those in other jurisdictions with an existing ETS. In that undesirable market features in the pilot carry over into these cases, a pilot can serve to fine-tune ETS design the full implementation phase. elements and demonstrate overall ETS impact within the jurisdiction. As a result, they can support implementation during subsequent phases, as policy makers can draw on 1.2.3 Limits of pilots While well-designed pilots can achieve many of the objectives practical experiences, in addition to theoretical models. outlined above, the lessons they hold for policy makers in terms of effectiveness of ETS design are nevertheless limited. 1.2.2 Pilot design For example, pilots are unlikely to be sufficiently long or ambi- There are several choices policy makers must make when tious to trigger the large investments that will cause major designing the pilot: emissions reductions. ▲▲ Length: When choosing the length of the pilot period, it is important that the time frame chosen be consistent with In addition, there are risks associated with ETS pilots in terms its objectives. If the principal aim is to collect data, a short of public perception and loss of support if experiments are pilot period may be sufficient, and the first compliance not viewed as successful. While the first phase of the EU phase can begin immediately after the end of the trial ETS brought a wealth of market and operational experience phase. However, if the objective is to build capacity and for governments and companies, it culminated in a sharp test systems, a longer pilot phase may be required. A lag allowance price decline, which had a negative impact on public prior to full implementation may also be necessary to make perception, as discussed in Box 10.3. Clearly communicating changes to systems. and managing expectations regarding a pilot phase will be important to mitigate such risks. In contrast to the EU expe- ▲▲ Coverage: Policy makers can choose to design a sys- rience, California chose not to use a pilot phase, but instead tem-wide pilot that covers as many entities as are due to went through a long planning process starting with discussions participate in the full compliance period. The first phase within the WCI. STEP 10: IMPLEMENT, EVALUATE AND IMPROVE 173 BOX 10.2 CASE STUDY: Chinese Regional ETS BOX 10.3 CASE STUDY: Lessons Learned from Pilots Phase I of the EU ETS On October 29, 2011, China’s National Development and The EU included what amounted to a trial phase in its ETS Reform Commission (NDRC) issued notice to establish ETS design—Phase I, which ran from 2005 through 2007, and pilots, with the purpose of implementing the 12th Five- allowed no banking of allowances into Phase II. In this Year Plan’s requirement to gradually establish national learning-by-doing period, both regulators and covered carbon trading markets and promote market mechanisms entities were able to gain experience with emissions trading. to achieve by 2020 China’s goal of controlling greenhouse As stipulated in Article 30 of the Directive establishing the gas at a low cost.a Among other objectives, the NDRC EU ETS, a full review of the EU ETS was then mandated directed the pilot regions to define the total GHG before the end of Phase I.a emissions control target, formulate an allocation plan, The first Phase was successful in creating a functioning establish a local carbon trading supervision system and market for allowances and putting a price on CO2 emissions registry, and establish a trading platform. so that, for the first time in Europe, emissions were of This pilot approach is based on the Chinese tradition of concern to financial controllers/accountants and not just shìdiǎ n (试点), wherein prior to launching a large govern- environmental and production staff. However, overallocation ment program it is considered prudent to first road-test of allowances during this trial phase ultimately led to a different variants of the proposal in multiple regions steep decline in carbon prices, with negative repercussions that feature different socio-economic circumstances. for public perceptions of the EU ETS. Based on the experi- This learning-by-doing approach allows policy makers to ence in Phase I, the Working Group charged with the review simultaneously avoid risks inherent in a one-size-fits-all assessed possible policy options to improve the system policy, discard those approaches that have proven to be going forward. In particular, they identified four major inadequate, and discover approaches that are particularly issues: appropriate to China’s diverse and unique circumstances. ▲▲ The process by which member states determine the free The pilot regions include the cities of Beijing, Chongqing, allowances for covered entities in their country, through Shanghai, Shenzhen, and Tianjin, and the provinces the National Allocation Plans (NAP), tended to overesti- of Hubei and Guangdong.b Collectively these areas mate emissions projections, giving regulated entities a represent approximately 29 percent of China’s 2014 GDP, higher allocation than needed and leading to low prices. and have a population of about 256 million. The first This reduced the incentive to invest and innovate; pilot (Shenzhen) was launched in June of 2013; the last (Chongqing) was launched a year later. Initially, the pilots ▲▲ The lack of harmonization across member states in their were scheduled to run for three years, though some of approach to determining NAPs caused distortion of them may be extended (see below). competition; ▲▲ Firms in some sectors receiving free allocation were able Lessons learned from regional pilots to pass through the market value of allowances in the Through a process of trial-and-error, the local officials form of higher prices for consumers, leading to windfall charged with developing and running the pilots are profits, with negative distributional impacts; and looking to craft programs that are tailored to their circumstances. Meanwhile, those developing a national ▲▲ The approval of NAPs was complex, and created a lot of ETS are monitoring the progress and implications of these uncertainty about the overall cap of the EU ETS.b policy experiments. The first phase was valuable in that it allowed these NDRC policy makers are thinking carefully about how to issues to be identified and addressed in subsequent segue from the current pilots to a national ETS. While it phases.c In particular, since Phase III, the Commission has is possible that the pilots terminate in their current form, centralized both the cap process and the allocation method. it is also plausible that some elements of the individual Additionally, only sectors considered at risk of carbon pilots will be incorporated into a successor, national ETS. leakage receive free allocation of allowances.d Further, local programs may in parallel cover entities that are excluded from a national ETS. In these instances, national and local policy makers may work together to a European Council (2003). b See EC (2008a); reports of all Working Group meetings are contained in Annex 1. identify program elements necessary to facilitate some c European Council (2009). degree of interaction and allowance/credit fungibility d The power sector receives no free allocation in Phase III as it is considered between the national and regional programs. capable of passing on the cost of carbon to consumers and industry. The rules 10. EVALUATION for Phase III also include possible adjustments in the free allocation from year to year, depending on whether there were substantial changes in activity level at the covered installations, whereas in Phase I and II no ex post adjustment was a NDRC (2011). allowed. b Zhang et al. (2014). 174 EMISSIONS TR ADING IN PR ACTICE 1.3 Gradual implementation include. It can then expand to include additional sectors and/or a larger number of participants over time; In addition to, or instead of, a pilot, policy makers may wish to consider gradually implementing aspects of the ETS. In con- ▲▲ Cap stringency: Gradual introduction can allow ambition, trast to a pilot, gradual implementation envisages a particular and associated costs to participants, to grow more slowly. end design of the ETS from the outset, but phases in the intro- The cap on emissions may be set at a less ambitious (more duction of some of the design elements. This section outlines generous) level at the outset and gradually be reduced the objectives of such a transition (and hence the benefits it over time; may bring), its elements, and some of the challenges it may ▲▲ Free allocation: Levels and methods of free allocation pose. could transition over time. Grandfathering for stranded asset compensation or to prevent emissions leakage may 1.3.1 Objectives of gradual implementation be necessary at the start of an ETS. However, even if major Similar to pilots, the objectives of gradual implementation are: trade competitors do not adopt comparable carbon pricing ▲▲ To build capacity: Gradual implementation can allow for mechanisms, taxpayers may not be willing to support capacity building both inside and outside of government, trade-exposed sectors indefinitely (see Step 3), and so free to build confidence in effective ETS operation before allocation methods may be reduced, phased out, or shifted obligations apply more broadly or with greater stringency, to more sophisticated approaches (benchmarking, OBA) or more complicated rules are introduced; over time. If free allocation is reduced, the introduction of large-scale auctions needs careful testing and upscaling; ▲▲ To test systems: While gradual implementation is associated with a particular ETS design in the long run, it ▲▲ Price controls: The government may also wish to provide nonetheless provides an opportunity for early review of the a higher degree of price control at the outset of an ETS, first stages of implementation, and for altering plans for when public and financial institutions needed for trading later stages accordingly; are at a nascent stage. The system may then transition towards greater liberalization as carbon pricing becomes ▲▲ To reduce upfront costs associated with implementa- more geographically widespread, the market matures, and tion: Introducing an ETS is a complex process, and the linking to other markets becomes feasible. The Australian perceived risks and costs of failure can be high (environ- ETS was an example of where the government had mentally, economically, socially, and politically). By moving intended to gradually relax price control features in order gradually, policy makers can mitigate some of these risks to allow time for the market to mature (see Step 6); and and complexities. Once each part of an ETS is operating, the costs and capability needed to sustain the system fall ▲▲ Linking: Some ETSs may launch as linked systems with significantly; and other jurisdictions from the beginning. However, in other cases, policy makers may want to preserve options for ▲▲ To enable time for adjustments in interlinked regulatory future linking in early phases and ensure their own ETS is frameworks: An ETS introduces a new commodity into the robust before establishing formal linking arrangements (see market, with far-reaching ramifications for other regulatory Step 9). frameworks, such as energy market regulation, competition policy, and financial market oversight. Not all interlinkages will be discovered fully ex ante or during a pilot phase. 1.3.3 Challenges associated with gradual implementation The following challenges are associated with gradual implementation: 1.3.2 Elements of the transition Some of the key design features of an ETS where a gradual ▲▲ Reduction in overall ETS impact: The overall environmen- implementation approach might be adopted include: tal impact of the ETS may be lower if fewer sources are covered initially. There will also be a loss of cost effective- ▲▲ Coverage: An ETS might start with a limited number of ness compared to the full market. As a result, the overall sectors and with thresholds that target the most significant emissions goals and cap needs to be adjusted to account emitters and those that are relatively straightforward to for lower coverage (see Step 2); STEP 10: IMPLEMENT, EVALUATE AND IMPROVE 175 ▲▲ Carbon leakage: Another, related concern is the potential for leakage between cov- TABLE 10.1 Timelines of Significant Changes in Five ETS ered and uncovered sources and sectors. Regional Greenhouse Gas Initiative (RGGI) This is likely to be only a short-term risk if it Date Event/Changes Made is clear that the uncovered sources will be 2005 MOU signed by the governors of Connecticut, Delaware, Maine, New Hampshire, New Jersey, New York, and Vermont. Model Rule outlines the framework for an entering the system in the medium-term. ETS. In this case, long-term investment decisions 2006 Substantive amendments made to Model Rule in response to public comments. should not be affected; 2007 RGGI, Inc. was established in July 2007, and Maryland, Massachusetts, and Rhode ▲▲ Perverse incentives: If sources are Island join RGGI. excluded from the initial stages of the ETS 2007–08 States codify Model Rule in state-specific legislation and/or regulation. but expect to be covered later, there may 2008 First auction held. be an incentive to bring forward emissions 2008–10 Offset protocols developed. from the future to an earlier point in time, 2009 First compliance period begins. to reduce their future liability. For example, 2011 New Jersey announces intention to withdraw. actors downstream from the point of obli- 2012 New Jersey withdrawal effective. gation could have an incentive to stockpile Cap reduced to 165 million short tons of CO2. high-emission fuels or products to avoid 2013 Updated Model Rule released after 2012 review: lowers cap; introduces Cost Containment Reserve and interim control period. future price increases. In New Zealand, even though forestry was the first sector 2014 Cap reduced to 91 million short tons of CO2. covered, once it was known that forest European Union Emissions Trading System (EU ETS) clearing would be covered in the ETS as of Date Event/Changes Made January 1, 2008, actors increased forest Sectoral coverage and linking Allocation clearance to reduce future liabilities (see 2007 Bulgaria and Romania accede to EU; join EU ETS. Box 1.6 in Step 1); (Start Phase I) ▲▲ Political expectations: A high initial cap Norway unilaterally links to EU ETS. risks low prices that may harm system 2008 ETS expands to include EEA countries (Iceland, Member states can auction credibility and reduce expectations for Liechtenstein, and Norway a). up to 10 percent of (Start Phase II) allowances. longer-term prices. Market participants may N2O emissions from production of nitric acid Penalty for noncompliance not be confident that the government will included. increases to €100/tonne. implement more ambitious caps in later 2012 Aviation sector included based on Directive stages; and 2008/101/EC. 2013 Rules for Phase III decided in Directive 2009/29/EC. Higher percentage of ▲▲ Stakeholders resistant to change: The auctioned allowances; (Start Phase III) Cap set at EU-level, decreasing linear trend set. initial market design could potentially create Auctioning becomes Post-2012 CERs from the CDM no longer accepted default for power sector. stakeholders that will be resistant to sub- (except from the LDCs). Projects involving the sequent change, making it more difficult to destruction of HFC-23 and N2O are excluded, regardless of the host country. move to the long-term desired design. For System expanded to include CO2 emissions from Free allocation determined example, sectors that are initially excluded petrochemicals, ammonia and aluminum; N2O by EU-wide, harmonized may find it easier to continue to resist emissions from nitric, adipic, and glycolic acid allocation rule. production; and perfluorocarbons (PFCs) from the entry (e.g., the agricultural sector in New aluminum sector. Zealand, see Step 1). Croatia accedes to EU; joins EU ETS. 2014 Backloading finalized, 900 million allowances moved The following tables provide a timeline for from 2014–16 auctions to 2019–20. significant policy changes in five ETSs. The last 2019 Market Stability Reserve (MSR) to become table (on New Zealand) distinguishes between operational. changes due to phased implementation and a Norwegian ETS subsumed by EU ETS. continued on next page those resulting from a review. 10. EVALUATION 176 EMISSIONS TR ADING IN PR ACTICE TABLE 10.1 Timelines of Significant Changes in Five ETS (continued) California Cap-and-Trade Program Date Event/Changes Made 2009 Multiple public meetings on various aspects of a (future) California Cap-and-Trade Program. 2010 First Draft Regulation published, including offset protocols for U.S. Forest Projects, Urban Forest Projects, Destruction of Ozone Depleting Substances, and Livestock Manure Digesters. 2011 Final Regulation adopted (including four compliance offset protocols). 2012 Program “initiated.” 2013 First enforceable compliance obligation period starts. 2014 Program linked to Québec. Compliance Offset Protocol Mine Methane Capture (MMC) Projects adopted. 2015 Program expanded to suppliers of transportation fuels and natural gas. Rice cultivation offset protocol approved; forest offset protocol expanded. Québec Cap-and-Trade Program Date Event/Changes Made 2011 “Regulation respecting a cap-and-trade system for greenhouse gas emission allowances” and amendments to “Regulation respecting mandatory reporting of certain emissions of contaminants into the atmosphere” adopted to bring the latter in line with the rules adopted by the WCI. 2012 Amendment to Cap-and-Trade Regulation to set the operating rules of Québec’s offset system. Amendment to Cap-and-Trade Regulation allowing the linking of Québec’s system to that of California. 2013 Launch of the System. 2014 Program linked to California’s. 2015 Upstream fossil fuel suppliers and first deliverers of electricity added to the program. Québec signs MOU with Ontario and Manitoba expressing the intent to collaborate to link their (planned) systems under the WCI. New Zealand Emissions Trading System (NZ ETS) Date Event/Changes made Sectoral coverage Allocation and surrender provisions 2008 Forestry enters. a One-time allocation to pre-1990 forestry.a One-time allocation to fisheries.a Free allocation to EITE with planned gradual phaseout.a Forestry removals implemented.a NZ ETS opens to international trading and accepts Kyoto units for compliance.a 2009 Stationary energy and industrial processes scheduled to enter, 1-for-2 surrender obligations introduced.b NZ ETS but deferred to mid-2010.b Phaseout of EITE free allocation scheduled, but deferred to 2016.b Review Agriculture deferred to 2015 (originally scheduled for 2013), but subject to reporting obligation.b 2010 Liquid fuels sector enters.a Stationary energy and industrial processes enter.b 2012 Agriculture deferred indefinitely.b Fixed-price measure introduced.b NZ ETS 1-for-2 surrender obligations extended.b Review New Zealand did not take a target under the Kyoto Protocol’s second commitment period.b 2013 Waste sector enters.b Auctioning enabled (not implemented).b 2015 NZ ETS stops accepting international Kyoto units for compliance.b Note: CER = Certified Emission Reduction; CDM = Clean Development Mechanism; EEA = European Economic Area; EITE = Emissions-Intensive Trade-Exposed; WCI = Western Climate Initiative. a Denotes changes due to phased ETS implementation or planned prior to ETS launch. b. Denotes changes after ETS review. STEP 10: IMPLEMENT, EVALUATE AND IMPROVE 177 2. ETS Reviews and FIGURE 10.1 Stylized Model of the ETS Policy Cycle Evaluations This section examines the following ele- Pilot ETS implementation ments: the rationale for reviewing an ETS; the types of reviews; data requirements for OR reviews and evaluations; and processes for responding to a review. ETS Review Phased implementation preparation 2.1 Rationale for reviews Evaluations and opportunities to review and make changes to the program are Adjustments/policy re-design crucial parts of an ETS. The most successful systems will be those that have an efficient and politically acceptable process to respond to new information on program performance Author: ICAP. and to changing local and global circum- stances. Figure 10.1 depicts a stylized model of an ETS policy cycle, including the stages policies. These interactions need to be analyzed and reflected on a regular of review and subsequent adjustments of and systematic basis. the policy. Reviews provide an opportunity to balance the trade-off between predictability Reviews are mainly necessary for the follow- and flexibility that is inherent in all aspects of ETS design. Ideally, they need to ing reasons: be “predictably flexible”175—a robust and predictable process for evaluation and review provides flexibility for making policy changes at a predefined point. Other ▲▲ Changes in external conditions: aspects of ETS design can support predictability outside of the review process. For example, an economic shock or For instance, issuing some units a long way in advance and including provisions new technologies could alter the cost for banking can give firms a vested interest in maintaining the ETS and keeping a of meeting a given cap, requiring stable price in the long term (see Step 5). Similarly, as discussed in Step 1, intro- reassessment; ducing complementary policies can help increase perceived political commitment ▲▲ Changes in international climate pol- to the attainment of targets. icies: For example, international policy developments might require an increase 2.2 Types of reviews in cap ambition, or offer new linking or offset opportunities; Clearly defined objectives are critical to any effective review. Often it is the emer- gence of new policy objectives—or the need to create a new balance among ▲▲ Learning from ETS experience: Issues them—that can justify a review in the first place, regardless of the effectiveness will arise from lessons learned about of the ETS in meeting original goals. emissions trading since the initial design, and will need to be taken into account; Three main types of review can be distinguished: ▲▲ Responding to administrative issues: 1. Comprehensive reviews that amend fundamental aspects of the ETS; An ETS is complex and interacts in 2. Regular reviews that amend administrative or technical aspects; and complex ways with other laws and regulations. Administrative problems may 3. Evaluations that support both comprehensive and regular reviews. need resolution; and ▲▲ Reflecting the evolution of the energy and climate policy mix: An ETS may 10. EVALUATION interact with other energy and climate 175 World Bank Institute (2010) defines “predictable flexibility” as allowing “for timely revision when the underlying social and political circumstances have changed” while being “explicit in defining the conditions under which its terms should be revised.” Similarly, among many others, Stern (2008) notes the importance of predictably flexible policy in order to provide long-term planning while being flexible enough to adapt to changing circum- stances. 178 EMISSIONS TR ADING IN PR ACTICE 2.2.1 Comprehensive reviews 2.2.2 Regular reviews Comprehensive reviews partly assist in resolving the predict- Regular reviews are complementary to comprehensive reviews. ability-flexibility trade-off discussed above. Scheduling com- They tend to be more administrative or technical in nature and prehensive reviews at planned intervals creates an expectation can be scheduled or unscheduled. that fundamental changes will occur only at specific times, ▲▲ Scheduled reviews of an ETS allow policy makers to assess providing predictability between review periods. Some of the basic functionality and make any necessary changes to the key issues that might be explored during a comprehensive design of the system to improve that functionality. Early review include the following: reviews, in particular, provide a good chance to engage ▲▲ Systematic adjustment of the cap to take account of the with stakeholders, learn from their experiences, and build broader context, including any change in the jurisdiction’s understanding and acceptance of emissions trading. Yet overarching mitigation targets, economic development they also have their limits—the limited amount of data trends, the availability of new technologies, and the relative available may not be sufficient to draw robust conclusions ambition of carbon pricing or alternative mitigation policies about the system as a whole. In many cases, early in other jurisdictions; perceptions of effectiveness are therefore unlikely to be an appropriate basis for informing fundamental changes to the ▲▲ Evaluations of how the ETS has performed relative to design of an ETS. expectations for allowance prices, compliance costs, and potential for leakage and competitiveness impacts; and ▲▲ Unscheduled reviews are needed where: ▲▲ Analysis of how much the carbon price has influenced ▲▲ An urgent problem is leading an entity to face non- behavior and investment to reduce emissions, particularly compliance, despite its best efforts; relative to other drivers such as international energy prices, ▲▲ Laws or regulations are found to be in conflict; or commodity demand, and other policies and regulations. ▲▲ There appears to be a loophole in regulations that Reviews also offer an opportunity to refresh and refine stake- market actors are exploiting. holders’ and officials’ understanding of how an ETS can most In contrast to comprehensive reviews, issues that are technical effectively operate, helping protect core features. and legal can be managed largely through an administrative An effective, comprehensive review process is likely to involve process run by officials and regulators. These reviews will individuals and institutions who are respected for their benefit strongly from input by stakeholders who can provide competence, objectivity, and integrity. They should bring a practical insights into challenges and potential solutions. wide range of perspectives and be politically independent For instance, California regulators use an adaptive man- or bipartisan. The process needs to be well resourced, both agement approach to implementation, evaluation, and financially and in terms of time frames—giving enough time improvement. As issues arise, necessary actions or policies for input, analysis and deliberation. to improve the effectiveness of the regulation are proposed. The EU ETS is an example of how comprehensive reviews These go through a lengthy public consultation process before between different phases can allow for the design of an ETS the California ARB makes any amendments. to evolve over time, as explained in Box 10.4. However, this experience also illustrates that such planned reviews can 2.2.3 Evaluations provide less flexibility to respond to changing, short-term Evaluations help inform the comprehensive and regular review circumstances. As a result, in practice, the design elements processes. They perform three roles: of the EU ETS have been reviewed and changed also within ▲▲ To identify program features that are working well; phases. These ad hoc reviews are discussed in the following sections. ▲▲ To inform redesign of elements that may not be working as well as they could; and ▲▲ To more generally assess the future role of emissions trading within the climate policy mix. STEP 10: IMPLEMENT, EVALUATE AND IMPROVE 179 BOX 10.4 CASE STUDY: Structural Reviews of the EU ETS EU Parliament environment committee EU Parliament and Council Accelerated backloading 8 votes in favor of backloading confirm support for backloading put in legislation 7 6 Negative vote against backloading by EU Parliament Dec-contract price (€) 5 4 Positive vote on backloading 3 by EU Parliament EU Parliament environment 2 EU Parliament industry committee EU Parliament environment committee committee initiates track to votes against backloading votes in favor of amended backloading accelerate backloading 1 0 Jan 13 Apr 13 Jul 13 Oct 13 Jan 14 Apr 14 Source: World Bank (2014). Three institutions are involved in EU ETS legislation: result, it is proposed the annual reduction factor for the ETS the Commission, the Council, and the Parliament. The be increased from 1.74 to 2.2 percent. In addition, changes Commission initiates legislative proposals (including new reg- are proposed to better target the fixed number of freely ulations or amendments to existing ones) while the Council allocated allowances and to develop two funds to assist firms and Parliament can suggest amendments to any proposal, in mitigating their emissions. This review is being carried out and ultimately need to approve any proposal for it to enter by the European Commission, using extensive consultations into force.a with stakeholders and experts. Opportunities for review and reform of the EU ETS process Outside of these planned reviews and the associated amend- were planned from the outset. Directive 2003/87/EC, ments to EU ETS legislation, the EU has also made unplanned establishing the EU ETS, stipulates that: “On the basis of changes in response to changing circumstances. For example, experience of the application of this Directive and of progress in November 2012, the European Commission proposed achieved in the monitoring of emissions of greenhouse gases “Options to Reform the European Carbon Market.” This and in the light of developments in the international context, unscheduled review was prompted by the large and growing the Commission shall draw up a report on the application surplus of allowances, which had arisen largely because of of this Directive.”b The Directive specifies which elements of the economic crisis depressing emissions more than antici- the ETS should be reviewed and what questions the review pated. This has led to lower than expected allowance prices, should answer. It also required the Commission to propose with a range of associated challenges (see Step 6). amendments in light of the first review, to be submitted to The review resulted in two major interventions. With the first the Parliament and Council by the end of June 2006. intervention, as a short-term measure to respond to excess For its first review, the Commission gathered information supply in the market, the Commission “backloaded” 900 through a survey among participants and stakeholders, and, million allowances through an amendment to the Auctioning in 2007, commissioned a Working Group consisting of repre- Regulations. This shifted allowances that were going to be sentatives of all interested member states and sectors. This auctioned in 2014–16 to the 2019–20 auctions. The second Group discussed scope; compliance and enforcement; further intervention, to be implemented in 2018 and commence in harmonization and increased predictability; and linking with 2019, is to create a Market Stability Reserve (MSR), which is other ETSs.c Directive 2009/29/EC amended the original ETS intended to increase the resilience to major shocks by adjust- Directive to take into account lessons learned from Phase I ing the supply of allowances to be auctioned (see Step 6 for through this review. Updates included changes to coverage, more discussion). However, implementation of these amend- cap setting, and allocation.d ments has created some uncertainty, which in turn may have contributed to volatile prices, as shown in the figure above. The EU ETS is currently undergoing a second review, aimed at providing input to changes for Phase IV of the EU ETS (commencing in 2021) and implementing the ETS portion of a EC (2015b). the 2030 Climate and Energy Framework agreed upon by b European Council (2003), Art. 30. 10. EVALUATION European heads of state in October 2014. The framework c EC (2008a). stipulates that ETS sectors will have to reduce their GHG d See Ellerman et al. (2007) and Ellerman et al. (2010) on review and reform processes in the EU ETS. emissions by 43 percent below 2005 levels by 2030. As a 180 EMISSIONS TR ADING IN PR ACTICE Evaluations are important as they help policy makers address TABLE 10.2 Examining Final ETS Impact by questions such as the following: Evaluating Intermediate Impacts ▲▲ Environmental effectiveness: Are emissions lower than Intermediate Impacts of ETS Final outcomes of they would be otherwise? ETS Features (examples only) social concern ▲▲ Cost effectiveness: Are costs acceptable and lower than Scope Total and facility-level emissions they would be with alternative policies? and Cap Compliance rates Allowance ▲▲ Fairness: Do some groups, especially vulnerable ones, bear distribution Carbon prices excessive costs? Offsets Price pass-through Compliance periods/ Company Board attention In order to identify causal relationships, an evaluation of an banking Electricity dispatch order Low Emissions ETS needs to occur in reference to a “counterfactual” scenario. Price management Clean Innovation Low leakage This is a hypothetical scenario that tries to anticipate what MRV Clean investments and Low costs would have happened without the ETS in place or if the ETS Governance infrastructure Short term had been designed differently. Three different methods can be Linkage Well-functioning markets Long term: used to develop these scenarios:176 Number and volume of low-emissions trades in spot and futures economy 1. Economy-wide models (such as computable general Price dispersion Fair distribution of equilibrium models) try to create a counterfactual against Levels of participation in gains and losses trade which real outcomes can be compared, controlling for Existence of brokers, external factors that are unrelated to the ETS. The actual insurance products, etc. outcome is compared to a modeled one; Banking 2. Qualitative interviews and surveys can be used to Additionality of offsets elicit stakeholder and expert opinions about ETS impacts Net and gross trades between linked systems that would not have happened without the ETS. The interviewees must try to separate out the ETS’s effects and other effects; 3. Econometric studies exploit “natural experiments,” where Amend ETS? behavior by covered entities (or sectors) in the ETS can be compared to their behavior before the ETS or to the behavior of similar firms not covered by the ETS. Given the challenges of developing a counterfactual, a com- explore their own research questions. Transparent evaluation plementary approach is to evaluate intermediate impacts— and consultation with stakeholders, and vigorous academic changes that would be associated with a well-functioning ETS discussion, will improve the quality of work and facilitate its and that may be more directly observable. Box 10.5 traces use to effectively revise the ETS. the intermediate impacts that might be expected if the ETS is functioning well to the final impacts of concern. For example, 2.3 Gathering data for reviews and the effectiveness of the system in reducing emissions is diffi- evaluations cult to assess in isolation but, if allowance prices are low, this When designing an ETS, policy makers must also consider the could suggest that the ETS is not driving significant emissions data needs of reviews and evaluations. This subsection consid- reductions or that the cost of reducing emissions is relatively ers the data required and options for gathering the data. low, allowing for potentially greater ambition. Analysis of intermediate steps can help identify the causes of problems 2.3.1 Data requirements and items for reform. Much of the relevant data for conducting reviews and evalua- When considering who should undertake an evaluation, policy tions is already collected for other purposes: energy prices and makers should adopt the same criteria as for comprehensive use, firm activity, revenue and profits, wages and employment, reviews. Ideally, researchers in academia or NGOs will be able product prices, patents, weather, land use, etc. Additional to make use of data from the evaluation to independently data will be generated by MRV and compliance systems, the registry recording transactions, and through the allowance 176 For a more comprehensive overview of how the different methods can be applied to estimate ETS impacts, refer to Sato, M. et al. (2015). allocation processes. STEP 10: IMPLEMENT, EVALUATE AND IMPROVE 181 However, some studies will require fresh data. These might consequences. ETS legislation might therefore indicate how include administration costs for government and covered the decision maker, typically the government, will respond to a entities, emissions from otherwise similar entities not covered review. It may specify: by the cap, interview information on new business practices, ▲▲ The process for sharing findings of a review with other investments, innovations, and the like. parts of the government and with stakeholders; To yield robust insights, these data need to be available to ▲▲ The time frame to announce changes; and authorities and other researchers in a timely way and with ▲▲ The minimum amount of advance warning for major adequate documentation. The aggregate data that are changes. generally released publicly are of limited value in addressing key questions of effectiveness and impacts; robust, detailed By establishing a transparent process in this way, policy mak- studies will require data on specific participants. ers can help both ensure balance and build trust in the quality of decisions. Certain governance processes will be locally 2.3.2 Methods of gathering data specific and depend on local political culture and existing In addition to publically available data, there are two methods institutions. The process used in New Zealand is discussed in of gathering information for a review or evaluation: Box 10.7. ▲▲ Reporting by firms: Data on firms’ commercial and emissions trading activities are generally kept confidential. BOX 10.5 CASE STUDY: Comprehensive Review of Special provision will often need to be made for confidential RGGI data to be provided to the entity undertaking the review and/or evaluation. This normally requires that the reviewing The RGGI Memorandum of Understanding (MOU) entity will maintain the confidentiality of data, but can stipulated that a “Comprehensive 2012 Review” would be undertaken, during which amendments could be made to still use those data to inform its findings. In the EU, data both the MOU and the Model Rule.a This review considered that do not have to be published by law are treated as five primary issues: program success, program impacts, confidential if the operator marks them accordingly; if additional reductions, imports and emissions leakage, and there are requests for disclosure, the operator has the offsets. In addition to the extensive empirical analyses right to prevent disclosure. In some cases, for example undertaken by numerous outside organizations, the review in New Zealand, these data can be made available in an incorporated extensive stakeholder participation. The par- anonymized form to trusted researchers (for example, in ticipating states held 12 stakeholder meetings, webinars, universities and ministries) under strict confidentiality and and learning sessions for the regulated and nonregulated communities, environmental nonprofits, consumers, and data security conditions; and industry advocates. ▲▲ Qualitative information: Surveys, interviews, or consulta- The two major findings of the review were that there was tions with participants and other stakeholders can comple- an excess supply of allowances and that the cost control ment analysis of quantitative data. They can help identify mechanisms in place at the time were ineffective. As a potential causes of perceived poor outcomes, and suggest consequence, the number of allowances was reduced from further empirical questions to avoid misinterpretation and 165 million to 91 million.b A cost containment reserve was enrich interpretation of data and results from their analysis. also created, with a trigger price of 4 dollars in 2014, 6 in 2015, 8 in 2016, 10 in 2017, and increasing by 2.5 percent per year after 2016. Some other minor adjustments were 2.4 Processes for responding to a review made concerning offsets, forests, reserve price, and the Changing an ETS can have implications for prices, asset values, retirement of unsold allowances.c The amendments to the and perceptions and attitudes. Changes can strengthen or system were released on February 7, 2013, and entered undermine predictability, depending on their drivers and on into effect in 2014. how they are decided and implemented. These implications A new program review commenced in late 2015 and will need to be anticipated and included in the decision-making consider, among others, additional reductions to the cap calculus when considering whether and how to implement post-2020.d change. A practical example of such a comprehensive change 10. EVALUATION is discussed in Box 10.6. a RGGI (2005). b RGGI (2013). Fundamental changes to an ETS following a comprehensive c Ibid. d Ibid. review may have far-reaching political and economic 182 EMISSIONS TR ADING IN PR ACTICE BOX 10.6 CASE STUDY: Review Processes in the QUICK QUIZ New Zealand ETS Conceptual Questions The 2008 legislation establishing the New Zealand ETS (NZ ETS) provided for two types of review processes:a ▲▲ How can an ETS balance the need to adapt to learning and changes in circumstances with the desire to ensure ▲▲ A mandatory review conducted by an independent predictability for investment? panel appointed by the Minister, before the end of each international commitment or 5-year period. The results ▲▲ What are common stages in an ETS review process? of these reviews would be made publicly available; and Application Questions ▲▲ A discretionary review of ETS operation and effective- ▲▲ Whatare the advantages and disadvantages of conducting ness that could be initiated by the Minister at any time, and conducted through any means. an ETS pilot in your jurisdiction? ▲▲ Would learning by doing through gradual introduction of The passage of the NZ ETS legislation was immediately followed by a change of government; the new government sectors into your jurisdiction’s ETS help build necessary launched a discretionary review of the NZ ETS in December capacities? What do you see as potential drawbacks? 2008. The review was carried out by a special, cross-party ▲▲ How can your jurisdiction collect data and make it Parliamentary select committee with the objective of available for high-quality evaluation? revisiting New Zealand’s climate change policy objectives and deciding whether to proceed with an ETS. After this review, the new government chose to retain the NZ ETS with substantial amendments to moderate its expected impact on the economy. The first mandatory NZ ETS review was conducted in 2011 by a panel of seven nongovernmental experts under the government’s terms of reference.b It included a six-week consultation period with public submissions and the preparation of expert reports. The panel publicly released an in-depth review report that the government took into consideration in its 2012 proposal for amendments to the NZ ETS.c The government ultimately chose to accept some—but not all—of the panel’s recommendations. The process helped influence the government’s decisions and build public understanding of the system. In its 2012 legislative amendments, the government changed the NZ ETS review process.d Reviews are now optional at the discretion of the Minister, no guidance is provided on the scope of the terms of reference, and there is no requirement to use an independent panel. If no panel is involved, the Minister must consult with stakeholders and representatives of Maori iwi (indigenous people) who are likely to have an interest. This change in review provisions reflected the perception that the initial review provisions were resource-intensive and resulted in a very lengthy process. 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