98290 Networked Carbon Markets A Knowledge Series Design Options for an International Carbon Asset Reserve July 2015 Networked Carbon Markets A Knowledge Series Design Options for an International Carbon Asset Reserve July 2015 This discussion paper was prepared for the World Bank Group by Juerg Fuessler and Martin Herren of the INFRAS consulting group. The paper benefitted from the guidance of Wendy E. Hughes and Bianca Ingrid Sylvester and from helpful comments provided by Christophe de Gouvello (Senior Energy Specialist, GEEDR), Michael A. Toman (Research Manager, DECEE), and Johannes Heister (Senior Environmental Specialist, GENDR), and the World Bank Group’s ‘Climate and Carbon Finance Unit’. The publication process was led by Mandkhai Bayarsaikhan and the paper was edited by Daria Steigman. PREFACE About the Networked Carbon Markets Initiative The World Bank Group’s Networked Carbon Markets (NCM) initiative is developing the services and institutions needed to enable a connected international carbon market that is liquid and delivers climate-smart financing more efficiently. Around the world, countries are developing ways to put a will have liquidity, be able to scale, and set the foundation for price on carbon to fight climate change. Nearly 40 nations stable carbon prices.  and more than 20 sub-national jurisdictions are participat- ing or preparing to participate in emissions trading systems. Three possible components under consideration to support Additional countries are considering such climate mitigation NCM initiative include the following. efforts as crediting mechanisms and market-based instru- 1. Carbon Asset Assessment Framework ments (e.g., tradable renewable energy standards, energy efficiency certificates, and carbon tax systems). These domes- This framework aims to determine the climate change tic initiatives are crucial to lowering greenhouse gas emissions; mitigation value of carbon assets in the international mar- however, this bottom-up development of climate mitigation ket. Current initiatives that assess climate mitigation efforts efforts has led to regulatory fragmentation and heterogeneity can be organized by the risks and contributions that they across jurisdictions. capture. These include a program’s carbon integrity risk; a jurisdiction’s policy/regulatory risk; and a jurisdiction’s The NCM initiative responds to the fact that governments relative contribution to the global climate mitigation effort. are designing and implementing climate mitigation efforts The NCM initiative understands that these efforts could in ways that best suit their individual contexts. While these benefit from an overarching, coordinating framework that unilateral efforts are to be commended, the resulting regula- establishes a common language, common concepts, and tory fragmentation has made it increasingly complex to track general principles; common methodologies to collect progress, compare achievements, and connect efforts across and interpret data; and tools to help guide users of such jurisdictions. In response, the NCM initiative aims to develop information. a framework for enhancing transparency, comparability, and fungibility of heterogeneous climate mitigation efforts. The 2. International Carbon Asset Reserve NCM initiative complements the World Bank Group’s ongoing The World Bank Group is exploring institutional structures low-carbon development activities and its efforts to promote to support a network of carbon markets and to help in ad- carbon pricing as critical to achieving climate mitigation on a dressing market risks and failures. One possible structure large scale in an effective and cost-efficient way. is a pooled reserve of carbon assets, or International Carbon Asset Reserve (ICAR), which could provide a To achieve this effort will require addressing the various bar- source of liquidity or play a market-maker function. While riers that currently make it difficult to link carbon markets. the form, scope, and functions of an ICAR are still being These barriers include the lack of common standards and explored, it is intended that such an international (or rules in the design of market systems as well as the lack of inter-jurisdictional) instrument is intended to complement an agreed-upon process to assess climate change mitigation and support, rather than replace, jurisdiction-level market value across heterogeneous markets. The end goal of the stabilization instruments. The ICAR builds on the idea that NCM initiative is thus to determine trading ratios for carbon carbon markets and the mitigation of their inherent risks units and a mechanism to support carbon market-related can be made more efficient by increased connectivity and functions. This is intended to facilitate connectivity of carbon the pooling of risk mitigation measures on an interna- pricing systems through “networking” such that these systems tional level. iii 3. International Settlement Platform The first paper in the NCM knowledge series is “Design Options for an International Carbon Asset Reserve,” which The World Bank Group is exploring the idea of an interna- was prepared by the INFRAS consulting group. It presents tional settlement platform to track cross-border trades and first concepts and insights on an International Carbon Asset possible clearinghouse functions. Reserve. In particular, it explores how different design options Networking domestic efforts can help countries achieve their can support a range of networked carbon pricing efforts. The climate mitigation objectives in a more cost-effective way. report provides an overview of key risks in carbon markets, When different carbon pricing systems are connected, they highlights the benefits of pooling risks on an aggregated scale, create a larger, potentially more liquid, market. The larger the and identifies potential design options and structures for an market, the more the price of carbon is resilient to volatility. In ICAR. The paper contributes to the wide effort to promote a addition, by connecting with different carbon pricing systems, long-term price on carbon and carbon market stabilization, countries can tap into other abatement options; this can also comparability, and networking. help to reduce costs. The cost and efficiency benefits that result from networking may, therefore, enable countries to increase the ambition of their climate mitigation efforts. Networked Carbon Markets Knowledge Series The World Bank Group’s Climate and Carbon Finance Unit has launched a Networked Carbon Markets (NCM) knowledge series in order to contribute to the technical and analytical foundations of the NCM initiative. The objective of this series is to inform ongoing discussion among key stakeholders within international financial institutions, governments, think tanks, and nongovernmental organizations. The papers published as part of the series will present recent findings from the initia- tive’s analytical work. It is expected that the proposed con- cepts and components will evolve based on consultations and discussions with stakeholders. Contents PREFACE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ii About the Networked Carbon Markets Initiative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ii Networked Carbon Markets Knowledge Series . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iii Acronyms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . viii Executive Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 1 Preliminary Findings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 1.1. Benefits of Pooling Risk Mitigation Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 1.2. Possible Design Options for an ICAR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 1.3. Role of the Public and Private Sectors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 1.4. Process of Implementation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 2 Overview of Carbon Market Related Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 2.1. Price-Related Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 2.1.1. The Risk of High Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 2.1.2. Other Price-Related Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 2.2. Non-Price-Related Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 2.2.1. Risk of Invalidity of Issued and Allocated Units . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 2.2.2. Risk of Non- or Underperformance of Mitigation Activity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 2.2.3. Risk of Non-Permanence of Agriculture, Forestry and Other Land Use Units . . . . . . . . . . . . 6 2.2.4. Risk of Non-Eligibility of Units in Carbon Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 3 The Benefits of Pooling Risk Mitigation Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 3.1. The Principle of Pooling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 3.2. Enhancing Risk Mitigation by Pooling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 3.3. Addressing Limits of Local Level Risk Mitigation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 3.3.1. Limited Capacity to Build a National Price Stabilization Scheme . . . . . . . . . . . . . . . . . . . . . . 9 3.3.2. Limited Capacity to Link or Network . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 vi 4 Design Options for an ICAR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 4.1. Potential Reserve Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 4.1.1. Mitigate High Price Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 4.1.2. Mitigate Low Price Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 4.1.3. Carbon Asset Eligibility Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 4.1.4. Provide Market Information and Intelligence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 5 Potential ICAR Structures to Address Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 5.1. Agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 5.2. Options for Structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 5.2.1. ICAR as a Pool of Carbon Units . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 5.2.2. Structures with Other Functions (Options B and C) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 5.2.3. International Support Fund (Option D) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 5.3. Institutional Setting and Roles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 5.4. Moral Hazard . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 5.5. The Need for Fungibility of Units . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 5.6. Capitalization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 5.6.1. Reserve of Carbon Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 5.6.2. Reserve of Financial Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 5.6.3. Cost of Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 5.7. Potential Role of the Private Sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 5.8. Implementation of an ICAR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 vii Appendix A: Risk Mitigation Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 A.1. Approaches to Mitigate the Risk of a High Unit Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 A.2. Explaining the Risk Mitigation Approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 A.3. Mitigating Other Price-Related Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 A.4. Mitigating Non-price Related Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 A.4.1. Risk of Invalidity of Issued and Allocated Units . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 A.4.2. Risk of Non- or Underperformance of Mitigation Activity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 A.4.3. Risk of Non-permanence of AFOLU Units . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 A.4.4. Risk of Non-eligibility of Units in Carbon Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 A.5. Risks Related to the Nature of Absolute Caps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Appendix B: Existing Price Containment and Reserve Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 B.1. Existing, Emerging, and Potential Regional, National, and Subnational Carbon Pricing Instrument . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 B.2. Overview of Current Price Floor and Ceiling Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 B.3. Summary of Current Price Floor and Ceiling Policies in Various ETSs . . . . . . . . . . . . . . . . . . . . . . . . . 28 B.3.1. California . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 B.3.2. Quebec . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 B.3.3. New Zealand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 B.4. EU Market Stability Reserve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 Appendix C: IEA’s Emergency Response System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Appendix D: Public and Private Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 viii Acronyms AFOLU Agriculture, Forestry and Other Land Use CARB California Air Resources Board CDM Clean Development Mechanism CER certified emissions reduction CO2 carbon dioxide ERPA Emissions Reduction Purchase Agreement ETS Emissions Trading Scheme EU European Union GHG greenhouse gas ICAR International Carbon Asset Reserve IEA International Energy Agency IEP International Energy Program l-CER long certified emissions unit NGO non-governmental organization RGGI Regional Greenhouse Gas Initiative t-CERs temporary certified emissions units tCO2e tons of carbon dioxide equivalent VCS Verified Carbon Standard WCI Western Climate Initiative 1 Executive Summary This paper is designed to stimulate a discussion among key It is envisioned that participation in the ICAR would be volun- stakeholders about an International Carbon Asset Reserve tary (opt-in), and differences across individual market designs (ICAR). It is not intended as a standalone document but would be accommodated. Furthermore, it is envisioned that rather as part of a wider effort to promote a long-term price an ICAR would not replace but rather complement and sup- on carbon and carbon market stabilization, comparability, port local risk-mitigation efforts. The ICAR may use several and networking. instruments to support domestic measures to address carbon market related risks. Depending on the circumstances and The idea of an ICAR, as an instrument to address carbon needs of the specific carbon markets, some of the options will market related risks, builds on the knowledge that carbon be more relevant and work better than others. markets and the mitigation of their inherent risks can be made more efficient by increased connectivity and pooling of risk- This paper provides an overview of key risks in carbon markets mitigation efforts. These risks can include carbon price related in chapter 2. Chapter 3 highlights the benefits of pooling risk risks such as the risk of high prices, low prices, and/or volatility mitigation efforts on an aggregate level. Based on this, chapter in prices. These risks are also non-price related and include 4 presents design options for an ICAR and discusses some of the risk of invalidity of issued and allocated carbon units, the the potential elements and characteristics. These options are risk of non- or underperformance of mitigation activities, and/ not meant to be prescriptive or exhaustive; rather, they aim to or the risk of non-permanence of carbon units. illustrate the field of potential design options and stimulate the discussion. In addition, while some of the discussed elements The benefit of pooling efforts to address such carbon market and functions of an ICAR could be implemented in the short related risks depends on the risk profiles of individual par- term, it is assumed that it would become more important in ticipants and their relative capacities to address these risks the longer term (i.e., in the context of a post-2020 frame- individually. The benefits of aggregation also depend on the work). The paper starts by summarizing the key findings of diversity of carbon units in the pool. By aggregating carbon the research. units that represent a variety of jurisdictions, sectors, and pro- grams, the risks embedded in the pool are lowered. 1 Preliminary Findings The key findings of the paper are summarized below. aggregating carbon units that represent a variety of jurisdic- tions, sectors, and programs, the risks embedded in the pool 1.1. Benefits of Pooling Risk Mitigation Measures are lowered. The lower the correlation between carbon units, the greater the reduction in risk that can be achieved. Carbon market related risks can include price related risks such as the risk of high prices, low prices, and/or volatility The process of jurisdictions coming together to negotiate on in prices. Besides the risks directly related to price, carbon the role and function of an ICAR may bring benefits in itself. market risks can also include the risk of invalidity of issued and For example, the exchange of information on different carbon allocated carbon units, the risk of non- or underperformance markets and negotiations on how risks can be efficiently of mitigation activities, and/or the risk of non-permanence of managed in a joint approach may help regulators in different carbon units. As carbon markets mature, their risk profiles may jurisdictions to better understand the different systems and to also change. make their own carbon markets more comparable and robust. While many risks may be addressed at the local level, there Figure 1.1 illustrates how an ICAR could be compatible with a are other risks that may benefit from pooling at an aggregated range of domestic risk mitigation instruments. There are also level. For example, pooling risk mitigation measures may concepts for the development of insurance solutions for some benefit those jurisdictions with limited capacity to design and (offsetting-based) carbon markets. Some carbon markets in operate a price stabilization scheme, which can be time- the landscape could choose to join an ICAR supporting their consuming, difficult, and require numerous capacities and domestic (limited) risk-mitigation systems and benefiting from skills. Aggregation may be a simpler option (particularly for the pooling of risks and related efficiency gains. smaller jurisdictions) and allow participants to benefit from the know-how and expertise of different carbon markets. 1.2. Possible Design Options for an ICAR Aggregating a diverse pool of carbon units, whose values Numerous functions, structures, and design options for an do not move up and down in perfect synchrony, can also ICAR may be considered. The possible design options for an enhance overall risk mitigation efforts. This is because, by ICAR to support jurisdictions to mitigate the risk of high carbon Figure 1.1: ICAR’s Compatibility with Domestic Risk Mitigation Instruments Linking Carbon Carbon Carbon Carbon Carbon Carbon Market Market Market Market Market Market A B C D E F Price Price Price Price Price Insurance Floor/Ceiling Floor/Ceiling Floor/Ceiling Floor/Ceiling Floor/Ceiling Insurance International Carbon Reserve Clearinghouse—Fungibility Source: INFRAS 2014. 1 Preliminary Findings | 3 Table 1.1: Possible Design Options for an ICAR Structure Description Ownership/Governance Option A1 • Coordination of local carbon reserves • Each member country owns and manages its • High price threshold triggers coordinated release of units own contribution to the pooled reserve from local reserves to market • Release of units follows agreed-upon rules • Decision making is “rule based” Option A2 ICAR is pool of • International pool of carbon units • ICAR owns and manages the reserve local reserves • High price threshold triggers release of units from ICAR to • Release of units follows agreed-upon rules that carbon market • Decision making is “rule based” Option A3 • International body manages risk of high prices by releasing • International body takes autonomous decisions units from ICAR pool to carbon market in need to release units • Decision making is “management based” ICAR enables • International body manages risk of high prices by allowing • International management body decides on connectivity for (partial) linking or networking between or among linking in line with regulations and guidance between or specific systems from participating jurisdictions among carbon • Decision making is “management based” markets ICAR is an • International body regularly analyses developments and • Member countries provide the international international risks in carbon markets and decides on measures to carbon management body with far-reaching management reduce risks and increase stability powers body • Decision making is “management based” ICAR is an • International fund to support countries and compliance • Mitigation action to be governed and international entities in financing the implementation of mitigation implemented by country support fund measures in case of too-high carbon prices • Support fund to decide on financial support for (“pool of money”) • Decision making is “management based” investments in mitigation prices, which is the primary focus of this paper, are summa- 1.4. Process of Implementation rized in table 1.1. Given the numerous regulatory and institutional complexities within and among participating carbon markets, a step-wise 1.3. Role of the Public and Private Sectors process appears to be a solid approach to the design and It is envisioned that ICAR would have a public form. On the implementation of an ICAR. one hand, private sector entities may be more efficient in their operational processes and may also provide access to larger funds. On the other hand, private sector entities do not have the political mandate to carry out the reserve functions that re- quire delicate balancing of participating jurisdictions’ economic and political interests. 2 Overview of Carbon Market Related Risks 2.1. Price-Related Risks fluctuations on market functioning (in particular in early phases of carbon markets), others see them as a distortion This section provides an overview of risks related to price that may prevent the formation of a clear price signal. This levels and the movement of carbon prices in carbon markets. paper does not review this debate but simply recognizes that This includes (perceived) risks that are relevant during the some jurisdictions have decided to include price containment build-up and early phases of emissions trading systems and instruments in their carbon market systems (see appendix A that may limit both government and private-sector support for an overview on existing [single jurisdiction] risk mitigation for the introduction of market-based instruments. As carbon measures and instruments). markets mature, their risk profiles may change, and this sec- tion also examines the price-related risks in developed carbon 2.1.1. The Risk of High Prices markets. The risk of high prices for units in a carbon market is one of A feature of most cap-based carbon market instruments (such the main risks mentioned when discussing the introduction as emissions trading systems) is that caps are set ex-ante, be- of emissions trading systems and other cap-based market fore the phase of emissions trading and compliance. In most mechanisms that impose a limit on carbon emissions in host cases, caps are set in absolute terms (i.e., in allowed tons of countries. During the design of allocation rules for trading sys- CO2 emissions per year) rather than in relative terms (i.e., in tems, the perceived risk of high prices, international competi- allowed tons of CO2 emissions per unit of activity, such as the tiveness, and uncertainties in emissions projections may lead tons of CO2 per ton of steel produced). Cap setting builds on regulators to refrain from stringent cap setting. This, in turn, future projections of a range of variables, including economic may support a tendency to over-allocate emissions to compli- development and growth, energy prices, the availability of ance entities in emissions trading systems [see Grubb, Azar, efficient technologies and low carbon fuels, and the rate of and Persson (2005) for Phase 1 EU-ETS]. implementation and effectiveness of other policies fostering Drivers of high prices can include: energy efficiency and renewable energy. These variables are fundamental in driving the balance between supply and de- • Low allocation of allowances in a (closed) system that has mand in carbon markets and, therefore, movements in carbon high marginal abatement costs prices. • Decrease in the supply of units for technical or regulatory reasons, because compliance entities need more units Some carbon market regulators want to make sure that for their own compliance, or as a result of a build-up of carbon prices are high enough to provide sufficient long-term speculative positions incentives to invest in emissions mitigation technologies. High prices in carbon markets may, however, affect economic • Increase in emissions due to (economic) growth and, growth in certain sectors that are subject to international therefore, an increase in demand for units competition—which some regulators may try to prevent by In a domestic market that is not subject to international com- introducing price-capping mechanisms. petition, the introduction of a carbon market instrument affects In addition, some regulators may seek to avoid large price vari- entities with compliance obligations (“compliance entities”) ability to ensure a stable environment that allows investors to differently. For example, high carbon prices can lead to higher adequately assess the viability of long-term investments in low production costs and lower competitiveness for less-efficient, carbon technologies. carbon-intensive compliance entities and lower production costs and/or higher carbon revenues for carbon-efficient com- Price and volatility controls in carbon markets are subject pliance entities. to considerable debate in both policy circles and the scien- tific community. While some see market intervention as an More broadly, higher carbon prices may lead to increased in- essential tool to prevent the consequences of large price vestment in greenhouse gas (GHG) mitigation measures and 2  Overview of Carbon Market Related Risks  | 5 Table 2.1: Other Price-related Risks Low unit prices Impacts on installations: General impacts: • Low profitability of some earlier GHG mitigation measures • The carbon market ceases to function • Risk of low prices leads to low investments in GHG mitigation • Low investments in GHG mitigation • Risk of policy switch to (economically potentially less-efficient) command-and-control policies or no climate policies Price volatility (in particular in early and small markets) Impacts on installations: General impacts: • High price volatility may lead to uncertainty in the investment • Carbon market ceases to function climate • Risk of policy switch to (potentially economically less-efficient) • High volatility may lead to business opportunities command-and-control policies or no climate policies • Implementation of mitigation measures may (i) be considered highly risky (because reward is uncertain); or (ii) be seen as a hedge against price volatility Lack of market information Impacts on installations: General impacts: • Uncertainty and less investment in mitigation activities • General market ignorance/uncertainty about existing trends, opportunities, and risks subsequent investment opportunities. This may also result in 2.1.2. Other Price-Related Risks additional revenue streams (earmarked or not) for the govern- In early carbon market phases, maintaining a robust floor price ment. For example, in emissions trading systems where parts may be a key to fostering long-term investments in GHG miti- of the units are allocated via auctioning, higher prices lead to gation actions. Table 2.1 provides an overview of these risks. higher revenues for the auctioning authority. While this paper does not further consider the risk of low unit For compliance entities that are subject to international prices, it does look later at the impact of an ICAR on contain- competition, the additional cost factor may lead to higher ing price volatility and consider market information activities end-user prices for goods and potentially lower international as a potential additional carbon reserve function. Please see competitiveness. For this reason, the impact on international appendix B for an overview of current price floor and ceiling competitiveness is one of the key aspects to consider when policies in various jurisdictions. designing carbon markets. A further consequence could be the transfer of production to other countries that may be sub- 2.2. Non-Price-Related Risks ject to less-stringent or even no carbon regulation. This may lead to carbon leakage, where reductions in emissions in the Besides the risks directly related to prices, there exist a num- emissions trading system with high prices may be more than ber of other risks that may be relevant in some jurisdictions. compensated for by an increase of emissions abroad—leading This section identifies additional risks in carbon markets where to a net increase in emissions. an international approach could help develop efficient risk mitigation measures. 6 |  Design Options for an International Carbon Asset Reserve 2.2.1. Risk of Invalidity of Issued and Allocated Units • Carbon cycle risks during methodology, registration, monitoring, verification and reporting, and at issuance There is a risk in current carbon markets that issued or allo- cated units that are accounted for in a carbon asset registry or 2.2.3. Risk of Non-Permanence of Agriculture, Forestry tracking system will be rendered invalid. Indeed, the principle and Other Land Use Units that issued certified emissions reductions (CERs) are not Measures that aim at increasing the terrestrial carbon stock, revoked is an important element to assure the confidence such as afforestation, reforestation, improved forest manage- of markets in carbon markets. In the Clean Development ment, and land use change (as well as carbon capture and Mechanism (CDM), for example, once CERs are issued by a storage projects) face the risk of non-permanence (i.e., that decision of the CDM Executive Board, the CERs maintain their at a given time after the implementation of the project, part full validity; this is true even though the methodology that was or the entire increase in the terrestrial carbon stock will be the basis for the issuance may later turn out to be flawed and released into the atmosphere). Reasons for non-permanence have led to over-crediting of units. risk in the Agriculture, Forestry and Other Land Use (AFOLU) Risks for issued and allocated units are, in most cases, limited activities include: to cases of fraud and crime (e.g., in recent cases in the EU- • Natural disasters, such as damage by fire, wind, hail, pests ETS, criminals acquired access to carbon registry systems and and disease, snow, ice, and/or flood carried out illegal transactions). Buyers of illegally obtained • Political risks, such as when a government no longer honors units risk losing the value of their purchases. legal contracts, changes in regulation, expropriation, and 2.2.2. Risk of Non- or Underperformance of Mitigation riots and other social unrest Activity 2.2.4. Risk of Non-Eligibility of Units in Carbon Markets Entities investing in mitigation activities incentivized by a carbon market build their investment decision, among other Compliance entities may purchase units with the aim of using things, on expectations about the performance of the activity them to fulfill their compliance obligations. However, there is a and its impact on greenhouse gas emissions and expected regulatory risk that certain asset trading systems may lose their revenues from carbon markets. Several risks may, however, eligibility. For example, in Phase 3 (post-2012) the EU-ETS re- undermine the performance of the mitigation activity: stricted the use of CERs from CDM projects that are registered after 2012 to projects from least developed countries. As a • Project risks, including technological risks and natural result, CERs from new projects in other countries lose their disasters eligibility for compliance under the EU-ETS. • Country risks, including political and regulatory risks and expropriation of assets trading systems 7 3 The Benefits of Pooling Risk Mitigation Measures 3.1. The Principle of Pooling Figure 3.1: The Benefit from Pooling Reserves from While many risks may be addressed at the jurisdiction or na- Different Carbon Markets tional level, there are other risks that may benefit from pooling at an aggregated level. As this section describes, the pooling a. Individual Reserves in Carbon of carbon market related risks on an aggregated level may address any risk mitigation limits at the local level and provide efficiency gains and benefits for a range of risk mitigation func- tions. Pooling the reserves of individual emissions trading sys- tems into an ICAR covering all the participating carbon markets may help to lower the need for reserves in the participating jurisdictions and, therefore, reduce costs.1 Market A Market B Market C Figure 3.1 illustrates the benefit of pooling reserves from dif- b. Required Reserves for All Carbon Markets ferent carbon markets. If several carbon markets agree to pool their (costly) reserves in an ICAR, the number of the required Lower reserves units in the pooled reserve per carbon market is smaller (yel- needed if pooled low) than if each carbon market held each individual reserve (orange). The benefit from pooling of reserves depends on the risk profiles of individual participating carbon markets and on their level of correlation. Individual Pooled Figure 3.1(a) assumes three (similar) carbon markets (A, B and C) that are not linked. In the absence of an international Source: INFRAS 2014. pool of reserves, each carbon market has its own reserve that is used to supply additional units to the market, increasing Figure 3.1(b), meanwhile, posits the pooling of reserve units the supply in order to defend a price ceiling. The number of in an ICAR that jointly serves all participating carbon markets units that is necessary for each reserve to serve this function in cases of high price levels. In this scenario, the required depends on a number of parameters, including the current number of units in the pooled reserve to defend the same unit price, the level of the price ceiling, the duration of pooled price level(s) with the same probability is lower. This reduces reserves, an estimate of future price volatility (depending on the costs to participating carbon markets of establishing and perception of risks), and the required level of certainty with maintaining the reserve function. Similarly, with a given num- which the instrument would defend the price ceiling (e.g., a ber of reserve units per carbon market, participating countries jurisdiction may require its local reserve to defend the price can increase their level of risk mitigation by pooling their re- ceiling with a probability of 95 percent). serves (i.e., they can afford a lower price ceiling with the same reserves per carbon market). The benefits of pooling depend on the risk profiles of indi- vidual participating carbon markets and their capacities to 1 In many carbon markets, building up and holding reserves for risk miti- mitigate risk. The benefits could also depend on their level gation comes at a cost. For emissions trading systems, at a given overall of correlation. The less correlated the price developments in cap that has been set based on an international pledge, putting aside allowances reduces the number of allowances available for compliance the carbon markets are, the higher the benefits from pooling. entities and therefore increases costs (at least in the short-to-medium This may make pooling of reserves from carbon markets on term). In crediting systems, units put into the reserve have to be de- ducted from the issued units from crediting activities, which reduces the different continents, for example, an instrument to explore in number of units available for monetization (again, at least in the short- more detail. to-medium term). 8 |  Design Options for an International Carbon Asset Reserve 3.2. Enhancing Risk Mitigation by Pooling Kyoto Protocol’s Clean Development Mechanism (CDM) have been the only large scale and liquid carbon markets in the The benefits of pooling of risks among different carbon past decade. The EU-ETS and the CDM are linked, and their markets lies either in the reduction in the need for potentially close correlation was an important feature of their prices until costly reserve capacity for the individual jurisdiction or in an the CDM market petered out. Meanwhile, the emerging land- increased level of risk mitigation for jurisdictions with the same scape of fragmented carbon markets suggests that most of reserve capacities. In either case, these benefits depend on these future markets are unlikely to be linked any time soon. the level of correlation between and among carbon markets. As economic development is one of the key factors determin- While there are numerous studies on the correlation between ing emissions, it is likely that the path of economic develop- energy and carbon markets (e.g., Koenig 2011), the correla- ment in different jurisdictions will be one of the main factors tion between different non-connected carbon markets is less determining the correlation among these various emerging well analyzed. The EU Emissions Trading System and the Figure 3.2: Illustration of Different Economic Developments 1.8 Brazil Canada Switzerland 1.6 Chile GDP (indexed 2008) China 1.4 European Union Indonesia 1.2 Japan Kazakhstan 1 Korea, Rep. Russian 0.8 Federation Turkey 0.6 2008 2009 2010 2011 2012 Source: World Bank 2014. 3  The Benefits of Pooling Risk Mitigation Measures  | 9 carbon markets. Without going into a deeper analysis of fac- 3.3.2. Limited Capacity to Link or Network tors that may influence the correlation of carbon markets, this Linking or networking could be an important mitigation mea- paper assumes that jurisdictions with lower levels of economic sure to lower overall mitigation costs and smooth out price integration may also exhibit lower levels of correlation in their spikes in individual emissions trading systems. So far, however, carbon markets in the absence of linking. full linking between and among carbon markets has proven to As each country is part of a global system, economic cycles be a difficult process. Only California and Quebec have linked; and fluctuations have an impact on the global economy, lead- the prospects of linking other schemes has recently become ing to a certain degree of correlation; however, each country less certain. has different stressors and responses to these patterns. Figure 3.2 illustrates how differently economies evolve and respond to global economic patterns, such as the financial crisis that began in 2008. The limited correlation between economies that can be observed today may hint to the possibility of limited correlation between future carbon markets. The less markets are correlated, the higher the potential efficiency gains from pooling risk mitigation instruments. 3.3. Addressing Limits of Local Level Risk Mitigation 3.3.1. Limited Capacity to Build a National Price Stabilization Scheme If a jurisdiction wishes to benefit from using a price stabiliza- tion measure or reserve, this requires considerable technical, institutional, and regulatory resources. In particularly, smaller and less affluent countries may not be in a position to de- sign, build, and operate jurisdiction-level price containment schemes to stabilize their emissions trading systems. This would be particularly relevant for smaller standalone emis- sions trading systems, where the limited number of compli- ance entities may lead to an illiquid market with high price variability. 4 Design Options for an ICAR The concept for ICAR is an international (or inter-jurisdictional) If carbon prices in Carbon Market A reach the agreed trigger instrument that would complement and support jurisdic- price ceiling, then the ICAR, in coordination with participating tions to address carbon market related risks (see chapter 2). jurisdictions, may take one or more of the following actions: Participation would be on an opt-in basis. In addition, it would 1. Release units to market from ICAR at price X USD/t (in be assumed that (local) jurisdiction-level risk mitigation limited or “unlimited” volumes) (see also structures A1– measures would be the “first line of defence” in addressing A3 in section 5.2) risks in the carbon markets. ICAR could then play an important supplementary role to local risk mitigation instruments, where 2. Allow Carbon Market A to borrow units from the ICAR local schemes are facing limits (see section 2.2) or where 3. Support temporary linking or networking of Carbon there are efficiency gains or other benefits from pooling some Market A to other existing carbon markets that are not of these functions at the international level (see chapter 3). linked (for a limited time/volume) (see also structure B in section 5.2) Numerous functions, structures, and design options for an ICAR may be considered. This chapter looks into some design 4. Enable a higher use of units from other carbon markets options in order to provide a starting point for discussion; this for compliance in Carbon Market A is not, however, an exhaustive analysis of the options. 5. Enable a higher use of offsets from crediting mechanisms for compliance in Carbon Market A Section 4.1 provides an overview of potential functions; it remains an open question, however, whether and how each 6. Enable a swap, in which there is an increase in the caps of these functions could be implemented at an international of compliance entities in carbon market A and, at the level. The subsequent sections in this chapter introduce the same time, a corresponding decrease caps in Carbon important elements of an ICAR, including potential structures, Market B (e.g., to reflect high economic growth in Carbon capitalization, and so forth. This preliminary analysis focuses Market A and low growth in Carbon Market B) on the function of mitigating the risk of high carbon prices. 7. Provide funds or loans to compliance entities in Carbon Many of the identified elements and observations are, how- Market A for the implementation of a specific mitigation ever, equally relevant for the other reserve functions outlined action, thus lowering emissions and demand and reduc- in section 4.1. ing prices 8. Issue derivative instruments. An ICAR could play a role in 4.1. Potential Reserve Functions providing market participants with financial instruments This section highlights a number of functions that an ICAR that compliance entities can use to hedge against the risk might serve. In line with the mandate for this paper, the focus of high prices. An ICAR may, for example, support private lies on functions to mitigate high unit price risks. sector financial institutions in the following functions: a. Acting as a market maker by providing participants in 4.1.1. Mitigate High Price Risk new carbon markets or asset classes with both buy The ICAR may use several instruments to mitigate high price and sell prices and by holding a limited amount of risk to support domestic measures. Depending on the circum- the units over a predetermined time frame. Providing stances and needs of the specific carbon markets, some of a market maker function may be especially impor- the options will be more relevant and work better than others. tant in early and not yet established carbon markets The following list provides an overview of potential functions where liquidity may be low. without going into a discussion of which options may work b. Selling futures on carbon market units (e.g., mar- better under which circumstances. ket participants could enter future contracts under which they would buy a fixed number of units at a 4  Design Options for an ICAR  | 11 predetermined price, thus hedging against future participating jurisdiction to exercise its own instruments should price increases). prices in the domestic market fall too low. c. Selling call options on carbon market units (e.g., 4.1.3. Carbon Asset Eligibility Risk market participants could purchase the right (but not the obligation) to buy a specific number of units at An ICAR could also be used as a buffer to insure project a fixed (strike) price at or before a fixed expiration participants in crediting mechanisms against the risk of non- date in the future, thus hedging against future price permanence of Agriculture, Forestry and Other Land Use increases while still being able to benefit from poten- (AFOLU) units; the risk of underperformance of mitigation tial price decreases). The price of the option would activity; and the risk of non-eligibility of units in carbon depend on the current unit price, the strike price, markets. An example might be a buffer pool for the non- the interest rate and the counterpart risk, expiration permanence risk of AFOLU projects. date, and estimate of future volatility (e.g., the Black- For the AFOLU sector, the permanence risk is inherent to Scholes formula). carbon sequestration activities and requires, in most crediting d. Support private sector institutions by providing certain systems, some sort of buffering. The permanence risk is that guarantees and covering higher risk layers. the carbon that has been sequestered in forests or other living biomass will be released at a later point in time (reversal) These derivative instruments have proven to be useful to because of natural disasters (fire, wind, and so forth), thus compliance buyers for short- to mid-term hedging purposes devaluing the issued carbon units. An ICAR could, in case of and have made carbon markets attractive for various specula- a reversal, directly compensate for the reduced carbon stock tive market participants. Such instruments may be useful to or provide funds for replanting the forest, thus restoring the cover short- to mid-term price risks, but may be less suitable carbon stocks indirectly over time. to cover long-term (systemic) risks in carbon markets. ICAR support for financial instruments would likely be faded out One example of an international buffer solution for AFOLU over time as markets, and financial instruments for carbon risks is the Verified Carbon Standard2 (VCS), which introduces markets, mature. a buffer to mitigate the permanence risk. Depending on an assessment of the permanence risk for each AFOLU project, In general, an ICAR could be empowered with the flexibility a specific share of issued units is set aside in a central buffer. to use a combination of the above instruments. With most of Buffer credits in the VCS are non-tradable and are maintained these instruments, the ICAR might typically have more of a in an AFOLU Pooled Buffer Account to cover the risk of un- coordinating role, with the decisions made by the participating foreseen losses in carbon stocks (reversal) across the AFOLU jurisdictions. project portfolio. 4.1.2. Mitigate Low Price Risk 4.1.4. Provide Market Information and Intelligence Similar to introducing price ceilings, an ICAR might also sup- An ICAR could provide markets with information and intel- port participating jurisdictions in sustaining price floors by us- ligence about the different participating jurisdictions, as well ing a buffer (section 2.1) or through opt-in rules that require a as market forecasts and risk analyses that may better prepare market participants to address potential risks. 2 See http://www.v-c-s.org/develop-project/ agriculture-forestry-projects 5 Potential ICAR Structures to Address Risk This chapter sketches out different options for carbon reserve of structures that could be used to implement an ICAR. structures that may mitigate the risk of high unit prices in car- Structures A to C are listed in increasing degree of autonomy bon markets. Similar structures could be considered for price of the ICAR. floor or price collar instruments and insurance pools. 5.2. Options for Structures 5.1. Agreement A wide range of options is included here to indicate the extent For any ICAR structure, there will need to be some kind of of options. This paper recognizes, however, that sovereignty agreement—or an opt in set of rules and requirements— considerations may make it difficult or even impossible for among participating countries and jurisdictions that seek to many governments to consider options that provide significant benefit from an international pooling of carbon reserve func- decision-making power to an ICAR (i.e., options A3, B, C). tions to mitigate risk. Table 5.1 provides a preliminary overview Table 5.1: Options for ICAR Structure Structure Description Ownership/Governance Option A1 • Coordination of local carbon reserves • Each member country owns and manages its • High price threshold triggers coordinated release of units own contribution to the pooled reserve from local reserves to market • Release of units follows agreed-upon rules • Decision making is “rule based” Option A2 ICAR is pool of • International pool of carbon units • ICAR owns and manages the reserve local reserves • High price threshold triggers release of units from ICAR to • Release of units follows agreed-upon rules that carbon market • Decision making is “rule based” Option A3 • International body manages risk of high prices by releasing • International body takes autonomous decisions units from ICAR pool to carbon market in need to release units • Decision making is “management based” ICAR enables • International body manages risk of high prices by allowing • International management body decides on connectivity for (partial) linking or networking between or among linking in line with regulations and guidance between or specific systems from participating jurisdictions among carbon • Decision making is “management based” markets ICAR is an • International body regularly analyses developments and • Member countries provide the international international risks in carbon markets and decides on measures to carbon management body with far-reaching management reduce risks and increase stability powers body • Decision making is “management based” ICAR is an • International fund to support countries and compliance • Mitigation action to be governed and international entities in financing the implementation of mitigation implemented by country support fund measures in case of too-high carbon prices • Support fund to decide on financial support for (“pool of money”) • Decision making is “management based” investments in mitigation 5  Potential ICAR Structures to Address Risk  | 13 5.2.1. ICAR as a Pool of Carbon Units between Options A1 and A2 may be rather small when trans- action procedures for units from local reserves are efficient. If ICAR were to be structured as a pool of carbon units, there would be different options for ownership and control of units. A purely rule-based decision structure (Options A1 and A2) In Option A1, the reserves would remain under the owner- may be easier to agree on between and among participating ship of the individual jurisdictions. The ICAR would act more jurisdictions than a structure where the decision for interven- as a coordinating body, organizing the joint release of units tion would be at the discretion of a more autonomous govern- from individual carbon market reserves to the carbon market ing body (Option A3). This is because “opt in” jurisdictions where the intervention is taking place (in loose analogy to the may have to give up some of their sovereignty. This could be coordination of national oil reserves in the International Energy mitigated, however, by adequate governance rules—which Agency [IEA]—see appendix C). In Option A2, the ICAR would could go as far as granting each participating jurisdiction with own and control its own units and release them directly to the a veto right to block any interventions from the reserve. From relevant carbon market to trigger the action. an efficiency perspective, a more elaborated carbon ceiling management (Option A3) might provide more subtle market Option A3 is similar to Option A2, but the release of units interventions than a simple rule-based approach. The reserve’s would not be purely rule based; instead, it would be at the governing body could anticipate upcoming risk and, together discretion of the governing body of the ICAR. Different modes with the participating jurisdictions, take preventive action be- for the management of market interventions could be consid- fore high price levels are reached. Furthermore, the governing ered, including limiting prices at an ex-ante fixed price ceiling, body could adjust the price ceiling to adequate levels in rela- defining timing and volumes to be released to the market; or tion to other factors. For example, the (carbon) price sensitiv- limiting prices at a level determined on an ad hoc basis by the ity in a jurisdiction with low economic growth may be much reserve’s governance body, taking into account other factors higher than in an economy that is in good shape and better (e.g., the economic situation in the considered jurisdiction). able to sustain higher carbon prices. The governing body of the ICAR could either be formed by It is clear that price management could directly impact key representatives from the participating jurisdictions or by a body economic parameters in participating jurisdictions. As a result, that is tasked by the participating jurisdictions (e.g., with the a reserve governance body would need to be able to take into objective to limit price levels in order not to damage economic account and balance the requirements and interests of each growth). Pursuing these objectives, however, would require a of its jurisdictions—and such a structure would need adequate certain level of independence in how and when to intervene time to develop. It might therefore be wise to start with a in markets, similarly to the autonomy that central banks have simple structure (Option A1). After the ICAR has proven its in pursuing their objectives (e.g., low inflation, low unemploy- functionality und usefulness, then it might be more appropri- ment, and economic growth3). ate to move to more elaborate and autonomous governance The coordination and pooling of locally held reserves (Option structures (Options A2 and A3). A1) may be easier to agree on between and among participat- ing jurisdictions than handing over units to a centralized ICAR 5.2.2. Structures with Other Functions (Options B and C) (Option A2). At a later stage, or if the number of participat- ing jurisdictions grows significantly, it may be more efficient Besides releasing units to specific carbon markets to mitigate to hand over units to the ICAR. In practice, the difference high price risks, an ICAR could also serve to stabilize participat- ing markets and/or provide insurance functions. Another im- portant function could be coordination or even management 3 Similar ideas for structures for rule-based market interventions and of (partial) linking activities between and among participating a “central bank“ approach for stabilizing a (single) carbon market are discussed by the Dahrendorf Working Group 4’s research activities carbon markets in order to mitigate high price risks (Option on structural options to strengthen the EU-ETS. See http://www. B). For instance, where there are high carbon prices in Carbon dahrendorf-symposium.eu/index.php?id=302 14 |  Design Options for an International Carbon Asset Reserve Market A, the ICAR could coordinate a controlled and limited in specific compliance entities in the carbon market in order to transfer of units from Carbon Markets B and C to ease the reduce demand. supply situation in Carbon Market A—even though the three markets would not otherwise be linked. Participation in such Such a support fund could operate as a standalone instru- partial linking could be completely voluntary or be governed ment or could be used to support some of the other reserve by the ICAR agreement. functions discussed above. In a supplementary role, and in (developing country) jurisdictions where access to financial Theoretically, an ICAR could have a whole spectrum of market sources for low carbon technologies is a major obstacle, management instruments at hand to mitigate high price risk. such a support fund could be an efficient tool to catalyze This could include the release of pooled reserves, partial link- low carbon investments and thus reduce demand for units ing of carbon markets, and adjustment of rules for borrowing, in the carbon markets. A support fund needs to be designed banking, and eligibility of units in different carbon markets carefully, however, so as not to lead to market distortions and (Option C). Similar to a central bank, such an ICAR would to minimize rent-seeking by compliance entities. A further manage these instruments independently to achieve the consideration is that a support fund instrument may be rather objectives defined by participating jurisdictions (following the slow and mitigate only in the mid-term—which may be too rules of the reserve’s agreement). slow for a market stabilization measure. The combination of different functions may significantly in- 5.3. Institutional Setting and Roles crease the efficiency of an ICAR’s market interventions as the reserve’s action could be tailored to the specific situation. For The ICAR could be founded on a multilateral agreement of the instance, partial linking may support price levels once the ICAR participating jurisdictions4 that would define the governance buffer of units is depleted (or might replace it altogether). A structure, regulatory setting, and opt-in requirements needed coordinated increase in allowed borrowing levels agreed on for the reserve to operate. The reserve could be managed, by the participating jurisdictions may be an efficient measure for example, by an executive board formed of representatives to further strengthen a price ceiling. Of course, the potential from participating jurisdictions. In establishing the reserve, transfer of market management functions from local jurisdic- there would need to be discussion about the role of mem- tions to the level of an ICAR would require an enormous ber jurisdictions, including addressing issues of sovereignty, amount of time and trust-building between and among par- decision-making power, and the right to set the rules. ticipating countries; this thus makes this more of a long-term In setting up the ICAR, there would need to be procedures vision than an option for a starting structure. established that specify how the reserve is used and who is 5.2.3. International Support Fund (Option D) in charge of making various decisions. This would need to include procedures for application into the reserve, require- A supporting fund is a qualitatively different function for an ments for deploying units from the reserve, and accounting of ICAR. Instead of units from participating carbon markets, under the units used in national and international carbon accounting Option D an ICAR would be a financial reserve to finance systems (e.g., an international transaction log). In addition, mitigation action as an instrument to contain unit prices. In there would need to be a set of rules to determine who owns case of high carbon prices in a participating carbon market, the carbon markets in the reserve as well as for determining such a fund could then be used to finance mitigation activities who would be eligible to use the reserve and to what extent. from offsets outside the carbon market (within or outside the jurisdiction) and to supply the carbon market with the gener- ated offset units to increase supply and lower prices in the carbon market (it may even be cost neutral); or to subsidize or provide loans for the implementation of mitigation activities 4 The international body could be structured to allow sub-national jurisdic- tions, such as regions and provinces, to participate. 5  Potential ICAR Structures to Address Risk  | 15 5.4. Moral Hazard 5.5. The Need for Fungibility of Units When different jurisdictions team up to implement a common An international pooling of reserve capacity is only possible ICAR system covering differing carbon markets in different ju- if the units from different carbon markets in the reserve can risdictions, risk for moral hazard exists. Using a price ceiling as be made fungible, at least for the limited number of units an example, participating jurisdictions may want to implement in the ICAR. Thus participating countries need to agree on a very low price ceilings in their carbon markets in order to spare mechanism for comparing the mitigation value of units among their compliance entities from high carbon compliance costs. participating carbon markets. The conversion rate could be As industries from different carbon markets compete, this one-to-one for similar asset types in markets of similar design could lead to a race to the bottom as each jurisdiction would and level of ambition. Alternatively, exchange rates for different want to set their ceiling very low, resulting in the frequent type of units from different markets could be established. triggering of interventions and rapid depletion of the ICAR. In addition, price ceilings set too low will prevent investments In the context of an ICAR, the introduction of such conversion in low carbon technologies. The higher level of connectivity rates for units from different markets may lead to additional between and among carbon markets that comes with an ICAR requirements. For example, the number of units that a specific may also lead to additional risk as the state of the carbon mar- jurisdiction has to deposit in the ICAR may depend on the ket in one jurisdiction may deplete ICAR capacity that may be value of the units compared to the units from other markets. needed in another carbon market at a later point in time. Furthermore, in the case of a change in the assessing of the units from a particular market system (e.g., an upgrading) and Moral hazard should be a key issue in the negotiations for a the related change in the conversion rate, the participating reserve agreement. As the ICAR will build on some form of jurisdiction might adjust (decrease) the number of its units in agreement among participating jurisdictions, moral hazard the ICAR. can be mitigated during the negotiations defining the gov- erning rules and the reserve’s interaction with participating 5.6. Capitalization carbon markets. Indeed, it will be in the interest of participat- Different options for the capitalization of the ICAR may be ing jurisdictions to include measures against moral hazards. considered. Jurisdictions wishing to participate in the reserve may even first need to adjust some of their own regulations and/or the 5.6.1. Reserve of Carbon Assets stringency level of their carbon markets. Where the reserve is a pool of carbon markets (tCO2e) from One way to mitigate the risk of moral hazard issues would be different carbon markets, various approaches for capitalization to have the ICAR act only as a supplement to the national car- may be considered. These include: bon reserves of participating jurisdictions. For example, there • A specified share of each allocation in a cap-based carbon could be an agreement under which the national reserve market (e.g., an emissions trading system) or each issuance would need to absorb the first tranche of risk layers of high in a crediting based carbon market could be assigned to the price risk. Only after the national reserve were depleted would ICAR. the ICAR step in and provide further units to hold a price ceil- • A specified number of units (which may depend, among ing. Another option would be to have the units, in order to be other things, on the agreed-upon “exchange rates” of the put on the market, be supplied by local jurisdictions and ICAR units) in each carbon market allocation could be assigned based on a fixed share (e.g., one-third locally provided and to the ICAR. Each jurisdiction may also buy units from its two-thirds contributed from the ICAR). carbon market for the ICAR with revenues (e.g., from their auctioning of allowances, from carbon taxes, and so forth). • Where participating jurisdictions agree to, for example, combine a price ceiling with a suitable floor price 16 |  Design Options for an International Carbon Asset Reserve mechanism (assuming that adequate safety valves are 5.7. Potential Role of the Private Sector included), interventions to buy units to sustain a price floor In recent years, the private sector has played an important at one point in time would increase the buffer. These units role as a risk taker and market maker in the EU-ETS, the CDM, may be released later if the price ceiling is triggered. and other liquid emissions markets. Banks and other financial 5.6.2. Reserve of Financial Assets institutions have developed a wide range of financial product for market participants to hedge against price risks and to The reserve could be designed as a pool of money (e.g., in speculate on market movements. In addition, the insurance U.S. dollars—structure D in section 5.2), and this could be industry has been designing insurance products to specifically implemented in the form of a multilateral fund. The fund cover the risks of investors in mitigation activities that seek to could be capitalized by the reserve’s member countries and/ tap into the revenues from selling carbon units. or by donors. It could also receive money from other funds (e.g., the Green Climate Fund). On a national/sub-national Private sector institutions are well-positioned to provide level, participating jurisdictions could draw funding from shares financial instruments and serve insurance functions (see of revenues from the auctioning of allowance units, from a section 4.1).The private sector can only play the role of a risk carbon tax, or from governmental budgets. The reserve could taker, however, if the risks can be adequately assessed. In also be set up by a private sector initiative (e.g., from the the early phases of emissions markets, in particular, private members of an industry association), with capitalization for sector entities may be reluctant to engage, in particular in this private sector insurance pool coming from the members. markets where assets are created by regulation (as in carbon markets) and are thus less tangible. In addition, the time span 5.6.3. Cost of Revenues over which private sector entities are prepared to engage may The required size for an ICAR depends, among other things, be shorter. As a result, in early phases of carbon markets in on the characteristics of the participating carbon markets particular, the role of financier and insurer may need to be and the required level of protection (e.g., level and robust- undertaken by the public sector. ness of price ceiling, correlations between carbon markets), and pooled reserves may be more efficient than individual It is difficult to foresee a private sector role in pooling reserves, reserves for most carbon markets (see chapter 3). one of the potential key functions of an international carbon market. On the one hand, private sector entities may be more Under certain circumstances, it may be possible to implement efficient in their operational processes and may also provide a reserve function in a cost-neutral way or even to generate access to larger funds. On the other hand, private sector enti- revenues for the jurisdiction. For example, if in a cap-based ties do not have the political mandate to carry out the reserve carbon market (emissions trading systems), the price is so functions that require delicate balancing of participating high so as to trigger price ceiling activities, the ICAR may make jurisdictions’ economic and political interests. Thus, one might additional units (of comparable environmental quality and derive that the ICAR should have a public form, implementing mitigation value) available to the market at the price ceiling an agreement between participating jurisdictions. level; these units may be priced significantly higher than the average price of the comparable units still in the reserve. This As a public institution, an ICAR could source out certain activi- (limited) exchange by the reserve of units with a comparable ties to private sector companies (e.g., administration, informa- mitigation value but lower price units from other carbon mar- tion technology). Once the reserve is established and up and kets into a high price carbon market may generate revenues, running, it can also consider collaborating with private sector as the reserve effectively would buy units at a lower price and entities in a public-private partnership in order to buy risk sell them at a higher price level. coverage from the market. The size of the reserve could be re- duced (in order to reduce costs), for example, if private sector 5  Potential ICAR Structures to Address Risk  | 17 Figure 5.1: Phased Implementation of an ICAR 1 2 3 4 Preparatory Negotiating Implementation Implementation Phase Agreement Phase I Phase II • Awareness raising • Negotiating rules • Reserve operational • Full reserve • Participant markets • Design of reserve • Limited scope • Opt-in markets • Risk assessment • Governance structure • Pooling benefits • More pooling benefits • Options for functions • Comparability • Gaining experience • Optimization entities replaced part of the reserve by privately held reserves for compliance, and so forth). The design and implementation or by insurance products.5 of an ICAR requires the close cooperation of all participat- ing jurisdictions and their agreement on key aspects of the 5.8. Implementation of an ICAR reserve. Jurisdictions wanting to opt in at a later point in time would, therefore, need to agree to a basic set of existing rules. Given the numerous regulatory and institutional complexities within and among participating carbon markets, it would seem In order for each jurisdiction to be able to assess the risks and to make sense to adopt a step-wise process in the design and benefits of its participation in the ICAR, an intensive exchange implementation of an ICAR. The phases illustrated in Figure of information on the rules and regulations of the participating 5.1 could be considered, depending on the characteristics and carbon markets, on emissions intensities, on cap allocation, on needs of the participating jurisdictions and the objectives and crediting rules, and on other factors is required. requirements of the ICAR function. The main challenges in building up an ICAR seem not to Experience from the design and implementation of ETSs be the technical issues and institutional questions of such a indicates that each phase typically takes 2-5 years. In addi- buffer function; these seem to be manageable. A key chal- tion, implementing an ICAR needs to be closely coordinated lenge in establishing and building an ICAR is the design of a and synced with the development phases of the participating step-wise process that leads participating countries/jurisdic- carbon markets. tions to a sound agreement on an ICAR and the mechanism for comparing the mitigation value of different types of assets In a network of carbon markets with partial linking, an ICAR in different type of markets. could complement and support domestic measures for the mitigation of carbon market risks by operating as an instru- Finally, the process of jurisdictions coming together to negoti- ment for participating countries to benefit from a pooling of ate on the role and function of an ICAR may bring benefits in market reserves. This function builds on the characteristics, itself. For example, the exchange of information on different rules, and regulations of the participating carbon markets—with carbon markets and negotiations on how risks can be ef- many elements having strong links to the local market regula- ficiently managed in a joint approach while efficiently limiting tions (e.g., on the assignment of units for the reserve and moral hazards may help regulators in different jurisdictions capitalization, the eligibility of units from other carbon markets to better understand the different systems and to make their own carbon markets more comparable and robust. In the end, assuring the robustness of carbon markets in competing 5 Such public-private partnerships might draw elements from existing economies may support the international competitiveness of structures, including the Pacific Catastrophe Risk Assessment and Financing Initiative. the industry in individual carbon markets. Appendix A: Risk Mitigation Measures A.1. Approaches to Mitigate the Risk of a High In addition to government intervention, the market itself can Unit Price also address the risk of high prices. For example, the use of derivative instruments in a financial market may help compli- Table A.1 provides an overview of risk mitigation approaches ance entities to hedge against the risk of high prices in the that regulators may use to address the risk of high prices. Each future. In the EU-ETS, a wide range of derivative instruments is of these approaches has its pros and cons, and some of the offered, including futures, calls, and collars. instruments are listed for completeness and may not provide for a robust approach to risk mitigation in all circumstances. Table A.1: Risk Mitigation Measures that Regulators Can Use to Address High Carbon Unit Prices Risk mitigation measure Examples • Units from reserve are sold at a fixed (threshold) • New Zealand, California (4 percent of price that is defined and published ex-ante allowances go to the reserve; quarterly sales at fixed prices) A) Implementation • Carbon market regulator decides on market • Similar to a national bank’s intervention of a jurisdiction-level interventions on an ad hoc basis and defines price to implement monetary policies (e.g., low carbon reserve buffer and volume of units to be introduced to market as inflation) and price ceilinga deemed fit to regulate the market price • Price signal may trigger release of units from the • No current example in carbon market reserve to the market in a rule-based approach B) Fixed penalty • Government imposes a fixed penalty on compliance • Swiss emissions trading systems existing in case of non- entities in case of non-compliance that is paid in penalty is 130EUR/tCO2 compliance that acts lieu of handing over allowances as a price ceiling • Price signal may trigger an increase in the level of C) Banking and permitted borrowing and the release of previously borrowing of units banked permits • Link or network with schemes that have lower unit • Linking with crediting scheme: EU-ETS, prices (i.e., high price signal may trigger increased Switzerland, New Zealand allow for (restricted) D) Linking or level of use of allowed offsets) use of CERs networking with ETS • Restrict transfer of units to schemes that have high • Regional Greenhouse Gas Initiative (RGGI) or crediting system demand (and high price) employs two upper price triggers (related to to access additional domestic offsets and international offsets) abatement options • Emissions trading systems linking: California with Quebec, and EU-ETS with Switzerland • Government increases the cap for individual • No current example in carbon markets. E) Adjusting the cap compliance entities and introduces additional units into the market • Use of returns from unit sales or other incomes • Switzerland: subsidy of low-carbon investments F) Supporting (e.g., taxes) for mitigation measures (e.g., through in housing and industry sector with revenues mitigation efforts subsidies on a sectoral level) from carbon tax a. The term “price ceiling” is often used for existing price containment instruments that mitigate the risk of high prices but do not provide for a price as- surance. For example, if the national reserve is depleted, the authorities lack the means to further sustain the price ceiling via this instrument. Appendix A: Risk Mitigation Measures  | 19 A.2. Explaining the Risk Mitigation Approaches additional supply in the market. This may trigger unit prices to decline. Respective countries, however, would need to imple- Table A.1 highlights six mitigation approaches, which are ex- ment additional measures to meet their international and/or plained in more detail here. domestic emissions reduction obligations. Furthermore, adjust- Under the carbon reserve buffer and price ceiling risk miti- ing the cap could introduce uncertainties in the market and gation approach, a pool of carbon units could be administered undermine the environmental integrity of the system. by either a governmental entity or a private institution. Units Finally, market prices could be steered indirectly by support- come from a certain percentage or a fixed amount of total al- ing mitigation efforts. This could foster further investment lowances in the emissions trading system or other cap-based and facilitate projects at both individual compliance enti- market. The buffer offers a hedge option: units from the car- ties and across sectors and, in turn, reduce the demand for bon reserve are introduced at a fixed price to the market when emissions units from the emissions trading systems (or other the unit price exceeds a certain threshold. This threshold can market trading systems). The funding for these support mea- either be defined ex-ante and communicated publicly (thus sures could come from the returns of auctioning of emissions facilitating planning certainty) or determined “just in time” as trading units or from ring-fenced carbon taxes. These mitiga- prices rise. Such fixed price ceilings, combined with (inevi- tion supports would need to be implemented at a sectoral or table) finite reserve capacities, require specific regulations to multi-sectoral level to target the compliance entities that they fend off potential speculators who may bet against the price are created for and to avoid rent-seeking by other entities. ceiling until the reserve is depleted. One way to ensure con- Eligibility restrictions and conditions for such support would tinuous price containment is to hold announced sales at one also need to be assessed beforehand in order to avoid market or different fixed prices. The board responsible for California’s distortions and not inadvertently provide perverse incentives emissions trading system, for example, offers allowances for for project implementation. sale four times a year in three price tiers. Penalties for non-compliance require compliance entities A.3. Mitigating Other Price-Related Risks to pay fixed penalties for each unit of the difference between Table A.2 provides an overview of mitigation approaches to their emissions and their allowances. In cases where penal- address the risks of low prices, price volatility and illiquidity, ties may be paid in lieu of handing over allowances, this in and a lack of market information. Each of these approaches practice results in a price ceiling. has its pros and cons and some of the instruments are only listed for completeness (and may not provide for robust ap- Allowance banking and borrowing of units is a mitigation proaches to risk mitigation). strategy designed to equilibrate present value prices across years and trading periods. However, borrowing could under- mine early abatement efforts. A.4. Mitigating Non-price Related Risk In addition to government intervention, the market itself can Connecting two or more emissions trading systems (or address the risk of carbon price volatility. For example, the use other market trading systems) is intended to extend markets of derivative instruments in a financial market may help com- and stabilize prices. High prices in emissions trading system pliance entities to hedge against the risk of volatility. On the A will decrease when linked to emissions trading system B other hand, such instruments could attract new market partici- when unit costs are lower than in emissions trading system A pants (e.g., property traders), which may or may not lead to (and/or the supply of units in its market is higher). There are an increase in price volatility. In the EU-ETS, a wide range of multiple approaches to connect systems, including both link- derivative instruments are offered, including futures, calls, puts, ing and networking. and collars. In addition, carbon market exchanges could be es- Raising the cap in the emissions trading system (or other tablished and, as an important prerequisite for liquidity, could market) allows for the generation of more units—and thus for help to address volatility risk. Examples of exchanges that 20 |  Design Options for an International Carbon Asset Reserve Table A.2: Other Price-related Risks Low unit prices Impacts on installations: General impacts: • Low profitability of some earlier GHG mitigation measures • The carbon market ceases to function • Risk of low prices leads to low investments in GHG mitigation • Low investments in GHG mitigation • Risk of policy switch to (economically potentially less-efficient) command-and-control policies or no climate policies Price volatility (in particular in early and small markets) Impacts on installations: General impacts: • High price volatility may lead to uncertainty in the investment • Carbon market ceases to function climate • Risk of policy switch to (potentially economically less-efficient) • High volatility may lead to business opportunities command-and-control policies or no climate policies • Implementation of mitigation measures may (i) be considered highly risky (because reward is uncertain); or (ii) be seen as a hedge against price volatility Lack of market information Impacts on installations: General impacts: • Uncertainty and less investment in mitigation activities • General market ignorance/uncertainty about existing trends, opportunities, and risks trade carbon market contracts include the European Climate A.4.2. Risk of Non- or Underperformance of Exchange and Nord Pool. Mitigation Activity An important instrument for mitigating non- or underperfor- A.4.1. Risk of Invalidity of Issued and Allocated Units mance risks is an Emissions Reduction Purchase Agreement There is a risk in current carbon markets that issued or allo- (ERPA) between a project owner/operator and the off-taking cated units that are accounted for in a carbon asset registry or carbon aggregator. ERPAs may include a prepayment that may tracking system will be rendered invalid. Risks for issued and or may not be reimbursable in case of project failure. The allocated units are, in most cases, limited to cases of fraud agreed price is often related to market prices and unit issu- and crime (e.g., in recent cases in the EU-ETS, criminals ac- ance volume. For example, ERPA structures routinely involve a quired access to carbon registry systems and carried out illegal floor price with upside sharing, guaranteeing a minimum price transactions). Buyers of illegally obtained units risk losing the for project owners and operators and, thus, a minimum profit- value of their purchases. This risk can be mitigated by imple- ability for the investment. Regarding issuance volume, the first menting best practice safety and security rules and regulations tranche may be bought at a higher price than for units that in carbon registry systems. The situation is a bit more complex exceed this tranche. in the case of units from carbon sequestration activities. The pooling of projects in a portfolio offers another strategy to mitigate risk. Carbon aggregators build up a portfolio of ERPAs with units from different projects. As in other financial portfo- lios, the pooling of risks and a diversity of project types and Appendix A: Risk Mitigation Measures  | 21 countries helps to reduce overall risk. Portfolio risk is assessed future contract should protect future cash flows and assure the by probabilistic modelling and carbon markets in portfolios sustainability of the investment. are routinely hedged with derivative instruments in the carbon market. A.5. Risks Related to the Nature of Absolute Caps A.4.3. Risk of Non-permanence of AFOLU Units Most of the existing and emerging emissions trading systems cover countries or jurisdictions that cover a single common Measures that aim at increasing the terrestrial carbon stock, economy or a national economy (e.g., the European Union, such as afforestation, reforestation, improved forest manage- New Zealand, Quebec, California, and the Republic of Korea). ment, and land use change (as well as carbon capture and As a result, economic cycles impact the entire economic area storage projects) face the risk of non-permanence (i.e., that of these systems in a similar way. Many emissions trading at a given time after the implementation of the project, part systems are cap-and-trade systems that define absolute caps or the entire increase in the terrestrial carbon stock will be for emissions trading systems compliance entities (i.e., caps released into the atmosphere). The following mitigation ap- are set ex-ante and are not (or only marginally) adjusted with proaches have been or could be used to address the risk of economic development). The process of ex-ante cap-setting non-permanence: usually takes into account historic and current emissions and • Temporary units: In the CDM, units for afforestation and production levels and/or projections of future growth. reforestation projects are issued on a temporary basis, and these temporary certified emissions units (t-CERs) and The level of emissions covered by an emissions trading sys- long CERs (l-CERs) needed to be replaced eventually by tem in a jurisdiction tends to depend heavily on the jurisdic- permanent units. This condition significantly limited the tion’s economic development. When the actual economic attractiveness of these market instruments, and the t-CER development within a jurisdiction significantly deviates from and l-CER markets have never taken off. the projections that were the basis for the cap-setting process, emissions trading systems with absolute caps may suffer from • Buffers: Under a buffer strategy, a specific share of issued extreme carbon price levels (at least compared to price levels units is set aside (e.g., by a forestry offset program or assumed in the cap-setting process). The more homogenous project participants) in a central buffer, and then released in the economy underlying an emissions trading systems, the the case of an event that results in non-permanence. more vulnerable the carbon market is to swings in the eco- • Insurance: It may also be possible to develop insurance nomic cycle: products that cover some or all of the relevant risks for • In case of an economic downturn or crisis, the entire non-permanence for single projects or portfolios of projects. economy is hit and emissions and carbon prices may Such insurance instruments could be built on existing drop sharply, causing severe stress on the capacity of the insurance products for natural disasters and (to a lesser national/jurisdictional price containment system to maintain extend) to hedge against political risk. Insurance may be a price floor. particularly efficient in combination with a buffer system. • In case of higher than expected economic growth, the A.4.4. Risk of Non-eligibility of Units in Carbon Markets growing emissions may lead to rising carbon prices, causing stress on the capacity of the price containment system to One way to mitigate changes in eligibility is to use financial maintain its predefined price ceiling. instruments for carbon markets that can act as a hedge. For example, investors in mitigation projects that will generate This suggests that, in a cap-and-trade system with absolute units can enter into future contracts that assure them that they caps, the more homogenous and uniform the underlying can sell those units in the future at a predetermined price. If, economy, the more vulnerable the price containment system later, the units from their specific project type lose their eligibil- to economic cycles. ity for compliance (and therefore their market value), the 22 |  Design Options for an International Carbon Asset Reserve Absolute caps are a risk that may limit the effectiveness and the level of linking between carbon markets (where feasible) functioning of national price containment measures. If the re- or, as an intermediate solution, by pooling the risks and price serve capacity is too low compared to the requirements of the containment measures over different carbon markets and economic cycle in terms of risk mitigation capacity, reserves jurisdictions that are less correlated or not correlated at all may be depleted. This risk may be mitigated by increasing (see chapter 3). 23 Appendix B: Existing Price Containment and Reserve Instruments The pros and cons of measures for carbon market price B.1. Existing, Emerging, and Potential Regional, stabilization have been the subject of healthy debates in National, and Subnational Carbon Pricing policy circles and academia (e.g., Burtraw, Palmer, and Kahn Instrument 2009; Jones, Purvis, and Springer 2013; Murray, Newell, and In the past couple of years, several new initiatives have Pizer 2009; Pizer 2002) ever since carbon markets were started their implementation process. Notably, in 2014 the established. This paper does not make the case for price implementation of pilot ETSs in Hubei and Chongqing have containment measures and they are not the subject of this started. Meanwhile, France and Mexico adopted carbon taxes discussion. This paper does, however, examine ways to sup- and Chile passed carbon tax legislation. Figure B.1 shows the port jurisdictions that would like to implement such measures increase in carbon pricing initiative over time as a share of and provide options to complement and support domestic global emissions covered while Figure B.2 illustrates existing, price containment measures with ICAR functions that may emerging, and potential regional, national, and subnational make these measures more efficient and effective. carbon pricing instruments. Table B.1 provides latest update The following section provides a preliminary overview of some on emerging carbon pricing schemes. existing and planned emissions trading systems and their regulation of carbon prices. Appendix C then provides a brief B.2. Overview of Current Price Floor and Ceiling description of the International Energy Agency’s Emergency Policies Response System of the International Energy Program is Figure B.3 provides prices of existing carbon pricing instru- provided, as this multilateral instrument may also serve as a ments. Table B.2 then provides examples of price floors and model from which to borrow ideas and concepts for an ICAR. price ceilings in various emissions trading systems. The infor- mation on price floors and ceilings are provided based on a review of current literature and is not exhaustive. 24 |  Design Options for an International Carbon Asset Reserve Figure B.1: Regional, National, and Subnational Carbon Pricing Initiatives: Share of Global Emissions Covered Source: World Bank. 2015. Carbon Pricing Watch 2015. Washington, DC: World Bank. Appendix B: Existing Price Containment and Reserve Instruments  | 25 Figure B.2: Summary Map of Existing, Emerging, and Potential Regional, National, and Subnational Carbon Pricing Instruments Source: World Bank. 2015. Carbon Pricing Watch 2015. Washington, DC: World Bank. 26 |  Design Options for an International Carbon Asset Reserve Table B.1: Latest Update on Emerging Carbon Pricing Schemes Countries Update Chilean parliament approved a carbon tax of US$5 per tCO2 in September 2014. Starting in 2018, this tax will be Chile applied to power generators with a thermal plant capacity greater than 50 megawatts. Following the start of the pilot ETSs in Beijing, Guangdong, Shanghai, Shenzhen, and Tianjin in 2013, and in Chongqing and Hubei in 2014, the designs of some of these schemes are rapidly evolving. Until March China 2015, approximately 17 million allowances worth US$100 million had been traded in all schemes combined. A nationwide ETS may be launched by the end of 2016 and be fully implemented in the course of 2019. Full implementation of the Kazakhstan’s ETS started in 2014, including enforcement and trading. The trading Kazakhstan volume was low, with only 35 transactions representing a total of 1.3 MtCO2. The average price of allowances in 2014 was KZT406 (US$2). The Korea ETS entered into force on January 1, 2015, and covers 23 subsectors. In the first phase—from 2015 Republic of Korea to 2017—ETS installations will receive a free allocation of 100 percent of their average 2011–13 GHG emissions. No auctioning will take place. In Portugal, a carbon tax of €5 per tCO2e (US$5 per tCO2e) was approved in November 2014, which entered into force on January 1, 2015. It applies to non-EU ETS sectors and covers approximately 26 percent of the Portugal country’s GHG emissions. The tax is expected to generate revenues of over €95 million (US$104 million) in 2015. In Switzerland, the first two auctions of allowances in its ETS took place in May and November 2014. Allowances in these auctions were sold at two different prices: CHF40 (US$42) and CHF20 (US$21), respectively. Switzerland Switzerland and the EU continued negotiations on linking, with a seventh round of talks taking place in March 2015, aimed at establishing an agreement in the first half of 2015. Source: World Bank. 2015. Carbon Pricing Watch 2015. Washington, DC: World Bank. Table B.2: Overview of Price Floors and Ceilings in Various ETSs Scheme Price floor Price ceiling Notes Source $10.71, increase $40/45/50, increase of 5% p.a. The floor appeared to influence California Air of 5% p.a. plus real. Reserve tranche volume the first auction and some future Resources Board— California inflation rate increasing over time. tranches CARB (2012); OCCP (2013) C$10, increase C$40/45/50, increase of 5% Linked to California as part of the Government of of 5% p.a. real p.a. real. Western Climate Initiative Quebec (2013); Quebec escalation, auction OCCP (2013) floor Regional $1.93 constant Cost Containment Reserve at The floor has been effective in RGGI (2013); Greenhouse auction floor price in $4 in 2014 increasing to $10 by sustaining prices despite chronic OCCP (2013) Gas real terms 2017, and an increase of 2.5% oversupply Initiative p.a. nominal post-2017 (RGGI) No Price ceiling at NZ$25 Effective ceiling lower due to 2 New Zealand New for 1 surrender provisions Government Zealand (2013); OCCP (2013) Appendix C: IEA’s Emergency Response System  | 27 Figure B.3: Prices of Existing Carbon Pricing Instruments (as of April 1, 2015) US$140/ tCO2 130 Sweden carbon tax 62 Finland carbon tax (transport fuels) US$60/ Switzerland carbon tax tCO2 53 Norway carbon tax (upper) 47 Finland carbon tax (other fossil fuels) US$40/ tCO2 38 Tokyo CaT US$/tCO2 27 UK carbon price floor Denmark carbon tax 10 Quebec CaT 24 BC carbon tax 22 Ireland carbon tax Switzerland ETS 9 Korea ETS Beijing Pilot ETS US$20/ 8 Iceland carbon tax tCO2 19 Slovenia carbon tax EU ETS Shenzhen Pilot ETS 7 Kazakhstan ETS 15 France carbon tax 6 RGGI Portugal carbon tax 13 California CaT Guangdong Pilot ETS 5 12 Alberta SGER New Zealand ETS Hubei Pilot ETS 10 Shagnai Pilot ETS 4 Tianjin Pilot ETS 9 Congqing Pilot ETS 8 Mexico carbon tax (upper) 3 7 Latvia carbon tax 6 Norway carbon tax (lower) 5 2 Estonia carbon tax 4 Japan carbon tax 3 2 US$0/ <1 Mexico carbon tax (lower) <1 tCO2 Poland carbon tax Source: World Bank. 2015. Carbon Pricing Watch 2015. Washington, DC: World Bank. 28 |  Design Options for an International Carbon Asset Reserve B.3. Summary of Current Price Floor and Ceiling Neither scheduled reserve in 2013 was held for this reason. If Policies in Various ETSs a reserve sale is held in the future, the reserve sale administra- tor will offer all of the allowances in the reserve at each sale. B.3.1. California The California Air Resources Board (CARB) has set in place an Compliance entities can also buy offsets from individual miti- emissions trading system to help California meet its emissions gation projects issued by the CARB but not covered under the reduction target (80-percent reduction from 1990 levels by emissions trading systems cap. Requirements for issuance are 2050). The program started at the beginning of 2012 and similar to the CDM standards. The limit for purchasing offsets foresees measures to contain the unit price, including re- is set at eight percent of the entities’ covered emissions. serves, for the purchase of offsets, and for linking with other The amount of offsets that can be used for compliance is systems. increased by the same quantity as the number of allowances put into the reserve. In order to reduce the risk that substantially higher-than-antic- ipated compliance costs are incurred, the CARB implemented The CARB also holds quarterly auctions to allow compliance an allowance reserve as a cost-containment mechanism. entities to buy allowances directly from the CARB. Each year, a This mechanism increases the amount of allowances avail- fixed floor price is determined ($10.71 in 2013); this increas- able from the reserve. The reserve is generated by taking four es by five percent per year (plus the rate of inflation). percent from the program’s allowance budget across all three Finally California linked its emissions trading system with compliance periods. Units from the reserve are made available Quebec in January 2014 according to the Western Climate quarterly at pre-established prices in three tiers with limited Initiative’s (WCI)6 design recommendations for regional cap- volumes each. and-trade programs. Each jurisdiction accepts the other’s com- In 2013, prices for tier 1, 2 and 3 were $40, $45, and $50 pliance instruments and they hold joint auctions. For offsets, per metric ton respectively. Since 2013, allowances from each respective projects have to be located in either Quebec or tier are being offered at prices equal to the tier prices from California, and only credits issued by one of the two states will the previous calendar year increased by five percent, plus be accepted for offsetting (CARB 2013). The first auction took the rate of inflation as measured by the most recently avail- place in November 2014. The scope of both programs was able 12-month value of a consumer price index. Compliance enlarged in 2015 to incorporate transport fuels.7 entities (compliance entities) decide whether they want to B.3.2. Quebec purchase allowances from the reserve. Once all allowances from the reserve are sold, the reserve will not be refilled; it Quebec has a very similar price containment mechanism thus would be exhausted as a price containment mechanism. in place as California—namely, a carbon cost-containment reserve to conduct strategic reserve sales up to four times per The implementation body for this cost-containment mecha- year for entities covered by the emissions trading system. The nism is the CARB itself, which sets the fixed prices of the tiers reserve holds one percent of the allowances under the cap for and monitors activities from reserve sales. Application of the 2013 and 2014. The reserve will hold four percent of the al- mechanism is rule based; as a result, sales are only held if lowances under the cap for 2015–2017, seven percent of the there are qualified applicants for a scheduled reserve sale. 6 The WCI is a nonprofit corporation formed to provide administrative and technical services to support the implementation of state and provincial greenhouse gas emissions trading programs (www.wci-inc.org). 7 World Bank. 2015. Carbon Pricing Watch 2015. Washington, DC: World Bank. Appendix D: Public and Private Institutions  | 29 allowances under the cap for 2018–2020, and then four per- B.4. EU Market Stability Reserve cent of the allowances under the cap for 2021 and beyond. The EU Commission envisions the establishment and opera- Prices in 2013 in tiers 1, 2 and 3 were $40, $45, and $50, tion of a market stability reserve in the EU-ETS (EC 2014). respectively (the same as in CARB). The Quebec emissions The Commission does not directly consider price containment trading systems planned to increase prices annually by five mechanisms. It would, however, regulate the amount of allow- percent. Unlike in the California emissions trading system, ances in the system: from 2021 onward, 12 percent of the 8 inflation is not considered in this increase. total number of allowances in circulation could be placed in the reserve if this amount were equal to or greater than 100 To contain overall compliance costs, Quebec allows the million allowances. The release of 100 million allowances purchase of offsets from individual mitigation projects outside would take place automatically if the total number of allow- the emissions trading system with the same utilization limit as ances in circulation in a given year falls below 400 million or in California (eight percent). Respective projects have to be if, for more than six consecutive months, the carbon price is located in either Quebec or California, and only credits issued more than three times the average carbon price during the by one of the two states are accepted for offsetting. two preceding years. The administrative implementation of this mechanism has been delegated to the Western Climate Initiative. The WCI organizes sales from the Quebec reserve on a mutual agreement between applicants and the WCI. As a result, the reserve mechanism is rule based, since sales only take place if demand for reserve units exists. In addition, there are regula- tions in place specifying who is eligible to buy reserve units. All requests for registration must be approved by a minister (simi- lar to the reserve sale administrator in California). The minister may also choose to use the reserve allowances to adjust the amount of free allowances allocated to emitters. B.3.3. New Zealand The New Zealand emissions trading system has been in operation since 2008; it covers emissions from forestry, stationary energy, industrial processes, and liquid fossil fuels. The price ceiling is set at NZ$25. Under the emissions trading system, compliance entities may import an unlimited number of CERs to fulfil their compliance obligations (New Zealand Government 2013). 8 The total number of allowances in circulation is defined as the differ- ence between all allowances issued and international credits used (since 2008) until the end of each year and verified emissions recorded since 2008 and allowances in the reserve at the end of that same year. Appendix C: IEA’s Emergency Response System The International Energy Agency (IEA) was founded in 1974 The decision to activate emergency response measures is by major industrial countries in response to the 1973 oil crisis taken by the IEA’s governing board, supported by advice and the actions of the Organization of the Petroleum Exporting from a panel of industry experts. The governing board is the Countries. The security of the energy supply of IEA member IEA’s main decision-making body; it is composed of energy countries and international cooperation among members are ministers (or their senior representatives) from each member important aims of the IEA. country. A central pillar of the IEA’s governing treaty is the Emergency In 1984 the IEA introduced a second layer of emergency Response System of the International Energy Program (IEP), measures, the Coordinated Emergency Response Measures. implemented by participating countries through the IEA. They may be activated if the oil supply disruption is not acute Though not a carbon market, it is an example of a commodi- enough to trigger the IEP emergency measures. ties market supply regulation instrument of international scope and voluntary participation—and implemented through an The IEP has been implemented within the complex geopoliti- international entity. Elements of its operational set-up and its cal context of international energy policies—and its operation institutional structure, regulation, and governance may serve and efficiency have been debated extensively. Some of the as a possible model for the design of an ICAR. In addition, les- preliminary lessons learned from this process include: sons learned from the implementation of the IEP illustrate the • The design, agreement, and implementation of international potential challenges and shortcomings of such structures. instruments are time consuming and difficult, in particular if a large number of countries are involved and consensus Through the IEP agreement, the participating countries commit needs to be sought. themselves to the following actions: • The emergency response system has only been triggered • National reserves. Each party has to maintain emergency three times since its inception (1990/91—Gulf/Iraq; 2005— reserves sufficient to sustain consumption for at least 90 Hurricane Katrina; and 2011—Libya). This may point to the days with no net oil imports. fact that the main market impact from such an instrument • Action plan. Each party has to prepare a program of comes mainly from its existence rather than from its actual contingent oil demand restraint measures, enabling it to application in emergency situations. In addition, it has been reduce its rate of final consumption by seven percent (or 12 argued that the last activation of emergency measures was percent in the event of a very severe supply disruption). triggered more to contain prices on oil markets (and, with • Allocation. In case of several supply disruptions, each party that, to stabilize global economic growth), as the trigger must participate in the allocation of its oil supplies according criteria of a 7-percent undersupply had not been reached. to IEA rules. This basically requires countries with higher • The quantitative requirement for countries to hold (public or reserves and fewer supply restrictions to supply to countries private) national oil reserves does not specify the quality of in need. Fair treatment of participating countries is sought the oil in the reserve. This, and the limitations in fungibility and the price should be based on “conditions prevailing for of different products in the reserve, should be taken comparable commercial transactions.” into account. As different countries have different (and sometimes limited) refinery capacities, , this has led to a The response system is triggered whenever “the group sus- situation in the past where, even though the overall national tains or can reasonably be expected to sustain a reduction in reserves and oil supply was sufficient according to IEP the daily rate of its oil supplies at least equal to seven percent criteria, the actually supplies were mostly crude oil while the of the average daily rate of its final consumption.” country suffered from a shortage of lighter fractions (e.g., diesel, gasoline). Appendix D: Public and Private Institutions  | 31 • The planning and operation of an emergency instrument to stabilize oil markets through an international agency requires extensive information and data on oil production and consumption patterns, changes in stocks, and so forth. The IEA has established itself as a leading provider of data, information, and analysis on energy markets and technologies. Appendix D: Public and Private Institutions The following table outlines examples of form, function, and organization of public and private international organizations as well as a public-private partnership. Member Compliance Institution Form Category Purpose Scope by Countries Public Institutions UN Framework Secretariat Convention or Coordination of negotiations Global Yes, countries co- Convention on under treaty related and information platform finance the Secretariat Climate Change convention (UNFCCC) International United Nations Program Surveillance, technical Global Quota determines Monetary Fund Specialized assistance, and lending financial commitments (IMF) Agency, Fund to member countries, and voting power stabilization of economy Bank for International Model of Serve central banks in their Global Yes, through International Bank action: clearing pursuit of monetary and respective member or Settlements financial stability, foster central banks, financial international cooperation, act contribution as a bank for central banks International Cooperation Framework Steering of international OECD Yes, financial Energy Agency Platform body energy policy: energy members contribution and security, economic only maintenance of stock development, and levels environmental protection Global Fund Convention Address global Global Yes, financial Environment mechanism, environmental issues contribution by Facility Fund while supporting national countries sustainable development initiatives Nordic Multilateral Provide loans and make Denmark, Yes, financial Environment Financial capital investments in Finland, contribution by Finance Institution, order to generate positive Iceland, countries Cooperation Fund environmental effects of Norway, and interest to the Nordic region Sweden World Business CEO-led Business Sustainable development Global (by Members make Council for Association of friendly platform for companies invitation knowledge and Sustainable Companies international to share knowledge, only) experiences as well Development NGO experiences, and best as human resources practices; and to advocate available. They also business positions publically report on their environmental performance Appendix D: Public and Private Institutions  | 33 Member Compliance Institution Form Category Purpose Scope by Countries Private Insitutions Cement Association of Business Platform to exchange Invitation only Commitment to the Sustainability Companies friendly information, provide data on initiative charter, Initiative international cement sector, development report on emissions NGO of chart for sustainable and energy use, development for cement implementing sector good practices, and contribution to the budget Carbon Disclosure Independent NGO Information platform, Global Members provide Project NGO disclose greenhouse gas information on their emissions, and other resource consumption environment related and emissions, information of major member fees apply companies Public-Private Partnership Pacific Joint Initiative PPP Initiative Provide Pacific Island SOPAC/SPC, Financial support by Catastrophe by International Countries with Disaster Risk World Bank Japan and GFDRR Risk Assessment Organizations, Modeling and Assessment Group, Asian technical support from and Financing Countries, Tools Development AIR Worldwide, New Initiative Academic Bank Zealand GNS Science, Institutions, Geoscience Australia, and Private Pacific Disaster Center, Companies Open Geo, and GFDRR Labs Bibliography Burtraw, D., K. 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Mapping Carbon Pricing Initiatives: Developments and Prospects. http://www.thepmr.org/ content/pmr-technical-work-program http://www.worldbank.org/en/topic/climatechange/brief/globally-networked-carbon-markets Contact: Bianca Ingrid Sylvester Tel: 202.473.4549 email: bsylvester@worldbank.org