ICAP  Training  Course  2014  on    

Emissions  Trading  for  Emerging  Economies    

and  Developing  Countries  

Santiago  de  Chile,  5  –  14  May,  2014  

ICAP Training Course 2014 on Emission Trading for

Emerging and Developing Countries

Santiago de Chile, 5 – 14 May 2014

Introductory Reader

Table of Contents

I.  Introduction   1  

II.  Basic  Concept  of  Emissions  Trading   3  

1.  Background   3  

2.  Prerequisites   4  

3.  Finding  the  Balance  between  Theoretical  Optimum  and  Political  Reality   4  

III.  Overview  of  ETS  Design  Elements   5  

1.  Setting  the  cap  and  determining  coverage  –  how  big  is  the  cake  and  who  gets  a  piece?   5  

2.  Allocating  allowances  –  who  gets  which  slice?  And  who  gets  it  free  and  who  pays?   10  

3.  Price  stability  and  cost  controls  –  how  to  make  the  cake  affordable   12  

4.  MRV  and  enforcement  mechanisms   14  

5.  Price  drivers   15  

6.  Market  instruments   17  

IV.  Conclusions   19  

V.  Endnotes   20  

Disclaimer:

This reader has been drafted by the Ecologic Institute | Berlin | Brussels | Vienna | Washington, DC for the purpose of the ICAP Training Course 2014.

The ideas expressed in this reader do not necessarily represent views of ICAP or its members, or the endorsement of any approach described herein.

1

I. INTRODUCTION

In recent decades, the rise of new environmental challenges has fuelled growing con-cern for the efficiency of policy measures, leading to the adoption of new regulatory ap-proaches after decades of mostly theoretical debate.i As a result, conventional performance targets have been joined or supplanted by market incentives, all with an aim to ‘improve the command system through better balancing of regulatory costs and benefits, improved risk analysis and management and greater flexibility.’ii

Emissions trading, or, more aptly, the creation of a market for tradable emission al-lowances, is representative of this trend. It has become an established feature of modern envi-ronmental policy, and, as such, needs to be adequately studied in its political and economic consequences, and – of equal importance – with a view to its legal and institutional ramifica-tions. For the purpose of mutual learning and an exchange of experience in establishing emis-sions trading system, leaders of more than 15 governments met in Lisbon, Portugal on Octo-ber 29, 2007, to launch the establishment of the International Carbon Action Partnership (ICAP). ICAP is made up of countries and regions that have implemented or are actively pur-suing the implementation of carbon markets through mandatory cap and trade systems. ICAP provides the opportunity for member countries and regions to share best practices. Linking current and emerging carbon markets at a global level establishes a level playing field for co-vered sectors and a consistent regulatory framework across national borders.

Today, ICAP consists of public authorities and governments (in total 29 members and

3 observers) that either have established or are actively pursuing carbon markets through mandatory cap and trade systems with an absolute cap. ICAP members share best practices and learn from each other's experiences through conferences, workshops, expert networks and the ICAP outreach and capacity building activities such as the trainings on emissions trading for representatives from emerging economies. The following map (Figures 1) developed by ICAP shows where emissions trading schemes are already in force, where the implementation of such a scheme is scheduled, or where an ETS is being considered as a potential climate mitigation instrument. The map, constantly updated, and with detailed descriptions of each jurisdiction and trading system is available at the ICAP website (www.icapcarbonaction.com).

2

Figure 1: Status of Emissions Trading Systems (ETS) Around the World

© 2013 by International Carbon Action Partnership (ICAP)

The purpose of this reader is to provide participants of the ICAP training courses on emissions trading a brief conceptual introduction to the central features of emissions trading as a policy instrument to mitigate greenhouse gas (GHG) emissions. To this end, the follow-ing sections outline the essential building blocks for an ETS. Readers are encouraged to fol-low up on ideas raised in the text by consulting additional literature which is offered in the reading suggestions and in the endnotes.

Reading suggestions on emissions trading systems worldwide: International Carbon Action Partnership (ICAP) (2013): Interactive ETS

Map. Berlin: ICAP. Available online at: http://icapcarbonaction.com/index.php?option=com_wrapper&view=wrapper&Itemid=147

Hood, C. (2010): Reviewing existing and proposed emissions trading sys-tems. Paris: IEA/OECD. Available online at: www.iea.org/papers/2010/ets_paper2010.pdf

A glossary on climate change acronyms can be found at: http://unfccc.int/essential_background/glossary/items/3666.php

3

II. BASIC CONCEPT OF EMISSIONS TRADING

1. Background

Emissions trading, or, more aptly, the creation of a market for tradable emission allowances, is based on a strategy of quantity rationingiii and dates back to earlier studies in environmental eco-nomics, notably by John H. Dales.iv At the core of this approach are allowances conferring the right to discharge a specified quan-tity of pollutants for a limited duration of time. Unlike economic instruments based on pricing control, such as charges imposed on pollutant emissions,v a system of transferable emission allowances requires regulatory authorities to determine either a technological baseline or a ceiling – also known as ‘cap’ – for overall emissions. Over time, the baseline can be changed to improve environmental performance, while successive cutbacks in the scope or number of allowances can be used to impose a gradually tightening ceiling on the aggregate pollutant burden. Ideally, the baseline or ceiling will reflect a level where marginal abatement costs and marginal environmental benefits meet.

Participants are assigned a number of allowances in an arranged procedure and may

sell these or purchase additional allowances at the respective market price, signalling the op-portunity costs of pollution as determined by the forces of supply and demand. Following initial allocation, thus, the distribution of allowances is left to market forces. If a participant is able to reduce pollutant discharges at fairly low cost, it will have an incentive to do so and sell the excess allowances to other participants. Those with high abatement costs, in turn, can opt for the acquisition of further allowances and thereby increase their own emissions quota, for instance to accommodate growth in economic activity. In the end, whenever the market price of allowances exceeds the cost of emissions reductions, it should prove beneficial to install better abatement technologies or take other action to lower emissions rather than purchase additional allowances. Accordingly, as prices for allowances rise in response to growing scarcity, the demand for them will gradually decrease.vi

The central benefits ascribed to a market for emission allowances are lowered abate-

ment costs relative to traditional control mechanisms.vii By providing an ongoing incentive to reduce emissions, a trading system may also encourage competition and the development of more efficient technologies.viii Despite the flexibility left to participants, the specified baseline or cap affords a greater degree of certainty than other economic instruments in the achieve-ment of a desired environmental objective. That, in turn, can help reduce adjustment costs incurred by frequent changes, which often become necessary in the case of pricing models.ix As opposed to fees and taxes, moreover, the use of allowances places emissions trading in closer vicinity to conventional permit schemes, lessening the administrative challenges in-volved in a departure from an established practice.x Some authors, however, have expressed more critical views of certain aspects, arguing, for instance, that the assignment of a price to pollution creates the impression of a ‘right to pollute’ and conceals the moral implications of environmentally detrimental behaviour.xi What is more, some of the savings offered by emis-sions trading are applied towards the costs of monitoring and ensuring operation of the trading

4

Box 1: Guiding principles for establishing an ETS • Keep it simple - Rules that are easy to under-

stand bring down transaction costs and ease enforcement. • Create confidence - If market participants can

rely on accurate GHG monitoring and verifica-tion processes and on rigorous enforcement, they are more likely to adhere to the rules of the game. • Provide investment certainty - If market par-

ticipants believe in policy-makers’ long-term commitment to a trading scheme, and if the scheme is established with consistent rules without ad hoc changes, they are more likely to take carbon prices into account in their in-vestment decisions.

market, as well as the transaction costs placed on participants. But that also applies to other policy instruments, which equally entail monitoring, administrative or other cost.

Emissions trading schemes can be designed to cover different types of entities, such as states, companies, or individual installations as ‘compliance entities’. International emissions trading, one of the three flexible mechanisms of the Kyoto Protocol, has the countries that are parties to the Kyoto Protocol and that have signed up to GHG emissions reduction targets as participating entities, allowing them to comply with their targets by trading so-called ‘as-signed amount units’ (AAUs). Subject to some restrictions, RMUs (‘removal units’ from land use, land-use change and forestry activities), ERUs (‘emission reduction units’ from Joint Implementation) and CERs (‘certified emission reductions’ from the Clean Development Mechanism) are also eligible compliance units. ETS that do not have countries or states as compliance entities, but rather companies or other GHG emitting entities (e.g. owners of buildings), are increasingly being established at the domestic and regional level as a policy instrument to achieve GHG reduction targets. These might be targets a country or other politi-cal jurisdiction has committed itself to, a voluntary targets for an industry sectors, or even an in-house target adopted by an individual company.

2. Prerequisites

Knowledge about past and present GHG emissions as well as likely trends in an economy is a prerequisite for an informed decision on design elements such as scope, cap setting and allocation. The better the data quality and economic modelling projections about likely future emission trajectories,xii the better policy-makers can try to accommodate individual sector circumstances in the design of an ETS while keeping up its environmental integrity and cost-effectiveness.

3. Finding the Balance between Theoretical Optimum and Political Reality

Ultimately, each ETS is different, because countries differ in many ways: their specific economic structures, their institutional capacity, the existing mix of climate policies and other instruments, the political culture, and the role of different stakeholders. Implementing an ETS means assigning costs and rents. Thus political dynamics can explain why real-life trading schemes differ in their degree of effectiveness and efficiency, and usually do not mirror the optimal design recommendations of economic textbooks. Often, the establishment of an ETS incorporates a ‘learning phase’ in which the structures are set up, but targets lack stringency. Having a learning phase is acceptable in order to gain political acceptance of the new scheme, but there should be a mechanism to increase stringency over time.

5

III. OVERVIEW OF ETS DESIGN ELEMENTS

The following overview briefly introduces some of the major factors that should be taken into consideration when designing an ETS (additional ones include e.g. competitiveness issues, carbon leakage, interaction with other policy instruments, and linking provisions).

Reading suggestions on the building blocks of an ETS: For a comprehensive and easy-to-understand guidebook on how to set up

an emissions trading system, see US EPA (2003): Tools of the Trade: A Guide to Designing and Operating a Cap and Trade Program for Pollu-tion Control. Washington, DC: EPA. Online available at: www.epa.gov/airmarkets/resource/docs/tools.pdf

A classic book on the best practices in an ETS, see Tietenberg, T. (2006): Emissions trading: Principles and practice, 2nd edition. Washington, DC: Resources for the Future Press.

For a summary of crucial design features of an ETS, see chapter 3 of Reinaud, J. and Philibert, C. (2007): Emissions Trends: Trends and Prospects. Paris: IEA. Online available at: www.oecd.org/dataoecd/60/38/39725657.pdf

Not exclusively on ETS, but on the use of market-based instruments in developing countries, see Aasrud, A, Baron, R, Karousakis, K. (2010): Market Readiness: Building Blocks for Market Approaches. Paris: OECD/IEA. Online available at: www.oecd.org/dataoecd/30/14/46563135.pdf

1. Setting the cap and determining coverage – how big is the cake and who gets a piece?

Probably the most important regulatory decisions in the establishment of an ETS is

how to set the emission cap. The cap refers to the total amount of the GHG emissions covered in a system (if using the analogy of cake, the cap would be equal to the size of the cake). Set-ting the cap means striking a balance between environmental ambition and the costs imposed on the covered entities. In the theoretical ideal, the cap is set where marginal abatement costs are equal to marginal benefits of reducing emissions. In real life, the cap is typically set up with a view to the (domestic or international) emission reduction targets that a country has set itself. In order to break this economy-wide target down into an ETS cap, policy-makers often look for the ‘bend in the cost curve’, that is the point before the costs per unit of emission reduction begins to rise rapidly (see figure 2), so that the implied costs of abatement stay ac-ceptable.xiii When introducing an ETS, it may be advisable to start with a lenient cap, and to increase its stringency over time as the market matures and as more reliable data becomes available.

6

Box 2: Absolute versus intensity-based caps Most existing schemes set a cap on absolute emissions: they guarantee a certain envi-ronmental outcome and they provide a reasonable amount of certainty for the market participants. An alternative model may be based on intensity-based caps, which link the level of allowable emissions (or the level of emission reductions) to economic growth. If growth is higher than anticipated, the cap increases, if it is lower, the cap falls. Since it is hard to predict economic growth, intensity-based caps create more uncertainty about the abatement effort needed, which translates into insecurity to the market, and thus affects price formation and the functioning of the market. The ad-vantage of intensity-based targets is that they do not impose any quantitative restric-tion on the economy, which makes them a popular concept particularly in many de-veloping countries. It is important to note that the nature of the target (absolute or intensity-based) says nothing about the level of ambition. There can be trading schemes with an absolute cap, which is nonetheless very lax – and there can be very ambitious intensity-based targets, which impose a real constraint (and cost) on the economy. Reading suggestions:

For a layman’s discussion of intensity targets see Herzog, T., Baumert, K. and Pershing, J. (2006): Target: Intensity. An Analysis of Greenhouse Gas In-tensity Targets. Washington, DC: World Resources Institute.

For a comparison of absolute and intensity-based targets from an economist’s perspective see: Ellerman, D. and Wing, I. (2003): Absolute vs. Intensity-based Emission Caps. In: Climate Policy, 3, Supplement 2, p.7-20.

Figure 2: Marginal Abatement Costs to Emission Sources

Source: EPA 2004: 3-9.

Setting the cap is eventually one of the most important factors for determining the economic value of an allowance and is significantly interconnected with determining the cov-erage of a system. The following parameters are decisive for defining the coverage of an ETS.

7

a. Gas coverage – more than just CO2?

Greenhouse gases: Most ETS focus on carbon dioxide emissions from combustion processes since these come from a relatively small number of sources and are relatively easy to measure, but also since they account for the bulk of greenhouse gas emissions in most countries. In contrast, CH4 and N2O emissions, as well as CO2 emissions from land use change, are emitted from a large number of small and diffuse sources. Accordingly, only a few trading schemes cover these gases. Energy-related CO2 emissions are relatively straight-forward to measure – provided that accurate fuel input data and emission factors are available. Other GHGs such as N2O emissions from certain production processes in the chemical in-dustry and perfluorocarbons from aluminium production may also be included. Table 1: Global warming potentials and relevance of GHGs Carbon

dioxide (CO2)

Methane (CH4)

Nitrous oxide (N2O)

Hydro-fluoro-carbons (HFCs)

Perfluorocarbons (PFCs)

Sulphur hexafluoride (SF6)

Global Warming Potential (CO2e)

1 21 310 140 - 117000

6500 – 85 000

23 900

Contribution to glo-bal anthropogenic greenhouse effect

81% 10% 6.5% 1% 0.5% 1%

Source: IPCC (1996): Guidance for National GHG Inventories.

b. Sectoral coverage – Try full house or go for a few rooms? In order to define the coverage of an ETS, there are some general considerations to be

made: • What is the (estimated) reduction potential in a given sector, and what is the abatement

cost they face? Here, the system should achieve a balanced mix of different abatement costs, to give incentives for trading.

• What are the emission trends in a given sector? Sectors with growing emissions are more problematic than those with stagnant or falling emissions – in a trading system, both should be included.

• Concentration of emissions and transaction cost: including every tiny emitter of GHGs would overburden the administration of the scheme, and lead to disproportionately high transaction costs (monitoring, reporting and verifying emissions, applying for and submitting allowances, etc.).

• Are there enough actors in the system? Too few market participants can also be dan-gerous: for trading to work, a sufficient number of actors need to be active in the mar-ket. The fewer actors there are, the more market power each actor has, and the easier it becomes to abuse their market position or collude with others to influence prices.

• How familiar is the sector with trading mechanisms? Sectors that are experienced with trading their inputs and outputs on a day-to-day-basis (such as power producers, air-lines or refineries) will find it easier to participate in the actual emissions trading.

• How ‘MRVable’ is the sector? Beyond the concentration of emissions and the associ-ated transaction costs, there may be other factors that make it structurally more diffi-cult and costly to reliably monitor emissions.

8

One consideration that should not affect the choice of sectoral coverage is the com-petitive situation of the sector: some sectors, e.g. industrial sectors manufacturing export pro-ducts will argue that a price on carbon damages their international competitiveness. But this does mean that the sectors ought to be excluded from trading, as there are options to alleviate the burden on these sectors inside the system, e.g. by a higher share of free allowance alloca-tion, a more generous use of offsets or other means of compensation for bearing the carbon price (see below). At a general level, this leads to the following alternatives for system coverage:

• Economy-wide: Ideally, an ETS covers all GHG sources of a nation’s economy. In theory, this would minimise the economy-wide cost of achieving a given greenhouse gas reduction target, as a great heterogeneity of sources implies a broader variety of abatement costs. An economy-wide scheme would also prevent any unwanted side-effects and distortions that can arise at the system boundaries (e.g. in transport, where a system that covers only rail and aviation might give an undesired incentive to use private vehicles).

• Sector-specific: From a cost-effectiveness perspective, sectors should be included in an ETS that provide a good balance in terms of reduction potential and abatement costs. There will be buyers and sellers in the market – it is therefore not necessary to cover only sectors that find it easy to reduce their emissions. Due to the aforemen-tioned problems in measuring GHG emissions, most ETS initially start with sectors which consist of large sources (thus easier to oversee and regulate), such as the power sector or large, energy-intensive industries. GHG emissions from land-use change, forestry, and agriculture are only rarely included at the outset (although there are ex-ceptions, e.g. New Zealand’s ETS). For sectors not included in the scheme at the out-set, there should either be a perspective for joining the scheme, or other policy meas-ures are needed that create a comparable incentive to the ETS.

Beyond the choice of sectors to be covered, there is also the option of designating

thresholds, related to the size of an installation or its activity. Thus, small emitters can be ex-cluded from the scheme, for which the costs of participating in the system would be dispro-portionate in relation to their emissions. Where size thresholds are used, these should always be linked to the capacity of an installation, not its actual emissions: this can avoid gaming, where emitters lower their emissions just below the threshold, in order to be exempt from the system. In contrast, the capacity of an installation is typically fixed, and cannot be changed easily. Bear in mind that, where emitters are excluded due to their low emissions or activity, they will still need at least a minimal amount of monitoring – so that the regulator can verify if they haven’t surpassed the threshold in the meantime or will do so in the future. There might also be a “voluntary opt-in” for emitters not covered, or an “opt-out” option for emit-ters, provided that other instruments are in place to reduce their emissions (this option existed for phase 1 of the EU-ETS)xiv.

The decision on coverage is highly politicized as various kinds of interest groups will lobby for a design that fits their needs. The path that appears most promising is therefore to begin with some core sectors first (which need to be large enough to allow for trading), and enlarge coverage with time, keeping a balance between mitigation ambition and abatement costs.

9

c. Point of regulation – Upstream or downstream?

• Trading systems can be distinguished as upstream and downstream systems, depending on where the obligation to surrender allowances is introduced: in an upstream system, the producer of fossil fuels has to surrender allowances for the carbon contained in the fuels; in a downstream system, the emitter has to surrender allowances for their actual emis-sions. The decision on whether to regulate allowance obligations “downstream”, “up-stream”, or in a combined fashion depends on how easily emitters are regulated.

• A typical upstream entity could be a refinery, which has to submit allowances for the fuels it produces – since these fuels will eventually be combusted and will then result in CO2 emissions. A typical downstream entity could be a power plant that has to submit al-lowances for its direct emissions in the production of electricity. In theory, the price sig-nal should be the same in both cases: in an upstream system, the fossil fuel producers in-clude the price of allowances into the price of their products. This carbon price is then passed on through the economy along the value chain – and ultimately paid by the con-sumer. In practice, though, it is argued that downstream systems are more likely to stimu-late behavioural change, as they provide a more immediate and tangible signal to the emitter. The disadvantage with downstream regulation is the number of emitters that need to be covered: while power plants are still manageable in number, obliging countless small businesses, let alone individual car owners, to engage in emissions trading would be cumbersome for any ETS administration.

• Most existing ETS are designed as downstream systems, but some ETS are designed as a hybrid scheme which combines upstream and downstream obligations. The Californian scheme, for example, covers electric utilities and large industrial facilities from 2013 on-wards (downstream), but will also include distributors of transportation, natural gas and other fuels from 2015 onwards (upstream). A particular challenge of such hybrid schemes is that the system boundaries need to be well-defined, in order to avoid double-counting of emissions or leakage from the system. For instance, a refinery might find itself covered in both categories: by the downstream system, for the emissions caused by combustion processes inside the refinery, and by the upstream system, for the carbon contained in the fuels produced.

• A particular variety of trading schemes that focus on indirect emissions: in a sense, these systems go even beyond downstream regulation. Currently, one such scheme operates in Tokyo: it obliges large power consumers to surrender allowances for their indirect emis-sions, i.e. for the CO2 that was released during the generation of the power consumed. The distinguishing feature is that this system does trade CO2 emissions (and not only power consumption), and sets an absolute limit for these CO2 emissions. But since the system is operated by the Tokyo Metropolitan Government, most of the actual emitters (power plants) are outside their jurisdiction, hence neither a classical upstream nor a clas-sical downstream approach is not feasible. The regulator therefore chose to target the emissions indirectly, through the power consumption, and using a fixed emission factor to convert power consumption to CO2 emissions.

Reading suggestion on point of regulation: Hargrave,T. (2000): An Upstream/Downstream Hybrid Approach

to Greenhouse Gas Emissions Trading. Center for Clean Air Policy: Washington, DC.

For a discussion on where to have the point of regulation in the Californian ETS, see Bushnell, J. (2008): The design of California’s cap-and-trade and its impact on electricity markets. In: Climate Policy, 8, p. 277–292.

10

2. Allocating allowances – who gets which slice? And who gets it free and who pays?

Once the coverage is defined and the cap is set, the carbon price will emerge, reflecting the stringency of the cap (i.e. the scarcity of allowances). The environmental effectiveness of an ETS is thus largely determined by the cap and coverage. A separate issue is the question of distribution: out of the given total (the cap), who receives how many allowances, and is this allocation for free or does it incur an immediate financial burden (using the cake analogy, this would refer to the size and distribution of cake slices). The decision on the allocation method is highly political: by setting the cap, the government effectively creates a valuable, scarce asset, which is then distributed to the different actors in the economy. This typically results in a rent-seeking game among the various interest groups, who then fight for their piece of the cake.

If installations receive their allowances (or a portion thereof) for free, the amount of allowances given to each installation needs to be decided on the basis of some pre-defined allocation rule. At the most fundamental level, one can distinguish between “grandfathering” (determining the number of allowances based on past emissions during a base period) or “benchmarking” (determining the number of allowances based on a defined performance measure for one homogeneous sector, product group, or economic output).

• Allocating allowances based on grandfathering is comparatively easy, since it only re-

quires the emissions data of the installations in question (although even having accurate data of all installations covered in a scheme can be a challenge). The downside of grand-fathering is that it rewards those that pollute most: irrespective of their efficiency, those that have the highest emissions will receive most allowances. Other limitations are that “early action” is not acknowledged – i.e. a firm that has taken action before the base pe-riod will find that this lowers its free allocation. This creates an incentive to delay any ac-tion until the ETS has started to operate fully. Secondly, grandfathering also creates an incentive for installations to overstate their emissions during the base period, in order to attract a higher allocation.

• Allocating allowances on the basis of benchmarks allows for an equal treatment of com-parable installations (i.e. different installations that produce the same output). Bench-marks can also provide incentives for entities to increase their emissions performance if efficient entities receive more allowances than others (e.g. as in the third phase of the EU ETS). Benchmarks are ideally defined per unit of output (i.e. tons of CO2 per kilowatt hour or per ton of cement clinker), and the allocation is then calculated using these benchmarks and the projected output of an installation. In theory, this allows for equal treatment – rewarding those that produce their goods more efficiently (i.e. with fewer

11

emissions per product), and penalising those with lower efficiency. The challenge is to determine the benchmarks for all the heterogeneous products of all industry sectors that are covered by an ETS. First, this requires definitions of homogeneous groups of products - which is relatively easy for electricity and heat, but much more difficult for paper or glass. Secondly, it requires the definition of the benchmarks that are both ambitious and realistic: for this, the regulator needs detailed, technical information on the efficiency of the production processes.

If allowances are not given out for free, they can also be sold (or auctioned). In this

case, the “cake slice” per installation does not need to be defined up front by way of a politi-cal decision, but the installations can purchase as many allowances as they consider neces-sary. With respect to efficiency and environmental effectiveness, auctioning is the most de-sirable allocation mechanism: it is the most efficient approach to discover the price of allow-ances, it reduces the incentive for lobbying and rent-seeking, and it shifts the information bur-den from the regulator to the regulatee: unlike with free allocation, it is not the regulator that needs to calculate the likely level of future emissions, but the regulated firms that need to form this hypothesis. And, last but certainly not least, one very real and tangible advantage of auctioning allowances is that it provides revenues for the government – which can flow into the general budget, but which can also be used e.g. to support the deployment of low-carbon technologies, or to alleviate the economic impacts of an ETS on emitters and consumers.

A particularly tricky aspect of the allocation are the rules for new entrants and closure rules. If new installations receive allowances for free, this should only be done on the basis of benchmarks (of some sort), as historical emissions are obviously not available for new plants. Yet, it has been argued that new entrant rules are particularly distortive: any investor that plans a new plant will obviously integrate the value of free allocation in his investment deci-sion. Thus, the free allocation perpetuates itself. For the regulator, this also means that some part of the overall cap must be set aside as a ‘new entrants reserve’.

The corresponding equivalent are closure rules that apply when a plant is shut down. In principle, closing a plant could be seen as a very radical way of emission abatement. In this logic, a company that closes a plant should be able to sell any remaining allowances it has received. This ‘scrapping bonus’ could then be used e.g. to invest in a new, more efficient plant. But since it may not be politically palatable to subsidise the closure of plants, most ETS have established closure rules, whereby the operator of a closed plant has to return (part of) the allocation received.

Reading suggestions on allowance allocation: On different design options for auctions, see Crampton, P. and

Kerr, S. (1998): Tradable Carbon Permit Auctions: How and Why to Auction Not Grandfather. Resources for the Future Discussion Paper.

For a discussion on how to set up an optimal grandfathering scheme, see Böhringer, C. and Lange, A (2005): ‘On the design of op-timal grandfathering schemes for emission allowances’. In: European Economic Review, 49, p. 2041–55.

For an economic modelling of the effects of the new entrants and closures provisions of the EU ETS on agent behaviour and output and emissions markets see: Ellerman, D. (2008): ‘New Entrant and Closure Provisions: How do they distort?’ In: The Energy Journal, 29, special issue, p. 63-76.

12

For a discussion of the distortive effects of new entrants and clo-sure provisions of the EU ETS phase I, see Neuhoff, K. et al. 2006: ‘Al-location, incentives and distortions: the impact of EU ETS emissions al-lowance allocations to the electricity sector’. In: Climate Policy, 6, p.73–91.

On the latest EU ETS guidance on new entrants and closures see: European Commission (2011): Guidance Document n°7 on the harmo-nized free allocation methodology for the EU ETS post 2012. Online available at: http://ec.europa.eu/clima/policies/ets/benchmarking/docs/gd7_new_entrants_en.pdf

3. Price stability and cost controls – how to make the cake affordable

The defining advantage of emissions trading is its cost-effectiveness in comparison to other policy instruments and the flexibility it gives to emitters in their decision where, when and how to invest in abatement technologies. As with any market, however, and especially with relatively immature, politically defined carbon markets, low trading volumes and li-quidity as well as price volatility and extremes can undermine the environmental effectiveness of the trading system. Still, there are several tools that can decrease market volatility and con-trol carbon prices. While most of these tools help to bring down the costs of emissions trad-ing, some of them may also endanger the environmental integrity of the scheme. Cost containment measures include:

• Banking allowances – keeping your cake slice for hungry times. If banking is allowed,

emitters can keep any surplus allowances and use them in the next commitment period (provided they do not want to sell them on the market in the current period). Banking can help limit the volatility of prices across trading periods: if banking is allowed, the allow-ance price will reflect not only the current scarcity of allowances, but also the expected future scarcity. Especially in situations where the cap is set (too) leniently in the first trading period, a lack of scarcity in the market, will fail to provide an appropriate price signal in the next period.

13

• Borrowing allowances – eating tomorrow’s cake slice today. If emitters can borrow

allowances from future trading periods, and use them for compliance in the present trad-ing period, the carbon price may be depressed. Unless borrowing is strictly limited and enforced, it may undermine the cap and therefore the environmental integrity of the entire scheme.

• Price floors. Price floors set a minimum carbon price and thus provide (at least minimal)

security to investors that their investments in abatement measures will pay off. Thus, they limit the volatility of carbon prices, and the uncertainty about future prices. However, price floors are only a second-best solution, as they don’t tackle the root of the problem: if the carbon price is perceived as too low, this indicates that a more ambitious cap could have been set.

• Price cap. Some ETS set a maximum price for allowances, to make sure that compliance

costs for emitters do not exceed a certain threshold. In such a case, if a certain maximum price is reached, the regulator increases the supply of allowances: by issuing additional allowances or by allowing (more) offset credits into the scheme. The downside is that such ‘safety valves’ increase the cap on emissions, and thus damage the environmental integrity: where safety valves are in place, the ETS loses its ability to achieve a guaran-teed environmental outcome (i.e. emissions ≤ cap).

• Offsets. Regulators may decide to allow emitters to use offsets to fulfil their obligations.

Offsets are certificates that credit GHG emission reductions from outside the coverage of the ETS. These can be domestic offsets (emission reductions in the same country, but in non-trading sectors) or international offsets from other countries, like JI or CDM. Emit-ters would do so in order to lower their compliance costs: offset schemes are built on the premise that it is often cheaper to reduce emissions elsewhere (in other countries or other parts of the economy). For this reason, offsets are usually traded at a lower price than the emission allowances traded in the scheme. Offsets also follow the logic that, for the envi-ronmental effectiveness of an ETS, it is irrelevant where on the globe the GHG emissions

14

are reduced – as long as it can be ensured that the offset project achieves a genuine, addi-tional, measurable emission reduction. Allowing offsets from domestic or international mitigation projects is therefore acceptable from an environmental integrity point of view, provided that the offset project emissions reductions are measureable, reportable and verifiable.

If offsets are allowed into a scheme, one also must decide on the extent and the kind of offsets that are eligible (domestic and/or international offsets). Ultimately it means strik-ing a balance between reducing costs for domestic industries and encouraging domestic emission reductions and the transition to a low-carbon economy. The Kyoto Protocol’s principle of supplementarity might offer a guideline: countries with reduction obligations agreed to use the flexible mechanisms only as a supplement to their domestic emission reduction efforts.

4. MRV and enforcement mechanisms

Emission trading schemes create new and valuable assets – the emission allowances. But these assets only have an economic value because of the regulation. Thus, in order to en-sure a functioning ETS market that is both credible and reliable, the state as the regulator needs to ensure that covered installations adhere to the rules of the game. A key part of this is accuracy in measuring actual emissions, in verifying them and in reporting the exact emis-sions. Preventing any fraudulent behaviour is crucial not only for the functioning of the mar-ket, but also to ensure the environmental integrity of the scheme. The authority overseeing the ETS must ensure that ”a ton must always be a ton”, no matter who emitted it, when and where. On the other hand, while monitoring has to be accurate and reliable, the cost of MRV also needs to be considered. Good practices of MRV in emissions trading schemes include:

• Devise monitoring rules which are appropriate for the nature and scale of the activity.

These can be differentiated e.g. for type and size of installation. • Reporting requirements must be clear and deadlines should be indicated, e.g. about the

submission of monitoring plans and the periodical emission reports by the operators to the authorities.

• Verification of emissions data is best done by external organisations. If third-party veri-fiers are employed, an accreditation process needs to be in place.

• Penalties for non-compliance have to be in place and their potential enforcements needs to be credible.

• The state authority should possess adequate capacity (financial, human and technical re-sources) to crosscheck compliance.

• Setting up an electronic registry is an important device to ensure the accurate accounting of all allowances being traded in an ETS. It keeps record of the holding of allowances and all transactions concerning those allowances (e.g. auctioning, trading, surrendering al-lowances and their deletion). A registry is comparable to a banking system that keeps track of the ownership of money.

Reading suggestions on MRV: For an example of how monitoring & reporting guideline for an ETS

might look like, see Commission Decision of 2007/589/EC of 18 July 2007 establishing guidelines for the monitoring and reporting of greenhouse gas emissions pursuant to Directive 2003/87/EC of the European Parliament and of the Council (MRG 2007).

15

For an overview of various MRV requirements in existing offsetting schemes (which are comparable to MRV requirements in cap-and-trade schemes) see: IETA (2011): Monitoring, Reporting and Verifica-tion (MRV) considerations for offset projects. A comparison of MRV Requirements across several GHG Offset Programs. Washington, DC: IETA. Online available at: http://ec.europa.eu/clima/policies/ets/monitoring/documentation_en.htm

For an animated demo clip on how the CITL (central registry of the EU ETS) works, go to: http://ec.europa.eu/clima/policies/ets/registries/docs/registrysystem_actions_en.exe

5. Price drivers Once the right to emit becomes a tradable commodity, markets and individual price

dynamics develop for allowances just as they do for agricultural commodities, metals, oil, gas or any other commodity traded by consumers and speculators alike.

As in all markets, prices for emission allowances (usually referred to as the ‘carbon price’) are determined by supply and demand. A stringent emissions cap (few allowances, low supply) in a region with very high emissions (many allowances needed, high demand) leads to high prices – there are not enough allowances to go around, so people are willing to pay more for them. Conversely, a weak cap on entities that do not emit much leads to low prices - there are enough allowances to meet demand, so people are not willing to pay much for them. In a typical economic price vs. volume graph, the carbon price is the point at which the downward sloping demand curve crosses the upward sloping supply curve at a given time.

However, in a carbon market the supply is fixed: there is only one cap – one total al-lowance ‘budget’ or amount of allowances the government puts into circulation each year. Demand, on the other hand, fluctuates according to emission levels. In an ETS that allows offsets, however, the supply is in fact a curve – there is additional supply of compliance units (offset units) depending on how much emitters are willing to pay for them – this is true only up to a certain total volume, if the ETS has a limit to how many offsets may be used. Both demand for allowances and supply of offsets depend on several factors that together deter-mine carbon prices:

a. Demand Since the largest currently active ETS cover emissions from the power and industry

sectors only, factors affecting these sectors determine their allowance demand fluctuation. In the power and industrial sectors, those factors are: • Fuel prices – Are natural gas prices going up, meaning it is cheaper to run power plants

that burn coal rather than those that burn gas? If so, carbon prices will likely rise because more power generators are burning higher-emitting coal and thus emitting more, meaning there is a higher demand for allowances. The relative coal and gas price is a significant price driver for European Union Allowances (EUAs) as European power companies have many coal-fired and many gas-fired plants and can run either, depending on makes sense given the current fuel costs.

16

• Weather – Temperature can determine the overall need for electricity and gas, as these are used for heating: colder winters and hotter summers make for higher carbon prices, as more electricity is needed and most electricity generation involves emissions. In addition, precipitation patterns affect the amount of renewable electricity available: in a drought, hydroelectric dams cannot provide a significant portion of a region’s power so emissions tend to go up when areas with significant hydro resources get little precipitation.

• Other electricity policies – Many countries have energy efficiency requirements, quotas for renewable energy, or feed in tariffs. These incentivize conservation and use of renew-able power, bringing down emissions relative to the level they would be at if an emis-sions trading program were the only policy applied.

• Longer term trends in power demand – A prolonged economic downturn or surge in growth can influence allowance demand because economic growth is (still though de-creasingly) linked with higher emissions. Higher growth makes for higher carbon prices. The international oil price is often an indicator used as a proxy for overall economic growth - oil powers vehicles and machinery, so if these are running at high capacity oil is scarce and thus expensive. Thus traders often refer to the fact that “carbon follows oil” meaning carbon prices tend to be high when oil prices are.

The transportation sector, on the other hand, has relatively low price-elasticity – it

takes a substantial change in fuel prices to compel much of a behavioral response by drivers. While a few cents change in the price of coal relative to gas can trigger changes in which power plants are running, drivers tend not to switch their behavior (drive less, buy more fuel efficient vehicles) unless fuel prices increase more dramatically.

b. Supply

Although supply is made up of the number of allowances in the cap plus the number of

offsets available, regulators can influence supply (and therefore price) via the flexibility mechanisms discussed above:

An auction reserve price (also called a ‘floor’ or minimum auction price, see also Sec-tion III.3.) ensures that allowances will not be sold below a certain price – some emitters may not be willing to buy allowances at prices above the floor, so supply is slightly constrained because not all allowances may reach the market at every auction. This occurred frequently in the U.S. Regional Greenhouse Gas Initiative (RGGI) auctions – the program was so over-allocated that the market price did not rise above the auction reserve price for long periods of time prior to the recent reform.

The opposite measure, a strategic or price containment reserve (see also Section III.3.), increases supply – regulators may set aside a portion of allowances to be released only when prices reach a certain (high) price, in order to provide short term relief when prices hit that level. The tight market is flooded with additional supply, decreasing the scarcity of allow-ances and thus bringing down prices. The Californian ETS has such a provision.

In addition to their influence on allowance supply, regulators can also influence offset supply (see also Section III.3.) by being more or less stringent about what is considered eligi-ble as an offset in the program. In the Californian ETS, only four project types are allowed to generate credits emitters can use for compliance – these project types in turn do not generate

17

many credits per project. The Kyoto Protocol’s Clean Development Mechanism, on the other hand, experienced a glut of offsets as many types are allowed, bringing down overall carbon prices because it reduces emitters’ need for allowances.

6. Market instruments

Turning the right to emit greenhouse gases into a commodity creates a market with distinct actors that usually take on typical roles and follow certain trading strategies. In addi-tion to the primary market, where entities buy allowances directly from the government (through auctions); the secondary market is where entities can buy and sell those allowances among each other.

Governments have several choices about how to run the primary market. They can run their auctions directly, outsource auctioning procedures to a private platform or external party, or hire financial institutions to sell allowances at their discretion in order to maximize reve-nue. Furthermore, governments may restrict who participates in auctions (for instance by al-lowing only compliance entities to buy allowances) or how many allowances can be bought at a given auction or by a given participant (California does this).

In the secondary market, exchanges can offer carbon products (offsets, allowances, de-rivatives of these) just like they offer other commodities. Offsets or allowances may also be traded over-the-counter, i.e. between two counterparties as per terms agreed in a contract. Exchanges make money by charging very small transaction fees in return for taking on coun-terparty risk and guaranteeing delivery, so they usually offer only products that trade in high volumes, like allowances for delivery right before the compliance date when emitters need them. Actors likely to use exchanges are large emitters, financial intermediaries, and specula-torswho need to procure or sell large volumes of compliance units at once, and can also meet the exchanges’ criteria for trading such as credit rating and minimum capital requirement. Over-the-counter transactions usually involve smaller volumes and pertain to specific actors seeking to meet a certain need, such as the promise to deliver allowances far into the future or only under certain fuel price conditions. Such transactions are often set up by brokers, who take a higher fee per transaction than exchanges.

In the EU, the carbon market evolved from mostly over-the-counter trading to mostly exchange trading, as exchanges learned which compliance units had high enough liquidity to be worth offering. In the US programs, exchanges began offering various allowance and off-set assets right away and actors were familiar with carbon commodities, so exchange trading has dominated the volume. Typically, large emitters like power companies and big industrial firms use exchanges and manage their compliance very actively – they have designated trad-ing desks and employees whose job it is to manage their emissions portfolio. Small firms typically look at their emissions vs. their allowance holdings close to the time compliance is due, and procure the necessary units then via brokers. Financial institutions often act as inter-mediaries in both kinds of transactions – they do not have a compliance obligation, but do have exchange memberships and can procure large amounts of allowances or offsets on behalf of other entities or for profit to themselves in a speculative transaction. ‘Speculation’ on mar-kets has earned a negative connotation lately, but financial institutions provide needed liquid-ity by making and facilitating transactions in a new, emerging market – by doing do, they facilitate price discovery and reduce transactions costs, which lowers the overall cost of com-pliance to a carbon cap.

18

The carbon products typically traded are: • Spot contracts, where the buyer pays for and receives the allowance at one time, usually

to fill an immediate compliance need. Only a small amount of transactions in the EU ETS takes place on the spot market – about 14 percent.

• Futures contracts (a derivative product) in which the transaction takes place at one time but the allowance is delivered and paid for at a later date . Futures contracts help manage risk because they ensure the product can be delivered at a certain price at a certain time.

• Option contracts (derivatives) in which a party buys the right (but not the obligation) to pay a certain price for the product at a later date – paying a premium now, for the right to transact the product at a certain price later. This is often done to lock in a minimum or maximum price for planning purposes, for instance under high price fluctuation.

Market participants have good reasons to use these different market instruments. An

industrial emitter, for instance, may conclude that if it installs a new efficient boiler now, its emissions will be well below its cap next year. It can sell allowance futures and use the money to finance the investment in the new boiler, since it will not need those allowances after the boiler has been installed. This way, it does not have to take out a loan to finance the equipment.

Similarly, a power company must incorporate the cost of allowances into the price it charges customers for their electricity. Utilities typically sell power up to three years in ad-vance, so for each unit of power they sell, utilities need to buy the matching allowance and incorporate that cost into the price of power. Locking in carbon price months or years in ad-vance through futures transactions limits risk exposure for these emitters.

19

IV. CONCLUSIONS

Implementation of market-based solutions to climate change is currently fully under-way at the international, regional and national plane, although it has also been met with a number of political and other challenges. Similar hurdles are also likely to arise in emerging and developing countries implementing sophisticated and far-reaching emissions trading sys-tems, starting with the creation of suitable administrative structures. Differences will arise from varying levels of commitment to and under a future international climate regime, and the different stages of domestic and regional policy development; states that have moved forward with the domestic operationalisation of climate policies will find it easier to overcome poten-tial resistance from domestic stakeholders, and instead face the challenge of elaborating trad-ing systems in an already complex framework of environmental rules and other norms. Clearly, however, emissions trading has become a central feature in national and international climate mitigation efforts around the globe, and participants in the resulting carbon market stand to benefit from a number of opportunities. Linking the emerging emission trading sys-tems into a network of interconnected markets or eventually even a global carbon market is becoming a feasible vision for the future.

Reading suggestion on experiences with emissions trading and the outlook for the carbon market: Michael Mehling (2013): ‘Between Twilight and Renaissance: Chang-

ing Prospects for the Carbon Market’. In: Carbon & Climate Law Re-view 6:4, p. 277-290. Available online at: http://www.lexxion.de/pdf/cclr/02%20Between%20Twilight%20and%20Renaissance.pdf

20

V. ENDNOTES i For an overview, see T. Tietenberg, ‘Economic Instruments for Environmental Regulation’ (1990) 6.1 Oxford Review of Economic Policy, 17; also L. Goulder and I. Parry ‘Instrument Choice in Environmental Policy’ (2008) 2:2,152–174  ii R. Stewart, ‘A New Generation of Environmental Regulation?’ (2001) 30 Capital University Law Review, 21; This trend also involves the ‘development of information-based systems to encourage internalization of envi-ronmental norms by business and other organizations; and integrated approaches to environmental planning and management nationally and at the ecosystem level’, ibid. iv J. H. Dales, Pollution, Property and Prices (Toronto: University of Toronto Press, 1968), 92-100; this instru-ment is also partly credited to T. Crocker, ‘The Structuring of Atmospheric Pollution Control Systems’ in H. Wolozing (ed.), The Economics of Air Pollution (New York, N.Y.: W. W. Norton, 1966), 61-86. v Such pricing models based on the notion of environmental fees date back to research by A. C. Pigou, and in-clude emissions or effluent charges, taxes, and subsidies set to cover the marginal damage caused by pollutant activities, thereby internalizing their costs, see W. J. Baumol and W. E. Oates, The Theory of Environmental Policy (Cambridge: Cambridge University Press, 1988), 58. vi An overview of this mechanism is given by N. Mercuro, ‘Environmental Economic Remedies’ in N. Mercuro (ed.), Ecology, Law and Economics (Lanham, MD: University Press of America, 1997), 200. vii For global CO2 emissions, for instance, studies estimate the savings in reduction costs at between 50 and 70 per cent of the initial burden, see J. B. Wiener, ‘Borrowing Something for Something Blue: Legal Transplants and the Evolution of Global Environmental Law’ (2001) 27 Ecology Law Quarterly, 1327. viii L.H. Goulder and B. Nadreau, ‘International Approaches to Reducing Greenhouse Gas Emissions’ in S. H. Schneider, A. Rosencranz and J. O. Niles (eds.), Climate Change Policy: A Survey (Washington, D.C.: Island Press, 2002), 122-5. ix Such corrective action can be needed to compensate the effects of economic growth and price inflation on effluent fees, or to adjust for overly low rates that fail to provide the intended behavioural effect. x This resistance to ‘wholesale changes in policy’ is cited as one of the main reasons for past reticence towards the adoption of economic instruments in environmental protection, see N. Hanley, Jason F. Shogren and B. White, Environmental Economics in Theory and Practice (Houndmills: Macmillan Press, 1997), 154-5. xi See, notably, S. Kelman, ‘Economists and the Environmental Policy Muddle’ (1981) 64 Public Interest, 106- 23. xii For the difficulty to arrive at robust emission forecasts see Grubb, M. and Ferrario, F. 2006: “False confi-dences: forecasting errors and emission caps in CO2 trading systems“. In: Climate Policy, 6, p. 495–501 xiii For more details on this method of approximation see EPA (2003): Tools of the Trade. A Guide to Designing and Operating a Cap and Trade Program for Pollution Control. Washington, DC: EPA. p. 3 - 9. xiv Directive  2003/87/EC  of  the  European  Parliament  and  of  the  Council,  Article  24.