Emissions trading

Emissions trading (or cap and trade) is an administrative approach used to control pollution by providing economic incentives for achieving reductions in the emissions of pollutants.

  A central authority (usually a government or international body) sets a limit or cap on the amount of a pollutant that can be emitted. Companies or other groups are issued emission permits and are required to hold an equivalent number of allowances (or credits) which represent the right to emit a specific amount. The total amount of allowances and credits cannot exceed the cap, limiting total emissions to that level. Companies that need to increase their emissions must buy credits from those who pollute less. The transfer of allowances is referred to as a trade. In effect, the buyer is paying a charge for polluting, while the seller is being rewarded for having reduced emissions by more than was needed. Thus, in theory, those that can easily reduce emissions most cheaply will do so, achieving the pollution reduction at the lowest possible cost to society^[1].

There are active trading programs in several pollutants. For greenhouse gases the largest is the European Union Emission Trading Scheme^[2]. In the United States there is a national market to reduce acid rain and several regional markets in nitrous oxide^[3]. Markets for other pollutants tend to be smaller and more localized.

Carbon Trading is sometimes seen as a better approach than a direct carbon tax or direct regulation. By solely aiming at the cap it avoids the consequences and compromises that often accompany those other methods. It can be cheaper, and politically preferable for existing industries because the initial allocation of allowances is often allocated with a grandfathering provision where rights are issued in proportion to historical emissions. In addition, most of the money in the system is spent on environmental activities, and the investment directed at sustainable projects that earn credits in the developing world can contribute to the Millennium Development Goals. Critics of emissions trading point to problems of complexity, monitoring, enforcement, and sometimes dispute the initial allocation methods and cap^[4].

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Overview

The overall goal of an emissions trading plan is to reduce emission. The cap is usually lowered over time - aiming towards a national emissions reduction target. In other systems a portion of all traded credits must be retired, causing a net reduction in emissions each time a trade occurs. In many cap and trade systems, organizations which do not pollute may also participate, thus environmental groups can purchase and retire allowances or credits and hence drive up the price of the remainder according to the law of demand. Corporations can also prematurely retire allowances by donating them to a nonprofit entity and then be eligible for a tax deduction. Allowances are accounted for in the balance sheet of the company as intangible assets, as recommended by the IAS 38 issued by IASB.

Because emissions trading uses markets to determine how to deal with the problem of pollution, it is often touted as an example of effective free market environmentalism. While the cap is usually set by a political process, individual companies are free to choose how or if they will reduce their emissions. In theory, firms will choose the least-cost way to comply with the pollution regulation, creating incentives that reduce the cost of achieving a pollution reduction goal.

Emissions trading principles are based on proposals by the Technocracy movement of the 1930's. Technocracy proposed a system of Energy Accounting, or emissions trading, to promote balanced and harmonious development throughout the world.

Cap & trade versus baseline & credit

The textbook emissions trading program can be called a "cap & trade" approach in which an aggregate cap on all sources is established and these sources are then allowed to trade amongst themselves to determine which sources actually emit the total pollution load. An alternative approach with important differences is a baseline & credit program ^[5] In a baseline and credit program a set of polluters that are not under an aggregate cap can create credits by reducing their emissions below a baseline level of emissions. These credits can be purchased by polluters that are under a regulatory limit. Many of the criticisms of trading in general are targeted at baseline & credit programs rather than cap type programs.

The economics of international emissions trading

It may be possible for a country to reduce its emissions using a Command-Control approach with regulation, direct and indirect taxes. The problem with such an approach to abatement is that it may cost the economy more to reduce the same amount of pollution when compared to the 'Emissions Trading' scenario.

The economic reason behind this extra cost is because of the different Marginal Abatement Costs (MAC) for taking action in different countries (e.g. China might need to spend only $2 to reduce a ton of CO₂, whereas, say, Sweden or the USA might need to spend more to abate the same amount of CO₂).

Here the Marginal Abatement Cost refers to the cost spent to reduce an extra unit of pollutant or other emissions. Taking advantage of the difference in MAC's is the principle behind the international emissions trading markets.

Example

Emissions trading can benefit both the buyer and the seller through 'Gains from Trade'.

Consider two European countries, namely Germany and Sweden. Each country can either reduce all the required amount of emissions by itself or it can choose to buy or sell in the market.

  For this example let us assume that Germany can abate its CO2 at a much cheaper cost than Sweden, e.g. MAC_S > MAC_G where the MAC curve of Sweden is steeper (higher slope) than that of Germany, and R_Req is the total amount of emissions that need to be reduced by a country.

On the left side of the graph is the MAC curve for Germany. R_Req is the amount of required reductions for Germany, but at R_Req the MAC_G curve has not intersected the market allowance price of CO₂ (market allowance price = P = λ). Thus, given the market price of CO₂ allowances, Germany has potential to profit if it abates more emissions than required.

On the right side is the MAC curve for Sweden. R_Req is the amount of required reductions for Sweden, but the MAC_S curve already intersects the market price of CO₂ allowances before R_Req has been reached. Thus, given the market allowance price of CO₂, Sweden has potential to profit if it abates fewer emissions than required internally, and instead abates them elsewhere.

In this example Sweden would abate emissions until its MAC_S intersects with P (at R*), but this would only reduce a fraction of Sweden’s total required abatement. After that it could buy emissions credits from Germany for the price 'P' (per unit). The internal cost of Sweden’s own abatment, combined with the credits it buys in the market from Germany, adds up to the total required reductions (R_Req) for Sweden. Thus Sweden can also profit from buying credits in the market (Δ d-e-f). This represents the ‘Gains from Trade’, the amount of additional expense that Sweden would otherwise have to spend if it abated all of its required emissions by itself without trading.

Germany made a profit by abating more emissions than required: it met the regulations by abating all of the emissions that was required of it (R_Req). Additionally, Germany sold its surplus to Sweden as credits, and was paid 'P' for every unit it abated, while spending less than 'P'. Its total revenue is the area of the graph (R_Req 1 2 R*), its total abatement cost is area (R_Req 3 2 R*), and so its net benefit from selling emission credits is the area (Δ 1-2-3) i.e. Gains from Trade

The two R* (on both graphs) represent the efficient allocations that arise from trading.

• Germany: sold (R* - R_Req) emission credits to Sweden at a unit price 'P'.
• Sweden bought emission credits from Germany at a unit price 'P'.

If the total cost for reducing a particular amount of emissions in the 'Command Control' scenario is called 'X', then to reduce the same amount of combined pollution in Sweden and Germany, the total abatement cost would be less in the 'Emissions Trading' scenario i.e. (X - Δ 123 - Δ def).

The example above applies not just at the national level: it applies just as well between two companies in different countries, or between two subsidiaries within the same company.

Applying the economic theory

The nature of the pollutant plays a very important role when policy-makers decide which framework should be used to control pollution.

CO₂ acts globally, thus its impact on the environment is generally similar wherever in the globe it is released. So the location of the originator of the emissions does not really matter from an environmental standpoint.

The policy framework should be different for regional pollutants ^[6](e.g. SO₂ and NO_X, and also Mercury) because the impact exerted by these pollutants may not be the same in all locations. The same amount of a regional pollutant can exert a very high impact in some locations and a low impact in other locations, so it does actually matter where the pollutant is released. This is known as the 'Hot Spot' problem.

A Lagrange framework is commonly used to determine the least cost of achieving an objective, in this case the total reduction in emissions required in a year. In some cases it is possible to use the Lagrange optimization framework to determine the required reductions for each country (based on their MAC) so that the total cost of reduction is minimized. In such a scenario, the Lagrange Multiplier represents the market allowance price (P) of a pollutant, such as the current market allowance price of emissions in Europe^[7] and the USA^[8].

All countries face the market allowance price as existent in the market that day, so they are able to make individual decisions that would maximize their profit while at the same time achieving regulatory compliance. This is also another version of the Equi-Marginal Principle, commonly used in economics to choose the most economically efficient decision.

Prices versus quantities, and the safety valve

There has been longstanding debate on the relative merits of price versus quantity instruments to achieve emission reductions^[9].

• An emission cap and permit trading system is a quantity instrument because it fixes the overall emission level (quantity) and allows the price to vary. One problem with the cap and trade system is the uncertainty of the cost of compliance as the price of a permit is not known in advance and will vary over time according to market conditions.
• In contrast, emission taxes are a price instrument because it fixes the price while the emission level is allowed to vary according to economic activity. A major drawback of such emission taxes is that the environmental outcome (e.g. the amount of emissions) is not guaranteed.

The best choice depends on the sensitivity of the costs of emission reduction, compared to the sensitivity of the benefits (i.e., climate damages avoided by a reduction) when the level of emission control is varied.

Because there is high uncertainty in the compliance costs of firms, some argue that the optimum choice is the price mechanism.

However, some scientists have warned of a threshold in atmospheric concentrations of carbon dioxide beyond which a run-away warming effect could take place, with a large possibility of causing irreversible damages. If this is a conceivable risk then a quantity instrument could be a better choice because the quantity of emissions may be capped with a higher degree of certainty. However, this may not be true if this risk exists but cannot be attached to a known level of GHG concentration or a known emission pathway ^[10].

A third option, known as a safety valve, is a hybrid of the price and quantity instruments. The system is essentially an emission cap and tradeable permit system but the maximum (or minimum) permit price is capped. Emitters have the choice of either obtaining permits in the marketplace or purchasing them from the government at a specified trigger price (which could be adjusted over time). The system is sometimes recommended as a way of overcoming the fundamental disadvantages of both systems by giving governments the flexibility to adjust the system as new information comes to light. It can be shown that by setting the trigger price high enough, or the number of permits low enough, the safety valve can be used to mimic either a pure quantity or pure price mechanism^[11].

All three methods are being used as policy instruments to control greenhouse gas emissions: the EU-ETS is a quantity system using the cap and trading system to meet targets set by National Allocation Plans, the UK's Climate Change Levy is a price system using a direct carbon tax, while China uses the CO2 market price for funding of its Clean Development Mechanism projects, but imposes a safety valve of a minimum price per tonne of CO2.

Major trading systems

United States

A prominent example of an emission trading system is the SO₂ trading system under the framework of the Acid Rain Program of the 1990 Clean Air Act in the USA. Under the program, which is essentially a cap-and-trade emissions trading system, SO₂ emissions are expected to be reduced by 50% from 1980 to 2010.

Some experts argue that the "cap and trade" system of SO₂ emissions reduction reduced the cost of controlling acid rain by as much as 80% versus source-by-source reduction.

In 1997, the State of Illinois adopted a trading program for volatile organic compounds in most of the Chicago area, called the Emissions Reduction Market System.^[12] Beginning in 2000, over 100 major sources of pollution in 8 Illinois counties began trading pollution credits.

In 2003, New York State proposed and attained commitments from 9 Northeast states to form a cap and trade carbon dioxide emissions program for power generators, called the Regional Greenhouse Gas Initiative or RGGI. This program will officially launch on January 1 2009, and by 2018 each state's carbon "budget" will be reduced 10% below their 2009 allowances.^[13]

Also in 2003, corporations began voluntarily trading greenhouse gas emission allowances on the Chicago Climate Exchange.

In 2007, the California Legislature passed Ab-32, which was signed into law by Governor, Arnold Schwarzenegger. This bill is aimed at curbing Carbon emissions. Thus far, flexible mechanisms in the form of project based offsets have been established for 5 main project types. A carbon project creates offsets by showing that it has reduced carbon dioxide and equivalent gases. The project types include; manure management, forestry, building energy, SF6, and landfill gas capture. California is now one of five states and one Canadian province that have joined to create the Western Climate Initiative, intending to set up a regional greenhouse gas control and trading environment.

European Union

The European Union Emission Trading Scheme (or EU ETS) is the largest multi-national, greenhouse gas emissions trading scheme in the world and was created in conjunction with the Kyoto Protocol. It is currently the world's only mandatory carbon trading program.

After voluntary trials in the UK and Denmark, Phase I commenced operation in January 2005 with all 15 (now 25 of the 27) member states of the European Union participating^[14].The program caps the amount of carbon dioxide that can be emitted from large installations, such as power plants and carbon intensive factories and covers almost half of the EU's Carbon Dioxide emissions.^[15] Phase I permits participants to trade amongst themselves and in validated credits from the developing world through Kyoto's Clean Development Mechanism.

Whilst the first phase (2005 - 2007) has received much criticism due to oversupply of allowances and the distribution method of allowances (via grandfathering rather than auctioning), Phase II links the ETS to other countries participating in the Kyoto trading system. The European Commission has been tough on Member States' Plans for Phase II, dismissing many of them as being too loose again.^[16] In addition, the first phase has established a strong carbon market. Compliance was high in 2006, increasing confidence in the scheme, although the value of allowances dropped when the national caps were met.

Australia

On 4th June 2007, Prime Minister John Howard announced a new Australian Carbon Trading Scheme to be introduced by the year 2012 but has been accused by the opposition that it is "too little, too late." ^[17] On the 24th of November 2007 John Howard lost office. The new government has promised to introduce a cap and trade system by 2010.

The New South Wales (NSW) state government has set up the NSW Greenhouse Gas Abatement Scheme to reduce emissions from the electricity sector by requiring electricity generators and large users to purchase NSW Greenhouse Abatement Certificates (NGACs) to offset a fraction of their GHG emissions. This has resulted in the rollout of free energy efficient compact fluorescent lightbulbs and other energy efficiency measures in NSW funded by the credits generated by these measures. The scheme set up by the NSW government has enabled the creation and trading of verifiable greenhouse abatement certificates. NGACs are generated and can be purchased from numerous companies.

Kyoto Protocol

The Kyoto Protocol is a 1997 international treaty which came into force in 2005, which binds most developed nations to a cap and trade system for the six major greenhouse gasses^[18]. (The United States is the only developed nation under Annex I which has not ratified and therefore is not bound by it.) Emission quotas were agreed by each participating country, with the intention of reducing their overall emissions to 1990 levels by the end of 2012. Under the treaty, for the 5-year compliance period from 2008 until 2012^[19], nations that emit less than their quota will be able to sell emissions credits to nations that exceed their quota.

It is also possible for developed countries within the trading scheme to sponsor carbon projects that provide a reduction in greenhouse gas emissions in other countries, as a way of generating tradeable carbon credits. The Protocol allows this through Clean Development Mechanism (CDM) and Joint Implementation (JI) projects, in order to provide flexible mechanisms to aid regulated entities in meeting their compliance with their caps. The UNFCCC validates all CDM projects to ensure they create genuine additional savings and that there is no leakage.

The Intergovernmental Panel on Climate Change has projected that the financial effect of compliance through trading within the Kyoto commitment period will be 'limited' at between 0.1-1.1% of GDP among trading countries^[20]. This compares with an estimate in the Stern report which placed the costs of doing nothing at five to 20 times higher^[21].

All EU member states have ratified the Kyoto Protocol, and so the second phase of the EU ETS has been designed to support the Kyoto mechanisms and compliance period. Thus any organisation trading through the ETS should also meet the international trading obligations under Kyoto.

Green tags

Green tags or Renewable Energy Certificates are transferable rights for renewable energy within some American states. A renewable energy provider gets issued one green tag for each 1,000 KWh of energy it produces. The energy is sold into the electrical grid, and the certificates can be sold on the open market for additional profit. They are purchased by firms or individuals in order to identify a portion of their energy with renewable sources and are voluntary.

They are typically used like an offsetting scheme or to show corporate responsibility, although their issuance is unregulated, with no national registry to ensure there is no double-counting. However, it is one way that an organization could purchase its energy from a local provider who uses a fossil fuels, but back it with a certificate that supports a specific wind or hydro power project.

The carbon market

This section deals with mandatory carbon emissions trading between nations. For voluntary carbon trading schemes for individuals, see Personal carbon trading and Carbon offset

Carbon emissions trading is emissions trading specifically for carbon dioxide (calculated in tonnes of carbon dioxide equivalent or tCO₂e) and currently makes up the bulk of emissions trading. It is one of the ways countries can meet their obligations under the Kyoto Protocol to reduce carbon emissions and thereby mitigate global warming.

Market trend

Carbon emissions trading has been steadily increasing in recent years. According to the World Bank's Carbon Finance Unit, 374 million metric tonnes of carbon dioxide equivalent (tCO₂e) were exchanged through projects in 2005, a 240% increase relative to 2004 (110 mtCO₂e)^[22] which was itself a 41% increase relative to 2003 (78 mtCO₂e)^[23].

Business reaction

With the creation of a market for mandatory trading of carbon dioxide emissions within the Kyoto Protocol, the London financial marketplace has established itself as the center of the carbon finance market, and is expected to have grown into a market valued at $60 billion in 2007^[24]. The voluntary offset market, by comparison, is projected to grow to about $4bn by 2010^[25].

23 multinational corporations came together in the G8 Climate Change Roundtable, a business group formed at the January 2005 World Economic Forum. The group included Ford, Toyota, British Airways, BP and Unilever. On 9 June 2005 the Group published a statement stating that there was a need to act on climate change and stressing the importance of market-based solutions. It called on governments to establish "clear, transparent, and consistent price signals" through "creation of a long-term policy framework" that would include all major producers of greenhouse gases.^[26] By December 2007 this had grown to encompass 150 global businesses.^[27]

Business in the UK have come out strongly in support of emissions trading as a key tool to mitigate climate change, supported by Green NGOs.^[28]

Enforcement

Another critical part of the bargain is enforcement.^[29] Without effective enforcement, the licenses have no value. Two basic schemes exist:

In one, the regulators measure facilities, and fine or sanction those that lack the licenses for their emissions. This scheme is quite expensive to enforce, and the burden falls on the agency, which then may need to collect special taxes. Another risk is that facilities may find it far less expensive to corrupt the inspectors than purchase emissions licenses. The net effect of a poorly financed or corrupt regulatory agency is a discount on emission licenses, and greater pollution.

In another, a third party agency certified or licensed by the government, verifies that polluting facilities have licenses equal or greater than their emissions. Inspection of the certificates is performed in some automated fashion by the regulators, perhaps over the Internet, or as part of tax collection. The regulators then audit licensed facilities chosen at random to verify that certifying agencies are acting correctly. This scheme is far less expensive, placing the cost of most regulation on the private sector. The transparency of this process helps act as a safeguard against corruption.

Criticism

There are critics of the schemes, mainly environmental justice NGOs and movements who see carbon trading as a proliferation of the free market into public spaces and environmental policy-making.^[30] They point to failures in accounting, dubious science and destructive impacts of projects upon local peoples and environments as reasons why trading pollution rights should be avoided.^[31] In its place they advocate making reductions at the source of pollution and energy policies that are justice-based and community-driven.^[32] Most of the criticisms have been focused on the carbon market created through investment in Kyoto Mechanisms. Criticism of 'cap and trade' emissions trading has generally been more limited to lack of credibility in the first phase of the EU ETS.

Critics argue that emissions trading does little to solve pollution problems overall, as groups that do not pollute sell their conservation to the highest bidder. Overall reductions would need to come from a sufficient and challenging reduction of allowances available in the system. Likely this would occur over time through central regulation, though some environmental groups acted more immediately by buying credits and refusing to use or sell them. The National Allocation Plans by member governments of the European Union Emission Trading Scheme came under fire for this recently when some governments issued more carbon allowances than emissions during Phase I of the scheme. They have also been criticised for the widespread practice of grandfathering, where polluters are given carbon credits by governments, instead of being made to pay for them.^[33] Nevertheless, the transfer of wealth from polluters to non-polluters provides incentives for polluting firms to change, especially if the market price for pollution credits is very high. Tight controls are necessary in order to establish a reverse commodity market like Green Tags as well. Regulatory agencies run the risk of issuing too many emission credits, diluting the effectiveness of regulation, and practically removing the cap. In this case instead of any net reduction in carbon dioxide emissions, beneficiaries of emissions trading simply do more of the polluting activity.

Many environmental activists and foundations consider Al Gore's strong advocation of carbon trading to be a denial of the imminence of climate change and a formalized failure of international policy to address the gravity of the carbon increase. Critics of carbon trading, such as Carbon Trade Watch argue that it places disproportionate emphasis on individual lifestyles and carbon footprints, distracting attention from the wider, systemic changes and collective political action that needs to be taken to tackle climate change.^[34]

A mistake may also be made by giving away emission credits rather than auctioning them. Emission credits are, in effect, money and therefore should be treated as such. The giving away of emission credits may also have the negative result of turning down investment dollars that might have been spent on sustainable technologies, if the government chooses to.^[35]

Economists also point out disadvantages of carbon trading schemes compared to emission taxes which they argue are a simple and economically efficient means of achieving the same objective. Possible problems with cap and trade systems include:

• Permit prices may be unstable and therefore unpredictable
• Cap and trade systems tend to pass the quota rent to business
• Cap and trade systems could become the basis for international trade in the quota rent resulting in very large transfers across frontiers
• Cap and trade systems are seen to generate more corruption than a tax system
• The administration and legal costs of cap and trade systems are higher than with a tax
• A cap and trade system is seen to be impractical at level of individual household emissions

The problem of unstable prices can be resolved, to some degree, by the creation of forward markets in caps. Nevertheless, it is easier to make a tax predictable than the price of a cap. The problem of passing quota rents to businesses is a political one, and can also be avoided by auctioning permits instead of giving them away, but government may be compelled to give them away in order to make the scheme politically acceptable.

The Financial Times wrote an article on cap and trade systems that argues that "Carbon markets create a muddle" and "...leave much room for unverifiable manipulation".^[36]

More recent criticism of emissions trading regarding implementation is that old growth forests (which have slow carbon absorption rates) are being cleared and replaced with fast-growing vegetation, to the detriment of the local communities.^[37]

Despite the criticisms and disadvantages, emission cap and permit trading systems are seen to be more politically feasible than emission taxes and are being adopted in various jurisdictions around the world. One explanation for their attractiveness could be that the cost increases are not as directly apparent to consumers as they are with a tax. Indeed, some would argue that any policy that contains the word 'tax' is a political taboo.

See also

• Acid rain
• Air pollution
• AP 42 Compilation of Air Pollutant Emission Factors
• Atmospheric dispersion modeling
• Carbon credit
• Carbon leakage
• Carbon project
• Coase Theorem
• Demand Responsive Transit Exchange
• Emission standards
• European Union Emission Trading Scheme
• Regional Clean Air Incentives Market (RECLAIM, an emission trading scheme in California)
• Flexible Mechanisms
• Green certificate
• Green tags
• Greenwash
• Low-carbon economy
• Mobile Emission Reduction Credit (MERC)
• Personal carbon trading

References

Carbon trading

• International Emissions Trading Association
• Carbon Trading White Paper
• http://www.hm-treasury.gov.uk/independent_reviews/stern_review_economics_climate_change/sternreview_index.cfm The Stern Review on the economics of climate change] - Chapters 14 and 15 have extensive discussions on emission trading schemes and carbon taxes
• Carry On Polluting - Comment and analysis piece by Larry Lohmann, published in New Scientist magazine on the 2nd December 2006
• Ways Forward - Chapter 5 of the book, "Carbon Trading: A Critical Conversation on Climate Change, Privatisation and Power", published October 2006 by Dag Hammarskjöld Foundation, Durban Group for Climate Justice and The Corner House.
• EU shows carbon trading is not cutting emissions
• Chandler: More Flexibility Needed for Effective Emissions Cap-and-Trade Policy Council on Foreign Relations