Capping and Trading

Measured by both volume and value, allowance-based systems dominate today's carbon markets. At least three such systems are currently operating—the European Union Emissions Trading Scheme, the New South Wales Market in Australia, and the Chicago Climate Exchange in the United States—and more are being formed.

The EU-ETS has grown to become the largest carbon trading platform. Established as an important component of the European Union's strategy for achieving its Kyoto-mandated emissions target, the EU-ETS allows European reduction credits to be bought and sold alongside credits created through projects in developing countries (through the CDM) or in economies in transition (through JI). The EU-ETS includes the 15 countries that originally committed through the protocol to collectively reduce their greenhouse gas emissions by 8 percent from 1990 levels by 2012 under what is known as the "European bubble." An EU Directive translated this commitment into specific emissions reduction targets for each member country. The EU-ETS also allows newer EU member states to participate in the

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trading scheme in order to meet their national reduction targets of 6-8 percent, as agreed under the protocol.10

The EU-ETS has recorded strong growth since it began operations, more than tripling the tons of CO2 equivalent traded in its first two years—from 321 million in 2005 to 1,101 million in 2006. The value of the traded carbon also tripled over that time, climbing from $7.9 billion in 2005 to $24.4 billion. The program currently involves at least 12,000 companies across the EU whose allowances and transactions are recorded in registries. These registries are vital for keeping track of legitimate transactions and making sure that credits are not double-counted or resold.11

During its initial test phase, from 2005 to 2007, the EU-ETS traded only CO2 emission allowances associated with power and heat generation and select industries, including oil refineries, iron and steel plants, and factories making cement, glass, bricks, ceramics, and pulp and paper. These sources account for 45 percent of CO2 emissions in the EU. The second phase corresponds with the Kyoto Protocol's first emissions reduction commitment period, which runs from 2008 to 2012. It is expected that this phase will integrate additional emissions sources, such as aviation, and other greenhouse gases beyond carbon dioxide.12

The New South Wales market is the second largest allowance-based market to date. Australia's most populous state, New South Wales, set mandatory emissions reductions targets in 2003; its market whirred into motion two years before trading began on the EU-ETS. Targets apply specifically to the state's power sector—meaning that large electricity buyers or sellers must reduce or offset emissions from production of the electricity they supply or use. They can buy certificates from low-emission generation of electricity, improved generator efficiency, reduced electricity consumption, or forestry carbon sequestration projects to meet their targets. (So far, this market does not include credits generated through the CDM or JI.) In 2006, 20 million tons of carbon dioxide equivalent were traded on this market, worth $225 million.13

The third largest allowance-based market is the Chicago Climate Exchange. Started in 2003, the CCX differs from the other two markets described here in that it was not established by a government. Any entity that joins the CCX does so voluntarily. CCX members must, however, legally adhere to the emissions reduction schedule stipulated by the exchange. Trading volume on the CCX surpassed its 2006 total in the first half of 2007, putting it on course to double its trading volume over one year.14

Businesses and organizations join CCX at different membership levels: full members have significant direct emissions, including industrial companies, states, and municipalities. They can purchase or sell credits. Associate members are organizations, universities, and companies with negligible direct emissions that agree to buy credits to offset 100 percent of the emissions associated with their energy purchases and business travel. CCX members have a range of motives for joining, such as to respond to public demand for action on climate change or to gain early experience with emissions trading on the assumption that mandatory U.S. systems will sooner or later be created.15

While the Chicago Climate Exchange grows, pressure is building within the United States for federal regulation of greenhouse gas emissions through a cap-and-trade system. Prospects for some form of national legislation improved in January 2007 with the formation of the United States Climate Action Partnership, an alliance of major U.S. com

SPECIAL SECTION: PAYING FOR NATURE'S SERVICES Improving Carbon Markets panies and prominent environmental organizations. The partnership, which has grown to include more than 30 businesses and organizations, is calling for national legislation on "significant reductions" of GHG emissions using a multi-pronged strategy based around a cap-and-trade program. More than a dozen competing pieces of legislation are currently being considered by the U.S. Congress.16

In the absence of effective federal action on emissions reductions, several other allowance-based carbon markets have been proposed or are in the process of being created by states and provinces within the United States and Canada. (See Box 7-1.) Meanwhile, the central government in Australia has announced that it will develop a national cap-and-trade market for greenhouse gas emissions by 2012. Legislators and regulators working to develop these systems are carefully studying the European experience.17

One of the biggest surprises at the EU Emissions Trading Scheme was the precipitous drop in the price of emissions contracts for credits to be counted in 2007 (known as December 2007 contracts); the price sank from a peak of $34 per ton to nearly zero in early 2007. The second phase will have more stringent emissions caps, so future contracts are currently trading at higher prices. (See Figure 7-1.) (Emissions contracts have an assigned date, according to the date the credits will be produced; contracts can be traded several years in advance, for delivery at future dates.) The price crash for December 2007 contracts coincided with the announcement that more permits had been allocated through the EU National Allocation Plan process than

Box 7-1. North American Carbon Trading Systems under Development

Regional Greenhouse Gas Initiative

(RGGI): This program was initiated in 2005 through the support of state governors in the northeastern United States. Cooperation between at least 10 states will lead to a regional cap-and-trade system that will regulate the emissions associated with most power plants in the region. Collectively, participating states have agreed to cap regional CO2 emissions at 1990 levels by 2014 and to reduce them to 10 percent below that level by 2018. When the program gets going in 2009, some 188 million carbon credits representing one ton of carbon each will be distributed to participating states, which will in turn allocate or auction them to power plants within their borders. The program could be extended beyond power plants to include other large emitters after the initial trading period is completed.

California: The state passed landmark legislation in 2006 that mandates a 25-percent reduction in CO2 emissions by 2020, with emissions reductions expected to reach 174 million tons of CO2 equivalent. It is expected to establish a cap-and-trade system based largely on emissions reductions among major emitters in-state. Emissions trading is scheduled to begin in 2012. California stands to benefit from the establishment six years ago of the California Climate Action Registry—a voluntary system of GHG emissions accounting that was set up to protect and reward companies that chose to take early action in anticipation of future regulatory requirements. (Other states, including Florida, Minnesota, New Jersey, and Oregon, have since passed similar legislation.)

Western Climate Initiative: Created in February 2007, this scheme involves California, five other western states, and the Canadian provinces of British Columbia and Manitoba. Modeled somewhat on RGGI, the initiative has set a regional emissions reduction goal of 15 percent below 2005 levels by 2020 and is establishing a market mechanism for achieving it. (Three other states and three provinces have also joined as observers.)

Source: See endnote 17.

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Figure 7-1. Average Price of EU Emissions Contracts, 2005-07

35 30 25 20

Source: ECX

J 15

Figure 7-1. Average Price of EU Emissions Contracts, 2005-07

Source: ECX

35 30 25 20

J 15

Apr 05 Sep 05 Feb 06 July 06 Dec 06 May 07 Oct 07

were needed, resulting in an oversupply for the first phase of the EU-ETS. Political and special interests lobbying led in part to overly generous permit allocations, combined with inadequate historical emissions data. This highlights the key importance of establishing high-quality baseline data if cap-and-trade markets are to function effectively.18

A significant problem in the recent EU-ETS experience was that the vast majority of emissions permits were distributed for free to large emitters rather than offered for sale through an auction. (See Box 7-2.) Whether permits are allocated or auctioned, the right to emit carbon gains a value when a carbon cap exisits—and that value is reflected in increased electricity prices. Because large emitters were given permits for free, they reaped windfall profits when electricity prices rose while their production costs did not. British power companies, for example, made an estimated $1.5 billion in profits as a result of the carbon permits they were issued for free by the U.K. government, and German utili ties are expected to enjoy windfall profits worth $44-91 billion between 2005 and 2012 as a result of emissions credits granted to them under the EU-ETS.19

There is a good side to the price rises, though: in general, consumers react to higher electricity prices by increasing energy efficiency and buying less electricity. Jörg Haas of the Heinrich Böll Foundation and Peter Barnes of the Tomales Bay Institute explain that "as emissions trading is meant as a way of internalizing external costs, it is necessary that prices reflect these new costs." But they and other critics nonetheless question whether large emitters should profit from free allocations of a public good: the atmosphere's capacity to absorb carbon. While allocating permits amounts to a subsidy for electricity companies, auctioning can encourage a more equitable distribution of permit revenues.20

The EU-ETS allows large emitters to meet their caps in part by purchasing credits via the Clean Development Mechanism and Joint Implementation program; this provision has also elicited criticism. Some groups worry that wealthy countries will fail to make significant in-country reductions, relying instead on the relatively cheap credits generated in developing countries or economies in transition. This fear is one reason that forestry-related credits have so far been banned from the EU-ETS. The World Wide Fund for Nature-UK (WWF-UK) recently

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Box 7-2. Who Gets Permission to Emit?

When carbon trading began under the EU-ETS, European governments had to decide how many emissions permits each company covered by the EU-ETS would receive. There were two major options:to auction permits or to allocate permits to companies based on their historical emissions. In an auction, companies list the amount they are willing to pay for a given quantity of permits, and a market price is established. Under allocation, or "grandfathering," companies receive permits for free based on the amount they emitted in past years.

Governments decided that in the first phase of EU-ETS (2005-08), no more than 5 percent of permits could be auctioned in each member country. (Only four countries used auctions at all.) In Phase II (2008-12), up to 10 percent of permits will be auctioned.

Prices will rise anytime carbon emissions are restricted—whether through allocation or auctioning. When permits are allocated to com-

panies, production costs usually remain about the same, despite the rise in electricity prices, because the permits are basically given as a sub-sidy—so businesses and associations favor this option. When permits are auctioned, the average cost of production can increase, and the revenue from the auction is redistributed either through tax breaks for consumers, assistance to energy-intensive sectors, or investments in low-carbon technologies. In general, economists support auctioning permits.

Some 80 percent of businesses polled said that the EU Directive should not allow for more auctioning in the future, in part because they are worried they will not be able to compete with sectors not covered by the EU-ETS or with companies abroad—worries that researchers say are largely unfounded due to domestic protections covering many industries.

Source: See endnote 19.

reviewed nine National Allocation Plans for the second phase of the EU-ETS, concluding that up to 88 percent of the EU emissions reductions required by 2012 could take place outside of the European Union. WWF-UK argues that this is contrary to the Kyoto Protocol and EU directives, both of which specify that Kyoto mechanisms be supplemental to domestic actions.21

Some lessons from Europe are already being incorporated there and elsewhere. Current prices indicate that the prices of contracts for the second phase of the EU-ETS will rise, with more-aggressive emissions caps making permits scarcer. As of early October 2007, EU-ETS contracts for December 2008 (for delivery just before emissions levels are evaluated for 2008) were trading around $30 per ton of carbon dioxide equivalent.22

And U.S. policymakers appear increasingly convinced that auctioning is the best approach for allocating permits. Under the Regional Greenhouse Gas Initiative in the northeastern part of the country, all participating states with announced rules have opted for 100 percent auctions, and California is considering a similar requirement for its climate registry. Most of the cap-and-trade proposals before the U.S. Congress call for a share of permits to be auctioned and for a percentage of the revenue generated to be allocated for public benefit.23

Under the auctioning systems being considered in the RGGI program, earned revenues would be used in part to finance public spending on climate-related programs, such as the promotion of energy efficiency. Federal proposals currently under consideration also envision investing auction proceeds in alternative energy development (including clean coal), cleaner transportation technologies, and climate-related initiatives to lessen the

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impacts of climate change on low-income communities in the United States and elsewhere. Peter Barnes has gone further, proposing that all citizens should share benefits from carbon emissions permits. When permits to "use" atmospheric capacity are auctioned, the revenues would be placed in a public trust. Through a mechanism similar to the Alaska Permanent Fund, which distributes royalties to Alaskans for oil extracted from the North Slope, citizens would receive their fair share of the trust's value. (See Chapter 10.)24

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