Ch 5: Setting the Cap and Commitment Period

5.9 Setting the cap and commitment period

As discussed above, the setting of the cap (establishing Q*) is the foundation of any emissions trading scheme. The cap establishes the level of scarcity of emissions allowances and therefore the supply-side of setting the carbon price in the regulated sectors. To provide environmental integrity, the cap should be set consistently with national, regional or multilateral emissions targets and be clearly below ‘business as usual’ (BAU) emissions. In practice this process is complicated due to uncertainty around what future emissions will be (Grubb and Neuhoff, 2006).

Figure 5.8 Constitutive elements of a cap-and-trade emissions trading scheme

Constitutive elements of a cap-and-trade emissions trading scheme

An important element of setting the cap and emissions right scarcity is the establishment of rules around the use of emissions credits generated from areas outside the regulated emissions market, such as through the Clean Development Mechanism (CDM). By allowing these outside emissions credits to be imported into the scheme the policy maker allows emissions to rise above the cap, within the geographical area which is regulated.

In practice the use of such flexible mechanisms is controlled in order to ensure that investment in domestic emissions reductions are made rather than the purchase of emissions credits from outside the regulated system. In theory, provided the purchased credits represent real emissions reductions, there is no reason why such restrictions should be imposed as it limits one of the most beneficial aspects of emissions trading – that emissions reductions occur where it is least cost to obtain them.

The commitment period is the temporal aspect of the cap. It set out over what time period emissions reductions at the company level must be obtained. If the benefits of emissions trading are to be realized the system must balance predictability in its shape and rules, with flexibility to take advantage of changing circumstances. As will be discussed later in the Chapter, a long commitment period, with banking and borrowing of emissions credits between periods, can provide greater certainty for investors and reduce policy risk (Helm, et al. 2005).

5.10 Allocation methods

The creation of a new market for greenhouse gasses requires property rights to be identified and made transferable where previously there were none. In practice this amounts to establishing ‘rights’ to use the atmosphere. This allocation process should not be confused with the buying and selling of these rights within an emissions trading scheme and the resultant price for emission credits which rises and falls once the system has been established.

There are two main allocation approaches involving either selling these rights to the atmosphere or giving them away. A hybrid system can also be used which incorporates a combination of the two. There is a vigorous debate around this allocation process and at its core lies an assumption about who initially should own the property right to the environment – the polluter, or the public at large (ie the taxpayer and government).

Under ideal theoretical conditions of perfect information and competition and in a static analysis each allocation method should be equally efficient as the agents involved face the same marginal costs of abatement (set through the market price of emissions credits). In practice, where there are firms entering and exiting a market full of market failures and externalities, selling permits (usually by auction) presents significant efficiency advantages although on the other hand giving permits away for free increases the acceptance of the scheme. To understand this, let us first examine the case of ‘free-allocation.

Free-allocation involves giving pollution rights away free of charge by some predefined rule such as ‘grandfathering’. This simply means that the property rights to the environment are allocated on the basis of prior use. This allocation method is usually argued strongly for by polluters as it recognises their implicit right to use the environment as they always have, albeit now under the constraint of a cap.

By sheltering industry from the full potential costs of implementing the emissions trading scheme, free allocation seeks to avoid the problem of stranded assets, that is investments made at a time when emissions of greenhouse gases were regarded as harmless and which lose value today following the introduction of an emissions market. For example, an investment in a coal power plant will become less profitable following the implementation of a CO2 emission trading scheme).

Alternatively, if the government elects to sell permits to industry it assumes that polluters had no prior right to the environment and that the atmosphere is a commons effectively owned by all citizens. Under this approach agents covered by the scheme face an upfront cost with participation as they have to bid for the right to use the atmosphere. Once they have this right it is recognised an asset and can be sold on if the firm decides to stop operating.

The value of these permits can be substantial, so their free allocation can be represented as a considerable ‘windfall’ to the firm (Sijm, et al., 2006).

Free allocations, based on rules such as grandfathering, also raise dynamic competitiveness concerns by implicitly favouring incumbent firms at the expense of new firms wishing to enter the market, who may not receive a free allocation but have to ‘buy in’. If there are no reserves for new entrants and all allowances have been granted to existing businesses, newcomers are penalized by having to buy all their allowances on the market.

For example, the United Kingdom’s peak industry Group, the Confederation of British Industry (CBI) argues that any plan to auction permits under the European Emissions Trading Scheme must take into account the competitiveness pressures that auctioning brings to bear on vulnerable sectors. They warn that energy intensive sectors including aluminium and steel production face a significant risk. Risk is defined as the nexus between international trade exposure and the impact of energy price increases on the final product. Firms which are unable to pass on costs due to competition from firms in non-EUETS countries face declining profitability and market share.

This then can lead to carbon leakage – the propensity for CO2 pollution to merely shift from the regulated to a non-regulated country. The result is the regulated country looses its polluting industry (and the economic activity it produces) but there is no environmental gain, or even worse emissions increase as emissions may be even less regulated than they were before. As a result of this, the CBI argues for ‘free allocation’ and will only support the full auctioning of permits if an international agreement can be achieved that sets similar standards for all major competitors of energy intensive British and EU industry.

Free-allocation may be less of an issue when capital markets work perfectly and take the opportunity costs of emissions into account when assessing the value of existing firms. This is because when an inefficient firm receives sufficient allowances to cover its existing emissions, it should be economically advantageous to close or scale down operations and sell surplus emission rights to an efficient new entrant (Bosquet, 2000). However, in practice this mechanism does not work perfectly, so states set aside a small quantity of unallocated rights for new entrants under free allocation systems.

In addition free allocation rules may have the danger of encouraging a ‘use it or loose it’ mentality among firms and discourage the closure of old or inefficient firms which are kept operational to secure valuable permits.

Auctioning also avoids the difficulty of defining rules for the sharing of available allowances between states or industries. In other words, no allocation rule needs to be defined. In a free allocation process, the allocation is a political process, and therefore is influenced by various forms of lobbying and can be very laborious (Joskow and Schmalensee, 1998). This also often results in over-allocation.

Finally, auctioning raises funds that can be used for other purposes, for example to address market imperfections in the labour market. Many environmental economists have advanced the hypothesis of a double dividend associated with environmental taxes or levies. The first dividend is an improvement in the quality of the environment. The second is the positive effect on employment and gross domestic product (GDP) resulting from the reduction of other more distorting taxes such as labour taxes (which penalise the incentive to work) thanks to the new funds collected through environmental taxation.

Some of the desirable features of free allocation include:

  • Allocative efficiency – a well designed auction system channels permits to those that value them the most, which allows resources to flow to their highest value use.
  • Efficient price discovery – important price information is provided by the interaction of bidders at an auction. This facilitates price discovery, which has a major role in stimulating behavioural change. For example, the revealing of each emitter’s willingness to pay for the right to pollute by helps entities manage their emissions obligations and make investment decisions more clearly than if permits are provided via free allocation.
  • Auction revenue – the sale of permits at auction generates revenue which can be used by the government for difference purposes.

It should be noted at that as the secondary emission market matures the benefits from the first two advantages diminishes.

Bosquet analyzed practical experiences and studies on the double dividend (Bosquet, 2000). His conclusion is rather mixed. In the short or medium term, benefits are significant in reducing pollution, but weak in terms of job creation. The fundraising aspect is an argument often advanced against auctioning because by creating a transfer of private funds to the state, auctioning tends to harm the competitiveness and profitability of businesses, compared to those outside the emissions trading scheme. In general, environmentalists argue that funds collected should be used for environmental protection while companies consider that funds should be used to compensate businesses, including through research and development support. In both cases, Bosquet found that such requests from pressure groups (green NGOs or industrial lobbies) prevent the realization of a double dividend.

An alternative method that can be integrated with free allocation or auctioning is benchmarking. If regulators decide to reward emissions reduction before the beginning of the scheme, governments can consider allocating emissions based on energy efficiency or a similar indicator. Such an allocation method uses a comparison of environmental performance across time.

While benchmarking is effective for the allocation of allowances to sectors producing welldefined products (for example mega watt hours of electricity per tonne of steel or cement) benchmarking is more complicated for sectors with differentiated products (for example, defining a CO2 benchmark for car manufacturers is less straightforward given the wide variety of models). When considering allocations between nations, a benchmark could be per capita emissions in the country (an option favoured by some developing countries), or emissions released per unit of gross domestic product.

Governments can also allocate allowances based on projections of future emissions in order to avoid excessive restrictions on expanding industries. However, such an approach requires a considerable amount of information which is often confidential. In practice, industries will tend to overestimate their forecasts for fear of not receiving sufficient allowances. Such an approach can lead to over allocation, as has been the case during the first phase of the EU ETS (Ellerman and Buchner, 2007).

Another option might be to allocate more allowances to industries that are more vulnerable to international competition. Companies that have to compete with other corporations not involved in an emissions trading system are more vulnerable because they cannot pass on the allowances costs to their customers. This has been claimed for steel, cement and chemicals industries, although analysis in the UK indicates that auctioning EU ETS permits would only affect companies producing less than 1% of GDP (Carbon Trust, 2008). In the case of the power industry, the price of allowances can easily be reflected in the price of electricity (at least in a fully liberalized market), since electricity is not transported in large amounts over very long distances.

In practice, governments sometimes develop a hybrid allocation method. Today with the development of emissions trading platforms, access to allowances is open and prices are publicly available. Indeed, auctioning can be open to all and interest groups (e.g. environmental or health promotion NGOs) may be able to buy allowances in order to further reduce the emissions cap to reflect their members interests. The extent to which auctioning is allowed will have a significant bearing on the perceived strength of the emissions trading scheme in question. While ‘free allocation’ offers scope to provide a subsidy to carbon intensive industry, therefore increasing acceptance of carbon reduction proposals (relative to say a carbon tax), such a subsidy should be carefully evaluated in terms of other competitiveness measures that might be taken such as border tariff adjustments.

5.11 Management of price volatility

A system such as an emissions trading scheme that sets a limit on quantities is less able to deliver certainty on prices. A cap-and-trade system can therefore lead to significant price variability. Such volatility potentially poses a significant threat to industries and economies in a carbon-constrained world. There are however various mechanisms to control volatility. The common characteristic of the different mechanisms presented here is that they reduce the potential price range for allowances over the course of the commitment period.

The first option is to allow banking of allowances for future use. This allows governments to encourage companies to further reduce their emissions today by allowing them to establish a reserve of allowances for the future. This can limit price volatility between trading periods and smooth prices (Amundsen et al. 2006).

Another, at this stage theoretical approach, would be to allow agents to borrow allowances from future periods (Mavrakis and Konidari, 2003). This would help limit the volatility in the short term but could lead to shocks between periods. In addition, borrowing would tend to allow increased short-term emissions that would be detrimental to climate change abatement.

Setting price floors and or ceilings is another method that could be also used. These would aim to provide a mechanism of safety valves to reduce the risk for investments in emission reductions (Jacoby and Ellerman, 2004). The price floor would insure the regulator against the emissions market collapsing due to either an over allocation of permits or a fall in demand for permits. The price ceiling, would insure industry against extremely high costs of abatement, however this would need to be weighed against the loss in environmental integrity that adding additional permits to the system would induce.

A minimum price can guarantee a minimum level of profitability for investments in emissions reduction technologies. If a project avoids the release of 10 tons CO2-e and costs £100, then setting a minimum price at £10 would help guarantee a safe investment. However, because this requires the regulator to buy emission rights this mechanism would be expensive for the regulator if the equilibrium price of allowances stabilized below the minimum price.

Despite this drawback, in practice such hybrid systems involving a combination of instruments based on quantity and price are quite popular. For instance, most mandated green certificates markets, that is, markets which have been established to support electricity from renewable energy include both price controls and quantity targets.

A second method used to limit price volatility is to link cap-and-trade schemes to baseline and credits projects outside the capped system. With baseline and credits project, an investor can generate additional emission credits by investing in emission reductions in other sectors or areas. These credits can then be used for compliance purposes in a capand-trade scheme. Emissions savings need to be defined relative to a counterfactual (a baseline without the investment, e.g. business as usual (BAU)). For instance, if it is too expensive for a British company to reduce its emissions, it can decide to invest in emissions reduction a country (for instance China) where investment can avoid emissions more cost effectively. The emission saving achieved through this investment (i.e. the difference between emissions after investment and emissions under the BAU scenario), after monitoring by an accredited external auditor, gives the right for emissions credits. These emissions credits are fungible with the allowances in the cap and trade scheme and therefore allow additional emissions.

Finally, in order to avoid fluctuations in a market, a government can link its system to another scheme. The linking mechanism is a way to improve market liquidity by increasing its size and the number of involved parties. In practice linking emissions markets is complex because of varying definitions. Some countries may have more severe monitoring and reporting guidelines, higher penalties for non-compliance and so on. Linking with a less reliable system can harm the effectiveness and credibility of a scheme and actually increase volatility so should be approached with caution.

5.12 Baseline and Credit Schemes

Baseline and credit schemes also rely on the creation of tradable permits. However, under these schemes no cap is set on overall emissions. Rather, a baseline is established and emissions credits or allowances are earned once actors involved in the scheme reduce emissions under this baseline. This baseline could be set at a project level (as in the case of the CDM), at a firm level (as in the case of the NSW Emissions Trading Scheme) or at the sectoral level or at the national level.

An environmentally stronger variant on this is where the baseline is also be used to provide emitters with a level of entitlement to emit. If actual emissions are below this entitlement then the actor has allowances it can sell. However, if emissions exceed the entitlement, then allowances must be purchased to account for emissions above their baseline.

There are several ways base lines can be set, depending on the policy objective, and desired environmental effectiveness of the scheme (Garnaut, 2008). For example, options include:

  • setting the baseline as emissions in a particular year,
  • average emissions per unit of production based on installed technology in a base year,
  • average emissions per unit of production based on best practice technology, or
  • any combination of these or other approaches.

5.12.1 Reduced Emissions from Deforestation in Developing Countries

Land use change in the tropics accounts for around 20 per cent of global emissions and represents the largest source of developing country emissions being the second largest source of emissions world wide after fossil fuel use.

However, in spite of the ‘Australia clause’ which allows developed countries to claim credits for slowing land clearing, ‘avoiding deforestation’ is excluded as a way for developing countries to generate emissions credits under the Kyoto Protocol, although afforestation and reforestation are eligible for credit generation.

This exclusion has led to the formation of the Coalition of Rainforest Nations and separately for Brazil to launch what has become know as the Reduced Emissions from Deforestation in Developing Countries (REDD) proposals.

The basis of these proposals centre around variants on baseline and credit forms of emissions trading, and have also been termed ‘sectoral CDM’ as opposed to the project based

The structure of the proposed baseline and credit schemes is illustrated in the figures below in the case of nations where the forest carbon stock has stabilized, is deteriorating and is improving. In each case, the establishment of the baseline would require the determination of some historical average of emission supported by satellite imagery and forest carbon flux ground truthing studies.

Figure 5.9.1 Static Baseline

Static Baseline

Figure 5.9.2 Deteriorating Baseline

Deteriorating Baseline

Figure 5.9.3 Improving Baseline

Improving Baseline

Such baseline and credit schemes can be use as a ‘no regrets’ climate policy, where once countries participate they are only exposed to the positive incentive side of achieving and exceeding the baseline. Emissions credits are generated according to the amount of addtionality achieved and can be sold into other carbon markets such as the EUETS.

However, some developing countries are cautious about such programs as once established the baseline can easily be transformed into a binding target and penalties imposed for noncompliance. Furthermore, some environmental groups worry that emissions reductions from deforestation would flood the carbon market with cheap credits (Fearnside, 2001). From an economic standpoint, it is beneficial to have emissions trading schemes with as broad a scope as practically possible, as this allows emissions to occur where it is cheapest for them to happen. Including the REDD proposals would have the further advantage of allowing nations to set stronger carbon targets and emission caps as part of emission trading design.

5.13 Conclusion

This Chapter has introduced the fundamental elements behind the theory and practice of emissions trading in the context of other policies to address climate change. While conceptually it can be useful to debate the pros and cons of emissions trading vis à vis other policies the reality of an economy riddled with market failure and the diversity of economic and political systems make it impossible to conclude that there is any one silver bullet policy mechanism to climate change. Instead, a ‘silver buckshot’ approach – which incorporates emissions trading, may offer the best and fastest solution to manage CO2 reduction.

As concern and understanding of the damage costs of climate change escalate, and the costs of CO2 mitigation fall, emissions trading becomes increasingly attractive from a theoretical perspective. This is because it can provide greater certainty around the physical quantity of emissions to be reduced as well as providing the economic incentive to allow pollution to only focus on the highest value sectors and to minimize the cost of abatement by fostering continuous innovation in low carbon technology.

Emissions trading schemes also tend to be more politically more attractive than other policies such as taxation, which make it harder to cushion the competitiveness impact of implementing a carbon constraint and can illicit rapid opposition such as in the case of ‘increasing prices at the pump’ for petrol. However, here there is still a gap that needs to be bridged between the theoretical benefits that emissions trading offers and its practical implementation – for instance sectors such as transport and emissions from deforestation have been left outside the scope of most emissions trading schemes.

Despite the practical challenges of implementing a new market system for the control of complex pollutants such as greenhouse gasses, emissions trading schemes offer a powerful and efficient logic for policy makers, organisations and individuals of all political persuasions. Emissions trading simultaneously satisfy the statist view of taking a tight regulatory approach while allowing for the application of incentive arrangements that provide for continuous innovation, favoured by market libertarians. It is perhaps this Coasian logic which bridges the old conceptual debate around how to manage environmental problems which best explains the growing popularity of emissions trading.

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