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The Debate over Greenhouse Gas Cap-and-Trade

Author: Toni Johnson
Updated: November 3, 2011
This publication is now archived.

Introduction

Global talks are intensifying over what policy should follow the Kyoto Protocol. The treaty's enforcement period mandated binding reductions of greenhouse gas emissions for thirty-six countries from 2008 until the end of 2012. Though the treaty itself will remain in effect, it is unclear whether there will be agreement on new binding targets, which could affect investment in nascent carbon markets. Central to Kyoto policy is an arrangement in which emissions are capped and industry and governments are allowed to generate and trade emissions allowances or offsets. The Obama administration and Democratic lawmakers have failed to follow through on pledges to enact legislation that would establish mandatory emissions targets for U.S. industries due to Republican opposition. However, some U.S. states have created trading schemes. The European Union, meanwhile, continues to expand its Emissions Trading Scheme (ETS)--created in 2005 and credited with helping it meet Kyoto targets. Challenges with the rollout of Europe's carbon market--the largest and most mature in the world--offer lessons for crafting new cap-and-trade policies.

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Defining Cap-and-Trade Programs

The Kyoto Protocol, which entered into force in 2005, established a market-based mechanism to allow developed countries with binding emissions targets to reduce greenhouse gases such as carbon dioxide, methane, carbon tetrafluoride, trifluoromethane, and nitrous oxide. Under the cap-and-trade system, industries would be allocated allowances limiting them to a certain amount of greenhouse gas emissions each year. Most trading schemes use one ton carbon-dioxide units for sale, or convert non-CO2 gases into CO2-equivalent units for the purposes of trading.

The buying and purchasing of allowances provide incentives to make emissions reductions more economical. Some facilities could find it cheaper to reduce their emissions and then sell their surplus allowances as credits, while others may find it cheaper to buy credits to offset their emissions rather than make direct reductions. Greenhouse gas emission credits can be purchased or sold from a carbon market as well as through projects and emissions credits certified by the UN. Cap-and-trade systems have been used before to reduce emissions. The cap-and-trade system instituted under the 1990 Clean Air Act in the United States is credited with achieving significant reductions in acid-rain-causing sulfur-dioxide emissions by power plants.

Greenhouse Cap-and-Trade Programs
  • Clean Development Mechanism. Kyoto's "Clean Development Mechanism" (CDM) is intended to provide a way for developing countries to reduce emissions without emissions caps. Nations with Kyoto targets are allowed to purchase emissions-offset credits from carbon-abatement projects in the developing world. Projects must be registered with the UN's CDM board, which certifies the amount of emissions reductions. Those "certified emissions reductions" (CERs) can then be sold to a nation or party with binding emissions caps. As of 2011, there were about 5,600 projects in the pipeline, representing nearly 745 million CERs expected to offset 2.7 billion metric tons of carbon dioxide by 2012.
  • Joint Implementation. This is nearly identical to the CDM but pertains to an industrialized nation. There were 236 projects in the pipeline at the end of 2010 with the potential to offset more 400 million tons of emissions by 2012, according to a UN report (PDF). The UN Framework Convention on Climate Change (UNFCCC) says Russia dominates this market with more than 65 percent of the estimated annual emissions reductions for Kyoto's enforcement period (2008-2012).
  • Assigned Amount Units (AAUs). Unlike the Joint Implementation mechanism, these allowances are not project based. Instead, each country is allocated AAUs in total to their allowable emissions under their Kyoto cap. Countries with emissions under their cap are able to sell their excess credits to other countries and entities needing to meet emissions goals.
  • European Trading System. The EU trading scheme is the largest of its kind in the world. Started in 2005, it covers more than 11,500 facilities across the bloc's twenty-seven members, plus Iceland, Liechtenstein, and Norway. The scheme now covers 40 percent of the region's greenhouse gas emissions. Facilities include coke ovens, coal plants, cement factories, and iron works. Trading began in 2005 and so far covers only carbon dioxide. In 2012, the regime is expected to begin requiring emissions permits for air travel, including international carriers, for flights taking off and landing within the union.
  • U.S. Regional Greenhouse Gas Partnerships. The Regional Greenhouse Gas Initiative (RGGI) was the first mandatory carbon cap-and-trade program in the United States when it took effect in January 2009. The initiative's ten northeastern and Mid-Atlantic states aim to reduce carbon dioxide emissions to 10 percent below 2009 levels by 2018. The initiative covers about 225 facilities in the power sector, and is the first mandatory carbon trading program to auction most of its allowances. The Western Climate Initiative, made up of seven states and four Canadian provinces, and the Midwestern Greenhouse Gas Reduction Accord, composed of nine states and two Canadian provinces, are attempting to craft similar cap-and-trade programs. In October 2011, California passed regulations to create a cap-and-trade program expected to launch in 2013 as part of compliance with its law to reduce emissions to 1990 levels by 2020.
  • New South Wales. Australia's New South Wales Greenhouse Gas Abatement Scheme is a state-level market that began in 2003. The state capped its overall emissions at a little over seven metric tons of carbon-dioxide-equivalent emissions annually in greenhouse gas. Australia also plans a country-wide carbon market.
  • New Zealand. In 2009, the country started the first mandatory, economy-wide cap-and-trade program outside of Europe to meet its pledge to reduce emissions by at least 10 percent below 1990 levels by 2020. Between 2010 and 2012, the scheme requires no emissions cap since entities will be provided with an unlimited supply of free allowances. After the transition period, entities will need to purchase allowances if their emissions exceed the ones they already hold.
  • Voluntary Cap-and-Trade. The Chicago Climate Exchange (PDF) was a voluntary cap-and-trade program, which began trading in 2003 and concluded in 2010. Although the exchange ended, according to a 2011 Bloomberg report, there is still a robust voluntary market (PDF) consisting of "over-the-counter" emissions offset purchases by individuals, companies, and non-governmental organizations.
The Volume of Trading

According to the World Bank's May 2011 report (PDF) on trading systems, the volume of trading allowances grew more slowly in 2009 than in prior years, increasing to $144 billion in 2009, up from just $135 billion in 2008 due to the global economic downturn. The amount of carbon-equivalent emissions credits traded rose from 4.8 billion tons to 8.7 billion over that time. Of the 2009 total, nearly $118 billion, covering about 6 billion equivale≠≠nt tons of carbon emissions credits, was traded on the EU market.

The RGGI market grew from less than $200 million in 2008 to $2.2 billion in 2009, covering 800 million tons of emissions. The AAU market grew from $276 million to $2 billion over that same period, covering 155 million tons of emissions. Meanwhile, the market for UN projects dropped from about $7.3 billion in 2008 to about $3 billion in 2009, reducing the volume of emissions covered from about 429 million tons to about 237 million tons. ≠≠The likelihood that AAUs will continue to grow as a market will largely depend on how talks on a new UN enforcement period conclude. The RGGI market is expected to continue to grow but faces uncertainty given the U.S. political climate.

Assessing the Global Carbon Market

The World Bank reports a number of challenges, including approval bottlenecks and diminishing investment because of the global economic crisis and falling expectations about a successor to the Kyoto Protocol. The issue remains whether countries with rapidly growing emissions (Bloomberg), such as China and India, should also have binding reductions targets or whether the regime under Kyoto should continue to focus on legacy emitters such as Europe. On the UN's emissions allowances regime, negotiations have focused on overhauling CDM to target the least developing countries to make it a real tool for development and on adding more allowances for deforestation. So far, the bulk of the projects continue to be located in relatively wealthy developing nations such as China, which in 2009 represented 72 percent of CDM credit sales, according to the World Bank's report. The EU has limited new CDM projects allowed in the ETS system to least developed countries starting in 2013.

Some experts have said investment in CDM projects could plummet if global talks on a post-Kyoto policy fail. Yet amid the uncertainty, the EU--the largest buyer of CDM allowance--appears committed to meet its internal pledge to reduce emissions at least 20 percent below 1990 levels by 2020. The EU Trading System remains the most robust carbon market in the world and is considered extremely successful in helping meet Europe's Kyoto targets. According an October 2011 report (PDF) from the European Commission, the original fifteen countries of the EU, which have a total cap under Kyoto of 8 percent below 1990 levels, had emissions in 2010 of nearly 11 percent below the baseline. The report says the trading scheme is considered one of the major sources of emissions reductions. An April 2011 report from Climate Strategies, a Cambridge-based policy research firm, says the EU's trading scheme holds lessons for new markets including:

- businesses can profit;

- impact on GDP can be relatively small;

- robust regulation of carbon markets is needed;

- prices can be volatile.

The airline issue also illustrates a long-held concern about mandatory cap-and-trade programs--ensuring competitiveness. Twenty-five countries have challenged plans to include international air travel in the scheme in 2012 as contravening international law and are asking the International Civil Aviation Organization (ICAO) to intervene. ICAO has been investigating ways to stem emissions from global air travel for nearly a decade, with the EU urging for a global carbon market solely for airline (GreenAir). But other member states have shown little desire to implement such a regime. Air travel accounts for about 2 percent of current global emissions, but air travel emissions are estimated to see an increase of 300 percent by 2050 without intervention. In October 2011, the U.S. House of Representatives passed a bill that would penalize any U.S. airline taking part in the EU trading scheme. China also has halted a $4 billion contract with Airbus in retaliation. Some experts say the issue could eventually wind up in the World Trade Organization.

Experts have warned that without an international regime with all the major players--including China and India--there is potential for trade disputes. In 2009, when U.S. lawmakers were trying to enact climate legislation, they included provisions that would have required importers of goods from countries without similar climate provisions to buy emissions allowances--in hopes of preventing companies from relocating to less regulated countries.

Carbon Markets in the United States

Cap-and-trade programs in the United States are proceeding slowly and remain under challenge. The three regional schemes cover roughly twenty-six states. By the end of 2010, RGGI states reported emissions 27 percent below (PDF) the initiative's emissions cap, which is attributed to an increase in the use of natural gas. Still, New Jersey Governor Chris Christie has expressed doubts about the usefulness of the program and said he plans to pull the state out of the program--but he will need the approval of the state legislature. There also is a campaign to have it repealed in New York, New Hampshire, and possibly others. California's program, which is expected to operate within the Western Climate Initiative, has survived a number of lawsuits and a ballot initiative to have it repealed. Advocates hope that RGGI and California's program will act as models (FastCompany) for other U.S. states.

At the federal level, Republican lawmakers have blocked legislation for a cap-and-trade program, and support for such legislation has been muted as the country's economic crisis has worsened. The Environmental Protection Agency has said it would impose rules for power plants in the United States to control their emissions, but those plans have been postponed several times and face opposition. Lawmakers on both sides of the aisle have stated concerns about how EPA regulations would affect energy prices. Democrats opposed to EPA plans say a specific climate law, not regulations under the Clean Air Act as the EPA plans, is the most appropriate way to address the issue. Congressional Republicans continue to find ways to hamper EPA efforts, such as attempts to defund the rulemaking process.

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