EMISSIONS TRADING IN PRACTICE: A Handbook on Design and Implementation SECOND EDITION EMISSIONS TRADING IN PRACTICE: A Handbook on Design and Implementation SECOND EDITION iii ACKNOWLEDGMENTS This update to the ETS Handbook was prepared by Vivid Economics, led by Stuart Evans and Thomas Kansy, and supported by Karishma Gulrajani and Christian Mortlock. The original 2016 edition was prepared jointly by a team of experts from Motu Economic and Public Policy Research and the Environmental Defense Fund, with significant contributions from Vivid Economics. The World Bank and the ICAP Secretariat jointly oversaw the revision of the handbook, including providing substantive inputs and managing the project. The World Bank team consisted of Joseph Pryor, Daniel Besley, Marissa Santikarn, and Harikumar Gadde. The ICAP Secretariat team consisted of Emma Krause, Constanze Haug, William Acworth, Baran Doda, and Stephanie La Hoz Theuer. Suzi Kerr (Environmental Defense Fund), Ruben Lubowski (Environmental Defense Fund), Duan Maosheng (Tsinghua University), Felix Matthes (Öko-Institut), and Michael Mehling (Massachusetts Institute of Technology) provided a technical review of the updated handbook. Michael Mehling and Duan Maoshaeng also contributed technical content for specific chapters of the updated handbook. Many representatives from ETS jurisdictions provided practical insights and knowledge related to designing and implementing ETS, both for the original version and the update of the handbook. We sincerely thank the following people who provided valuable review of the updated handbook: Rachel Gold, Jason Gray, Derek Nixon, Amy Ng, Rajinder Sahota, Stephen Shelby, Francis Supriya (California); Francisco Dall'Orso León and Juan Pedro Searle (Chile); Andres Camilo Alvarez Espinosa, Carolina Diaz Giraldo, Germán David Romero Otálora, and Leidy Caterine Riveros Salcedo (Colombia); Johannes Enzmann, Joao Serrano Gomes, Polona Gregorin, Martin Hession, Tilmann Morata Liebert, Lavinia Teodorescu, and Julia Ziemann (European Commission); Suriel Islas Martinez, Maria De La Paz Ortiz Rodriguez, and Yutsil Guadalupe Sangines Sayavedra (Mexico); Erik van Andel (the Netherlands); Vanessa Chalk, Matthew Cowie, and Ted Jamieson (New Zealand); Jonathan Beaulieu, Jean-Yves Benoit, Claude Côté, Julie Côté, Steve Doucet-Héon, Thomas Duchaine, Charles-Adrien Huraux, and Stéphane Legros (Québec); Zhibin Chen, Ethan Lin, and Sun Yuntong (SinoCarbon); Klaus Hammes (Swedish Energy Agency); Sophie Wenger-Hintz (Switzerland); Masayuki Aoki, Satoshi Chida, Koyo Hayakawa and Takuya Ozawa (Tokyo); Joe Cooper, Michael Evans, Alice Karcevska, and Hannah Lewis (UK). We wish to acknowledge additional input and peer review provided by Frank Jotzo (Australian National University); Lambert Schneider (Öko-Institut); and Yong-Gun Kim (Korea Environment Institute). We wish to thank the following ICAP staff for research assistance: Leon Tobias Bernstein, Alexander Eden, Maia Hall, Christopher Kardish, Ernst Kuneman, Kai Kellner, Victor Alejandro Ortiz Rivera, and Lisa Storcks. We wish to thank Kate Epstein, Liz Crooks, and Kelly Clody for their careful editing and proofreading of the report. Design, layout, and graphics were provided by Fathom Creative. ICAP staff also provided significant research input and illustrations. ICAP would like to thank Switzerland for their financial contribution to the update of the handbook. © 2021 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org This work is a joint product of the staff of the World Bank and adelphi, representing the International Carbon Action Partnership (ICAP), with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of the World Bank, its Board of Executive Directors, or the governments they represent, nor of ICAP and its members. The World Bank and adelphi do not guarantee the accuracy of the data included in this work. 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Cover design: Fathom Creative, Inc. v Contents CONTENTS SYNTHESIS Emissions trading: Bringing it all together___________________________________________ 1 STEP 1 Prepare___________________________________________________________________________ 13 STEP 2 Engage stakeholders, communicate, and build capacity___________________________ 35 STEP 3 Decide the scope__________________________________________________________________ 55 STEP 4 Set the cap________________________________________________________________________ 77 STEP 5 Distribute allowances______________________________________________________________ 97 STEP 6 Promote a well-functioning market________________________________________________ 123 STEP 7 Ensure compliance and oversight_________________________________________________ 149 STEP 8 Consider the use of offsets_______________________________________________________ 171 STEP 9 Consider linking__________________________________________________________________ 189 STEP 10 Implement, evaluate, and improve________________________________________________ 211 REFERENCES __________________________________________________________________________________ 229 vi EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION LIST OF TABLES Table 1-1 Comparison of carbon taxes and ETSs________________________________________________________ 16 Table 1-2 Advantages and disadvantages of complementary measures____________________________________ 27 Table 2-1 Assertions against an ETS and possible counterarguments______________________________________ 48 Table 3-1 Gases covered in existing ETSs_______________________________________________________________ 60 Table 3-2 Decisions on scope_________________________________________________________________________ 66 Table 4-1 Summary of cap setting approaches__________________________________________________________ 84 Table 5-1 Allocation methods in different ETSs_________________________________________________________ 101 Table 5-2 Trade exposure and emissions intensity in different ETSs_______________________________________ 115 Table 5-3 Summary of methods of allocation against objectives__________________________________________ 117 Table 5-4 Summary of performance in reducing the risk of carbon leakage for different methods of allocation__________________________________________________________________________________ 120 Table 5-5 Summary of data requirements for different methods of allocation______________________________ 121 Table 6-1 Advantages and disadvantages of different approaches to PSAMs______________________________ 147 Table 7-1 Legal acts resulting in EU ETS design changes________________________________________________ 153 Table 7-2 MRV approaches by ETS____________________________________________________________________ 157 Table 7-3 Penalties for noncompliance with surrender obligations across jurisdictions______________________ 164 Table 8-1 A simple illustration of offsetting in an ETS____________________________________________________ 174 Table 8-2 Key considerations for reliance on externally administered crediting mechanisms_________________ 183 Table 8-3 Aspects of standardization of methodologies_________________________________________________ 184 Figure 8-4 The general process for project registration and credit issuance________________________________ 185 Table 9-1 Past, present, and future of linkages between ETSs____________________________________________ 192 Table 9-2 Benefits and risks of linking_________________________________________________________________ 198 Table 9-3 Summary of factors to be considered in linking________________________________________________ 203 Table 10-1 Timelines of significant changes in five long-lived systems______________________________________ 225 LIST OF FIGURES Figure 0-1 ETS design in 10 steps________________________________________________________________________ 3 Figure 1-1 ETS design in 10 steps_______________________________________________________________________ 18 Figure 1-2 Establishment of ETSs worldwide over time____________________________________________________ 19 Figure 1-3 Emissions trading around the world___________________________________________________________ 19 Figure 1-4 The impact of companion policies on ETS outcomes____________________________________________ 24 Figure 1-5 MAC curve plotting abatement options in order of their costs____________________________________ 30 Figure 1-6 An example of two firms with different abatement costs_________________________________________ 31 Figure 1-7 Applying a uniform standard to each company_________________________________________________ 31 Figure 1-8 Trade saves costs relative to an allocation that prescribes equal emissions by each company_______ 32 Figure 1-9 Damages and savings from emissions_________________________________________________________ 32 Figure 2-1 ETS stakeholders and key considerations in stakeholder mapping_______________________________ 38 Figure 2-2 Role of stakeholders in ETS decision-making__________________________________________________ 41 Figure 3-1 Sector coverage by ETS_____________________________________________________________________ 59 Figure 3-2 Cost pass-through at different points of regulation______________________________________________ 61 Figure 3-3 Examples of market concentration across sectors______________________________________________ 62 Figure 3-4 Variation in thresholds across selected jurisdictions (metric tons CO2e/year)______________________ 65 Figure 3-5 Abatement channels under a carbon price signal in liberalized electricity sectors with full cost pass-through___________________________________________________________________________ 69 Figure 4-1 Aligning the ETS cap with overarching emissions target_________________________________________ 80 Figure 4-2 EU emissions reduction targets and the EU ETS cap____________________________________________ 82 Figure 4-3 Top-down and bottom-up approaches to cap setting___________________________________________ 83 Figure 4-4 Setting the ETS cap with a top-down approach________________________________________________ 87 Figure 4-5 MAC curve plotting abatement options in order of their cost_____________________________________ 89 Figure 5-1 Possible evaluation of primary allocation method as an ETS matures____________________________ 119 vii Figure 6-1 ETS allowance price formation_______________________________________________________________ 126 Figure 6-2 Stylized model of banking in an ETS over time________________________________________________ 130 Figure 6-3 Case study: Banking in Phase 3 of the EU ETS________________________________________________ 131 Figure 6-4 Technical note: The impact of supply adjustment measures_____________________________________ 140 Figure 6-5  Case study: The impact of supply adjustment measures in RGGI________________________________ 142 Figure 6-6 Case study: The EU ETS Market Stability Reserve_____________________________________________ 146 Figure 7-1 Overarching compliance and monitoring structure_____________________________________________ 151 Figure 7-2 Hierarchy of norms: The normative pyramid___________________________________________________ 152 Figure 7-3 Legislative timeline of the EU ETS____________________________________________________________ 153 Figure 7-4 MRV in the EU ETS_________________________________________________________________________ 156 Figure 7-5 Simplified example of annual emissions monitoring (calculation) in a hard coal power plant________ 158 Figure 8-1 International offsets and imported risk________________________________________________________ 179 Figure 8-2 Sources for offsets for an ETS_______________________________________________________________ 180 Figure 8-3 Offset programs around the world___________________________________________________________ 181 Figure 8-4 The general process for project registration and credit issuance________________________________ 185 Figure 9-1 Types of linkages___________________________________________________________________________ 192 Figure 9-2 Illustration of gains from trade in a bilateral linkage____________________________________________ 194 Figure 9-3 Chronology of WCI linkage events___________________________________________________________ 204 Figure 10-1 ETS pilot design___________________________________________________________________________ 215 Figure 10-2 Phases of ETS implementation______________________________________________________________ 219 Figure 10-3 Types of ETS reviews_______________________________________________________________________ 220 LIST OF BOXES Box 0-1 Checklist for the 10 steps of ETS design________________________________________________________ 4 Box 1-1 Technical note: Comparison of cap and trade and baseline and credit systems____________________ 16 Box 1-2 Technical note: What the Paris Agreement means for markets___________________________________ 20 Box 1-3 Technical note: Other climate policy instruments_______________________________________________ 23 Box 1-4 Technical note: Incentives for innovation to complement ETS____________________________________ 25 Box 1-5 The FASTER Principles for Successful Carbon Pricing__________________________________________ 29 Box 2-1 Case study: Stakeholder engagement during design and implementation of the Tokyo ETS_________ 42 Box 2-2 Case study: California’s formal expert engagement in ETS design________________________________ 43 Box 2-3  Case study: Germany’s experience with the Emissions Trading Working Group____________________ 44 Box 2-4 Case study: Government coordination in New Zealand ETS design_______________________________ 45 Box 2-5 Technical note: Communicating carbon pricing_________________________________________________ 46 Box 2-6 Case study: Stakeholder engagement in the lead-up to the introduction of ETS in Mexico__________ 49 Box 2-7 Case study: Overcoming legal challenges: The case of the California Cap-and-Trade-Program______ 50 Box 2-8 Technical note: ETS simulations for capacity building___________________________________________ 52 Box 2-9 Case study: Building capacity for the Chinese national ETS______________________________________ 52 Box 3-1 Technical note: Regulation and behavioral impacts_____________________________________________ 62 Box 3-2 Case study: Upstream regulation_____________________________________________________________ 63 Box 3-3 Case study: Electricity imports in the California Cap-and-Trade Program__________________________ 67 Box 3-4 Technical note: Emissions trading in jurisdictions with regulated electricity market_________________ 68 Box 3-5 Case study: Inclusion of the commercial building sector in Asian ETSs___________________________ 70 Box 3-6 Case study: EU aviation and international measures to regulate aviation emissions________________ 72 Box 3-7 Case study: Deforestation in the New Zealand ETS_____________________________________________ 74 Box 3-8 Case study: New Zealand and agricultural emissions___________________________________________ 75 Box 4-1 Technical note: Determining the level of ETS ambition___________________________________________ 81 Box 4-2 Case study: Accounting for uncertainty of emission projections in cap setting for Phase 1 of the EU ETS (2005–2007)___________________________________________________________________ 86 Box 4-3 Technical note: Data considerations under an intensity-based cap_______________________________ 87 Box 4-4 Case study: Jurisdictions have taken a range of approaches to cap governance___________________ 90 Box 4-5 Case study: Australia’s and New Zealand’s cap mechanisms____________________________________ 92 viii EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Box 4-6 Case study: The linear reduction factor for the EU ETS__________________________________________ 95 Box 4-7 Case study: Ambition and cap design in the California Cap and Trade Program____________________ 95 Box 5-1 Technical note: Allocation terminology explained______________________________________________ 100 Box 5-2 Technical note: Carbon leakage channels_____________________________________________________ 104 Box 5-3 Technical note: Auction design for ETSs______________________________________________________ 106 Box 5-4 Case study: Partial use of consignment in California auctions___________________________________ 107 Box 5-5 Case study: Auction revenue use____________________________________________________________ 108 Box 5-6 Case study: Fixed historical benchmarked allocation in Phases 3 and 4 of the EU ETS____________ 112 Box 5-7 Technical note: Impacts of output-based allocation____________________________________________ 113 Box 5-8 Technical note: Alternative approaches to carbon-leakage protection____________________________ 116 Box 5-9 Technical note: Updating free allocation provisions____________________________________________ 118 Box 6-1 Case study: Banking in Phase 3 of the EU ETS________________________________________________ 131 Box 6-2 Case study: Holding and purchase limits in California and Québec______________________________ 132 Box 6-3 Case study: Allowance borrowing and financial distress________________________________________ 133 Box 6-4 Technical note: Vintage allowances and advance auctions______________________________________ 134 Box 6-5  Technical note: Compliance, reporting, and phasing___________________________________________ 134 Box 6-6 Technical note: Financial products in secondary carbon markets________________________________ 137 Box 6-7 Technical note: The impact of PSAMs________________________________________________________ 140 Box 6-8 Case study: The Allocation Committee in the Korean ETS______________________________________ 141 Box 6-9 Case study: RGGI’s PSAMs_________________________________________________________________ 142 Box 6-10 Case study: Carbon price floor to foster investment in the UK___________________________________ 143 Box 6-11 Case study: California’s PSAMs______________________________________________________________ 145 Box 6-12 Case study: The EU ETS Market Stability Reserve_____________________________________________ 146 Box 7-1 Technical note: Legal pedigree and legislative timeline in the EU ETS____________________________ 152 Box 7-2 Technical note: Legal nature of allowances____________________________________________________ 154 Box 7-3 Technical note: Annual emissions monitoring (calculation) in a hard coal power plant______________ 158 Box 7-4 Technical note: Monitoring emissions from a lime kiln__________________________________________ 159 Box 7-5 Technical note: Default emission factors for balancing cost with accuracy________________________ 160 Box 7-6 Case study: Fraud and cyberattacks in the EU ETS____________________________________________ 167 Box 7-7 Technical note: Contracting ETS transfers____________________________________________________ 168 Box 8-1 Technical note: Offsets and ETS_____________________________________________________________ 173 Box 8-2 Technical note: Negative emissions technologies as offsets_____________________________________ 175 Box 8-3 Technical note: Buyer and seller liability______________________________________________________ 177 Box 8-4 Case study: International offsets and imported risk____________________________________________ 178 Box 8-5 Case study: From Kyoto to Paris – market mechanisms in the international climate regime_________ 181 Box 8-6 Case study: Offset use in the Chinese ETS pilots and China’s national ETS_______________________ 187 Box 9-1 Technical note: Gains from trade via linkage__________________________________________________ 194 Box 9-2 Case study: EU-Switzerland linkage__________________________________________________________ 202 Box 9-3 Case study: Linkage between California and Québec based on the design recommendation developed through the WCI_________________________________________________ 204 Box 9-4 Case study: Australia and the EU: Learning about alignment____________________________________ 205 Box 9-5 Technical note: ETS links and accounting under the Paris Agreement____________________________ 207 Box 9-6 Case study: De-linking in RGGI and WCI______________________________________________________ 209 Box 10-1 Case study: Korea’s Target Management System______________________________________________ 213 Box 10-2 Case study: Mexico pilot ETS________________________________________________________________ 214 Box 10-3 Case study: Chinese regional ETS pilots______________________________________________________ 215 Box 10-4 Case study: Lessons learned from Phase 1 of the EU ETS______________________________________ 216 Box 10-5 Case study: China ETS construction phases__________________________________________________ 218 Box 10-6 Case study: Structural reviews of the EU ETS_________________________________________________ 221 Box 10-7 Case study: Comprehensive review of RGGI__________________________________________________ 222 Box 10-8 Case study: Review processes in the New Zealand ETS________________________________________ 223 Acronym list ix Acronym list ACRONYM LIST Acronym Acronym AB Assembly bill (California) GVA Gross value add AFOLU Agriculture, forestry, and other land use GWP Global warming potential APCR Allowance Price Containment Reserve HFC Hydrofluorocarbons BAU Business as usual IAP2 International Association for Public Participation BECCS Bioenergy with carbon capture and storage ICAO International Civil Aviation Organization CARB California Air Resources Board ICAP International Carbon Action Partnership CCER Chinese Certified Emission Reduction IEA International Energy Agency CCR Cost Containment Reserve IETA International Emissions Trading Association CCS Carbon capture and storage IPCC Intergovernmental Panel on Climate Change CDM Clean Development Mechanism ITL International Transaction Log (Kyoto Protocol) CEM Continuous emissions monitoring ITMO Internationally transferred mitigation outcome” CER Certified Emission Reduction JCM Joint Crediting Mechanism (Japan) CO2 Carbon dioxide JI Joint Implementation (Kyoto Protocol) CO2e Carbon dioxide equivalent ktCO2e Kiloton of carbon dioxide equivalent CORSIA Carbon Offsetting and Reduction Scheme for LRF Linear reduction factor International Aviation MAC Marginal abatement cost CPF Carbon price floor MfE Ministry for the Environment (New Zealand) CPLC Carbon Pricing Leadership Coalition MoU Memorandum of understanding CPM Carbon Pricing Mechanism MRV Monitoring, reporting, and verification CPS Carbon price support MSR Market Stability Reserve DACCS Direct air carbon capture and storage Mt Megaton EAAC Economic and Allocation Advisory Committee MtCO2e Megaton of Carbon Dioxide equivalent EC European Commission (EU) MRR Monitoring and Reporting Regulation (Croatia) ECR Emissions Containment Reserve MW Megawatt EDF Environmental Defense Fund N2O Nitrous oxide EEA European Economic Area NCV Net calorific value EI Emissions intensity NDC Nationally Determined Contributions EITE Emissions-intensive, trade exposed NDRC National Development and Reform Commission EMAC Emissions Market Assessment Committee (China) EPA Environmental Protection Agency (United States) NET Negative emissions technology ERU Emission reduction unit NGO Non-governmental organization ESD Effort Sharing Decision NZ ETS New Zealand Emissions Trading Scheme ESR Effort Sharing Regulation NZU New Zealand Units ETS Emissions Trading System OBA Output-based benchmarked allocation EU European Union OECD Organisation for Economic Co-operation and Development EU ETS European Union Emissions Trading System PCU Price ceiling units EUAs EU allowance units PMI Partnership for Market Implementation GDP Gross domestic product PMR Partnership for Market Readiness GHG Greenhouse Gas PSAM Price or supply adjustment measure Gt Gigaton RGGI Regional Greenhouse Gas Initiative GtCO2e Gigaton of carbon dioxide equivalent x EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Acronym SB Senate bill (California) SEMARNAT Mexican Ministry for Environment and Natural Resources SINAMECC National Climate Change Metrics System t Ton (= metric ton, in the United States) tCO2 Ton of carbon dioxide tCO2e Ton of carbon dioxide equivalent TCI Transport and Climate Initiative TE Trade exposure TNAC Total number of allowances in circulation UK United Kingdom UN United Nations UNFCCC United Nations Framework Convention on Climate Change US United States VAT Value added tax WCI Western Climate Initiative Synthesis 1 Synthesis - Emissions Trading: Bringing It All Together SYNTHESIS SYNTHESIS Emissions Trading: Bringing It All Together Why emissions trading?________________________________________________________________________________ 2 ETS design in 10 steps_________________________________________________________________________________ 3 Step 1: Prepare___________________________________________________________________________________ 5 Step 2: Engage stakeholders, communicate, and build capacities_______________________________________ 5 Step 3: Decide the scope___________________________________________________________________________ 6 Step 4: Set the cap________________________________________________________________________________ 7 Step 5: Distribute allowances_______________________________________________________________________ 7 Step 6: Promote a well-functioning market___________________________________________________________ 8 Step 7: Ensure oversight and compliance____________________________________________________________ 9 Step 8: Consider the use of offsets__________________________________________________________________ 9 Step 9: Consider linking___________________________________________________________________________ 10 Step 10: Implement, evaluate, and improve__________________________________________________________ 11 Shaping the future of ETS design______________________________________________________________________ 12 BOXES Box 0-1 Checklist for the 10 steps of ETS design______________________________________________________ 4 FIGURES Figure 0-1 ETS design in 10 steps______________________________________________________________________ 3 2 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION WHY EMISSIONS TRADING? INTRODUCTION SYNTHESIS Currently, about 46 national jurisdictions and 35 cities, entrepreneurs in developing low-carbon products and states, and regions — representing almost a quarter of innovations, thereby driving progress towards reducing global greenhouse gas (GHG) emissions — are putting a emissions. A price on carbon makes clean energy more price on carbon as a central component of their efforts profitable, allows energy efficiency to earn a greater return, to reduce emissions and place their growth trajectory on makes low-carbon products more competitive, and values a more sustainable footing.1 An increasing number of the carbon stored in forests. An increasing number of firms these jurisdictions are approaching carbon pricing through and investors are advocating for carbon pricing policies from the design and implementation of Emissions Trading government and applying an internal carbon price to guide Systems (ETS). As of 2021, ETSs were operating across investment in advance of government policy to that effect. four continents in 38 countries, 18 states or provinces, and six cities covering over 40 percent of global gross Carbon pricing by itself cannot address all of the domestic product (GDP), and additional systems are under complex drivers of climate change; some combination of development.2 regulations, standards, incentives, educational programs, and other measures will also be required. However, as As jurisdictions adopt increasingly stringent climate part of an integrated policy package, carbon pricing can targets, the question as to which policy package reliably harness markets to drive down emissions and help build puts them on track to deliver the required emissions the ambition needed to sustain a safer climate. ETSs in reductions is becoming ever more prevalent. To move to particular can provide a backstop to ensure that a policy a low-carbon future and achieve the aim of holding the package achieves set climate goals. An ETS imposes increase in the global average temperature to well below a cap on the total emissions in one or more sectors of 2 degrees above preindustrial levels, action will be needed the economy. The regulator issues a number of tradable on multiple fronts, from decarbonizing electricity and allowances not exceeding the level of the cap. Each electrifying transport to moving to low-carbon industry allowance typically corresponds to one ton of emissions. and protecting and enhancing carbon sinks in forests Entities covered by the ETS are then allowed to trade these and soils. This will require a shift in investment patterns allowances, resulting in a market price for the allowances. and behaviors, as well as innovation in technologies, infrastructure, financing, and practice. Policies will be To maximize effectiveness, any ETS needs to be designed needed that achieve this change through reflecting local in a way that is appropriate to its context. This handbook is circumstances, creating new economic opportunities, and intended to help decision makers, policy practitioners, and supporting all citizens’ well-being. stakeholders achieve this goal. It explains the rationale for emissions trading and sets out the most important steps For many jurisdictions, GHG gas emissions pricing (or, of ETS design. In doing so, it draws both on conceptual as it is more commonly referred to, “carbon pricing” or analysis and on some of the most important practical “emissions pricing”) is emerging as a key driver of this lessons learned to date from implementing ETSs around transformation. By aligning profits with low-emission the world, from the European Union to the Regional investment and innovation, a uniform price on carbon Greenhouse Gas Initiative, California, and Québec; and can channel private capital flows, mobilize knowledge from New Zealand to Kazakhstan, Korea, and China.3 about mitigation within firms, and tap the creativity of 1 World Bank 2020. 2 International Carbon Action Partnership 2021. 3 As of January 2021, ETSs in force include the European Union ETS, the United Kingdom ETS, the German National ETS, the Swiss ETS, the California Cap-and-Trade Program, the US Regional Greenhouse Gas Initiative, the Massachusetts Limits on Emissions from Electricity Generators, the Québec Cap-and-Trade System, the Nova Scotia Cap and Trade Program, Mexico’s ETS, the Kazakhstan ETS, the New Zealand ETS, the Chinese National ETS, the Korean ETS, Japan’s Saitama Target Setting ETS, and the Tokyo Cap and Trade Program. A range of regional pilot ETSs are also in force in China and are expected to be gradually transitioned into the national system. See https://icapcarbonaction.com/en/ets-map for a continuously updated list of ETSs in-force, under development, or under consideration. Synthesis 3 ETS DESIGN IN 10 STEPS SYNTHESIS This handbook sets out a 10-step process for designing allowances across time, and to promote participation and implementing an ETS (see Figure 0-1). These steps are in the market. The use of price or supply adjustment interdependent, and the choices made at each step will measures (PSAMs) can also improve market functioning have important repercussions for decisions in the other and help the system better weather shocks (Step 6). It steps. In practice the process of ETS design will be iterative will also require effective compliance and enforcement rather than linear. The need to adjust and adapt policies mechanisms that discourage noncompliance (Step 7). over time is reflected in the update of this handbook, which S Cooperate and expand: Broadening incentives from was first released in 2016. New insights, approaches, and carbon pricing can reduce costs and provide other designs have proliferated adjusting the way ETSs operate benefits. Given this, policymakers should consider and further developing our understanding of them. whether the use of offsets (Step 8) or linking with other S Prepare and engage: Before implementing an ETS, ETSs (Step 9) are appropriate options for their market. it is important to prepare (Step 1). This includes understanding carbon pricing options and what role Even with good initial design, an ETS will need to change they may play in a jurisdiction’s climate policy mix. This over time to remain fit for its purpose. Ongoing evaluation should be followed by stakeholder engagement (Step and improvement (Step 10) can ensure that change occurs 2), including communication, and capacity building in a robust and predictable way. with stakeholders in government, business, and civil Throughout the handbook, we provide checklists, society. Engagement should continue throughout the summarized in Box 0-1, to provide guidance on the design and operation of the ETS, with stakeholder input key decision points and insights on ETS design and into evaluations helping to guide improvements to ETS implementation. design over time. Across the remaining steps, a series of initial Figure 0-1 ETS design in 10 steps high-level decisions define the fundamental shape and direction of the ETS. These 6. Promote a well-functioning can be broadly grouped as market follows: 7. Compliance & enforcement S Create the market: First, policymakers should decide which 4. Set the Cap sectors to cover and where to place the points of regulation for covered 2. Engage Stakeholders sectors (Step 3). A 8. Consider second set of decisions offsets concerns the type and 3. Scope ambition of the cap, both initially and over time (Step 4). These 1. Prepare decisions will influence the way in which emissions allowances are distributed (Step 5). 5. Allocate allowances S Operate the market: A successful carbon market will require appropriate rules for 10. Evalute 9. Consider managing the use of & improve linking 4 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Box 0-1 Checklist for the 10 steps of ETS design INTRODUCTION SYNTHESIS Step 1: Prepare Step 6: Promote a well-functioning market ✔ Understand what carbon pricing and emissions ✔ Establish the rationale for, and risks associated trading are and how they work with, market intervention ✔ Determine the objectives for your ETS ✔ Establish rules for banking and borrowing ✔ Decide the ETS’s role in the climate policy mix ✔ Establish rules for market participation ✔ Understand the ETS’s interaction with other ✔ Identify the role played by a robust secondary policies market ✔ Select criteria to assess ETS design options ✔ Choose whether to intervene to address low prices, high prices, or both Step 2: Engage stakeholders, communicate and ✔ Choose the appropriate price or supply build capacities adjustment measure ✔ Map stakeholders and respective positions, interests, and concerns Step 7: Ensure oversight and compliance ✔ Coordinate across departments for a transparent ✔ Identify the regulated entities decision-making process and to avoid policy ✔ Manage emissions reporting by regulated entities misalignment ✔ Approve and manage the performance of verifiers ✔ Design an engagement strategy for consultation ✔ Establish and oversee the ETS registry of stakeholder groups specifying format, timeline, ✔ Design and implement the penalty and and objectives enforcement approach ✔ Design a communication strategy that resonates ✔ Regulate and oversee the market for ETS with local and immediate public concerns emissions allowances ✔ Identify and address ETS capacity-building needs Consider the use of offsets Step 8:  Step 3: Decide the scope ✔ Outline the potential role of offsets within an ETS ✔ Decide which sectors to cover ✔ Decide on the type of offsets allowed within ✔ Decide which gases to cover the system (both geographical scope and ✔ Choose the points of regulation governance of program) ✔ Choose the entities to regulate and consider ✔ Weigh costs of establishing a domestic offset whether to set thresholds program versus making use of an existing ✔ Choose the point of reporting obligation program ✔ Decide on qualitative and quantitative limits on Step 4: Set the cap the use of offsets ✔ Determine the ambition of the cap, type of cap, and approach to cap setting Step 9: Consider linking ✔ Create a robust foundation of data to determine ✔ Identify potential linkage partners the cap ✔ Determine the type of link ✔ Choose time periods for cap setting ✔ Identify the benefits and risks associated with the ✔ Agree upon formal legal and administrative link governance arrangements ✔ Discuss compatibility of key program design ✔ Agree on a long-term cap trajectory and strategy features for providing a consistent price signal ✔ Form and govern the link Step 5: Distribute allowances Step 10: Implement, evaluate, and improve ✔ Match allocation methods to policy objectives ✔ Decide on the timing and process of ETS ✔ Define eligibility and methods for free allocation implementation ✔ Define treatment of entrants, closures, and exits ✔ Decide on the process and scope for reviews ✔ Set up auctions to play an increasing role over ✔ Identify why the design of the ETS may need to time while reducing free allocation change over time ✔ Evaluate the ETS to support future improvement Synthesis 5 STEP 1: Prepare Lessons learned: An ETS works best as part SYNTHESIS of a well-thought-out policy package to achieve Checklist for Step 1: Prepare climate targets and drive sustainable development. ✔ Understand what carbon pricing and emissions Jurisdictions have taken different approaches to trading are and how they work positioning their ETS relative to other policies. In the ✔ Determine the objectives for your ETS case of California, the ETS was adopted within a broad climate change policy portfolio, and the ETS ✔ Decide the ETS’s role in the climate policy mix price signal was expected to serve as a backstop ✔ Understand the ETS’s interaction with other policies to ensure that emission targets would be met if the ✔ Select criteria to assess different ETS design options other measures proved less effective than hoped. In contrast, New Zealand currently employs an ETS as its primary mitigation instrument. Ensuring the right policy Before proceeding to designing their ETS, policymakers mix can improve overall outcomes and help build need a clear understanding of what carbon pricing is and public support for the introduction of an ETS. what it can and cannot do. Considering this, they need to define the ETS objectives for their jurisdiction. They must establish the system’s priorities: how much it should contribute to the low-carbon economic transformation and sustainable development; the level and cost at which they want to achieve emissions reductions; the importance of STEP 2: Engage stakeholders, co-benefits; and whether the system should raise revenue. communicate, and build capacities They must also build public awareness and acceptance of the need to reduce emissions to make it easier to adopt Checklist for Step 2: Engage stakeholders, and implement an effective ETS. communicate, and build capacities All ETSs are developed within a broader policy and legal ✔ Map stakeholders and respective positions, framework, including other climate change policies. To interests, and concerns position the ETS strategically within the broader policy ✔ Coordinate across departments for a transparent portfolio, it is important to have a clear view of how the ETS decision-making process and to avoid policy will contribute to a jurisdiction’s climate policy objectives misalignment and its relationship with other current or planned policies. ✔ Design an engagement strategy for consultation of Other policies in the climate change portfolio and in other stakeholder groups specifying format, timeline, and relevant sectors (together called “companion policies”) objectives can affect the operation of the ETS, including the level of ✔ Design a communication strategy that resonates emissions reductions, the carbon price, and the system’s with local and immediate public concerns distributional impacts. These policies can help improve the ✔ Identify and address ETS capacity-building needs effectiveness of the ETS. For example, they may remove non-price barriers to reducing emissions by providing enabling infrastructure. On the other hand, they may Developing a successful ETS requires enduring public and duplicate incentives provided by the ETS, or in some cases, political support. It also depends on practical collaboration counteract the intended effect of the ETS. The ETS can across government and market players. This collaboration also positively or negatively affect the functioning of other should be based on shared understanding, trust, and policies, including the achievement of economic, social, capability. The manner and, in particular, the transparency or environmental goals. These policy interactions must be with which ETS policymakers engage with others in managed carefully and considered when designing the ETS. government and external stakeholders will determine the long-term viability of the system. Engagement should start Policymakers may wish to assess different ETS designs at the beginning of ETS planning and continue throughout against a range of criteria, the most crucial of which are the design, rollout, and operation of the ETS. the system’s environmental integrity, ability to deliver cost-effective mitigation, and appropriateness to local Communication about an ETS needs to be clear, context. Other criteria jurisdictions may consider include consistent, and coordinated, and the government needs to accountability and transparency, robustness, compatibility maintain integrity and credibility throughout the process. with other policies, fairness, policy predictability, policy Major changes to the system should be announced well flexibility, administrative cost, and compatibility with other in advance, and the government should consider carefully jurisdictions. how to manage commercially sensitive information. Developing an ETS also requires strategic capacity building. Government decision makers and administrators 6 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION need to build specialized technical expertise and between the covered and non-covered sectors to meet INTRODUCTION administrative capacity to develop and operate an ETS. economy-wide emission reduction targets. SYNTHESIS ETS participants, market service providers, business associations, and civil society representatives hold In determining ETS scope, important differences across specialized knowledge that can help policymakers design sectors and emissions sources should be considered. an effective system, but these stakeholders also need Key considerations include the jurisdiction’s emissions to build sufficient capacity to participate in the system. profile and its expected evolution; the market structure Investing time and resources for capacity building will of emissions-intensive industries; the ability and cost of generate valuable returns. monitoring, reporting, and verification across emission sources; and, the existing regulatory structures and policies. Consideration should finally be given to the Lessons learned: Government decision-making potential for non-price barriers to limit carbon price can be facilitated by strong executive and ministerial pass-through, exposure to international markets, and the leadership, the clear allocation of responsibilities potential for co-benefits. across departments, and the designation of interdepartmental working groups. Governments Generally, broader system coverage is desirable as it typically underestimate the strategic importance increases the range of low-cost mitigation options, allowing of meaningful stakeholder engagement and public emissions reductions to be achieved at the least cost. communications in securing enduring support for Broader coverage also reduces competitive distortions an ETS. Some jurisdictions have found that it took 5 (as competing firms and sectors operate within the same to 10 years of engagement and capacity building on market rules) and enhances market liquidity. However, climate change market mechanisms to enable informed sectors differ in their ease of coverage under an ETS, with and broadly accepted ETS policymaking. Tapping the electricity industry being easier to cover and others, stakeholder expertise will improve ETS design and help like the waste and land sectors, typically presenting more gain trust, understanding, and acceptance. Creating challenges. A broader system may impose a greater and executing a communications strategy can help regulatory burden on small and diffuse emissions sources, broaden support for an ETS. Developing a suitable which may also be relatively difficult to regulate. Therefore, and persuasive narrative about the ETS will be vital to the benefits of broader coverage must be balanced against gaining popular support. Because the ETS will need any additional administrative effort and transaction costs. to change and be adapted over time, it is important Using thresholds to exclude small emitters and placing the to continue to engage stakeholders to identify when point of regulation at the most concentrated part of the circumstances change and promote enduring broad supply chain can help manage this trade-off. support for the ETS. Lessons learned: There is a great diversity across existing ETSs in terms of scope, suggesting there is no single “right” approach. Almost all systems cover at least the power and industrial sectors. A STEP 3: Decide the scope phased approach can be useful to allow time to build the capacity to include smaller or more complex Checklist for Step 3: Decide the scope sectors. All systems cover carbon dioxide; many cover other gases as well. While some jurisdictions have ✔ Decide which sectors to cover placed the point of regulation for emissions from fuel ✔ Decide which gases to cover combustion upstream to reduce administrative costs ✔ Choose the points of regulation (for example fuels in California, Québec, and New ✔ Choose the entities to regulate and consider Zealand), others have opted for regulation at the point whether to set thresholds where emissions are generated for alignment with ✔ Choose the point of reporting obligation existing regulatory or reporting systems (for example the European Union). Still other systems have opted for hybrid coverage because energy prices are regulated The scope of an ETS refers to the geographic area, and carbon price signals would otherwise not pass sectors, emissions sources, and greenhouse gases for through the supply chain (for example the Korean ETS which allowances will have to be surrendered, as well and ETSs in China). as which entities will have to surrender them. The ETS scope defines the boundaries of the policy. It therefore has implications for the number of regulated entities, the share of emissions facing an allowance price, and effort sharing Synthesis 7 STEP 4: Set the cap Lessons learned: A cap should rest on a solid SYNTHESIS foundation of robust underlying data and assumptions. Checklist for Step 4: Set the cap Cap setting will benefit from early data collection and greater reliance on historical data as compared to ✔ Determine the ambition of the cap, type of cap, and approach to cap setting counterfactual projections. While most jurisdictions have chosen absolute caps to facilitate alignment ✔ Create a robust foundation of data to determine the between caps and targets as well as linking, they have cap also built in some flexibility over allowance supply to ✔ Choose time periods for cap setting maintain price predictability (see Step 6). In practice, ✔ Agree upon formal legal and administrative partly because of a concern about high prices, initial governance arrangements caps in many existing ETSs were relatively loose, ✔ Agree on a long-term cap trajectory and strategy which contributed to prices that were significantly for providing a consistent price signal lower than expected. To support effective market operation and build confidence among market participants, a long-term cap trajectory should be The ETS cap sets a limit on the total amount of emissions combined with a transparent, rules-based process of produced by the regulated entities, which is then reflected possible modifications to the cap and advance notice in the number of allowances issued over a specified time of future changes. period. All else equal, the lower the cap, the higher the carbon price will be and the stronger the incentive to reduce emissions. However, other design features such as access to offsets, linking, and different PSAMs interact with the cap to determine the overall emissions constraint and the resulting carbon price. In practice, cap setting is STEP 5: Distribute allowances a balancing act, as it accounts for environmental integrity and ambition, cost constraints, and fairness within the Checklist for Step 5: Distribute allowances broader policy context. ✔ Match allocation methods to policy objectives Setting the cap requires an assessment of the jurisdiction’s ✔ Define eligibility and methods for free allocation historical emissions, its projected emissions (which depend ✔ Define treatment of entrants, closures, and removals on both anticipated improvements in emissions intensity ✔ Set up auctions to play an increasing role over time and projected economic growth and development), while reducing free allocation and mitigation opportunities and costs. It should reflect considerations of how other current or planned policies could influence ETS outcomes. Whereas the cap determines the emissions impact of an ETS, allowance allocation is an important determinant of The cap should be aligned with the jurisdiction’s the distributional impacts of an ETS. It can also affect the overall mitigation target, such as those expressed in a efficiency of the system through influencing abatement Nationally Determined Contribution (NDC). In setting the incentives. It therefore merits careful attention. cap, policymakers need to manage trade-offs between emissions reduction ambition and system costs, aligning The government can distribute allowances for free, cap ambition with target ambition, and assigning auctioning, or through some combination of the two. mitigation responsibility across covered and uncovered Free allocation methods vary according to whether they sectors. Absolute caps set targets for the level at which are based on entities’ historical emissions — referred emissions should be limited for each compliance period. to as grandparenting — or are based on an emissions However, flexibility can be provided by banking provisions, benchmark, and depend on whether allocation changes allowance reserves, offset credits, linking, and PSAMs. when output changes. To differing degrees these options Intensity caps prescribe the number of allowances to be can protect against leakage (the concern that carbon issued per measure of output (for example gross value pricing causes geographic relocation of emissions rather added or kilowatt-hour of electricity), which allows them than genuine emissions reductions) and can also help to adjust automatically to fluctuations in economic output compensate for economic losses that compliance with the but provides less certainty over emission outcomes. ETS might otherwise cause. Absolute caps are by far the more common type of cap. Jurisdictions that choose intensity caps will have a smaller Auctioning generates government revenue, which can body of knowledge and experience to draw on and might be used to meet a number of objectives: pay for cuts in face challenges when considering linking. distortionary taxes, reduce debt, support spending on public programs (including other forms of climate action) or be returned to households directly to address adverse 8 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION social outcomes. Auctioning also supports the operation of After the initial allocation, ETS participants can trade their the secondary market through enabling price discovery. allowances. The allowance price depends on the balance between the policymaker-controlled supply on the one The risk of carbon leakage in emissions-intensive, trade- hand, and demand among market participants on the exposed sectors has been a major concern in ETS design other, which in turn depend on a host of broader economic and implementation and is likely to remain a core political and technological trends. This means that the allowance consideration in the short- to medium-term, although price can vary substantially over time. empirical evidence on leakage is limited to date. This issue will also decline in importance as carbon pricing is adopted A well-functioning market that sees prices adjust more widely or harmonized globally. predictably to external events and changed information is important for an ETS to operate as intended. Policymakers should therefore work to ensure market depth and liquidity, Lessons learned: Because large amounts of as well as transparent rules facilitating price discovery. resources are at stake, allocation decisions can become highly contentious and a key focus of Fluctuations in the carbon price are often desirable as stakeholder attention and political discussion. The they represent the transmission of price signals about objectives of allocation (for example, reducing carbon abatement costs to market participants. However, large leakage risk or preserving incentives for cost-effective price variability can occur as a result of exogenous abatement) should be transparently stated upfront shocks, regulatory uncertainty, or market imperfections. and subsequent decisions on allocation design issues Policymakers can support the development of a well- should be explained and justified by reference to functioning market through rules for temporal flexibility these objectives. Both the objectives of allocation and and regulatory and governance structures that support allocation design features can be expected to evolve secondary market development. over time. Decisions on entities’ individual allocation should be made separately from decisions on the cap. Temporal flexibility is determined by the degree to which Auctioning has typically been introduced on a limited banking (reserving allowances in the current period for use scale initially, but with the intention that it will gradually at a later time) and borrowing (using allowances from future displace free allocation over time. Allocation methods allocations) are allowed. Banking is generally seen as positive can vary across sectors; for example, the power sector since it encourages earlier reductions and helps smooth is a typical candidate for auctioning as it is often less costs (and allowance prices) across compliance periods. In prone to carbon leakage than other ETS sectors, while contrast, borrowing carries the risk of delaying mitigation manufacturing sectors have typically received some action and is typically avoided. The length of the compliance form of free allocation at least in their initial years. period determines the length of time during which firms Using auction revenue strategically can be a powerful need to monitor, report, and verify their emissions and then selling point for an ETS. surrender the relevant number of allowances. Policymakers must decide on who can participate in the market and the institutions that will support market development. Financial market players can play an important role in adding liquidity and providing access STEP 6: Promote a well-functioning to risk-management products but can add complexity to market the market. The degree to which the government itself participates in the market is also something that should be Checklist for Step 6: Promote a well-functioning considered. market Even with a relatively well-functioning secondary market, ✔ Establish the rationale for, and risks associated there remain risks of excessive price variability in carbon with, market intervention markets. As such, it is now common practice for ETSs ✔ Establish rules for banking and borrowing to adopt some form of PSAM. PSAMs help jurisdictions ✔ Establish rules for market participation achieve a predictable and effective market that ensures ✔ Identify the role played by a robust secondary prices are consistent with those necessary for longer-term market decarbonization, while avoiding periods of excessive costs. ✔ Choose whether to intervene to address low prices, Examples of PSAMs addressing low prices include auction high prices, or both reserve prices, hard price floors, or the levying of additional ✔ Choose the appropriate price or supply adjustment fees and charges on top of the allowance price. PSAMs measure addressing high prices include cost containment reserves, or hard price ceilings. Alternatively, PSAMs can also help Synthesis 9 manage supply by responding to quantity-based criteria functions. The approach to ETS compliance and oversight like the number of banked allowances. needs to balance the costs to regulators and regulated SYNTHESIS entities against the potential risks and consequences of noncompliance. The existing regulatory culture will Lessons learned: Excessive price variability risks influence the optimal balance for each jurisdiction. undermining mitigation in an ETS and reducing Regulators can draw from experience with other markets public confidence in the system. Rules regarding dealing in commodities and financial instruments. temporal flexibility and market participation affect how markets operate. Banking can help smooth fluctuations over time, while the inclusion of financial Lessons learned: A robust compliance regime is market participants in the carbon market can reduce the backbone of the ETS and a precondition for its volatility and help provide access to risk-management credibility. The government may need to actively products. Even so, policymakers now generally adopt identify new regulated entities as firms are established PSAMs to ensure the resilience of ETSs to exogenous and change over time. It can be costly to monitor shocks while achieving underlying emissions emissions with high levels of accuracy and precision; reductions objectives. lower-cost approaches such as using default emissions factors can provide unbiased estimates for predictable sources of emissions. Regulators should take advantage of existing local environmental, tax, legal, and market systems where relevant STEP 7: Ensure oversight and compliance when establishing ETS compliance and oversight. Making emissions data transparent strengthens Checklist for Step 7: Ensure oversight and market oversight but data management systems compliance must protect potentially confidential or commercially sensitive information. Under-regulation of the trading ✔ Identify the regulated entities market may allow for fraud and manipulation, while ✔ Manage emissions reporting by regulated entities over-regulation may increase compliance costs ✔ Approve and manage the performance of verifiers and eliminate many of the flexibilities that give ✔ Establish and oversee the ETS registry carbon markets their efficiency. In some systems, the reputational implications of noncompliance, ✔ Design and implement the penalty and enforcement especially when reinforced by public disclosure of ETS approach performance, have proven to be a strong deterrent, ✔ Regulate and oversee the market for ETS emissions but a binding system of penalties is still needed. When allowances problems with compliance arise, the ETS regulator and the government should respond quickly to safeguard Like other climate policies, an ETS needs rigorous the integrity and liquidity of the market and maintain enforcement of participants’ obligations and effective the trust and confidence of market participants. government oversight of the system. A lack of compliance and oversight can threaten not just emissions outcomes by noncompliant entities, but also the basic functionality of the market, with high economic stakes for all participants. STEP 8: Consider the use of offsets Implementing effective systems for monitoring, reporting, and verification (MRV) of greenhouse gas emissions early Checklist for Step 8: Consider the use of offsets in the process of ETS development will greatly support compliance and the operation of markets. This includes ✔ Outline the potential role of offsets within an ETS legal and administrative considerations around identifying ✔ Decide on the type of offsets allowed within the regulated entities and developing detailed methodologies system (both geographical scope and governance and guidance for emissions monitoring. Emissions of program) reporting can utilize existing data collection activities for ✔ Weigh costs of establishing a domestic crediting energy production, fuel characteristics, energy usage, mechanism versus making use of an existing industrial output, and transport. crediting mechanism ✔ Decide on qualitative criteria and quantitative limits Depending on the strength of existing auditing systems, on the use of offsets government regulators may need to play a stronger role in verification during the early phases of implementation while third-party verifiers are building their capacity to fulfill new 10 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION An ETS can allow offsets — credits for emissions INTRODUCTION Lessons learned: Offsets can provide a tool reductions or removals in uncovered sources and SYNTHESIS for containing compliance costs, expanding sectors — to be used by regulated entities to meet their mitigation incentives beyond the covered sectors, compliance obligations. This can enable emissions from and generating co-benefits. Policymakers need regulated entities to be higher without compromising to decide whether to make use of an externally overall environmental outcomes. The increase in emissions administered crediting mechanism or whether to set is counterbalanced, or offset, by emissions reductions up a domestic crediting mechanism, which requires elsewhere. This provides a new pool of low-cost additional effort. In either case, valuable experience compliance units for regulated entities and can significantly gained with the use of offsets to date highlights reduce ETS compliance costs. the need to maintain credibility and environmental Offsets can come from a variety of sources: uncovered integrity through robust rules and methodologies. sectors or sources within the jurisdiction (for example Quantitative limits may be used to control the inflow depending on the system: transport, waste, forestry, or of low-cost offset credits and the relocation of agriculture); unregulated entities outside the jurisdiction’s mitigation co-benefits, and qualitative criteria may borders; and early (pre-ETS) reductions from covered be designed to achieve specific policy objectives sources. Jurisdictions may choose to establish their and to address environmental integrity risks. own domestic crediting mechanism, or rely on externally administered mechanisms. Crediting mechanisms, if designed and implemented properly, broaden the carbon price signal to uncovered STEP 9: Consider linking sectors and provide an avenue to generate abatement incentives in sectors that are difficult to include in the Checklist for Step 9: Consider linking scope of the ETS for technical, political, or other practical reasons. This increases the economic efficiency of the ETS ✔ Identify potential linkage partners by expanding the set of mitigation opportunities available ✔ Determine the type of link and facilitates investment flows into sectors where financial ✔ Identify the benefits and risks associated with the support is needed to stimulate low-carbon development. By link lowering compliance costs and creating a new, supportive ✔ Discuss compatibility of key program design political constituency for the ETS in the form of project features proponents, the use of offsets may make an ETS more ✔ Form and govern the link attractive to the private sector, community groups, or local governments that may choose to participate. This may allow policymakers to set a more ambitious cap and Linking occurs when an ETS allows regulated entities broaden coverage as sectors develop their MRV capabilities to use allowances issued by another jurisdiction for and may support policy stability. Crediting mechanisms compliance or permits its own allowances to be used can also be designed to target specific policy goals for compliance in another system, with or without including improved air quality, restoration of degraded restrictions. Linking broadens flexibility as to where land, and better watershed management. Finally, crediting emissions reductions can occur, and so takes advantage mechanisms can also support low-carbon investment, of a broader array of abatement opportunities than those learning, and engagement among uncovered sources. available domestically. This lowers the aggregate costs of meeting emission targets. It can also improve market At the same time, the acceptance of offsets presents liquidity and price predictability, help address leakage potential challenges. Offsets represent a risk to and competitiveness concerns, and facilitate international environmental integrity if they are not additional (for cooperation on climate policy. example if an actor would have undertaken an activity even in the absence of the crediting mechanism), not real (for Linking can also incur risks. It reduces jurisdictions’ control example, if the emissions reductions did not actually occur), over the carbon price, potentially exposes the jurisdiction or not permanent (for example if they are reversed and to external shocks, reduces control over the level of released into the atmosphere at a later stage). The inclusion domestic abatement effort (including the potential loss of of offsets may also create an incentive for jurisdictions to local co-benefits) and limits the jurisdiction’s autonomy implement lax climate commitments in offset-generating over ETS design features. The changes in the allowance sectors and sources, weakening global environmental price due to the linkage could raise distributional concerns outcomes. Robust and transparent accounting measures and may imply large financial transfers. should be employed to prevent double counting. While unrestricted linkage may bring greater economic benefits, restricted linking (typically implemented through Synthesis 11 limits on the quantity or quality of foreign allowances that can facilitate capacity building and learning before full can be used for compliance) may allow jurisdictions to implementation. This can be done by ETS pilots and/or SYNTHESIS retain some control over design features, and safeguard phasing in sector coverage, ambition, and the degree of against risks associated with linking. government intervention in the market. Linking requires mutual trust between systems, and ETS design is an evolutionary process that should facilitate a degree of compatibility between design elements. change over time as circumstances evolve and experience Structural elements that must be tightly aligned, if not increases. Policymakers should therefore design their identical, include the voluntary or mandatory nature of policy and institutions to facilitate change over time in the system and type of cap. Other elements that do not a predictable and constructive manner. Reviews of ETS require strict compatibility but must deliver comparable performance, both frequent targeted reviews and less- outcomes in the linking systems include PSAMs, the use frequent comprehensive reviews, are important to enable and environmental integrity of offsets, rules on borrowing this continual improvement and adaptation. Targeted and banking allowances, and potential for linking with reviews are used to assess specific aspects of the ETS, additional systems. covering more technical details. Comprehensive reviews assess the ETS at a higher level to investigate whether the ETS has met its objectives and assess how fundamental Lessons learned: Linking requires clear understanding design elements could be improved. and acceptance of the current and future levels of ambition in partnering jurisdictions’ ETSs. In successful Any possible changes resulting from these reviews need links to date, partners have had strong existing to be balanced against the risks of policy uncertainty. The relationships that facilitated the negotiations leading latter can be mitigated by establishing transparent and up to the link and the subsequent joint governance predictable processes through which ETS changes are of the market. Key design features need to be made communicated and implemented. compatible to ensure environmental integrity and price stability when linking. For other features, there needs to be confidence that the linking partner or partners’ Lessons learned: Every ETS has required an ETS designs will deliver comparable outcomes. This extensive preparatory phase to collect data and alignment will take time and may need to be phased in. develop technical regulations, guidelines, and In practice, linking partners to date have aligned system institutions. Relying on existing institutions where design to a greater extent than strictly necessary for possible can control costs. ETS pilots can generate market functioning. Poorly managed links can have valuable learning, but they also risk leaving a legacy unintended consequences, so jurisdictions should start of negative public perceptions if they encounter thinking about and preparing for linking as early as difficulties, and not all lessons may be applicable possible, but link strategically and only when suitable. when the ETS is fully launched. Phasing in an ETS can ease the burden on institutions and sectors but can reduce the ETS’s initial environmental impact and can anchor stakeholder expectations on lower ambition in the future. Providing a predictable review process and schedule can reduce policy uncertainty, a major STEP 10: Implement, evaluate, and barrier to low-emission investment, but additional improve unanticipated changes may be unavoidable. Reviewing an ETS’s performance can be challenging; data is Checklist for Step 10: Implement, evaluate, and often limited, and external drivers of economic activity improve and emissions make it hard to distinguish the effect of ✔ Decide on the timing and process of ETS the ETS from that of other policies or macroeconomic implementation developments. Starting data collection before the ETS ✔ Decide on the process and scope for reviews starts, making entities’ data public where possible, and encouraging external evaluations will provide the ✔ Identify why the design of the ETS may need to best chance for successful reviews. Good governance change over time and stakeholder engagement processes are key to ✔ Evaluate the ETS to support future improvement successful implementation. Operating an ETS requires regulators and market participants to assume new roles and responsibilities, embed new systems and institutions, and launch a functional trading market. Gradually introducing an ETS 12 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION SHAPING THE FUTURE OF ETS DESIGN INTRODUCTION SYNTHESIS The goal of this handbook is to draw on the experiences of that can be shared globally will be key to improving the jurisdictions with an ETS to assist other jurisdictions with effectiveness of carbon pricing as a driver of low-emission the design, implementation, and operation of an effective development. and credible ETS. The fundamental concept of emissions trading is as simple as it is powerful. By drawing on the The handbook was originally published in 2016. An lessons outlined in this handbook, over the next decade updated edition was published in 2021 to reflect the decision makers, policy practitioners, and stakeholders developments that have taken place in the world of can implement ETSs tailored to their specific geographic emissions trading, including the launch of new systems and and socioeconomic contexts. In doing so, learning from significant changes to existing systems. existing systems and finding creative new design solutions Step 1: Prepare 13 Step 1 - Prepare STEP 1 Prepare PREPARATION STEP 1 At a Glance_____________________________________________________________________________ 14 1.1 Understand emissions trading______________________________________________________ 15 1.2 Determine objectives for the ETS____________________________________________________ 20 1.3 Consider interactions between an ETS and companion policies_______________________ 22 1.4 Keys to effective ETS design________________________________________________________ 27 1.5 Emissions trading and economics: A primer__________________________________________ 29 1.6 Quick Quiz________________________________________________________________________ 33 1.7 Resources________________________________________________________________________ 33 BOXES Box 1-1 Technical note: Comparison of cap and trade and baseline and credit systems_____ 16 Box 1-2 Technical note: What the Paris Agreement means for markets____________________ 20 Box 1-3 Technical note: Other climate policy instruments________________________________ 23 Box 1-4 Technical note: Incentives for innovation to complement ETS_____________________ 25 Box 1-5 The FASTER Principles for Successful Carbon Pricing___________________________ 29 FIGURES Figure 1-1 ETS design in 10 steps_______________________________________________________ 18 Figure 1-2 Establishment of ETSs worldwide over time____________________________________ 19 Figure 1-3 Emissions trading around the world___________________________________________ 19 Figure 1-4 The impact of companion policies on ETS outcomes____________________________ 24 Figure 1-5 MAC curve plotting abatement options in order of their costs____________________ 30 Figure 1-6 An example of two firms with different abatement costs_________________________ 31 Figure 1-7 Applying a uniform standard to each company__________________________________ 31 Figure 1-8 Trade saves costs relative to an allocation that prescribes equal emissions by each company______________________________________________________________ 32 Figure 1-9 Damages and savings from emissions_________________________________________ 32 TABLES Table 1-1 Comparison of carbon taxes and ETSs________________________________________ 16 Table 1-2 Advantages and disadvantages of complementary measures____________________ 27 14 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION AT A GLANCE incentive requires undesirably high allowance prices. An Checklist for Step 1: Preparation ETS therefore works best as part of a well-thought-out ✔ Understand what carbon pricing and emissions policy package to achieve climate targets and drive trading are and how they work sustainable development. PREPARE STEP 1 ✔ Determine the objectives for your ETS To position the ETS strategically within the broader policy ✔ Decide the ETS’s role in the climate policy mix portfolio, it is important to have a clear view of how the ETS ✔ Understand the ETS’s interaction with other policies will contribute to achieving a jurisdiction’s climate policy ✔ Select criteria to assess different ETS design options objectives and how it relates to and interacts with other current or planned policies. Ensuring the right policy mix can improve overall outcomes and help build and maintain Carbon pricing aims to make it more expensive to emit support for the ETS. carbon dioxide and other greenhouse gases, to ensure that market actors take account of the costs of emissions when Other policies in the climate change portfolio and in making commercial decisions. When facing a carbon price, other relevant sectors (called here “companion policies”) firms will seek to minimize costs by investing in the most can affect the operation of the ETS, including the level cost-effective abatement solutions, and consumers will of emissions reductions, the carbon price, and its change their behavior to substitute away from emissions- distributional impacts. These policies can help improve the intensive goods. Carbon pricing instruments therefore help effectiveness of the ETS (complementary policies) but can channel economic activities toward a low-carbon future. also duplicate incentives provided by the ETS (overlapping policies), or in some cases, counteract incentives provided An emissions trading system (ETS), also referred to by the ETS (countervailing policies). Conversely, the ETS as a “cap and trade” system, is one of the main policy can also positively or negatively affect the functioning of instruments used to price carbon (alongside carbon other policies in a jurisdiction, including the achievement of taxes and crediting mechanisms). An ETS imposes a limit economic, social, or environmental goals. (cap) on the total emissions in one or more sectors of the economy, and issues tradable allowances not exceeding Before designing an ETS, policymakers should clearly the level of the cap. Each allowance typically corresponds establish the objectives that they want the ETS to deliver. to one metric ton of emissions. Entities covered by the ETS This in turn will guide choices in ETS design. The most are then allowed to trade them, resulting in a market price crucial criteria for an ETS are the system’s environmental for these allowances. integrity, ability to deliver cost-effective mitigation, and appropriateness to local context. In addition, broader The primary objective of an ETS is simple: it limits total good governance considerations regarding accountability covered emissions while providing incentives for mitigation and transparency, robustness, compatibility with other to be achieved at the lowest possible cost. It also aims to policies, fairness, policy predictability, policy flexibility, drive a sustainable economic transformation by aligning administrative cost-effectiveness, and compatibility with profits with low-emission investment and innovation. other jurisdictions should be considered. These objectives relating to reducing greenhouse gas (GHG) emissions go hand in hand with achieving a wide Section 1.1 lays out the fundamental principles behind range of positive outcomes including improved air quality, carbon pricing, how it works, and the different policy increased energy security, induced technological change, instruments that can be used to implement it. Section 1.2 the creation of green jobs, and other benefits. Finally, by provides insight into the potential benefits of an ETS and auctioning allowances rather than distributing them for the objectives it can serve. Section 1.3 then presents free, an ETS also generates revenue for general use or to a framework to understand the ETS’s role within a be earmarked to support programs and policies targeted at wider climate change mitigation policy portfolio, and specific environmental or social outcomes. its interactions with the policy landscape. Section 1.4 describes criteria against which ETS design options can An ETS alone, however, cannot address all of the barriers be evaluated. Finally, Section 1.5 gives an overview of the to cost-effective emissions reductions; for example, theoretical basis for carbon pricing and emissions trading. where non-price barriers like consumer preferences or information gaps exist, or where providing a strong-enough Step 1: Preparation 15 1.1 UNDERSTAND EMISSIONS TRADING 1.1.1 HOW CAN POLICYMAKERS PRICE (called the baseline) and generating “credits” if CARBON? firms reduce emissions to below the baseline level, or by permanently sequestering carbon. Crediting Carbon pricing aims to make emitting carbon dioxide and PREPARE mechanisms thus create a supply of verified credits but STEP 1 other greenhouse gases more expensive and ensure that cannot operate in the absence of sources of demand, market actors take account of the true costs of emissions which often comes from linking these to an ETS or a when making commercial decisions. Businesses and carbon tax (where credits can be used for compliance). households are incentivized to change their production and consumption behavior, promoting lower-emissions An important theoretical difference between ETSs and other outcomes. Firms and businesses will seek to minimize the carbon pricing instruments is that the level of emissions costs associated with a carbon price by investing in the reduction is more certain (because the cap dictates the most cost-effective abatement solutions. At the same time, total emissions from covered sectors), but the price is not consumers will substitute lower-emissions products as fixed and is determined by the demand for allowances. these gain a relative cost advantage. Through this process, over time low-emissions producers will gain market share In practice, most carbon pricing mechanisms act as a over high-emissions producers. Carbon pricing can hybrid, including elements of carbon taxes, ETSs, and therefore play a critical role in decarbonizing the economy. crediting systems. For instance, most ETSs employ price or supply adjustment measures (PSAMs) to control the price The three main policy instruments used to price carbon are: or quantity of allowances, leading to more certain prices S Carbon taxes: Carbon taxes set a fixed price per unit and less certain emissions reductions (see Step 6). This of emissions to help internalize the cost of emissions makes the distinction between ETSs and taxes less clear. and provide incentives for emissions reductions. Different carbon pricing policies can also exist alongside S Emissions each other at the same time: for instance, a carbon tax trading systems: An Emissions Trading could apply in the transport sector, while emissions trading System (ETS) imposes a cap on the total emissions operates in the industry and power sectors. in one or more sectors of the economy. The regulator issues a number of tradable allowances not exceeding Table 1-1 provides a brief comparison of an ETS and the level of the cap.4 Each allowance typically a carbon tax, the two main instruments employed by corresponds to one ton of emissions.5 Entities covered jurisdictions with a carbon pricing regime. Box 1-1 by the ETS are then allowed to trade these allowances, discusses the difference between cap and trade style ETSs resulting in a market price for the allowances. This type and baseline and credit systems. of ETS is also called a “cap and trade system.”6 S Crediting mechanisms: These mechanisms credit emissions reductions or carbon sequestration. They come in various forms, but generally operate by establishing a reference emissions level or intensity 4 Alberta Carbon Competitiveness Incentive Regulation (CCIR) sets a facility-level emissions intensity target (as opposed to an absolute cap). 5 Allowances can be issued in units of tons carbon dioxide, or tons of carbon dioxide equivalent. The latter includes carbon dioxide as well as other GHGs (for example methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons, sulphur hexafluoride, and nitrogen trifluoride) on the basis of their relative global warming potential. It is also possible that an allowance could correspond to a different mass of GHGs, for example, in Regional Greenhouse Gas Initiative (RGGI), an allowance corresponds to a short ton, which is approximately 0.9 metric tons. 6 The remainder of this report uses the term ETS to specifically mean a cap and trade system. However, it should be noted that, in theory, any mechanisms by which participants can trade emissions commitments is an ETS. The most notable is a baseline and crediting system, where firms have either credits or liabilities depending on their performance relative to a baseline function like an ETS — credits are traded between firms to meet any liabilities. However, it is distinct from a cap and trade system as it does not have a set limit or cap on emissions. 16 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Table 1-1 Comparison of carbon taxes and ETSs Element Carbon Tax ETS Certainty of It is difficult to estimate emissions reductions The cap provides certainty on an upper limit of emissions for emissions achieved through a tax ex ante, making it hard to the ETS, enabling its alignment to a certain policy target (for levels align to an emissions target.7 example carbon budget).8 PREPARE STEP 1 A tax does not reap the economic efficiency An ETS allows for economic efficiency between and within Cost- gains of trading between entities and across sectors (as a result of trading) and over time. However, market effectiveness sectors and offers less temporal price flexibility for power, lack of liquidity, and excessive volatility in allowance regulated entities. prices can reduce cost-effectiveness. Like an ETS, a tax requires a robust monitoring, An ETS is more complex to implement because in addition to reporting, and verification (MRV) system. However, the infrastructure required for a tax it also involves a secondary Ease of it does not require setting up an infrastructure market for trading allowances. The regulator and regulated administration for trading allowances, and the ability to rely entities therefore need to have additional capabilities. This might and scope on existing tax infrastructure makes it easier to make it more difficult to include certain sectors in the scope. implement in a broad range of sectors. The carbon price is set by predefined tax rates. The carbon price is determined by the market. This Price This provides a stable price signal to inform automatically adjusts for economic conditions but might predictability investment decisions. lead to price volatility.9 PSAMs can be used to increase price predictability in an ETS. Box 1-1 Technical note: Comparison of cap and trade and baseline and credit systems Theoretically, there are two types of emissions trading systems: cap and trade, and baseline and credit.10 However, in practice, references to ETSs generally mean cap and trade systems. The primary difference between the two systems is that under cap and trade, an upper limit on emissions is fixed (and emission allowances are either auctioned or distributed for free according to specific criteria), while there is no fixed limit on emissions under a baseline and credit system. Entities have either credits or liabilities depending on their performance relative to a baseline. Under both systems, emissions reductions or excess allowances can be traded between entities.11 Additionally, baseline and credit schemes are more complex, and generally more costly to administer. They involve calculating a baseline for every emitting activity or sector under the system, and then measuring the performance of each entity relative to the baseline. Cap and trade systems, on the other hand, do not require the calculation of a baseline. Instead, the key decision that drives mitigation ambition within these schemes is the level of the cap. Some baseline and credit mechanisms use facility-specific targets to determine emissions baselines for crediting. While simple, this approach can be detrimental to more efficient facilities within an industry. This can lead to adverse effects, whereby less emissions-intensive facilities are made less competitive relative to more emissions-intensive facilities. 7 It can also be difficult to set an economically “optimal” tax rate, which suitably prices carbon but does not introduce market distortions. See the World Bank’s Carbon Tax Guide: A Handbook for Policy Makers for further details. 8 However, PSAMs that permanently remove or add allowances to the cap may alter the emissions reductions achieved. 9 A dynamic price set by market forces will vary with the supply and demand of ETS allowances. Assuming the emissions level corresponds to economic activity, an economic contraction would lead to reduced demand for allowances from regulated entities, and therefore lower prices. Conversely, allowance prices would rise with a growing economy and growing emissions. However, rapid change in demand or supply can cause price volatility. 10 Organisation for Economic Co-operation and Development (OECD) 2019. 11 The presence of a system-wide cap is the main theoretical difference between a cap and trade and a baseline and credit system, but in practice, they can be made equivalent if all allowances are allocated for free using grandparenting (see Step 4). Step 1: Preparation 17 The remainder of this handbook focuses on developing incentive for businesses to avoid the carbon price by and maintaining an effective ETS. See also the forthcoming reducing their emissions. In this way, the allowance price Partnership for Market Readiness (PMR) Guide on acts as a signal that favors lower-emission goods and Developing a Carbon Pricing Roadmap for a step-by-step services. Setting the cap in advance provides a long- approach to selecting the right instrument for varying term market signal so participants can plan and invest jurisdictional circumstances.12 accordingly (for example, sourcing lower emission options when scheduled equipment upgrades occur). PREPARE STEP 1 1.1.2 WHY EMISSIONS TRADING? Allowances can be allocated for free — based on some combination of historic emissions, output, and/or Carbon pricing instruments help channel economic performance standards — or sold at auction. Auctioning activities toward a low-carbon future. The attractiveness allowances generates revenue for the government that of an ETS in particular is simple: it sets a limit on total can help pay for cuts in distortionary taxes, support emissions while providing incentives for mitigation to be spending on public programs (including other forms of achieved at the lowest possible cost (see Section 1.5 for climate action or to remedy adverse distributional effects the theory behind an ETS’s cost-effectiveness).13 of carbon pricing), or be returned to affected stakeholders directly.15 Additional mechanisms can be used to support price predictability, cost containment, and effective market 1.1.3 HOW DOES AN ETS WORK? operation (see Step 6). This section sets out a nontechnical explanation of how an ETS works. See Section 1.5 for detail on the economic Confidence that an ETS is reducing emissions can be theory behind an ETS, and why it delivers cost-effective ensured through ambitious caps, robust MRV requirements, emissions reductions. and the enforcement of penalties for noncompliance. This is facilitated by registries that are responsible for issuing Under an ETS, the government imposes a limit (cap) on allowances, tracking them as they are traded between the total emissions in one or more sectors of the economy different participants, and canceling them when they are and issues a number of tradable allowances not exceeding used for compliance. Market oversight provisions safeguard the level of the cap. Each allowance typically corresponds the integrity of trading activity. to one ton of emissions.14 The regulated entities in an ETS are required to surrender one allowance for every ton of Different jurisdictions can choose to link their ETSs directly emissions for which they are accountable. Entities that hold or indirectly through mutual recognition of allowances and additional allowances after surrendering the allowances other emission reduction units. Linking broadens access to needed for compliance can sell them or bank them for future least-cost mitigation, supports market liquidity, increases use; entities that require additional allowances may buy price stability, and enables political cooperation on carbon them on the market. They may also be able to use eligible pricing.16 emission allowances from other sources, such as domestic or international offsets mechanisms or other ETSs. 1.1.4 ETS DESIGN IN 10 STEPS Placing a cap on allowances and establishing a market This handbook sets out a 10-step process for designing an to trade them generates a uniform allowance price (the ETS (illustrated in Figure 1-1). Each step involves a series “carbon price”). The price incentivizes businesses to of decisions or actions that will shape major features of the reduce the emissions from their operations if the cost system. However, as stressed throughout the handbook, of reducing emissions is lower than this price. The price the decisions and actions taken at each step are likely to reflects the stringency of the cap: a more stringent cap be interlinked and interdependent, which means that the means fewer allowances are issued. All else being equal, process for working through them will not necessarily be this results in higher prices and therefore a stronger linear. 12 PMR (forthcoming). 13 For the specifics around assigning property rights, see Coase (1960). Among practical policy instruments, emissions trading is the instrument that most directly implements a Coasian solution. See Crocker (1966), Dales (1968), and Montgomery (1972) for discussion on the effectiveness of trading allowances. See Fischer and Newell (2008) for a comparison of environmental policy instruments and their relative performance on emissions reduction, efficiency, and other outcomes. 14 Allowances can be issued in units of tons carbon dioxide, or tons of carbon dioxide equivalent. The latter includes carbon dioxide as well as other GHGs (for example methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons, sulphur hexafluoride, and nitrogen trifluoride) on the basis of their relative global warming potential. It is also possible that an allowance could correspond to a different mass of GHGs; for example, in RGGI, an allowance corresponds to a short ton, which is approximately 0.9 metric tons. 15 See the PMR’s Using Carbon Revenues report and ICAP’s report The Use of Auction Revenue from Emissions Trading Systems for further detail. 16 ICAP has developed a series of ETS briefs that provide a basic introduction to emissions trading and its benefits. These are available at https://icapcarbonaction.com/en/icap-ets-briefs. 18 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Figure 1-1 ETS design in 10 steps 6. Promote a well-functioning market 7. Compliance PREPARE & enforcement STEP 1 4. Set the Cap 2. Engage Stakeholders 8. Consider offsets 3. Scope 1. Prepare 5. Allocate allowances 10. Evalute 9. Consider & improve linking 1.1.5 EXTENSIVE EXPERIENCE WITH experience with internal carbon pricing, which is not EMISSIONS TRADING covered in this guide. GHG trading has spread since then, and jurisdictions have used a variety of different designs Emissions trading for GHGs originated in attempts to and approaches, as indicated in Figure 1-2. As of 2020, control local air pollutants from power plants in the United 28 different ETSs have been implemented or are under States in the 1970s.17 It was implemented in earnest during development globally (see Figure 1-3).19 Important lessons the phase down of leaded gasoline in the United States can also be drawn from detailed policy proposals that during the 1980s, leading to an eventual phase out. The were drafted but not implemented (as in the case of the US US Clean Air Act Amendments of 1990 established the federal-level proposals) or implemented and then repealed first large-scale trading program with an absolute limit on (for example in Australia). emissions of sulfur dioxide emitted by power plants.18 The development of ETSs occurs within the broader global Soon thereafter, the focus shifted toward climate, and climate policy context. Article 6 of the Paris Agreement of some countries began experimenting with GHG emissions December 2015 affirmed the role of voluntary mitigation trading. The 1997 Kyoto Protocol established provisions cooperation between countries, tying it to provisions for the trading of emissions/emission reductions among to ensure its environmental integrity (see Box 1-2). Art. its parties. In 2005, the European Union (EU) and Norway 6 therefore sends an important signal that is likely to established domestic ETSs and Japan instituted a accelerate the spread of carbon pricing, the establishment voluntary trading program to help implement its Kyoto and linkage of ETSs (see Step 9). commitments. Some large companies have also gained 17 Cap-and-trade was first introduced by Dales (1968). For a history of emissions trading in the United States, including these early years, see, for example, Ellerman, Joskow, and Harrison (2003). 18 Schmalensee and Stavins (2013) provide a good history. 19 See the State and Trends of Carbon Pricing 2020 report (World Bank 2020). Step 1: Preparation 19 Figure 1-2 Figure Establishment 1-2: of ETSs Establishment of ETSs worldwide worldwide over over time time. 2005 2007 2008 2009 2010 PREPARE STEP 1 • European Union ETS • Norway, Iceland, • Switzerland ETS • RGGI • Tokyo ETS (EU ETS) and Liechtenstein • New Zealand ETS • Norway ETS join EU ETS 2015 2014 2013 2012 2011 • Republic of • China ETS pilots • Kazakhstan ETS • New Jersey • Saitama ETS Korea ETS (Hubei, Changqing) • California ETS leaves RGGI • California and Québec • Québec ETS link their ETSs • China ETS pilots (Beijing, Shanghai, Tianjin, Guangdong, Shenzhen) 2016 2018 2019 2020 2021 • Fujian ETS • Massachusetts ETS • Nova Scotia ETS • Mexican pilot ETS • Germany pilot • EU and Switzerland national fuel ETS link their ETS • Virginia joins RGGI • New Jersey rejoins • UK ETS RGGI • China National ETS Figure 1-3 Emissions trading around the world UK Transportation and Climate Initiative (TCI-P) Québec Finland Regional Greenhouse Gas Initiative (RGGI) Germany China Nova Scotia Kazakhstan Ukraine Sakhalin Island (Russia) Washington Oregon Massachusetts California Pennsylvania Turkey Japan New York City New Mexico North Carolina Pakistan Saitama Tokyo Montenegro Korea Mexico Switzerland Taiwan (China) Chinese Pilots EU ETS Thailand Philippines Vietnam Colombia Brazil Indonesia In force Chile New Zealand Under development Under consideration Source: Adapted from International Carbon Action Partnership (ICAP) 2021. 20 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Box 1-2 Technical note: What the Paris Agreement means for markets The Paris Agreement,20 adopted by 195 nations in December 2015 under the auspices of the United Nations Framework Convention on Climate Change (UNFCCC), recognizes the role of international cooperation through carbon markets in its Article 6. The article stipulates that parties to the Paris Agreement can voluntarily cooperate in achieving Nationally Determined Contributions (NDCs) to “allow higher ambition … and to promote sustainable development and environmental integrity” (Article 6.1). PREPARE STEP 1 International cooperation includes: S Cooperative approaches involving the use of “internationally transferred mitigation outcomes” (ITMOs) toward NDCs21 under Article 6.2, which is largely understood as a channel of international cooperation, including an international accounting framework, under the authority of the parties involved. Article 6.3 requires that the use of ITMOs toward NDCs are authorized by all parties involved. S Emission reductions generated by a central crediting mechanism under Article 6.4. This new mechanism, sometimes called a “sustainable development mechanism,” will operate under UNFCCC oversight. It will “contribute to the mitigation of GHG emissions and support sustainable development,” must “deliver an overall mitigation in global emissions,” and will generate a share of proceeds to assist developing countries in adapting to the impacts of climate change. In both approaches, double counting is to be avoided. In the decision accompanying the agreement, countries agreed to develop guidance for cooperative approaches under Article 6.2 (paragraph 36), as well as the rules, modalities, and procedures for the sustainable development mechanism (paragraphs 37–38). Rules for Article 6, however, have proven highly contentious: as of the end of 2020, parties under the Paris Agreement have yet to reach agreement on detailed rules for Article 6, and continue to work toward agreement. It is important to note that the Paris Agreement does not prevent parties commencing international cooperation under 6.2 in the absence of agreed rules. In the meantime, jurisdictions are likely to continue work on domestic emissions trading, generating knowledge, standards, and practical experience, which will be critical to the development of guidance under the UNFCCC. Some parties are already pursuing ETS linking, and jurisdictions are also likely to continue to engage across different carbon markets. “Pilots” under Article 6.2 of the agreement have also been initiated through bilateral cooperation between countries. These, in turn, may facilitate future linkages and international trading. 1.2 DETERMINE OBJECTIVES FOR THE ETS The fundamental objectives of an ETS are twofold: limiting complexity could increase through learning and experience, emissions to a determined quantity and providing a robust jurisdictional ambition could rise, or the global climate policy price incentive for long-run investment in low-carbon landscape might evolve. This means policymakers should technology. In addition to these objectives, policymakers review the ETS design periodically along with the system’s can design an ETS to support other environmental, goals and anticipate improvements to their ETS over time economic, and social goals consistent with their (see Step 10). For example, an ETS may wish to graduate jurisdiction’s priorities. Some of the objectives frequently from free allocation to a greater use of auctioning as stated for ETSs include driving sustainable development, businesses and policymakers develop sufficient readiness. reducing emissions at low cost, promoting innovation and competitiveness, delivering co-benefits like reducing air pollution, and finally, raising revenue through auctioning 1.2.1 DRIVE ECONOMIC allowances. These objectives are described in more detail TRANSFORMATION AND in the following subsections. SUSTAINABLE DEVELOPMENT The design of an ETS is an evolutionary process, and Accelerating the low-carbon economic transformation goals and circumstances may mature with time. For requires a shift in investment patterns and behaviors, as example, policymakers’ and participants’ ability to handle well as innovation in technologies, infrastructure, and 20 UNFCCC 2015b. 21 Article 6.2 only speaks of the use of ITMOs toward NDCs. Paragraph 77(d) of decision 18/CMA.1, however, broadens this to parties that authorize the “use of mitigation outcomes for international mitigation purposes other than achievement of its NDC.” Step 1: Preparation 21 financing. In particular, action is needed to decarbonize the for reducing their GHG emissions over time, on either an production of electricity, electrify transportation or switch absolute or an intensity basis. to cleaner fuels, improve efficiency and reduce waste in all sectors, and preserve and increase natural carbon sinks In this context, carbon pricing can be a key driver of like forests. Policies need to achieve these changes in ways decarbonization. Both theory and empirical studies that reflect local circumstances, create new economic suggest that carbon pricing is one of the most cost- opportunities, and support the well-being of all citizens. effective tools for reducing emissions, especially in the PREPARE STEP 1 short- to medium-term.24, 25 In turn, these lower costs open For many jurisdictions, carbon pricing is emerging as a the opportunity to take more ambitious action. key driver of this transformation.22 By aligning profits with low-emission investment and innovation, a price on GHG emissions can channel private capital flows, mobilize 1.2.3 PROVIDE CO-BENEFITS OF knowledge about mitigation within firms, tap the creativity MITIGATION of entrepreneurs in developing low-carbon products and Reducing GHG emissions goes hand in hand with a wide innovations, and hence drive progress toward reducing range of benefits that can include improved air quality, emissions intensity. increased energy security, induced technological change, A price on emissions makes clean energy more profitable, the creation of green jobs, preservation of forests, and allows energy efficiency to earn a greater return, makes lower urban congestion from the reduced use of passenger low-carbon products more competitive, and, depending vehicles. on the sectoral coverage, can value the carbon stored A notable source of co-benefits is the improvement of local in forests and other greenhouse gas sinks. Firms are air quality. Air pollution has detrimental impacts on public able to leverage industry-specific private knowledge in health and productivity and is a major issue in urban areas order to reduce emissions efficiently, without the need for in both the developed and developing worlds. Emissions- governments to provide detailed regulation. An increasing intensive processes are associated with high levels of local number of firms and investors are advocating for carbon pollutants and poor air quality, notably due to coal-fired pricing policies from government, and some are applying power plants and road transportation. One study estimates an internal carbon price to guide investment in advance of that a 50 percent reduction in GHGs by 2050 relative to government policy to that effect.23 2005 levels could lead to a 20 to 40 percent reduction in premature deaths due to air pollution over the same time period.26 The potential for reducing air pollution has been 1.2.2 REDUCE GREENHOUSE GAS among the most important considerations in establishing EMISSIONS AT LOW COST ETSs in California and China alike. In international negotiations, most recently through the Paris Agreement, countries have agreed on the need to Preserving local environments can be similarly important, reduce global GHG emissions to limit temperature rise and in particular when forests and land-use change are either avoid the worst impacts of climate change. Governments included in the ETS or linked via offsets (see Step 8). For have also increasingly recognized the benefits from a green example, avoiding carbon losses from tropical forest economic transition for economic growth and sustainable destruction can help reduce flooding and drought, development. Governments at all levels have set targets contribute to the preservation of biodiversity and other ecosystem services, and support the livelihoods of forest- dependent communities. 22 Martin, Muûls, and Wagner (2016) find that firms are responding to climate policy in the EU, with industrial firms reducing emissions by as much as 10–26 percent in France and Germany. Wilson and Staffel (2018) found that the United Kingdom’s carbon price was a primary driver for its rapid switch from coal to natural gas. Murray and Rivers (2015) also found significant effects of carbon pricing, estimating that British Columbia’s carbon tax resulted in an emissions reduction of 5–15 percent reduction compared with the counterfactual. Best et al. (2020) analyzed data from 142 countries over two decades, finding that the average annual growth rate of CO2 emissions from fuel combustion has been around two percentage points lower in countries that have had a carbon price compared to countries without one. 23 Recent examples of engagement of public–private coalitions advocating for carbon pricing include the statement “Putting a Price on Carbon” (June 2014) supported by over 1,000 companies and investors along with national and subnational jurisdictions (see World Bank 2014); an open letter to governments and the United Nations from six major oil companies (June 2015) calling for an international framework for carbon prcing systems (see UNFCCC 2015a); the launch of the Carbon Pricing Leadership Coalition (November 2015), whose government and private sector participants are committed to building the evidence base for effective carbon pricing (see Carbon Pricing Leadership Coalition 2015); and a pledge from the CEOs of the world’s largest oil and gas companies and investment funds to adhere to the Paris Agreement (see Fortune 2019). 24 In order to avoid the risk of lock-in of carbon-intensive assets over the longer term, policy signals that are complementary to a carbon price will also be important. This is discussed further in Section 3.4 below. 25 Fischer and Newell (2008) provide evidence on the cost-effectiveness of carbon pricing compared to other policies like performance standards, renewables subsidies, renewables share requirements, and research and development subsidies. 26 Bollen et al. (2009) survey the literature on co-benefits of climate change policies, mainly focusing on local air pollution. Their empirical analysis shows that a global reduction of 50 percent in GHG emissions in 2050, relative to 2005 levels, could reduce the number of premature deaths due to air pollution by 20 to 40 percent in 2050. Under this scenario the benefits in China were valued at 4.5 percent of GDP. Parry, Veung, and Heine (2014) find that domestic environmental benefits exceed the CO2 mitigation costs, even leaving aside climate benefits. 22 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Further information on potential co-benefits from the end of 2019, ETSs globally had raised over USD 78 carbon pricing is included in the PMR’s forthcoming The billion (EUR 70.3 billion) in cumulative auction revenue.30 Co-benefits of Carbon Pricing.27 Fluctuations in the carbon price can have a large effect on the size of revenues (as evidenced by the dip in allowance prices and carbon revenues due to the global coronavirus 1.2.4 RAISE REVENUE pandemic in 2020). However, it is expected that revenues will generally continue to grow as carbon prices rise PREPARE ETS allowances can be distributed through auctioning, STEP 1 free allocation, or a combination of the two (see Step 5). in conjunction with jurisdictions’ ratcheting ambitions Allowances allocated through auctioning generate revenue under tightening climate goals and the Paris Agreement.31 for the government, which can flow into the fiscal budget Additionally, the number of allowances auctioned will also for general use or be earmarked for environmental or social increase as more established ETSs transition from free purposes.28 For example, revenues from the RGGI have allocation to auctioning. been used to offer low-income customers assistance with Further discussion on raising revenue and guidance electricity bills and to fund job-training programs.29 Raising on using revenue to address any distributional impacts funds for the pursuit of developmental objectives like health of the ETS can be found in Steps 2 and 5. The PMR’s and education, to ease adverse distributional impacts of Using Carbon Revenues report and International Carbon carbon pricing, or to increase investment in low-carbon Action Partnership’s (ICAP) Use of Auction Revenue from technology or research might be important objectives for Emissions Trading Systems report also provide an in-depth the ETS. look into the ways in which revenue from carbon pricing As the price of ETS allowances has increased, global has been and can be used. revenues from carbon pricing have grown significantly. By 1.3 CONSIDER INTERACTIONS BETWEEN AN ETS AND COMPANION POLICIES The design and introduction of an ETS will invariably take 4. understanding where additional companion policies place in a broader context of climate and energy policies, may be needed to achieve overarching climate targets as well as other public policies that will either support or and drive sustainable development. run counter to mitigation objectives (collectively called “companion” policies). Policymakers will therefore face Each of these four issues is explored in more detail below. trade-offs between the benefits of an ETS and those To support an assessment of this sort, it is crucial to begin of other policies, and must choose the role of the ETS identifying and classifying (or “mapping”) companion within the wider policy mix to best suit their jurisdictional policies and assessing their potential interactions with the context. As such, it is important to conduct a systematic ETS.32 While the most obvious policies to include in such assessment of potential policy interactions with a focus on a mapping exercise are other policies focused on climate four key areas: change mitigation or energy (see Box 1-3) it may also be 1. the role of the ETS in the climate policy mix; helpful to include policies relating to other issues. These 2. the impact of companion policies on ETS outcomes; include, among others, policies related to environmental 3. the impact of the ETS on the attainment of companion issues, financial market regulation, energy market policy objectives; and regulation, taxation, international trade, foreign affairs, industrial development, transportation, infrastructure, research and innovation, economic development, social welfare, and education. 27 PMR (forthcoming). 28 The possible options for revenue use will also depend on the jurisdiction’s legal framework. Some jurisdictions have strict rules about ex ante earmarking of revenues. 29 See RGGI 2018. 30 ICAP 2020b. 31 This is discussed further in the PMR’s Using Carbon Revenues report. 32 The PMR’s forthcoming Guide to Developing a Carbon Pricing Roadmap provides a template for mapping policy interactions. Hood (2013) provides a comprehensive list of questions to assist in mapping the potential interactions between emission pricing and existing energy policies, while OECD’s (2015) Aligning Policies for a Low-Carbon Economy provides a comprehensive overview on low-carbon policy alignment. Step 1: Preparation 23 Box 1-3 Technical note: Other climate policy instruments Carbon taxes set a price on carbon emitted, without a firm emissions limit. Taxes, along with emissions trading (together known as “market-based approaches”), are widely regarded as the most cost-effective policies to reduce emissions. Standards and other “command and control” regulation typically set uniform rules that new and/or existing emitting facilities must follow, with regard to levels/rates of GHG emissions and/or co-pollutants, technologies used in production, energy efficiency, or the end product itself. Targets for renewable energy or renewable fuels production PREPARE STEP 1 and energy efficiency are especially relevant for GHG emissions, as well as building codes and land-use zoning and regulations. Depending on how standards are set, they can be complemented by market-based elements that enable obligations to be met in a more flexible way (for example, US renewable portfolio standards for renewable electricity generation with tradable credits across systems or India’s Perform, Achieve, and Trade system for energy efficiency). Such combinations of standards and flexibility mechanisms have similarities to an ETS, except the quantitative target is on a different measure (for example renewable energy as a percentage of energy production or consumption) rather than on emissions themselves. Government provision of public goods and services includes funding research, strategic infrastructure, public transportation services, conservation of state-owned resources, or any other government action with the intent and result of reducing emissions. Subsidies, tax rebates, concessionary finance, or risk guarantees can be used to encourage renewable energy production, energy efficiency, or other investments that will allow emissions reductions. They may also correct for market failures in the research, development, and deployment process by supporting new technologies. Subsidies for high-emitting industries can perversely increase their output.33 Information and education programs include raising awareness about emission impacts of decisions and about mitigation opportunities and increasing the salience of price signals. Environmental certification or labeling programs, for example, help consumers make more informed decisions. Voluntary measures refer to any agreement by private parties to achieve environmental goals above and beyond what is regulated. Examples might include companies focusing on achieving carbon neutrality or other sustainability goals across their own supply chains and procurement practices. Policy measures may be designed to encourage such steps. 1.3.1 THE ROLE OF THE ETS IN THE To position the ETS strategically within the broader policy CLIMATE POLICY MIX portfolio, it is important to have a clear view of how the ETS will contribute to achieving a jurisdiction’s climate policy The climate policy landscape can differ greatly from one objectives and its relationship with other current or planned jurisdiction to another. This means the most suitable policies. Ensuring the right policy mix can improve overall carbon pricing approach for one jurisdiction may not be outcomes and help build public and maintain support for appropriate for another jurisdiction, with local context the ETS. being a key consideration in choosing the best policy instrument. Further discussion on this can be found in the Jurisdictions have taken different approaches to PMR’s report Developing a Carbon Pricing Roadmap.34 positioning their ETS relative to other companion policies. The EU ETS was established to help meet An ETS works best as part of a well-thought-out policy EU-wide emissions reductions targets cost-effectively package to achieve climate targets and drive sustainable by introducing a common emissions price signal across development. It provides a price incentive for abatement, Member States. The EU ETS covers electricity generation but this may not be fully effective in all circumstances; for and energy-intensive industries. In parallel, emissions from example, where non-price barriers exist, or where creating sectors outside the scope of the EU ETS are regulated a strong enough incentive requires undesirably high through targeted policies at the EU or Member States allowance prices. Section 1.3.4 provides more detail on level. The EU climate targets are reflected in the EU ETS identifying areas where companion policies may be needed. emissions cap and national emissions reductions targets for uncovered sectors, and are integrated within a broader 33 For example, Tsao, Campbell, and Chen (2011) study renewable portfolio standards, concluding that increasing their level not only would not reduce emissions reduction, but could also benefit coal and oil, and make natural gas units worse off. Levinson (2011) discusses the interactions of different traditional regulations with an ETS and suggests that the administrative costs involved in traditional regulations would hamper the cost-effectiveness of the latter. See Fischer and Preonas (2010), who draw a similar conclusion. 34 PMR (forthcoming). 24 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION set of objectives at the EU level (which also include energy provided by carbon markets (overlapping policies), or in efficiency and renewable energy). However, Member States some cases, counteract incentives in carbon markets have a clearly defined ability to define their own energy (countervailing policies). mix, ensure security of supply, and determine the way in which to achieve these targets.35 Figure 1-4 summarizes the types of potential effects companion policies can have and provides examples of In the case of California, the ETS was adopted within a broad specific interactions. The types of companion policies are PREPARE STEP 1 climate change policy portfolio, alongside an array of sector- then discussed below. specific regulations and programs. The ETS price signal was expected to primarily impact those parts of the economy that Complementary policies could not be reached by targeted regulation, while serving Complementary companion policies enhance the impact of as a backstop to ensure that emission targets would be met an ETS in constructive ways. For instance, they can if the other measures proved less effective than hoped.36 S provide greater policy certainty to participants about In contrast, New Zealand currently employs an ETS as its the transition to a low-emission economy; primary mitigation instrument, emphasizing that it offers S facilitatethe pass-through of carbon prices across the an equitable approach by covering all sectors and gases over time, and enables linkages to international markets supply chain to change behavior; that would support meeting its international commitments S put in place enabling infrastructure; at least cost. In other jurisdictions, for example China, S reduce the disproportionate or regressive impacts of ETSs are designed in a way that reflects specific regulatory emission pricing; arrangements for certain sectors (for example the electricity S provide incentives for innovation and early sector) and the respective emission abatement levers. commercialization of mitigation technologies; or In some cases, a gradual start to the introduction of an S reduce other non-price barriers to mitigation (for ETS may be appropriate, with the role of the ETS taking on instance information problems, skills gaps, or non-price greater importance over time (see Step 10). For instance, behavioral barriers).37 a gradual start to an ETS may be appropriate while a jurisdiction develops its MRV systems, or while it engages in capacity building for Figure 1-4 The impact of companion policies on ETS outcomes liable firms. Likely impact on Each of these approaches is legitimate and allowance demand and carbon price reflects the specific circumstances of the Examples in an ETS implementing jurisdictions. Taking the time to consider the role of an ETS at an early stage Complementary can help clarify objectives and ensure that later improve • energy market reform functioning of (e.g. facilitating cost pass-through) design decisions on specific elements reflect carbon markets • infrastructure upgrades these objectives. • energy efficiency labeling • pollution/emissions measurement 1.3.2 THE IMPACT OF COMPANION POLICIES Overlapping ON ETS OUTCOMES duplicate • feed in tariffs incentives in • green certificate programs, such Existing and new companion policies can carbon markets as renewable energy targets affect the operation of the ETS, including the level of emissions reductions, the emissions price, and the system’s distributional Countervailing impacts. These policies can help improve oppose • fossil fuel subsidies the effectiveness of carbon markets incentives in • industry tax breaks and special carbon markets treatment (complementary policies), duplicate incentives 35 Article 192 of the Treaty on the Functioning of the European Union. 36 California Air Resources Board 2017. 37 For further discussion on developing an effective package of emission pricing and complementary policies, refer to Matthes (2010), Hood (2013), and Schmalensee and Stavins (2015). Step 1: Preparation 25 Box 1-4 Technical note: Incentives for innovation to complement ETS Potential innovators do not account for the social benefit their innovations will achieve, leading to less innovation activity than is socially optimal. Just as pricing carbon can effectively internalize the negative externality and make emitters face the true cost of their actions, subsidizing innovation can internalize this positive externality. When, for example, governments support the research and development of low-carbon and energy efficiency technology, innovators face price signals that better reflect the true social value of their ideas and activities. Once the technology PREPARE is deployed, the subsidies can decrease. STEP 1 This process is known as “directed technical change.” By providing additional incentives for new technologies, through policies external to the ETS, and reducing those incentives as the learning-by-doing spillover takes hold, governments can help stimulate innovation within the market to a much greater extent than under an ETS alone. The key challenges with this approach are to limit the support given to technologies that will ultimately prove to be socially unproductive, and to enable the reduction or removal of subsidies when a technology is mature and no longer needs support. Practice shows that in some circumstances direct intervention over and above the incentive provided by the ETS may well be justified. California’s Solar Initiative alongside its comprehensive Cap-and-Trade Program is one notable example of directed technical change.38 German feed-in tariffs have had a similar effect, subsidizing large-scale renewables deployment, alongside the European Union ETS. However, the impact of such companion policies on system functioning needs to carefully assessed and accounted for in cap setting (see also Section 1.3.2). Overlapping policies other objectives. As such it is important that countervailing Companion policies may be overlapping, particularly if policies are considered on a case-by-case basis. This is they are not reflected appropriately in the design of the discussed further in Section 1.3.3 below. ETS. This is most likely to be a challenge in relation to energy-sector policies and regulations, especially those Managing policy interactions addressing energy efficiency, low-carbon energy, or An approach to managing the ETS’s interactions with technology innovation. If these policies lead to emission companion policies can include ensuring that: reductions in sectors already covered by the ETS and not S Policy interactions are analyzed carefully, and the accounted for in the cap, then this causes the allowance impacts of complementary policies are taken into price to fall (as demand for allowances will be lower) and account in the design features (such as cap setting and dilutes the price signal. It also allows emissions from other PSAMs) that affect the emissions reductions achieved covered sectors under the emissions cap to rise. This stops by the ETS. This enables the different policies to the ETS from delivering short-term, least-cost mitigation.39 support each other as much as possible. S Overlapping policies should be reviewed to ensure There are often good reasons for operating overlapping policies in parallel with an ETS, including supporting the their goals are clearly defined and to identify potential penetration of certain transformational technologies, changes that could improve interactions. Overlapping addressing behavioral biases, or avoiding lock in of capital policies often pursue important objectives such as in assets that may be stranded in the future. Vehicle encouraging the deployment of mitigation options fuel efficiency standards, for example, may overcome to lower their long-term costs, inducing changes in consumer inertia or motivate changes in purchasing behavioral patterns that the ETS price signal cannot behavior where the carbon price is not sufficient to do so. address, or other objectives such as improved air quality. Where overlapping policies do not seek to Countervailing policies address issues in addition to those targeted by the ETS, or if detrimental impacts of overlapping policies are In general, jurisdictions should try to avoid countervailing large, then policymakers should consider redesigning or policies (like fossil fuel subsidies) that oppose carbon removing these policies. market incentives. However, this too requires careful S Countervailing policies should be removed, unless there analysis, as these policies may achieve other policy objectives that may be of value. Policymakers must trade are compelling strategic objectives (such as security off achieving emissions reductions with the importance of of energy supply) that they seek to achieve. In many 38 See Acemoglu et al. (2012), who show that optimal climate policy involves both a carbon price and research subsidies. See also van Benthem, Gillingham, and Sweeney (2008), who look specifically at the case of solar subsidies in California. 39 Alternatively, if an ETS forces greater emission reductions than would happen under coexisting policies, the latter may be rendered redundant, at least from the point of view of cost-effective mitigation, at an administrative cost to both the government and regulated entities. This type of impact is described in Section 3.3. 26 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION cases, these policies can be amended to ensure they 1.3.4 UNDERSTANDING WHERE continue to serve these objectives, while reducing ADDITIONAL COMPANION negative effects on the ETS. POLICIES MIGHT BE NEEDED Finally, policy interactions do not occur solely between As well as considering the interactions, in both directions, an ETS and other climate — or even energy and between an ETS and existing policies, the introduction environmental — policies. An ETS has to be implemented of an ETS may prompt policymakers to consider whether PREPARE STEP 1 through a legal framework consisting of different rules additional companion policies are needed to increase the and procedures (see Step 7). This, in turn, can be affected effectiveness of the ETS and/or to meet related policy by or conflict with rules and procedures in a number of objectives. These policies may be introduced in covered or other areas of law, such as financial market regulation, uncovered sectors. Each of these cases is discussed below. property law, contract law, tort law, tax law, and financial accounting law. Before elaborating the legal framework of Covered sectors the ETS, therefore, regulators have to carefully consider all An ETS aims to reduce emissions by transmitting a price such interactions and overlaps to ensure coherence and signal (in the form of the allowance price) to regulated consistency with the broader legal system. entities, which then find cost-effective ways to abate emissions. Policymakers may wish to support these entities by implementing additional policies that, for example, 1.3.3 THE IMPACT OF THE ETS ON THE reduce transaction costs, establish enabling infrastructure, ATTAINMENT OF OTHER POLICY or overcome non-price barriers to implementing abatement OBJECTIVES solutions. They may also wish to support certain sectors As well as considering the impact of companion policies with additional policy measures to ease the transition on the cost-effectiveness and environmental efficacy of an to carbon pricing, and align with national development ETS, the effect of an ETS on these policies should also be strategy. However, benefits from doing so might come considered. Again, the ETS’s effect on these policies could at the cost of increasing the complexity of the regulatory be complementary, overlapping, or countervailing. environment and diluting the price signal (as a result of downward pressure on allowance prices). The ETS may affect the achievement of economic, social, or environmental goals. For instance, the promotion of energy Reasons for implementing companion policies in covered efficiency facilitated by an ETS may facilitate meeting sectors include policy objectives related to energy security by lowering S Overcoming non-price barriers: Even for sectors energy consumption. An ETS that prices emissions from covered by an ETS, various market and regulatory the forestry sector may also complement environmental barriers can prevent the diffusion of cost-effective regulation by creating a further financial incentive for technologies and practices.40 For example, electricity landowners to enter into long-term forest protection grid management regulations may not easily covenants. On the other hand, the potentially regressive accommodate distributed generation from solar panels, impacts of carbon pricing on low-income households and or building developers may not be able to recover cost small and midsize enterprises, or carbon-leakage effects savings from energy efficiency investments that would for exposed industries, could run counter to other policies provide benefits to future tenants.41 The introduction supporting their advancement (see Step 5, Section 1.1.2). of complementary policies such as energy efficiency standards can reduce these regulatory or market The revenues raised from ETS allowance auctions can also barriers that would otherwise discourage the use of be used to promote other policy objectives or counteract low-cost mitigation options from covered sectors. the regressive distributional impacts of carbon pricing S Incentivizing innovation and investment in long- (by, for example, reducing distortionary taxes or providing funds to identified policies and programs in line with policy term solutions: In the longer term, complementary objectives). A more detailed discussion on the use of measures can pave the way for additional emissions revenues from ETS auctioning can be found in the PMR’s reductions, even if applied to sectors covered by the Using Carbon Revenues report and in ICAP’s Use of ETS. While an ETS provides a price signal that at Auction Revenue from Emissions Trading Systems report. least partly addresses the externality associated with GHG emissions, it does not address another positive externality: the spillover from low-carbon innovation, 40 Fischer and Newell (2008) and Lehmann and Gawel (2013), for example, suggest that policies to support renewables development and deployment would be good complements to ETSs. 41 See Jaffe and Stavins 1994, Scott 1997, and Schleich and Gruber 2008. Step 1: Preparation 27 in the form of increased knowledge and other social The advantages and disadvantages of considering benefits. This may well provide a justification for complementary measures are summarized in Table 1-2. additional policy action to create incentives for private investment in research and development for clean Table 1-2 Advantages and disadvantages of energy and other abatement technologies. complementary measures S Directing strategic outcomes in certain industries: As PREPARE a broad price instrument, an ETS cannot necessarily be Advantages Disadvantages STEP 1 used to guarantee specific strategic outcomes in covered S Can help overcome high S Can reduce price sectors. The government may wish to consider whether transaction costs and other under ETSs and, additional policies are desired to influence where, how, or barriers to adopting energy thus, lead to weaker when specific types of mitigation investments, technology efficiency and other low- emissions reductions emissions technologies signals in other changes, or structural reform occur. S Possible additional GHG sectors under the emissions reductions in the cap if the cap is not Covered sectors Uncovered sectors long run due to targeted adjusted to account technological innovation, for reductions Policymakers might consider the use of complementary enabling stricter future ETS made through policies in uncovered sectors for two reasons: caps complementary S Easier to target where policies S Preventing leakage: Complementary policies (like emissions occur and, thus, efficiency standards) can be introduced in sectors that target reductions in areas are politically or logistically difficult to regulate through where there were preexisting an ETS. While covering them in the ETS (and therefore air quality concerns, provide other local co-benefits, and equalizing carbon price across these sectors) is the support just transition for best option to reduce domestic leakage, other policies heavily affected sectors can also help level the playing field between ETS and non-ETS sectors. S Emissions reductions in S Typically less Uncovered sectors sectors or sources not cost-effective than S Reducing emissions: Typically, a mix of policies will otherwise included in ETS including sectors or be required to deliver on overarching climate targets. S Lower potential leakage from sources under the cap covered sectors at least for the short- Complementary policies applied in uncovered sectors and medium-term help increase abatement effort and drive sustainable development in the wider economy of the jurisdiction. 1.4 KEYS TO EFFECTIVE ETS DESIGN Once objectives for the ETS have been determined, enough confidence in the level of long-term prices to policymakers may wish to decide a set of criteria drive investment in low-carbon solutions. Minimizing consistent with those objectives against which to assess the risk of carbon leakage (the shifting of production ETS design options. These must be reviewed regularly or investment to areas outside the cap, resulting in an after implementation to ensure they continue to reflect the increase in global emissions) is another determinant of latest best practices, improved capacity, and local policy environmental effectiveness, as is ensuring the integrity landscape. of emission units, such as offset credits entering the system from outside the cap. Some of the most important criteria are discussed below.42 S Cost-effectiveness of mitigation. Economic efficiency S Contribution to mitigation by limiting emissions. and cost-effectiveness are at the core of ETS design. Environmental integrity is perhaps the key criterion for Emissions trading is intended to minimize abatement assessing whether an ETS is successful. This requires costs given a particular mitigation goal. The greater the a sufficiently tight emissions constraint coupled with flexibility as to when and where emission reductions effective MRV to ensure that reported emissions are take place, the higher the potential for low-cost accurate, the cap is being enforced, and there is emissions reductions. The effectiveness of an ETS in 42 For alternative criteria, see Government of Australia (2008b), California Market Advisory Committee (2007), US Environmental Protection Agency (2003), Goffman et al. (1998), and Weishaar (2014), among many others. Further discussion on effective design is provided by the FASTER Principles for Carbon Pricing (Fairness, Alignment of policies and objectives, Stability and predictability, Transparency, Efficiency and cost-effectiveness, Reliability and environmental integrity), which were jointly developed by the OECD and World Bank Group. 28 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION delivering least-cost abatement across covered sectors alignment, policymakers should initiate regular energy can also be influenced by how well it is integrated with policy and carbon pricing policy reviews, and establish other policies (for example energy) affecting emissions institutional setups that facilitate policy coordination. in those sectors (see Section 1.3). S Fairness. Equity and fairness are inherently important S Accountability and transparency. Strong MRV, concepts to consider in the design of environmental enforcement principles, and robust registry design policies. Furthermore, emissions trading is not possible PREPARE ensure the accountability and transparency of without political support. Ensuring fairness to all STEP 1 the system. Design decisions must also be made involved, especially in the distribution of costs and transparently to help build trust in the system and allow benefits, is at the core of gaining and maintaining that market participants and investors to plan ahead. support, and hence giving stakeholders confidence that S Appropriateness to local conditions. ETS design is the system will endure. driven by local objectives and context. While a common S Policy predictability. The more predictable the set of building blocks can be used to construct an ETS, system, the smoother its operation and the more in order for it to function effectively the precise features cost-effective emissions reductions will be. Deciding of each system must be tailored to the jurisdiction. This on, and effectively communicating, key design features includes the preexisting regulatory and market context; early in the process, and providing clear processes and the size, growth rate, and composition of the economy; parameters for future changes, enhances predictability. the emissions and abatement opportunity profile of the S Policy flexibility. Given the long-term nature of the economy; the ambition of the jurisdiction’s climate target; climate challenge and various economic and scientific and the capacity and strength of relevant institutions. uncertainties, there is a need to preserve policy S Robustness. Experience with existing ETSs shows that flexibility and allow decision makers to adjust the appropriate mechanisms to manage price and quantity overall target or the schedule for achieving the target shocks must be built into the system and need to be and specific design features in response to changing considered at the design stage. While some volatility conditions. However, there will often be some tension in prices is to be expected, and is in fact desired in between policy flexibility and ensuring predictability. order to transmit signals about abatement costs to S Administrative cost-effectiveness. Administrative market participants, excessive price variability as a costs are most directly affected by the scope of the result of exogenous shocks, regulatory uncertainty, and system, the choice of point of obligation, the frequency market imperfections might necessitate intervention in with which data needs to be reported and compliance the market. Policymakers must gauge the acceptable proven, and the requirements for compliance and level of variability for their local conditions and enforcement. There is a careful trade-off to be made design PSAMs to ensure a consistent price signal for between reducing transaction costs and achieving ideal investment and robustness of the system. accountability and transparency outcomes, particularly S Compatibility with other policies. An ETS that has with respect to MRV requirements. a well-defined place within the jurisdiction’s climate S Compatibility with other jurisdictions. Consistent policy ecosystem is more likely to achieve the desired ETS design features across jurisdictions allow for a mitigation most efficiently. A review of existing and coordinated climate policy architecture, most directly proposed climate and energy policies is necessary to in the form of linking, which can enable emissions units avoid duplicating effort through overlapping policies, from other systems as valid compliance instruments and higher than necessary costs due to countervailing within an ETS. Greater compatibility can also reduce policies. ETS design should also be aligned with regulatory and administrative burdens for companies existing companion policies in order to maximize operating in multiple jurisdictions and allow for greater benefits and minimize costs (see Section 1.3). transparency, as systems and outcomes are comparable. S Maintaining policy alignment over time. As well as seeking policy alignment at the time at which an The World Bank and the Organisation for Economic ETS is introduced, policymakers will need to ensure Co-operation and Development (OECD) have also that policies remain aligned over time. As part of a developed a more succinct set of criteria for successful broader process for establishing and maintaining policy carbon pricing policies, the FASTER Principles, which can be found in Box 1-5 below. Step 1: Preparation 29 Box 1-5 The FASTER Principles for Successful Carbon Pricing The FASTER Principles for Successful Carbon Pricing43 were developed jointly by the World Bank and the OECD based on the practical experience of different jurisdictions with implementing carbon taxes and emissions trading systems. The FASTER Principles include S Fairness: Reflect the “polluter pays” principle and contribute to distributing costs and benefits equitably, avoiding disproportionate burdens on vulnerable groups; PREPARE STEP 1 S Alignment of Policies and Objectives: Use carbon pricing as one of a suite of measures that facilitate competition and openness, ensure equal opportunities for low-carbon alternatives, and interact with a broader set of climate and non-climate policies; S Stability and Predictability: Implement carbon prices as part of a stable policy framework that gives a consistent, credible, and strong investment signal, the intensity of which should increase over time; S Transparency: Be clear in design and implementation; S Efficiency and Cost-Effectiveness: Ensure that design promotes economic efficiency and reduces the costs of emission reduction; and S Reliability and Environmental Integrity: Allow for a measurable reduction in environmentally harmful behavior. 1.5 EMISSIONS TRADING AND ECONOMICS: A PRIMER While designing an ETS policy in practice entails a certain abatement opportunities will be profitable to undertake. amount of complexity, the economic theory of emissions Some abatement technologies are cheap and, in some trading is quite simple. The rest of this chapter provides a cases, may even have “negative” costs, which means brief overview of the basic economics behind emissions that they would be profitable to implement without any trading as a policy tool. It proceeds through three steps: carbon price — although in these cases there are likely to 1. an explanation of what a marginal abatement cost be non-price barriers that prevent the abatement being curve is, undertaken. Energy efficiency measures are a typical example. These solutions (like energy-saving lightbulbs) 2. an illustration of how trading facilitates cost-effective are slightly more expensive than their conventional abatement using the simplest possible example counterparts in terms of upfront cost, but result in involving two firms, and significant cost savings over their lifetime through lower 3. a brief section comparing the regulation of quantities electricity bills (i.e., they are the profit-maximizing choice). (ETS) versus the logic of regulating prices (carbon However, uptake of these measures can be low due to taxes). non-price barriers like consumer preferences, behavioral biases, transaction costs, or information failures. By contrast, other abatement technologies are more difficult to 1.5.1 INCREASING MARGINAL implement — and, thus, more expensive. ABATEMENT COST CURVES Depicting these technologies in the sequence of abatement Different abatement opportunities have different costs cost in order from lowest to highest cost results in an per ton of abatement (i.e., emission reduction) achieved. increasing marginal abatement cost (MAC) curve. The first An abatement opportunity will be undertaken only if unit of emissions reductions costs very little, perhaps even it is cheaper than the carbon price. Firms are profit less than zero, but the cost per ton of reductions rises with maximizing, and will therefore choose the lowest-cost emission reductions as more expensive opportunities are option available to them; in this case, if the compliance pursued. A simple MAC curve is presented in Figure 1-5, cost of emitting (that is, buying an allowance) is lower with cost of technologies increasing from left to right. than the cost of investing in abatement, they will choose The size of the box represents the size of the mitigation to pay the compliance cost. As a result, absent other opportunity. policy signals, the carbon price will determine which 43 World Bank and OECD (2015). 30 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Figure Figure 1-51-5: MAC MAC curve plotting curve plotting abatement abatementoptions in order options of their in order of cost their costs 150 Annual abatement cost of the mitigation option ($/ tCO2e) Option 9 Option 9 100 Option 8 has the PREPARE Option 1 has the STEP 1 highest cost lowest cost and should be Option 7 50 Option 6 undertaken first Option 5 Option 4 0 Option 3 -50 Option 2 Option 1 -100 Mitigation options with negative cost -150 100 200 300 400 500 600 700 Annual abatement potential of the mitigation option (tCO2e) The same logic applies to companies as well as economies: Without regulation, both companies pollute — even the first unit of emissions reductions a company might Low-Cost Inc. finds it cheaper to emit than to install its pursue can be undertaken cheaply, but as more ambitious clean energy innovations and basic efficiency ideas. A emission reductions are sought, the cost per unit of government might decide to reduce the emissions of emission reduction rises. For example, installing energy- these two companies. For instance, rather than allow both efficient lighting or lowering heating needs through insulation firms to emit 100 units, the government might limit total might be relatively cheap or even prove financially beneficial. emissions across the two firms to 100 units. On the other hand, deeper emissions cuts might require capital-intensive solutions such as updating equipment for The simplest way to achieve the limit may be to set a a lower emissions production process. Moreover, different uniform standard (see Figure 1-7): both companies are companies will at different points in time face different required to limit their emissions to the same amount (50 marginal abatement costs; for some companies, reducing units apiece). Low-Cost Inc. will find it relatively easy (and emissions will be cheaper than for others. cheap) to comply, but this will be considerably more costly for High-Cost Corp. This can be seen by comparing the vertical height of the curves at the point where each has 1.5.2 A TWO-COMPANY EXAMPLE delivered 50 units of emission reductions: it is significantly higher for High-Cost Corp than for Low-Cost Inc. As such, Next we look at the simplest example: two companies with this requirement, emissions are limited to 100, but total in the same industry, producing the same products, compliance costs could be high. that might be called High-Cost Corp. and Low-Cost Inc. High-Cost Corp. does not have many options for reducing It is in this context that cap and trade can be valuable. The emissions at a certain point in time (for example, due to government still sets an overall limit on emissions equal to the structure of capital stocks, or because it is at the latest 100 units. But instead of telling each company how much stage of the equipment modernization cycle). Low-Cost to emit directly, it distributes or auctions allowances to Inc., on the other hand, has several cheap carbon-reducing each regulated entity as well as potentially to other parties. ideas that it has not yet adopted. This is shown in the Each allowance provides the right to emit one unit. The total back-to-back graph depicted in Figure 1-6, where both number of allowances adds up to the overall cap of 100. companies’ emissions are plotted on the X axis, but oriented in opposite directions. Next comes trade (see Figure 1-8). Regardless of how allowances are distributed, it is unlikely that the initial allocation process will have resulted in the allocation that Step 1: Preparation 31 establishes the least-cost (“cost- 1-6: An Figure 1-6 Figure Anexample example two of of firms two withwith firms different abatement different costs costs abatement effective”) distribution of emissions across the two companies. For example, in a case in which the Low-Cost Inc. (L) and allowances have been allocated Marginal savings High-Cost Corp. (H) have very different equally to both firms, High-Cost from emissions for marginal savings High-Cost Corp. Corp. will want to find extra from emissions given PREPARE (avoided marginal STEP 1 Cost per unit of CO2e abated very different allowances while Low-Cost Inc. will abatement costs, MACH) marginal abatement be willing to sell — for a price. cost curves (MAC) The price that will emerge will Marginal savings from emissions for High-Cost Corp.’s ensure that emissions are reduced Low-Cost Inc. curve is steeper; in the least-cost manner. High- (avoided marginal its savings from abatement costs, not abating the Cost Inc. will be willing to buy MACL) 50th metric ton of allowances until the point where emissions is almost the cost for reducing emissions twice as high as for Low-Cost Inc.’s. Its reductions is equal to the price cost of having to go of allowances on the market. to zero emissions is too high to show on Similarly, Low-Cost Inc. will be 0 50 100 this graph. Emissions from High-Cost Corp. willing to reduce emissions and, 100 50 0 thus, sell surplus allowances Emissions from Low-Cost Inc. until the point where its costs for installing its own emissions- CO2 emissions for High-Cost Corp. and Low-Cost Inc. reducing measures equal the allowance price borne by the Note: Two firms with different “abatement” (emission reduction) costs: High-Cost Corp., with emissions shown from left to right, and hence abatement from baseline emissions in reverse, has a steeper incremental or marginal abatement cost market. curve and thus steeper marginal savings from emissions; Low-Cost Inc., with emissions plotted from right to left, has a flatter curve. Note that the total emissions are the same (and equal to 100) at every point along the horizontal axis; what changes is how those emissions are allocated between the two firms. The overall outcome will be that Low-Cost Inc. will pursue significant emission reductions, limiting emissions to 30, leaving it Figure 1-7 Figure Applying 1.7: a uniform Applying a uniform standard standard to each to each company company with around 20 to sell. High-Cost Corp., on the other hand, takes a handful of measures on its own (limiting emissions to 70 units) but Avoided The goal is to cap then buys on the open market the MACH emissions at 100 units. rest of the allowances (20) that A uniform pollution standard would imply it needs to cover its emissions. emissions of 50 units by Cost per unit of CO2e The result is that the same total each Low-Cost Inc. (L) and High-Cost Corp. level of emissions is achieved — (H), regardless of their but at lower total cost for both marginal abatement companies as well as the system cost curves (MAC). as a whole. Avoided The shaded areas MACL represent total In reality, of course, things are abatement costs to more complicated, including the each company. existence of many more firms, questions around market power, 0 50 100 and administration/transaction Emissions from High-Cost Corp. costs. But even this simple 100 50 0 example raises some important Emissions from Low-Cost Inc. questions: CO2 emissions for High-Cost Corp. and Low-Cost Inc. S Is it fair to give each company an equal number of Note: A uniform standard limits each company to the same amount of emissions: Low-Cost Inc. and High-Cost Corp. each emit 50 units, for a total of 100. allowances? 32 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION S Should allowances be given Figure 1-8 Trade saves costs relative to an allocation that prescribes equal away — “freely allocated” — Figure 1-8:emissions by Trade saves each costs company relative to an allocation that prescribes equal emissions by each company or should they instead be auctioned off? S If auctioned, should the Companies will trade proceeds be used to reduce their emissions permits Avoided until the point where PREPARE taxes elsewhere, or should STEP 1 MACH their marginal costs for the money be spent on an additional metric ton of abatement are equal. other measures to reduce This is also the point Cost per unit of CO2e emissions, protect vulnerable that maximizes cost consumers, or compensate Cost savings savings. with trade stakeholders under the program? High-Cost Corp. now emits 70 and Low-Cost Avoided Inc. emits 30. If each One of the important features is allocated allowances MACL of cap and trade is that while for 50 units of emissions, High-Cost the answers to these questions Corp. will buy 20 from are crucially important from Low-Cost Inc. to cover political and distributional its higher emissions and compensate the perspectives, they do not 0 50 70 100 extra abatement by Emissions from High-Cost Corp. change the overall effectiveness Low-Cost Inc. 100 50 30 0 of the cap. Regardless of how a Emissions from Low-Cost Inc. fixed number of allowances are distributed, total emissions do CO2 emissions for High-Cost Corp. and Low-Cost Inc. not exceed the limit. 1.5.3 REGULATING PRICES VERSUS QUANTITIES Emissions trading is only one policy instrument available to combat climate change. The most Figure 1-9 Damages and savings from emissions direct alternative is to tax GHG emissions. Price- based mechanisms (like a tax) and quantity-based mechanisms (like an ETS) both have theoretical Marginal savings advantages and disadvantages, as discussed in from emissions (avoided Section 1.1.1. Which is preferred (on economic abatement costs) efficiency grounds) will depend on the relative Cost per metric ton of CO2e importance of being certain about marginal costs (favoring a carbon tax) or being certain about marginal benefits from improved environmental outcomes (favoring a cap and trade system).44 The political Marginal societal feasibility of either approach will also differ across damage from P* emissions different contexts. A cap and trade system, in its purest form, ensures that the emissions limit is firm, but keeps the price flexible. By contrast, a tax sets the price, keeping emissions flexible. In a world of certain and known marginal 0 Q* abatement costs and social benefits, either approach could be designed to achieve the same outcome, as Quantity of emissions shown in Figure 1-9. However, the world is uncertain; there is imperfect knowledge regarding both the Note: With no uncertainty around marginal abatement costs and damages from emissions, by setting a cap at Q*, the market price will adjust to P*. Setting a tax at P* marginal abatement cost curve and the marginal social will result in emissions level of Q*. 44 Under a cap, if marginal abatement costs are higher than expected, the market price for one ton of CO2 — and, thus, the overall cost of the policy — will be higher than expected. Under a tax, a higher-than-expected marginal abatement cost will not affect the price, but it will lead to fewer emissions reductions than expected. Step 1: Preparation 33 benefits curve. As a result, an ETS and a tax — even if only quantity, and a tax, which controls only price. While a designed to be equivalent in expectation — will likely have “hybrid” design provides policymakers with greater control different outcomes. Which one is preferred (on economic over the carbon price (and therefore marginal cost), it may efficiency grounds) will depend on the relative importance reduce certainty around the achievement of the initial cap. of minimizing marginal costs (favoring a carbon tax) or being certain over environmental outcomes (favoring a cap However, despite the differences between an ETS and and trade system). a carbon tax, there is widespread agreement among PREPARE economists that a price on emissions, created through STEP 1 PSAMs seek to balance objectives regarding the carbon either approach (or through a combination — for instance, price and the quantity of emissions reductions by altering using price floors and ceilings) is critical to reducing GHG the supply of allowances (see Step 6). These measures emissions in a cost-effective manner. blur the distinction between a “pure” ETS, which controls 1.6 QUICK QUIZ Conceptual Questions 1. How does an ETS work? 2. What is the difference between an ETS and a carbon tax? Application Questions 1. What might be the key goals of an ETS in your jurisdiction? 2. What existing regulations in your jurisdiction could help or hinder an ETS? 3. What policies might be useful in addition to an ETS in your jurisdiction? 1.7 RESOURCES The following resources may be useful: S State and Trends of Carbon Pricing 2020 S Carbon Tax Guide: A Handbook for Policy Makers S Benefits of Emissions Trading: Taking Stock of the Impacts of Emissions Trading Systems Worldwide S Emissions Trading Worldwide: Status Report 2020 S Carbon Pricing Assessment: A Guide to the Decision to Adopt a Carbon Price (forthcoming) S The Co-benefits of Carbon Pricing (forthcoming) 34 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION PREPARE STEP 1 This page intentionally left blank. STEP 2: ENGAGE STAKEHOLDERS, COMMUNICATE, AND BUILD CAPACITY 35 Step 2 - Engage stakeholders, communicate, and build capacity STEP 2 Engage stakeholders, communicate, and build capacity At a Glance_____________________________________________________________________________ 36 STAKEHOLDERS 2.1 Objectives for engagement_________________________________________________________ 37 STEP 2 2.2 Understanding your stakeholders___________________________________________________ 37 2.3 Design an engagement strategy____________________________________________________ 40 2.4 Communication Strategy___________________________________________________________ 45 2.5 Stakeholder engagement process management______________________________________ 47 2.6 Capacity building__________________________________________________________________ 51 2.7 Quick Quiz________________________________________________________________________ 53 2.8 Resources________________________________________________________________________ 53 BOXES Box 2-1 Case study: Stakeholder engagement during design and implementation of the Tokyo ETS______________________________________________________________ 42 Box 2-2 Case study: California's formal expert engagement in ETS design________________ 43 Box 2-3 Case study: Germany's experience with the Emissions Trading Working Group_____ 44 Box 2-4 Case study: Government coordination in New Zealand ETS design_______________ 45 Box 2-5 Technical note: Communicating carbon pricing_________________________________ 46 Box 2-6 Case study: Stakeholder engagement in the lead-up to the introduction of ETS in Mexico______________________________________________________________ 49 Box 2-7 Case study: Overcoming legal challenges: The case of the California Cap-and- Trade-Program______________________________________________________________ 50 Box 2-8 Technical note: ETS simulations for capacity building____________________________ 52 Box 2-9 Case study: Building capacity for the Chinese national ETS______________________ 52 FIGURES Figure 2-1 ETS stakeholders and key considerations in stakeholder mapping________________ 38 Figure 2-2 Role of stakeholders in ETS decision-making___________________________________ 41 TABLES Table 2-1 Assertions against an ETS and possible counterarguments______________________ 48 36 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION AT A GLANCE Stakeholder engagement normally begins by clarifying Checklist for Step 2: Engage stakeholders, communicate, and build capacities the key objectives from the stakeholder engagement process and developing a comprehensive map of relevant ✔ Map stakeholders and respective positions, stakeholders. This mapping exercise can go beyond simply interests, and concerns identifying stakeholders by also working to understand the ✔ Coordinate across departments for a transparent profiles, interests, and values of affected parties. In doing decision-making process and to avoid policy so, a stakeholder engagement process can illuminate key misalignment priorities for engagement. STAKEHOLDERS ✔ Design an engagement strategy for consultation of STEP 2 stakeholder groups specifying format, timeline, and Developing a stakeholder engagement and objectives communications strategy from the outset can be ✔ Design a communication strategy that resonates of enormous value. The strategy, and subsequent with local and immediate public concerns engagement, should consider the different forms of ✔ Identify and address ETS capacity-building needs engagement available and which forms may be most effective for different stakeholder profiles. By drawing on stakeholders’ expertise it is possible to improve ETS design Implementing an emissions trading system (ETS) requires and help build trust, understanding, and acceptance. enduring public and political support, as well as practical Stakeholder engagement is not without risk, which should collaboration across government actors and market be proactively managed to avoid poor outcomes. Publicly players. This should be based on shared understanding documenting the engagement increases transparency and and trust, alongside consideration of the respective improves stakeholder confidence in the process. capabilities of government and regulated entities. ETS impacts can be significant and far-reaching, making their Communication with stakeholders aims to improve development and operation politically sensitive and of information flows as well as awareness and acceptance of interest to a broad array of stakeholders. Stakeholders the ETS. Communication strategies can build on stakeholder are those who will in some way be affected by the ETS inputs and profiles to develop tailored narratives that will policy. Stakeholders are not only those that will be directly resonate with different audiences, considering different regulated by the ETS, like regulated entities and industries, means of communication. While developing and running the but include those that contribute to the shaping of policy ETS, the government’s communication strategy should be and those who are more widely affected, including clear, consistent, and coordinated. indirectly affected firms, other government agencies, and environmental advocacy and civil society groups. Developing an ETS also requires strategic capacity building for specific stakeholder groups. Policymakers and ETS Stakeholder engagement plays an important role in all service providers, in addition to ETS participants, need to stages of an ETS from the initial assessment, design, and build the specialized technical expertise and administrative implementation of an ETS through to stakeholder input as capacity to develop and operate an ETS. part of a post-implementation review cycle. Engagement opens communication channels between policymakers Section 2.1 guides policymakers through the objectives and stakeholders. Policymakers can help stakeholders of stakeholder engagement. Section 2.2 then presents understand the ETS policy to build acceptance, while an approach to understanding relevant stakeholders. receiving stakeholder input. The results from engagement Section 2.3 elaborates on the guiding principles and should be used to improve ETS design to ensure it is key aspects of engagement strategies. Section 2.4 appropriate for the local circumstances. Some jurisdictions looks specifically at the design of a communications have found that it takes 5 to 10 years of engagement and strategy. Section 2.5 outlines the most important aspects capacity building on climate change market mechanisms of managing the stakeholder engagement process. to build knowledge and promote acceptance across Section 2.6 presents an approach to building the capacity stakeholder groups. For this reason, the topics discussed of policymakers, regulators, ETS participants, service in this chapter hold key lessons that are relevant to all other providers, and other stakeholders. steps of ETS design. STEP 2: ENGAGE STAKEHOLDERS, COMMUNICATE, AND BUILD CAPACITY 37 2.1 OBJECTIVES FOR ENGAGEMENT Mapping key stakeholders and engagement strategies business processes and existing regulatory markets. should be based on the main objectives for engagement. Wide-ranging stakeholder information is an essential These may include: precondition to creating effective regulatory bodies.47 S Meeting statutory obligations: Each government S Building credibility and trust: Long-term goals is likely to have statutory requirements and standard need to be credible, and rules and enforcement practices for public engagement on major policy and mechanisms should be clear. ETS participants and legislation.45 Whatever approach is applied to the other stakeholders are more likely to have confidence STAKEHOLDERS ETS should be consistent with local requirements. in an ETS if they receive, and have the chance to However, it will be important to consider whether any review, pertinent information. Conversely, they are STEP 2 changes or additions to the standard approaches are more likely to be suspicious of the government’s required.46 For example, extra time may be needed to assessments if these are conducted confidentially and allow stakeholders to consider particularly complex ETS without independent review. External, peer-reviewed elements. Governments may need to make a special research can help ensure that conclusions are as effort to reach out to stakeholder groups that are not transparent as possible. Ensuring the predictability of often involved in policymaking and simplify complex the decision-making processes and ETS operation is technical information. equally important. Unexpected changes to ETS design S Building understanding and expertise: Regulated will reduce trust in the system and could discourage entities need to learn about an ETS, how it works, and investment in low-greenhouse gas (GHG) technology its potential impacts before they can support it and (see Step 10), so engagement on changes can improve participate in it. Potential entities to be covered by acceptability and efficiency. the system will also have access to better information S Building acceptance and support: A sustainable ETS than regulators about their emissions, mitigation does not require universal support, but it does require potential and costs, and competitiveness concerns. enduring social acceptance.48 This can take the form of They may also have valuable sector knowledge that a “quiet majority,” even if it is overshadowed by a vocal could positively affect program design. For example, opposing minority.49 Broad political support will help recent technology developments that reduce the cost ensure the long-term viability of the system through of abatement may influence the degree of support political cycles, and will also be key to the overall offered to the sector. Access to information from legitimacy of the system and public authority. Perceived multiple well-informed stakeholders, such as industry long-term viability and legitimacy of the ETS will also players, environmental regulators, climate experts, likely have positive effects on investments in abatement and jurisdictions already operating an ETS allows technologies (see Step 10). for smoother implementation and better integrates 2.2 UNDERSTANDING YOUR STAKEHOLDERS Understanding stakeholders is key to successful policy. It needs and preferences of different stakeholders, thereby is particularly important for ETSs, which aim to be in place increasing the chances of the ETS being a success. for the long term. For this reason, stakeholder engagement is of paramount importance and is required throughout This section presents an approach to stakeholder mapping. the lifetime of an ETS. By understanding stakeholders, It covers the identification of relevant stakeholders in policymakers can tailor the ETS, and the broader Section 2.2.1 and how to build stakeholder profiles environmental policy landscape, to better respond to the in Section 2.2.2. These profiles can then be used to 45 Organisation for Economic Co-operation and Development 2009. 46 During the development of the EU ETS, the German government identified the need to create a new institution for more in-depth stakeholder engagement than would be achieved under standard practice (Matthes 2013). 47 A case in point is the treatment of space heating in Beijing’s ETS. Government analysts assumed that boilers would be more efficient in the richer central city and allocated emission allowances based on that assumption. However, extensive stakeholder engagement revealed the opposite: in fact, boilers in the outlying areas were more efficient. The large range in emissions intensity for space heating influenced the eventual choice to forgo a standard benchmark for the entire industry. 48 Caron-Malenfant and Conraud 2009. 49 For a description of a “silent majority” refer to Government of South Australia (2013). 38 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION prioritize stakeholders for engagement, as described in rights, tax, or law. The departments responsible for Section 2.2.3. An overview is provided in Figure 2-1. these policy areas will also be important bodies to engage with. At the political level, a broad range of stakeholders are relevant, including legislators, whose 2.2.1 IDENTIFYING STAKEHOLDERS support will be needed to pass the ETS into law and who are vital to engage with early, to explain the key ETS stakeholders include individuals and organizations concepts and build support. Opposition parties will that affect, are affected by, or have an interest in, be important to engage with, particularly if partisan ETS design and implementation. Identifying relevant politics are a feature within the jurisdiction. Bipartisan stakeholders will help the design and implementation of an political support can help to depoliticize the policy and effective engagement strategy. to maintain ETS ambition through political cycles. STAKEHOLDERS S Firms affected but not regulated directly by the STEP 2 Relevant stakeholders for an ETS are listed below. ETS, including manufacturers and suppliers at different S Regulated entities are an important group as they are points in the supply chain, will have an interest. Trade directly affected by the ETS. They will be fundamental and industry associations can play an important role in to gaining access to the robust information and data presenting aggregate views on business interests and on which the operation of an ETS is based. Their serve as a conduit of information to their members and participation and compliance are also required once the consumers. system is in place. Engagement can be targeted toward S Market service providers could include banks, both gaining executive commitment to constructively participate in the ETS and securing the involvement exchanges, and other financial intermediaries such as of operational staff in designing effective monitoring, specialized consultancies, brokers and trading houses, reporting, and verification (MRV) procedures and other verifiers and auditors, offset project developers, and systems. S Government Figure 2-1: Figure ETS Stakeholders 2-1 ETS and Key stakeholders and in stakeholder Considerations in key considerations Stakeholdermapping Mapping stakeholders play a key role in ETS design and implementation. Government stakeholders Government Civil society: include bodies with input on understanding stakeholders: key legislative functions, role in ETS design & and managing ETS implementation departments involved impacts directly in ETS design and implementation, departments whose operations will be affected by the ETS, ETS participants: Media: acceptance and Build Meet directly affected & and departments whose support for ETS, build understanding statutory their data provides credibility and trust support is essential, as & expertise obligations foundation of ETS well as other national and subnational authorities. Academics & STAKEHOLDER The government researchers: help MAPPING & departments and agencies design options, model OBJECTIVES ETS impacts, evaluate/ that are likely to be most improve ETS Firms not directly regulated: also affected involved include those and may serve as Build Build with responsibilities for credibility acceptance information conduit environmental, energy, & trust & support and economic affairs; treasuries; accreditation General public: bodies; and market support key for social acceptance and regulation and oversight. electoral support Market service An ETS can be a broad providers: support instrument, which may also effective operation of ETS raise issues in areas such Other ETS jurisdictions: valuable knowledge or as transport; industrial experience & can discuss policy; forestry; or property linking STEP 2: ENGAGE STAKEHOLDERS, COMMUNICATE, AND BUILD CAPACITY 39 legal advisors, and verifiers, all offering professional 2.2.2 UNDERSTANDING THEIR services that can support the development and effective INTERESTS operation of an ETS. For instance, by developing secondary market products, as well as guarding against Once stakeholders are identified, it is important to market manipulation and fraud (see Step 7). understand their respective interests by building a S Civil stakeholder profile so policymakers can strategically society organizations, such as environmental, design their ETS engagement.50 This helps policymakers social justice, health, and governance nongovernmental understand how each group will be affected and what is organizations (NGOs); labor organizations; and consumer important to them. Knowing this, policymakers can start groups will have an interest in the ETS. They can provide to prioritize groups that may require more engagement to valuable input on understanding and managing ETS reduce opposition to policy introduction. Opposition may STAKEHOLDERS impacts, as well as communicating with members or come from not only those opposed to action on climate other stakeholders to build support for an ETS. STEP 2 change, but also those that support climate action but are S The media is crucial to building acceptance and opposed to an ETS. Stakeholder profiles can cover groups support for an ETS. Accurate and objective media of stakeholders or individual stakeholders, as appropriate. coverage can help build broad-based credibility and They may answer questions such as: trust, whereas persistent biases and misreporting may S What role will they play in ETS implementation? yield the opposite effect. S How will they be affected by the ETS, and how S Academics and researchers are an important significant will that impact be? resource that policymakers can leverage to evaluate S What is their understanding of emissions trading and and improve ETS design and can help explain to the public the rationale for and benefits of an ETS. As broader climate change policy? experts, their involvement and studies can help build S What are their priority issues or concerns regarding an credibility and trust in the system. Leveraging their ETS? expertise to help build long-term and robust models, S What will they expect from the government? For as well as other analyses for the ETS can help support instance, stakeholders might wish to be informed of government policymaking. major decisions and developments, have an opportunity S The support of the general public is key for building to influence policy, give feedback on how the ETS is the enduring social acceptance and broad political operating, or simply understand the rules of the ETS. support necessary for a sustainable ETS. S What is the government’s current relationship with S Other jurisdictions with an ETS may be engaged them, and how willing are they to engage? early and throughout the design process to share their S How might they interact with other stakeholders on experience and knowledge. They can also identify these issues? and resolve potential barriers to linking — if that is an objective of the ETS. Other jurisdictions can also be Once policymakers understand how stakeholders will be engaged by participating in international fora such as the affected, modeling, or another quantitative analysis such Partnership for Market Readiness (PMR) and International as cost benefit analysis, can be used to understand the Carbon Action Partnership (ICAP), through formal fact- scale of impacts on affected parties. The potential impact finding missions, and through informal contacts. of an ETS on business competitiveness and distributional S Trading partners who place a premium on mitigation impacts (see Step 5) are often a focus of analysis. Various ambition, or who are considering trade measures such types of modeling can be used to identify the impacts as border carbon adjustments, should be consulted of a carbon price on business competitiveness, industry to streamline and integrate future policymaking on output and employment. Similarly, analysis may consider international mitigation action and trade impacts. how an ETS alters household costs, for instance through increased electricity bills, use of gas for heating, or fuel for transport.51 This analysis can be used to refine the ETS design to reduce negative impacts. Presenting the findings from the analysis and how potentially negative impacts have been addressed can allay concerns regarding the impacts of an ETS and provide evidence that policymakers have thought through its potential impacts.52 50 For an example of stakeholder mapping of positions and concerns in the context of the introduction of California’s Global Warming Solutions Act (AB32), see Table 2 in PMR (2013). 51 For example, Adelphi (2018) looks into the distributional impacts of carbon pricing and how they can be addressed. 52 The potential ways in which these impacts can be assessed are considered in further detail in the PMR’s forthcoming Developing a Carbon Pricing Roadmap guide. 40 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION The costs of an ETS are important to understand, but 2.2.3 PRIORITIZING ENGAGEMENT so are the potential benefits from using carbon revenues and wider benefits that arise from a carbon price. Any The last step of stakeholder mapping is to prioritize the policy that reduces GHG emissions has the benefit of stakeholders to engage and the level of engagement. As not only mitigating the effects of climate change but also human and financial resources are likely to be limited, producing local benefits such as improved air quality, engagement should be targeted at the most important attracting low-carbon investment, innovation, and stakeholders. Priority may, for example, be assessed by employment. Carbon pricing is increasingly recognized as the extent to which a lack of engagement would pose a risk an important source of government revenue. If used wisely, to the successful design, implementation, and sustainable carbon revenues can support further climate mitigation; operation of the ETS. This assessment can be based on industry competitiveness; and pursuit of other economic, the stakeholder profiles drafted in the previous step. Given STAKEHOLDERS distributional, and developmental objectives. For example, limited resources, outreach activities that can be targeted STEP 2 in California, the Cap-and-Trade Program works to address to multiple audiences, or can be scaled up and replicated existing social issues by leveraging investments made with without additional cost — such as an online information auction revenue, 35 percent of which must directly benefit platform — can help maximize the impact of engagement disadvantaged and low-income communities, also referred efforts. to as “priority populations.”53 Options for how to leverage auction revenue are discussed further in Step 5.54 2.3 DESIGN AN ENGAGEMENT STRATEGY Engagement activities need to be undertaken strategically z Coordinate engagement on similar issues across at each stage of ETS design and implementation. The government to avoid duplicative efforts and potential complexity of this effort warrants the development “consultation fatigue.” of a formal strategic engagement plan that involves, S Transparent and has buy-in, across government departments. The components of the engagement plan should be customized z Clearly define the goals, target audience, and timeline to local circumstances, but some of the main aspects for each engagement activity. that might be considered are the guiding principles z Engage in good faith, providing enough time and of engagement (Section 2.3.1), the different forms of information for stakeholders to evaluate government engagement (Section 3.2), and the engagement needed proposals and for the government to incorporate within government (Section 2.3.3). The PMR’s Guide to substantive feedback into final decisions. Communicating Carbon Pricing provides further insights S Inclusive into the design of an engagement strategy. Aspects like extensive market research to understand the reasons z Engage broadly where possible so that both majority behind stakeholder groups’ beliefs, clear and jargon-free and minority views can be considered. communication, and picking the right communicators are z Accommodate engagement to the needs and all relevant to designing a successful engagement strategy. capabilities of the target audience (for example, providing multiple channels for engagement such as written submissions, public meetings, or different 2.3.1 GUIDING PRINCIPLES media channels). An effective engagement plan should be guided by several S Accountable core principles, including: z Ensure public accountability by maintaining a public S Timely record of engagement and reporting back what z Engageearly, sufficiently often and in a well-targeted information was received and how the government manner, so that the government can make well- took it into consideration. informed decisions at each step of the process. z Evaluateand continually improve the effectiveness of engagement activities. 53 California Air Resources Board 2020c. 54 Further details on these and other options for revenue use and how they can affect a range of stakeholders are detailed in the PMR’s Using Carbon Revenues report and ICAP’s paper Use of Auction Revenue from Emission Trading Systems. STEP 2: ENGAGE STAKEHOLDERS, COMMUNICATE, AND BUILD CAPACITY 41 2.3.2 DIFFERENT FORMS OF Figure 2-2: Role of Stakeholders in ETS Decision Making Figure 2-2 Role of stakeholders in ETS decision-making ENGAGEMENT Different forms of engagement are appropriate for different stakeholders and at different stages of ETS development. The International Association for EMPOWER Public Participation (IAP2) has developed a useful Increasing influence on decision-making framework for considering engagement options in its public participation spectrum (see Figure 2-2).55 It distinguishes five forms of engagement, ranging COLLABORATE from those that are appropriate for a low level of STAKEHOLDERS public influence over decision-making (“Inform”) STEP 2 to those that involve a high level of influence INVOLVE (“Empower”). The IAP2 framework can be applied to ETS design and implementation as follows: CONSULT S Inform: Defined as “to provide the public with balanced and objective information to assist them in understanding the problem, INFORM alternatives, opportunities and/or solutions.”56 In the ETS context, this may involve: z producing green/white papers57 that explain Source: Adapted from IAP2 (2014) the government’s proposals with supporting discussion and analysis; z creating a central website, hotline, or help desk where z commissioning independent experts to assess ETS information can be obtained about the ETS; design and operation; z releasing modeling results and other government z enabling substantive dialogue with stakeholders, analysis; formally and informally; and z issuingregular updates on the progress of ETS z holding multi-stakeholder workshops for the public planning; and exchange of views. z providing plain-language summaries of technical S Collaborate: Defined as “to partner with the public in documents, legislation, and regulations. each aspect of the decision including the development of alternatives and the identification of the preferred S Consult: Defined as “to obtain public feedback on solution.”60 This may involve: analysis, alternatives and/or decisions.”58 This may involve: z inviting stakeholders and technical experts to work with the government in modeling ETS impacts by z meeting with staff of companies that are likely to be reviewing data, assumptions, and outcomes; and ETS participants; z creating joint government/stakeholder working z engaging with consultants and researchers; groups to discuss key issues and develop related z invitinggeneral public input on government proposals regulations and guidelines for ETS participants. during ETS design; and S Empower: Defined as “to place final decision making in z mandating public consultation on legislation, the hands of the public.”61 This may involve: regulations, and ETS reviews. z ensuring that the introduction of an ETS is identified S Involve: Defined as “to work directly with the public early and clearly in campaign platforms, political throughout the process to ensure that public concerns programs, and legislative dockets to facilitate a and aspirations are consistently understood and robust civil society debate; considered.”59 This may involve: 55 From informing to empowering, including consulting, involving, and collaborating, the IAP2 Public Participation Spectrum is a useful tool to better understand the role stakeholders can be given (IAP2 2007). 56 Ibid. 57 In this context, a green paper is a government document presenting preliminary or tentative policy proposals that is circulated among interested parties for consultation. The ensuing government white paper presents firm policy proposals for further testing and refinement prior to the introduction of legislation. 58 IAP2 2007. 59 Ibid. 60 Ibid. 61 Ibid. 42 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION z establishingpublic legitimacy, for instance, through z In developing the Tokyo ETS, government officials extensive community engagement or potentially tailored the format of engagement to meet the through devolved decision-making such as a public evolving needs of different stakeholder groups across referendum on whether to proceed with an ETS;62 and different phases of work. (See Box 2-1.) z delegating authority for technical aspects of allocation plan development to experts. Box 2-1 Case study: Stakeholder engagement during design and implementation of the Tokyo ETS In developing the Tokyo ETS government officials tailored the format of engagement to meet the evolving needs STAKEHOLDERS of different stakeholder groups across different phases of work.63 The Tokyo ETS was established after two prior STEP 2 phases of mandatory reporting and revised reporting.64 The mandatory reporting program, started in 2002, provided the backbone of data needed for the later stages. Under the revised reporting program, staff from the Tokyo Metropolitan government visited almost all facilities to discuss emissions reduction opportunities, which resulted in a strong foundational understanding of emission trading. In designing its ETS, the Tokyo Metropolitan government held stakeholder meetings between July 2007 and January 2008. Business groups, companies with interests in climate change, environmental NGOs, and the Tokyo Metropolitan government took part in meetings that were open to the public. Each meeting attracted over 200 attendees.65 Stakeholder meetings were held after the initial design of the ETS, but before the detailed program regulation was drafted. Through these meetings, the Tokyo Metropolitan government was able to respond to the concerns of the public, build trust, and enrich the design of the ETS. The meetings directly helped shape the design of the ETS. For instance, companies that had already made reduction efforts expressed concerns that allowance allocation would not reflect their past efforts.66 As a result, the Tokyo Metropolitan government established a “Top-Level Facility Certification,” allowing qualifying facilities with the greatest progress in energy efficiency to ETS phase Stakeholders engaged Format face less-onerous targets under the S Facility managers and engineers at S Publications Pre-cap and regulated companies S Report submissions and feedback ETS. Similarly, 67 trade reporting S Seminars property owners were concerned S Experts S Expert panels about their Draft program S Facility managers, experts, and engineers S Environmental councils design and ability to control at regulated companies S Questionnaires proposal S Local business groups the emissions S Stakeholder meetings from tenants. In S Business groups (local and national) S Thematic meetings response, a system Introduction S NGOs S Collection of public comments was developed that S General public S Forums obliged tenants of large floor areas S Local business groups S Negotiations or high electricity Detailed S Leaders in building sector S Discussions (one-to-one, use to cooperate program design S Engineers at regulated companies one-to-some) S Experts (for example, academia, lawyers) S Seminars and forums in mitigation efforts, including Implementation S Facility managers and engineers at S Report submissions and feedback the requirement to and improvement regulated companies S Help desk submit their own reduction plans. Source: Adapted from PMR (2013) 62 For example, holding a public referendum played a key role in the development of the ETS in California. 63 See Kimura (2014, 2015) for accounts of stakeholder meetings in the design of the Tokyo Cap and Trade Program. For a discussion of Tokyo’s larger approach to stakeholder engagement, see PMR (2013). Also of interest is Environmental Defense Fund (EDF) and International Emissions Trading Association (IETA 2015h). 64 See Kimura (2014, 2015) for accounts of stakeholder meetings in the design of the Tokyo Cap and Trade Program. For a discussion of Tokyo’s larger approach to stakeholder engagement, see PMR (2013). Also of interest is Environmental Defense Fund (EDF) and IETA (2015h). 65 Kimura 2015. 66 Kimura 2015. 67 EDF and IETA 2015d. STEP 2: ENGAGE STAKEHOLDERS, COMMUNICATE, AND BUILD CAPACITY 43 Laying out an engagement schedule in advance, allocating Box 2-2 provides a specific example of engagement with sufficient time and resources to complete each stage of a stakeholder group, looking into California’s process of work, and aligning engagement activities with policymaker acquiring input on its ETS from experts. deadlines will all help make engagement more manageable. Box 2-2 Case study: California's formal expert engagement in ETS design The design process for the California Cap-and-Trade Program included regular public meetings from its inception. In total, more than 40 public meetings were held between 2009 and 2012.68 The California Air Resources Board (CARB) also relied on experts and economic analysis from different committees established for this purpose to inform the STAKEHOLDERS design and implementation of the system on specific issues: STEP 2 S The Market Advisory Committee (MAC) was appointed in 2007 to advise on creating a market-based mechanism for reducing greenhouse gases and was composed of experts who had experience in creating other ETSs, including the European Union (EU) ETS and the Regional Greenhouse Gas Initiative.69 S The Economic and Allocation Advisory Committee (EAAC) was appointed in May 2009 to provide recommendations on the provision of allowance value and allowance distribution. The EAAC was composed of 16 economic, financial, and policy experts, split across different subcommittees — economic impacts, allocation methods, allowance value provision, legal issues, and constraints.70 S The Emissions Market Assessment Committee (EMAC) was commissioned in order to identify market issues in the California Cap-and-Trade Program. EMAC held public meetings with stakeholders and conducted confidential meetings with CARB staff. The committee worked particularly on the price containment reserve, information sharing, resource shuffling, and linking with Québec.71 S The Market Simulation Group was established in June 2012 to identify, through simulation analysis, specific concerns with market rules.72 Risks of market disruption or potential for market manipulation were assessed, especially regarding the allowance price containment reserve. The work of the group was presented publicly and released for stakeholder comment. Its work led to the report Competitive Supply/Demand Balance and the Potential for Market Manipulation.73 Taken together, this process enabled a broad cross-section of experts and stakeholders to contribute on various details of ETS design and operation and helped create buy-in to the system. The work of the committees, which brought together experts with different backgrounds, improved ARB’s knowledge base for decision-making. 68 See California Air Resources Board (2015c) for archived and scheduled meetings. 69 See California Market Advisory Committee (2007) for a description of the role of Market Advisory Committee (MAC) and the committee’s findings. 70 See Economic and Allocation Advisory Committee (2010) for the full report of EAAC’s recommendations to CARB. 71 See California Air Resources Board (2014) for a description of the role of EMAC. 72 CARB 2015b. 73 Borenstein et al. 2014. 44 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Box 2-3 provides an example of the benefits of stakeholder with setting up a permanent working group to support ETS engagement, outlining Germany’s positive experiences engagement. Box 2-3 Case study: Germany's experience with the Emissions Trading Working Group Stakeholder outreach in Germany has a long tradition through industry associations. In the context of the EU ETS, this took the form of an Emissions Trading Working Group (AGE), established in 2000. The founding members were major industrial and energy companies, the federal government (represented by the Ministry for the Environment), and environmental NGOs. Including representatives of civil society in the process from the start was important in establishing an open and trusted exchange of views. This was also helped by the fact that the group operated under STAKEHOLDERS the Chatham House Rule. STEP 2 The working group was established as a permanent and continuous stakeholder process on all matters related to emissions trading, and as a platform for examining the interactions of the EU ETS with other climate policy instruments. Particularly during the establishment and early phases of the EU ETS, the group proved very helpful for sharing information, discussing stakeholder concerns, or, in other cases, better understanding the practical impact and challenges associated with EU ETS implementation and compliance. The timing and sequencing of engagement also helped make the group more effective. For example, detailed technical discussions took place only after political decisions on overall targets had been made. The working group operates with its own budget (financed jointly by the Ministry for the Environment and the participating companies) and a secretariat. The group is headed by the Ministry for the Environment and co-chaired by the Ministry for Economic Affairs and Energy. It now consists of 75 members engaged in regular sub-working and plenary group dialogues on a range of technical, political, and crosscutting issues. The plenary convenes seven times a year. As of 2020, the working group continues to focus on implementation of the EU ETS, currently in its third phase, but also discusses other regulatory developments and prospects in German and EU climate policy, such as measures under development to meet Germany’s 2030 targets, the German national ETS for fuels, issues at the intersection between ETS and the German energy transition policy (Energiewende), and the potential future use of offsets and linking of the EU ETS. 2.3.3 ENGAGEMENT WITHIN S Ensure appropriate leadership: Clear executive and GOVERNMENT ministerial leadership and commitment help in securing departmental engagement and support. The government is an important stakeholder, as a range S Designate decision makers: Assigning a specific of different ministries, departments, and agencies will department, team, or manager to lead ETS development be needed for the design and implementation of an ETS. and be accountable for delivery, including to other Equally, several government functions may be affected by government departments, will help define clear lines of an ETS. authority and avoid uncertainty. S Establish special working groups: These can A key question to consider is how the leading policy designers will engage with other departments and with facilitate interdepartmental collaboration at different political decision makers to garner support and deliver levels, enabling challenging issues to be raised and successful outcomes at each stage of the design and discussed. implementation process. To this end, each department’s S Develop communication channels: Coordination needs, priorities, and concerns must be taken into account, can be supported by establishing regular channels noting that emissions trading may be perceived to run to communicate progress, share information, and counter to some departments’ goals. The stakeholder- document decisions. profiling exercise described above will facilitate this process. S Document outcomes: Documenting technical and policy decisions and their rationales at different levels Providing clarity about the range of roles in ETS design and stages of the process will facilitate final political and implementation may help engage other government decision-making and provide a solid information base departments (see the experience with the New Zealand for future reviews of, or legal challenges to, the ETS. ETS in Box 2-4). Some elements to consider include: STEP 2: ENGAGE STAKEHOLDERS, COMMUNICATE, AND BUILD CAPACITY 45 Box 2-4 Case study: Government coordination in New Zealand ETS design In preparing the New Zealand ETS (NZ ETS), the government established an intragovernmental Emissions Trading Group to lead the design and implementation of the system. This team included officials seconded from the Ministry for the Environment (MfE), the Treasury, and the Ministries of Economic Development, Transport, and Agriculture and Forestry. It was based at the Treasury and led by an MfE manager with joint oversight by the chief executives of both the Treasury and MfE. This allowed a small and highly qualified group of officials from key departments to collaborate directly on technical ETS design while helping to secure support from their wider departments. These arrangements enabled the economy-wide NZ ETS to be developed rapidly with alignment of technical design and political decision-making across government. The Emissions Trading Group started work in April 2007 and legislation for the NZ ETS was passed in September 2008. However, this should be seen in the context of New STAKEHOLDERS Zealand having considered both emissions trading and carbon taxes since the 1990s, and having previously begun STEP 2 to develop the institutional capacity to implement a carbon tax, before political support for this earlier initiative receded. At the time of the second review of the NZ ETS, the government employed a different model, with a focus on setting a climate framework in legislation and then turning to the nuts and bolts of implementation. The process occurred in two stages: the first was the mandated second review (more information can be found in Box 10-8, Review Process in the New Zealand ETS) and the second was the process of drafting and legislating the Climate Change Response (Zero Carbon) Amendment Act and the Climate Change Response (Emissions Trading Reform) Amendment Act. The first point of focus was to develop the Zero Carbon Bill to set robust greenhouse gas emissions reduction targets, and thus a framework and context to then develop reforms to the New Zealand ETS. The MfE facilitated a series of sprints — one- or two-day meetings — that brought together key government officials from the MfE, the Ministry for Primary Industries, the Treasury, and others. The sprints were led by one of the MfE Directors of Climate Change and focused on addressing a list of relatively uncontentious issues quickly, as well as providing an entry point for particularly difficult topics such as how to set New Zealand’s domestic emissions targets given the goal of reducing net emissions to zero, and how to incorporate methane into the target. These discussions, and the resulting decisions, laid the groundwork for subsequent public consultations in September 2018 on key ETS policy issues, such as phasing down free allocation and a strategy to incorporate the agriculture sector in the NZ ETS. The Climate Change Response (Zero Carbon) Amendment Act became law on November 13, 2019, and the Climate Change Response (Emissions Trading) Amendment Act was passed on June 16, 2020. 2.4 COMMUNICATION STRATEGY It is important to build a communications strategy place, which would harm the public’s perception of alongside the engagement and ETS design process. the ETS and may lead to opposition. Communication Communications strategies can reach a wide variety of differs from stakeholder engagement in that it places stakeholders and look to increase awareness, provide a greater emphasis on informing and awareness, while information, and build acceptance of the ETS. The stakeholder engagement focuses on the dialogue between messages conveyed in a communications campaign are policymakers and stakeholders. However, both the varied, addressing topics including the reason for the communications strategy and stakeholder engagement policy and its benefits, the impact of ETS on prices or will have lessons that can be shared between them. The preempting opposition messages. Without proactive, PMR’s Guide to Communicating Carbon Pricing provides well-considered communications around carbon pricing, extensive guidance on this topic. Box 2-5 summarizes the disinformation and negative publicity could take its key steps discussed in the guide. 46 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Box 2-5 Technical note: Communicating carbon pricing The Guide to Communicating Carbon Pricing draws on case studies, research, and best practice to provide guidance on the design and implementation of effective carbon pricing communications strategies. The Guide outlines eight steps for communications design: 1. Preparing for communications design should be done early in the process and in parallel with designing the policy. The communications design should outline what the government wants to achieve from the communications campaign and be tailored to the local context. For example, the level of polarization in politics will dictate how varied the communications will need to be between different groups. STAKEHOLDERS 2. Identifying audiences is necessary to effectively communicate to different groups. The Guide STEP 2 identifies three main audiences: internal government policymakers, priority stakeholders, and the general public. These audiences can be separated into four different segments according to their attitudes and demographics: base audiences, open audiences, opposing audiences, and disengaged audiences. Open audiences are those who have intermediate views and are open minded. They are the audience to focus on in communications because their opinion can be swayed toward favoring carbon pricing. Opposing audiences should have different strategies depending on the nature of their opposition to the policy. Those who believe there should be a response to climate change but oppose carbon pricing will need a different strategy than those who are fundamentally opposed to any response to climate change. Base and disengaged audiences are a lesser focus; however, base audiences can be encouraged by the communications. 3. Research should aim to understand the attitudes, values, and concerns of target audiences. It is important to get a mix of quantitative and qualitative research in the process. Quantitative research (for example polls and surveys) can provide a broad, population-level opinion; qualitative research (for example focus groups) can provide a deeper understanding of why people hold certain views. Research should be done in two phases, with the first being an exploratory phase to map the values and profiles of different audiences. This is followed by the second, testing phase, which assesses what communications approach works best and is a central to guiding overall communications design. 4. The messages in the communications campaign should be designed in a way that speaks to the values of the target audience(s). Communications that focus on cost and use economic terminology may not work in winning support, whereas positive narratives that speak to the audiences’ worldviews have had some success. There are two primary strategies for communications. Carbon pricing can be presented as either an effective solution to climate change or as part of a broader narrative focused on the benefits of reducing reliance on fossil fuels. When talking about carbon pricing, successful cases to date have centered on three core narratives: fairness, common sense, and a shift to clean energy. Fairness speaks to the fact that carbon pricing presents a fair way to share responsibility for carbon pollution. Common sense focuses on the balance and flexibility carbon pricing provides. A shift to clean energy emphasizes the modernizing of the energy sector with new, clean energy. Learning and building from previous communication campaigns will help ensure a successful campaign. 5. Explaining how carbon pricing works is central to dispelling public concern. Plain language must be used, with different explanations for different audiences. While explaining carbon pricing to regulated companies may be important for their future compliance, policymakers need to decide on the degree to which carbon pricing will be explained, or alternatively to focus on what the carbon pricing achieves instead, for example stimulating investment toward low-emissions technology and raising funds for government services. 6. Choosing communicators who are trusted is of central importance for effective communications. Public trust in government may be low, with trusted peer communicators allowing engagement to increase support of the carbon pricing by tapping into the social cues used to form decisions on topics that people do not fully understand. Equally, governments may not be expert communicators, focusing more on the technical design and solutions. Having communicators outside government can help depoliticize issues and can help get buy in from a broader audience, giving policymakers time to help rebuild trust in government. For instance, conversations around early ETS design elements or involving certain sectors could be done by non-governmental groups. Targeting specific groups will require using trusted individuals within that group.  STEP 2: ENGAGE STAKEHOLDERS, COMMUNICATE, AND BUILD CAPACITY 47 7. Integrating communications with policy enables governments to design carbon pricing that is communicable and ensures coherence between policy and narratives. Engagement with ministers, legislators, and relevant government departments is crucial for building broad support for carbon pricing and developing a coordinated and consistent position on carbon pricing within government. External consultation with stakeholder groups, for example industry, and civil society provides a way of testing how acceptable the policy is and the reaction to the communication narratives given to support the policy. Public consultation can be beneficial in cases where development of the carbon price is expected to become a high-profile issue. 8. Designing a communications campaign. This is discussed step by step in the Guide. STAKEHOLDERS The guide provides tips for successfully communicating carbon pricing. These include: STEP 2 S Incorporate communications throughout the process: Strategic communications should be considered equal to the policy design and thus incorporated throughout the process. S Set clear objectives: These will guide the communications strategy. S Define and engage priority audiences across the political spectrum: Early definition of the audiences will inform the communications strategy and help build the narrative. S Base communications on robust research: This will help understand different audiences and the best strategies. This research should include a testing phase to avoid counterproductive communications. S Be consistent: The narrative and framing of communications should remain consistent throughout and stay tied to the objectives to avoid undermining the integrity and trust in carbon pricing. S Keep it simple: Public discussion should refrain from technical language to keep the communications accessible. S Anticipate opposition early: Strong opposition can severely undermine carbon pricing policy. Identifying opposition early and designing communications to avoid generating opposition is therefore important. S Engage and listen to stakeholders: This can help design and revise the policy and communications strategy, as well as providing information on where the policy may be challenged. S Use trusted messengers: These will have detailed knowledge on the needs and concerns of different audiences that can be used to develop trust in the policy. In avoiding unsuccessful strategies, the guide outlines the following framing to avoid: S Cost: Narratives built on cost appeal only to economic audiences and are unnecessarily negative in their framing of carbon pricing. Instead, communications should focus on the positive benefits. S Expert consensus: There is no evidence that this is an effective strategy for the wider public, and in other fields there are cases where overreliance on expert consensus was counterproductive. Expert support may be effective with specific stakeholder groups. S Threat of climate change: If climate change is seen as a contentious issue, communications can instead focus on other benefits that arise from carbon pricing, like reductions in air pollution and generating jobs. 2.5 STAKEHOLDER ENGAGEMENT PROCESS MANAGEMENT Once the stakeholder engagement process is underway, 2.5.1 RISK MANAGEMENT sound management must keep the activities on course. Stakeholder engagement can give rise to risks. Proactively Policymakers need to manage risks (Section 2.5.1), ensure identifying potential risks and responding rapidly to transparent outcomes (Section 2.5.2), and finally evaluate risks that eventuate can help ensure the effectiveness of and review the overall process (Section 2.5.2). engagement activities. Box 2-6 provides an example of how Mexico’s stakeholder engagement managed these risks. The types of risks that must be managed include 48 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION S Procedural risks. Some stakeholders may feel reporting. Table 2-1 outlines the common assertions overlooked or marginalized, statutory obligations against ETSs that may proliferate. may not be adhered to, or formal processes may be S Legal challenges. Stakeholders whose concerns are not disrupted by opposing entities. fully addressed may choose to challenge the government S Political risks. Formal engagement activities can raise on legal grounds. Litigation can block or delay ETS the public profile of issues and create focal points for implementation. The government should thoroughly public opposition and demonstrations. assess the legal context in which it is operating, and any S Communication risks. Misinformation can be potential for legal challenges regarding the ETS. Box 2-7 disseminated through inaccurate media or stakeholder discusses California’s experience of legal disputes regarding its Cap-and-Trade Program. STAKEHOLDERS STEP 2 Table 2-1 Assertions against an ETS and possible counterarguments Assertion Response supporting an ETS Notwithstanding their benefits, all emission reduction policies impose costs on emitters and therefore on the economy. This cost, however, needs to be weighed against the likely severe long-term cost of inaction against climate change and the local benefits of these policies. By providing a single and clear price signal to An ETS imposes regulated entities, a well-designed ETS can deliver targeted emission reductions at a lower cost than other additional costs on the interventions, such as command-and-control policies or technology standards that target the same level of economy. emission reductions. Moreover, it can incentivize regulated entities to innovate, making them more productive in the long run and reducing their costs. Compared to other policies, an ETS can save money for regulated entities as they can choose how to reduce their emissions. A carbon tax is better A carbon tax and an ETS each have strategic merits and differences that should be individually considered by than an ETS. each jurisdiction based on its own domestic circumstances (see Step 1). Emissions trading An ETS limits the system’s total emissions but leaves it up to individual regulated entities to decide whether it allows polluters to avoid is better for them to reduce their emissions or purchase allowances to comply with their obligations under the responsibility for reducing system. Entities that choose not to reduce their emissions always bear the full cost of that decision by having their emissions. to purchase an allowance at the market-determined price. Though not a necessary part of an ETS, a well-designed offset program with a high degree of environmental Polluters can simply integrity can provide additional flexibility and help regulated entities manage their costs (for more information surrender offsets and buy on offset programs see Step 8). It can support emissions reduction activities domestically and internationally their way out. in sectors and jurisdictions not covered by an ETS. All current ETSs place an upper limit on the use of offsets for compliance, which ensures that most of the abatement occurs inside the scope of the ETS. An ETS can avoid or mitigate adverse and disproportionate impacts on emissions-intensive, trade-exposed An ETS will place industries during the transitional period before carbon pricing is more widespread among trade competitors. businesses’ Free allocation of allowances, price or supply adjustment measures, and incremental changes to the cap competitiveness at risk can all help address business competitiveness and carbon leakage risk. Importantly, an ETS provides and send production financial advantages to firms that improve their emissions intensity and innovate. This can help improve their overseas. competitiveness in the longer term, especially as carbon regulations and climate policy develop around the world. Well-targeted free allocation, whether permanent or temporary, can help firms and other affected entities Free allocation is adapt more smoothly and gradually to carbon pricing. It can reduce pressure to shift production and a subsidy from the investment offshore and prevent job losses in the regulated jurisdiction or sector. The share of free allocation government to polluters. is generally reduced over time as ETSs mature and the incentive to reduce emissions is maintained (see next argument). Free allocation in an ETS is not considered a subsidy under international trade rules. Participants who receive Free allocation helps recipients manage the costs of ETS obligations while maintaining the economic free allocation have no incentive to reduce emissions. If participants do not reduce emissions, they have to buy allowances if their incentive to reduce their share of free allowances is insufficient. They also lose the opportunity cost of not being able to sell their emissions. allowances as they need them for compliance. Market mechanisms As with all forms of regulation, an ETS requires strict monitoring and enforcement to maintain environmental cannot be trusted to solve integrity. While an ETS alone will not solve the market’s failure to price the environmental impacts from the problems created by emissions, a well-designed, sufficiently stringent market mechanism is a critical component of the solution. market failures. ETSs are unfair and Small emitters may indeed face relatively higher transaction costs when complying with ETSs. However, administratively jurisdictions generally have addressed this when designing the scope and compliance mechanisms of the burdensome for smaller ETS (see Steps 3 and 7). emitters. STEP 2: ENGAGE STAKEHOLDERS, COMMUNICATE, AND BUILD CAPACITY 49 Mexico engaged in extensive stakeholder consultations Mexico handled some of the risks of stakeholder prior to the launch of its ETS. Box 2-6 illustrates how engagement. Box 2-6 Case study: Stakeholder engagement in the lead-up to the introduction of ETS in Mexico Stakeholder engagement was a key component in developing the Mexican ETS pilot. It allowed regulated entities to be part of the design of the instrument and raised support and trust in a measure that is now a central component of Mexican climate policy. The engagement process began in 2016, when the Ministry of Environment (SEMARNAT) announced plans to implement an ETS. This announcement led to informal meetings between SEMARNAT and representatives from STAKEHOLDERS sectors likely to be covered by the ETS, such as the steel, cement, mining, and chemical industries. Initial reactions STEP 2 by the private sector were critical and negative. In response, SEMARNAT emphasized the importance of sectorial contributions and the fact that the reality of the Mexican Nationally Determined Contribution ruled out the possibility of inaction. By 2018, SEMARNAT consolidated the engagement process into a working group with private-sector representatives to maintain a continuous dialogue on policy design. The working group met frequently, allowing regulators to identify industry concerns and incorporate their comments and suggestions into the draft ETS regulations. Private-sector support for the ETS grew to the point that, when a new administration took office in 2018, industry representatives supported the implementation of the pilot ETS. As the Mexican pilot is implemented, stakeholder engagement will continue: the ETS regulation establishes a consultative committee that was installed in June 2020 with the objective of supporting SEMARNAT in issuing recommendations on ETS design, evaluating the pilot phase, and other tasks. Throughout this process, SEMARNAT — with the support of the PMR and the German Corporation for International Cooperation — commissioned a wide range of studies on technical ETS aspects, such as cap setting, policy interactions, carbon leakage risks, offsetting mechanisms, and ETS evaluation, among others. These studies have been fundamental not only to building on international best practices and adjusting policy design to the national context, but also as an additional channel of engagement with the private sector and, importantly, with other stakeholders within the Mexican government. The studies were also important within the government in the final stages of ETS policy approval and preparations for the implementation of the ETS, as they helped maintain institutional memory on policy choices. Several capacity-building activities were also carried out, including an eight-month-long ETS simulation exercise with key emitters, workshops for regulated entities, training programs for government officials, and study trips to learn from international experience. Altogether, the stakeholder engagement process is seen by both policymakers and private-sector representatives as a mechanism to find common ground and to position the ETS as a feasible option for GHG mitigation in Mexico. 50 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Legal challenges are fair more likely when ETS are Box 2-7 discusses California’s experience of legal disputes introduced in a politically contentious environment. regarding its Cap-and-Trade Program. Box 2-7 Case study: Overcoming legal challenges: The case of the California Cap-and-Trade-Program In California, political disputes led to lawsuits challenging the Cap-and-Trade Program, as well as a political referendum. However, the strong record that California created over years of planning, learning, and outreach, which carefully identified each decision and why it was reached, provided a strong foundation for defending these challenges. California has ultimately prevailed in every legal challenge adjudicated to date. Three of the key legal challenges include: STAKEHOLDERS S Initial Scoping Plan Challenge. In 2009, a coalition of environmental justice groups, which favored a carbon STEP 2 tax over cap and trade, brought a lawsuit challenging whether California’s proposed approach laid out in the Scoping Plan would adequately protect low-income, pollution-burdened communities as required by Assembly Bill (AB) 32.74 After first requiring further analysis under the California Environmental Quality Act, the court ultimately declared the authority of CARB under AB 32 as broad and sufficient to encompass the cap and trade approach. While many environmental justice groups still have concerns, equity issues have been further addressed by ensuring that at least 35 percent of all revenue from the Cap-and-Trade Program benefits low-income, pollution-burdened communities. S Offsets Challenge. In 2012, the Citizens Climate Lobby and Our Children’s Earth Foundation challenged the use of offsets under California’s Cap-and-Trade Program, claiming the design of the Cap and Trade Regulation and Compliance Offset Protocols did not conform to statutory and regulatory requirements, particularly related to permanence and additionality. In 2013, the state trial court ruled in favor of California, offering unequivocal support for the legality of the offset program. After an appeal by Our Children’s Earth, the state appellate court upheld the trial court’s ruling. The California Supreme Court denied a petition for review. S Auctioning or “Cap and Trade vs. Taxes” Challenge. Lawsuits filed by the California Chamber of Commerce and the Morning Star Packing Company, an entity regulated by the Cap-and-Trade Program, were consolidated into a single legal challenge in 2013 alleging that auctioning allowances exceeded the authority delegated to CARB in designing a market-based mechanism to tackle greenhouse gas emissions. Furthermore, they claimed that the revenues generated at auction amounted to a tax, which violated the necessary legislative requirements for the enactment of taxation. In 2017, California’s Third District Court of Appeals ruled in favor of CARB, upholding its authority to auction emission allowances in its Cap-and-Trade Program and rejecting the interpretation that the auctioning system constituted a tax. The California Supreme Court denied a petition for review. S Linking Challenge. In 2019, the US federal government filed a lawsuit in the federal district court for the Eastern District of California challenging the constitutionality of California’s linkage of its Cap-and-Trade Program with the Province of Québec’s cap and trade system. The lawsuit claimed that the linkage of California’s and Québec’s cap and trade programs violated the US Constitution for four reasons: the linkage regulations and agreement violated the US Constitution’s Treaty Clause, the Compact Clause, the Dormant Foreign Commerce Clause, and the Foreign Affairs Doctrine.75 Over the course of two briefing schedules in early and mid-2020, the federal district court ruled in favor of California on all claims. The United States may still appeal the district court’s decision. 2.5.2 TRANSPARENCY AND REVIEW should ensure that it is accountable to stakeholders and the public for its response to this information. Transparency is an important component of stakeholder engagement. It helps ensure that stakeholders have Stakeholder engagement also requires evaluation and confidence that their concerns are considered in the review. This can follow standard guidelines of evaluation design and operation of the ETS. However, creating a and review of government activities. Good practices platform for discussion is not sufficient in and of itself. For can include facilitators seeking immediate feedback engagement to be credible, the information obtained from after meetings with stakeholders, and surveys among the engagement should be documented transparently ETS participants to solicit feedback on the stakeholder by policymakers and the planned use of the information engagement process. should be made clear to stakeholders. The government 74 The environmental justice movement started in the United States in the 1980s and is a social movement that focuses on the fair distribution of environmental benefits and burdens, recognizing that low-income and minority communities have traditionally born disproportionate pollution burdens. 75 US Department of Justice 2019. STEP 2: ENGAGE STAKEHOLDERS, COMMUNICATE, AND BUILD CAPACITY 51 2.6 CAPACITY BUILDING Designing and implementing an ETS will require capacity account, acquiring and trading allowances, managing building, particularly in jurisdictions unfamiliar with market the accounting and tax implications of ETS obligations, mechanisms for climate mitigation. This section covers and hedging against new risks and uncertainties.77 key capacity-building needs (Section 2.6.1), possible S Other market participants will need the capacity approaches to meeting those needs (Section 2.6.2), the to analyze the implications of government decisions possibility of introducing pilot or voluntary systems first on the marketplace, design facilitative services, and (Section 2.6.3), and the necessity to evaluate and review engage in the development of supporting processes capacity-building activities (Section 2.6.3). STAKEHOLDERS and institutions such as offsets mechanisms, trading exchanges, and third-party verification of entities’ STEP 2 emissions reporting. Legislators will need to understand 2.6.1 IDENTIFYING CAPACITY-BUILDING the implications of decisions on ETS and other NEEDS environmental legislation to effectively represent the interests of their constituents. “Capacity” is the specialized understanding, skills, institutions, processes, and resources required to design and implement an ETS. All stakeholders will need 2.6.2 METHODS AND TOOLS FOR the capacity to make informed judgments about the CAPACITY BUILDING acceptability of an ETS and the degree to which they will be involved or affected. This requires familiarity with the After assessing the current capacity of relevant objectives of the ETS, its design features, and its potential stakeholders, policymakers can identify the gaps that need impacts.76 There is a need to build capacity early in the to be filled. A program for ETS capacity building can be process so stakeholders can effectively engage in the policy designed based on a gap analysis. This program can build design process. A deeper level of understanding will be on existing ETS materials and tools from other jurisdictions required for those more closely involved in design, decision- and organizations; governments do not need to start from making, implementation, and technical advice. For example: scratch. Key elements may include: S Government departments involved in ETS design S providing basic educational materials with plain- and implementation will need the capacity to fulfil new language information about ETS design, impacts, and functions, such as obligations;78 z identifying and evaluating ETS design options; S developing guidelines and technical documentation z draftingETS legislation, regulations, and technical through a process of participant input and review to guidelines; ensure they are comprehensible and practical; S holding workshops and events that create an z administering core ETS functions, including cap setting, allocation, monitoring, reporting, verification, opportunity for information sharing; enforcement, verifier accreditation, registry, and S providing training to staff who will be involved in record keeping; ETS-related activities; z designing and administering offset mechanisms, if S running ETS simulations to provide experience with applicable; trading and compliance in a controlled setting made to z managing ETS fiscal implications and impacts be as realistic as possible (see Box 2-8); on other government policies, measures, and S engaging researchers to help develop an ETS design administrative systems; and tailored to the local context, based on experiences z negotiating linking agreements, if applicable. gained elsewhere; and S encouraging learning from other systems by S Regulated entities will need the capacity to fulfil their engaging those with prior experience in ETS design. obligations under the ETS for MRV and unit surrender. Study tours and inviting outside experts to present can They will also need to develop new skills and processes be helpful in showing stakeholders how other ETSs are for factoring carbon prices into business decisions, operating. The PMR, ICAP, and other organizations, developing overall mitigation and investment strategies, as well as donor countries, can assist with capacity applying for free allocation, operating a registry 76 Hausotter and Mehling 2012. 77 For case studies on companies’ practical experience in preparing for emissions trading, see PMR (2015e). 78 See, for instance, the ICAP ETS Briefs, short leaflets that are available in several languages from the ICAP website at www.icapcarbonaction.com, which provide a general overview of the basics of ETS design, arguments for emissions trading, and information about the systems in operation and under planning worldwide. 52 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION building through information resources, technical provides an example of how these resources were used training, and country-to-country exchanges. Box 2-9 in China. Box 2-8 Technical note: ETS simulations for capacity building Carbon market simulations are programs, models, virtual environments, and/or games that allow stakeholders to participate in a fictitious process of designing or participating in an ETS.79 A number of jurisdictions have used them as a relatively low-cost tool to engage, train, research, and test designs, particularly in the early stages of carbon market development. Most ETS simulations are designed as “games” where participants assume specific roles and enact trading in a market or simulate a policy design process. While some simulations are developed for one specific STAKEHOLDERS user group others target multiple ETS stakeholders including industry, government, academia, and civil society. Most simulations to date focus on either ETS policy design, where participants take on various stakeholder roles to simulate STEP 2 the design and engagement process, or trading, in which participants simulate trading and compliance obligations for regulated companies. Over the years, simulations have taken place nationally in Brazil, China, Turkey, the EU, the Nordic region, Germany, Mexico, Japan, and Korea, as well as at the subnational level in Alberta and California. The experiential learning for participants from these exercises increases ETS literacy and illustrates how policy outcomes are a function of design. Simulations can also strengthen relationships among key stakeholders and help build support for emissions trading as a policy option. Finally, simulations provide participants with a safe and risk-free opportunity to try out new ideas, make mistakes, and draw lessons that can serve to speed the adoption of effective ETSs. Box 2-9 Case study: Building capacity for the Chinese national ETS While building capacity is a key step to the launch of any domestic carbon market, the challenge has been nowhere as big as it is in China, the world's largest ETS. Already in its initial phase, the Chinese carbon market will cover more than 2,200 companies. All participating entities need in-house expertise on emissions management, abatement options, and how to comply with the system. The same is true for officials at the national level, who assume policy coordination, and in the provinces, who are responsible for allowance allocation and enforcement. Various actors contribute to supporting capacity development in China, including the PMR, the EU, the German government, the Asian Development Bank, ICAP, the Environmental Defense Fund, the Energy Foundation, and the governments of Norway, the United Kingdom, and the Netherlands. Initial capacity-building efforts focused on supporting the Chinese ETS pilots and included bringing in experiences and lessons learned from existing ETSs into specific local and regional contexts. The experiences from the pilots and the capacity built there in turn helped inform discussions and progress preparations for the national system. Overall, capacity-building efforts have contributed to knitting together different pieces of knowledge, both international and domestic, to support the development and implementation of the national ETS as well as identify knowledge gaps. The shift in responsibilities for the national ETS from the National Development and Reform Commission to the Ministry for Ecology and Environment in 2018 proved a temporary damper on the rollout of capacity building across China. Many actors who had been trained for assuming roles in management of the ETS at national and provincial levels were no longer responsible for this issue, and new counterparts required renewed capacity building. At the end of 2019, the Ministry for Ecology and Environment coordinated a large-scale capacity-building initiative focusing on the National ETS Allowance Allocation Plan and other ETS policies. The objective was not only to enable all participants’ understanding of allowance allocation standards, but also to receive their feedback for the sake of continuous improvement of China’s national ETS allocation methods and overall design. Nearly 5,000 participants were trained in seven weeks at 17 training sessions across China, enhancing the readiness of public and private- sector stakeholders to engage in the construction and ultimately operation of the Chinese national ETS. Taken together, the Chinese experience illustrates that capacity building remains relevant well beyond the launch of a system, using multiple formats and methods, and gradually shifting from international expertise-sharing to domestic stakeholders acting as multipliers, thus consolidating and broadening the domestic knowledge base. 79 ICAP and Carbon Pricing Leadership Coalition 2020. STEP 2: ENGAGE STAKEHOLDERS, COMMUNICATE, AND BUILD CAPACITY 53 2.6.3 EVALUATION AND REVIEW in the process of continuous improvement of the ETS. In the longer term, standardized ETS capacity-building Evaluation and review of capacity-building programs activities can become part of the routine training for new can be a valuable exercise. Capacity-building needs staff in both government departments administering the will evolve as ETS development moves from scoping to system and entities fulfilling ETS obligations. There may be design, authorization, operation, review, and amendment. a place for learning by doing through a pilot or voluntary Collecting information within and outside of government ETS while regular reviews and independent evaluation of on the effectiveness of capacity-building activities and an ETS will also support learning. These are discussed in materials, as well as remaining gaps in capacity, can assist Step 10 of the handbook. STAKEHOLDERS STEP 2 2.7 QUICK QUIZ Conceptual Questions 1. Why is it important to engage with stakeholders throughout development of an ETS? 2. What are different methods of engagement that could be used during development of an ETS? Application Questions 1. What would be the key stakeholder groups to engage with in your jurisdiction? What would be their key interests? 2. What type of capacity building would be needed to build sufficient understanding and acceptance of climate change market mechanisms for decision-making on an ETS by key government and other stakeholders? 3. Who might be potential “champions” of an ETS both within government and outside of government? 2.8 RESOURCES The following resources may be useful: S Guide to Communicating Carbon Pricing 54 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION STAKEHOLDERS STEP 2 This page intentionally left blank. STEP 3: DECIDE THE SCOPE 55 Step 3 - Decide the scope STEP 3 Decide the scope At a Glance_____________________________________________________________________________ 56 3.1 Introduction_______________________________________________________________________ 57 3.2 Scope design______________________________________________________________________ 58 3.3 Scope considerations in practice___________________________________________________ 66 3.4 Quick Quiz________________________________________________________________________ 76 3.5 Resources________________________________________________________________________ 76 STEP 3 SCOPE BOXES Box 3-1 Technical note: Regulation and behavioral impacts______________________________ 62 Box 3-2 Case study: Upstream regulation______________________________________________ 63 Box 3-3 Case study: Electricity imports in the California Cap-and-Trade Program__________ 67 Box 3-4 Technical note: Emissions trading in jurisdictions with regulated electricity market_____________________________________________________________________ 68 Box 3-5 Case study: Inclusion of the commercial building sector in Asian ETSs____________ 70 Box 3-6 Case study: EU aviation and international measures to regulate aviation emissions__________________________________________________________________ 72 Box 3-7 Case study: Deforestation in the New Zealand ETS______________________________ 74 Box 3-8 Case study: New Zealand and agricultural emissions____________________________ 75 FIGURES Figure 3-1 Sector coverage by ETS______________________________________________________ 59 Figure 3-2 Cost pass-through at different points of regulation______________________________ 61 Figure 3-3 Examples of market concentration across sectors______________________________ 62 Figure 3-4 Variation in thresholds across selected jurisdictions (metric tons CO2e/year)_______ 65 Figure 3-5 Abatement channels under a carbon price signal in liberalized electricity sectors with full cost pass-through____________________________________________ 69 TABLES Table 3-1 Gases covered in existing ETSs_______________________________________________ 60 Table 3-2 Decisions on scope__________________________________________________________ 66 56 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION AT A GLANCE compliance can be enforced most easily, and where Checklist for Step 3: Decide the scope regulation can generate a price signal that incentivizes ✔ Decide which sectors to cover behavioral change (either directly or through cost pass- ✔ Decide which gases to cover through). While measurement of emissions is usually most accurate at the point where GHGs are released ✔ Choose the points of regulation into the atmosphere (the “point source”), there are ✔ Choose the entities to regulate and consider good reasons to regulate emissions further up or lower whether to set thresholds down the supply chain (“upstream” and “downstream” ✔ Choose the point of reporting obligation respectively). The administrative costs of monitoring emissions are usually lowest at the point where the The scope of an emissions trading system (ETS) refers to supply chain is most concentrated (i.e., where the the sources of emissions and types of GHGs covered by fewest firms operate). In some markets, particularly the the system. Decisions about scope are some of the most energy sector, this will be upstream; however, this may differ by sector. Regulating closer to the point source STEP 3 SCOPE critical design elements of an ETS. of emissions may involve higher transaction costs if the There are several arguments in favor of making the scope supply chain is more diffuse. However, these additional of an ETS as broad as possible. A broad scope means the costs may be mitigated if there is existing regulatory ETS encompasses a greater portion of the jurisdiction’s infrastructure in place, such as existing emissions emissions, providing more certainty on attaining jurisdiction monitoring and reporting requirements for other air emission targets. It can also have several additional benefits pollutants. Hybrid designs are used in many ETSs, where including lowering the overall cost of emissions reductions certain sectors are covered at the point source, while to society, reducing compliance costs for entities, reducing others may be covered upstream or downstream of the competitiveness impacts between sectors, and improving emissions source. Selecting the point of regulation also the depth and performance of the secondary market. requires careful consideration of carbon leakage risks, other competitive distortions, and distributional effects. On the other hand, an ETS with a broad scope can involve S Should there be emissions thresholds to avoid higher administrative costs because of the higher number including too many small entities? Thresholds are of entities involved. This trade-off can be managed by commonly used to help reduce compliance costs for instating a minimum level or threshold, so that only entities small entities, as well as lower the administrative costs of a certain size are covered by the ETS. This excludes of operating an ETS. However, a desire to reduce costs small emitters and lowers the administrative burden. must be balanced against the fact that thresholds Additionally, the point of regulation, or the part of the reduce the number of actors incentivized to reduce supply chain at which emissions must be monitored and emissions, thereby forgoing some of the environmental allowances surrendered, can be placed where there are effectiveness of the ETS. Thresholds may also cause the fewest number of firms. Expanding the ETS to sectors competitive distortions between entities on either side with comparatively high marginal abatement costs should of the threshold. Any threshold needs to be calibrated also be carefully considered, as it can result in significant to jurisdiction-specific factors. Opt-in provisions can distributional effects and may be better addressed by an offer some flexibility. alternative policy instrument. S Where should the reporting obligation be placed? Consideration of the scope of an ETS raises the following A further important design characteristic concerns important questions: who is legally responsible for complying with the ETS S Which sectors and gases to include? In general, it is regulations, that is, for surrendering to the regulator preferable to include sectors and gases that account for an allowance for each ton of emissions. The choice a significant share of greenhouse gas (GHG) emissions, depends on which entities can be held legally liable provided those emissions can be monitored easily. and where data is available and auditable. Often these Often, the areas worth including in the scope are those factors depend on existing regulatory structures. where there is otherwise insufficient financial incentive The ETS scope may evolve over time to reflect the to reduce emissions and where co-benefits may be jurisdictional context, including changes in ambition, realized from achieving emission reductions. capacity, or the role of the ETS in the policy mix. S At what point should regulation be introduced? Policymakers will also need to integrate lessons learned Emissions should be regulated at a point where they from implementation, which might involve changes to can be monitored accurately with low uncertainty, scope (see Step 10). STEP 3: DECIDE THE SCOPE 57 This chapter considers the sources of emissions and types questions that policymakers need to address. Section 3.3 of GHGs that might be covered by an ETS and how their examines some of the specific issues that are likely to arise regulation might be affected. Section 3.1 introduces the when considering covering certain emissions sources. issue. Section 3.2 considers some of the general design 3.1 INTRODUCTION The scope of an ETS refers to the sources of emissions uncovered sector as a result of product substitution, and types of GHGs covered by the system. Decisions without the desired abatement action. about scope are some of the most critical design elements S Market operation. A broader scope may improve the of an ETS. operation of the resulting carbon market: a greater number of (diverse) trading entities in a market generally STEP 3 SCOPE A number of factors point toward considering as broad a makes for higher liquidity, a more stable price, and scope as possible. The advantages of a broad coverage a reduced potential for any one entity to gain market include: power.80 S Certainty on predefined emissions target. By ensuring coverage is broad (i.e., more emissions However, there are four key reasons why broad coverage are included in the ETS cap), policymakers can be may not be appropriate: more confident about meeting a predefined national 1. Transaction and administrative costs. Despite emissions reduction target. economies of scale associated with broad coverage, S Enhanced cost efficiency. Including a larger number of technical and administrative barriers can make a sectors increases the potential to achieve cost-effective broad scope infeasible — the logistics and cost of emissions reductions because there is a wider array of monitoring emissions in particular differ across sectors abatement options (with varying costs). This increases and sources (which do not scale easily). Benefits of the probability of entities being able to achieve gains broad coverage may be outweighed by administrative from trading emissions allowances (see Step 1). or other monitoring, reporting, and verification (MRV) Including as many sectors as possible might also have costs faced by the regulated entities and the regulator. some positive economies of scale, where administrative 2. Distributional challenges. Including sectors with costs can be spread across a larger number of entities, comparatively high marginal abatement costs in an ETS reducing the cost per regulated entity. could result in undesirable distributional effects. This is S Intersectoral competitiveness impacts or domestic because compliance costs may end up concentrated leakage. Broad coverage can reduce the likelihood of in sectors that are not able to achieve a reasonable competitiveness impacts that may arise if one sector degree of cost pass-through. The political and social or type of emitter is included but another is not. These implications of these distributional effects need to be distortions are most likely to occur between products carefully considered when deciding on the scope. that can be easily substituted for one another. For 3. Carbon leakage risk. While a broad scope minimizes example, steel and aluminum may be substitutable the risk of domestic leakage, coverage of certain building materials, and gas and oil could be substituted industrial sectors may put emissions-intensive, for electricity generation. Substitutions may also trade-exposed entities at risk of carbon leakage arise because of technology change — for example, internationally. If some jurisdictions regulate emissions electrification of transport or the development of the but others do not, there is a risk of production wood-pellet industry. While substitutions away from relocation or changes in investment patterns to emissions-intensive industries and processes are an unregulated jurisdictions.81 This can have undesirable intended result of an ETS, those that arise only because economic, environmental, and political consequences. one sector is included in the ETS but another is not However, these concerns can be addressed, including may be undesirable and distortive. They may result in by establishing transitional free allocations for sectors emissions simply “leaking” from a covered sector to an particularly susceptible to international carbon leakage, or in the extreme case, excluding the sector from the 80 Geographic extension of the ETS through linking can also lessen competitiveness impacts and improve market operation; see Step 9 – Consider Linking. 81 A detailed discussion of leakage issues is given in PMR 2015g. 58 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION scope of the ETS. A further discussion on carbon entities while maintaining sectoral scope) can help manage leakage and tools to address it is provided in Step 5. this trade-off. Hence, there are four key questions that 4. Complexity of regulatory environment. In most if not policymakers need to consider when determining the all jurisdictions, some sectors will already be subject scope of the ETS: to other policies and measures aimed at reducing S What sectors or emission sources will the ETS cover? GHG emissions. The combination of existing policies S What should the points of regulation be in those and measures with an ETS might lead to a regulatory sectors? environment that is overly complex. However, ongoing S What is the emissions threshold below which an entity reviews of, and updates to, the policy mix to maximize should not be regulated by the ETS? mitigation is still desirable. S With whom does the compliance responsibility lie: Policymakers must balance the benefits of broader companies or installations or a combination of both? coverage against the additional administrative effort and transaction costs when deciding on the scope of an ETS. The ETS scope may evolve over time to reflect the They must also consider the effectiveness and availability jurisdictional landscape, including changes in ambition, of alternative or companion policies. Design features such capacity, or the role of the ETS in the policy mix. as using thresholds to exclude small emitters and placing Policymakers will also need to integrate lessons learned STEP 3 SCOPE the point of regulation at the most concentrated part of the from implementation, which might involve changes to supply chain (therefore reducing the number of regulated scope (see Step 10). 3.2 SCOPE DESIGN This section discusses factors policymakers must consider sector coverage, with a focus on including sectors that when deciding the scope of an ETS: account for significant shares of emissions. S sector and gas coverage, S Currently available and future mitigation options. S point of regulation, While some sectors may seem to have more low-cost mitigation options, this is hard for regulators to S threshold, and understand and predict. This difficulty is one of the S level of reporting obligation. major justifications for using carbon pricing: it allows businesses to find the cheapest solutions based on Effective governance of an ETS involves a regular review industry knowledge, and incentivizes innovation. In of design choices. Accordingly, the scope might be the longer run, abatement options are even harder to expanded or revised in future periods. It is possible, and predict, and all sources need to reduce emissions to even prudent, to start with a narrow scope that is later achieve the global goal of net zero emissions. If short- expanded and deepened as capacity among businesses term mitigation opportunities seem to be expensive and and regulators increases. scarce, the sector may be a good target for research and development assistance to unlock its abatement 3.2.1 SECTOR AND GAS COVERAGE potential. S Market structure (i.e., number and size of emitters). Differences across sectors and emissions sources can To be effective, an ETS requires that emissions can be affect the extent to which they are worth covering within an measured and monitored with low uncertainties and ETS. Important considerations include: at reasonable cost. Covering sectors dominated by a S The share of a jurisdiction’s GHG emissions a small number of large regulated entities can provide high sector represents. The benefit of including a sector benefits relative to administrative effort. These emitters depends on the proportion of emissions it accounts can be included, while smaller emitters can be excluded for. In many industrialized countries, for instance, land (for example, through minimum emission thresholds). By use or waste may account for less than 5 percent of contrast, covering sectors composed of many small or GHG output while power and industry account for 40 diffuse emission sources may involve high administrative or 50 percent. Conversely, in developing countries or costs relative to benefits. The waste sector is a typical developed countries with a large agricultural sector (like example. It often consists of a number of small landfills New Zealand), land use might account for a significant accepting waste from local communities. Tracking the share of emissions. These jurisdiction-specific emissions from each landfill and holding owners of small circumstances must be considered when determining landfill sites accountable can increase the regulatory STEP 3: DECIDE THE SCOPE 59 burden of the system. However, in some sectors, such primarily benefit urban areas. While the mitigation as transport, it might be possible to regulate emissions benefits alone might be insufficient to justify the cost higher up in the supply chain, where the number of of including a particular sector in the ETS, factoring in market players is smaller. The transport sector is difficult co-benefits could tip the scale in favor of covering it. to cover at the point source of emissions (for example S Regulatory environment. If the regulatory at the level of each vehicle), but emissions can be arrangements for certain sectors do not allow the regulated upstream (for example at the fuel distributor reflection of carbon prices for operational or investment level, as is the case in California’s and Québec’s ETSs). decisions, these sectors might be of secondary S Regulation and transaction costs. Some sectors might importance for the scope of an ETS. The electricity be particularly cost-effective and easy to regulate due to sector is a possible example, where existing regulations existing data on emissions and MRV infrastructure. Even might require careful consideration of carbon pricing when these sectors account for only a small share of design (see Section 3.3.1). emissions, they can be included with little additional cost. Figure 3-1 shows the global experience in terms of sector S Co-benefits of coverage. Co-benefits can also play coverage. It shows that nearly all ETSs globally cover an important role when determining sectoral coverage. electricity generation and industrial emissions — both Although the benefits from GHG emission reductions are process emissions (for example from cement and steel) STEP 3 SCOPE completely independent of the location of the reductions, and emissions from fossil fuel combustion in industry. many co-benefits are location specific. For instance, Coverage of emissions associated with building use is co-benefits from covering road transport may include relatively common, while road transport and domestic reduced air pollution or traffic congestion, both of which Figure 3-1 Sector coverage by ETS A UNI RNI TED IFO KIN CAL A TO IN GDO KY CH O * M Forestry SW SE ITZ * INE S ER LA CH ILOT N an , Fuji ang- P D Gu g, Waste g , d on ghai, ijin i, an Be ngha n Sh njin a e Tia g, i, Sh enzh ijin h Be ngha n S a Sh nzhe Domestic Sh e Aviation SAITAM A EU ETS Sectors Transport covered * * tive) as Initia Green house G egional GERMA Buildings RGGI (R NY Industry REA KO * KA OF Z AK L IC * HS EP UB * TA N Power R * MA * SS AC * H EC US ÉB IA ET NEW ZEALAND * COT QU TS MEX VA S NO ICO * indicates which sector represents upstream coverage Note: Agriculture is a major source of biological emissions; however, the sector does not yet face direct compliance obligations under any existing ETS. Currently, in New Zealand, agricultural emissions must be monitored and reported under the ETS, and some offset programs (e.g. California) allow for offset projects in the sector. Adapted from ICAP 2021. 60 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION aviation are less so. Only a minority of ETSs cover (GWP) of a gas combines both radiative efficiency and emissions from waste or activities in the forestry sector. how long the gas stays in the atmosphere into a score, calculated relative to carbon dioxide, which has a GWP The decision on which sectors to include is closely related of 1. For example, methane, which has a high radiative to the question of which gases to include. Considerations efficiency but short lifetime, has a GWP of 28 over 100 are broadly the same: increasing the scope increases the years; for nitrous oxide the GWP is 265 over 100 years.82 possibility for low-cost abatement and jurisdiction-wide environmental certainty. However, depending on the local emissions profile, these benefits may be exceeded by the 3.2.2 POINT OF REGULATION administrative cost. Table 3-1 shows the range of choices Once policymakers decide to include a sector or source of made by current ETSs in terms of gas coverage. emissions in an ETS, a critical design feature is the point at which those emissions are regulated. There are several Table 3-1 Gases covered in existing ETSs points in the supply chain at which emissions can be regulated. These include: Jurisdiction CO2 CH4 N2O HFCs PFCs SF6 NF3 S At the source of emissions. This is where the California ● ● ● ● ● ● ● GHGs are physically released into the atmosphere. STEP 3 SCOPE The European Union (EU) ETS, for example, covers China national and pilots* ● emissions at the point source by regulating power generation and industrial facilities.83 EU ● ● ● S Upstream. This is a point in the supply chain before Kazakhstan ● the point source of emissions. It is often used for Massachusetts ● energy emissions, where a fossil fuel is covered at the point at which it is first commercialized by extractors, Mexico Pilot ● refiners, or importers. For example, in the California New Zealand ● ● ● ● ● ● Cap-and-Trade Program, the point of regulation for Nova Scotia ● ● ● ● ● ● ● transportation fuels that will be combusted and thus Québec ● ● ● ● ● ● ● cause GHG emissions is where they enter commerce. In practice, the point of regulation is at terminal racks Republic of ● ● ● ● ● ● and large refineries where transportation fuels are Korea physically transferred. The German fuel ETS regulated Regional fuel distributors and final consumption suppliers, which Greenhouse Gas Initiative ● are also upstream of the point of combustion. In both (RGGI) cases, the owners of these facilities pass the costs Switzerland ● ● ● reflecting the embedded carbon dioxide (CO2) through to the consumer in the form of higher fuel product Toykyo-Saitama ● prices. Figure 3-2 illustrates this cost pass-through. * With the exception of Chongqing, which covers all the above gases. S Downstream. This is a point in the supply chain after the point source of emissions. For instance, the Globally, carbon dioxide makes up by far the largest portion Tokyo-Saitama ETS covers emissions from electricity of GHGs and all ETSs include this gas. Many systems also used in buildings, which is downstream of the source include other gases. As methane and nitrous oxide are of emissions. Downstream coverage has also been sometimes a significant portion of domestic emissions (for considered for emissions from other sectors, such as example from industrial processes, fossil fuel extraction, agriculture, where coverage at the point of emissions landfills, and agriculture), coverage of these gases may be would have significant administrative costs. important to consider, especially in developing countries The appropriate point of regulation will differ depending and economies with large agricultural sectors. on the sector and sources of emissions, as well as the Despite the smaller volume of other gases, it is important regulatory environment in each jurisdiction. Ideally, the to consider including them within the ETS scope because point of regulation should be placed where: they might have a greater ability to absorb heat (i.e., a S Emissions can be measured with high accuracy. higher “radiative efficiency”). The global warming potential Accurate emissions monitoring ensures that the 82 This refers to the GWP values for methane and nitrous oxide from IPCC’s Fifth Assessment Report, 2014 (AR5). However, in some ETSs GWPs from IPCC’s Fourth Assessment Report, 2007 (AR4) are still used (25 for methane and 298 for nitrous oxide). 83 While the point of regulation in the EU ETS is at the source of emissions, this is often referred to as “downstream” because the point of regulation is downstream from where the fuel is produced. STEP 3: DECIDE THE SCOPE 61 carbon price is providing Figure 3-2 Consumers Figure 3-2: Cost pass-through at different face the same points of price, regardless regulation of the point at which regulation is placed the appropriate level of liability for a given level of emissions, and therefore Cost Elements Upstream regulation Point source regulation is accurately targeting incentives to reduce these Extractors Extractor or Extractor or emissions. Changing and importer importer’s cost importer’s cost the point of regulation (upstream) may alter the accuracy + of monitoring because different data sources will Carbon price + be available at different points in the supply + chain. For instance, in the Generators Generator’s cost Generator’s cost (point source) energy sector upstream measurement can be + quite accurate because STEP 3 SCOPE Carbon price the carbon content of fuels is known, whereas Consumers (downstream) = = for industrial process emissions the diversity Extractor cost + generator cost + carbon price of processes can make it difficult to accurately measure emissions except Note Note: : This assumes This 100 assumes percent 100 pass-through percent of of pass-through the carbon the price carbon at at price extractor/importer and extractor/importer generator and levels. generator levels. at their point source. S A direct price signal can be generated or cost are often calculated at the facility or company level, pass-through is possible. For the ETS to be effective implying that there can be administrative efficiencies in changing behavior, the point of regulation must be from also having the point of regulation at this level. able to influence behavior, and therefore, emissions. This can occur either directly or via passing the cost To date, most jurisdictions have chosen to cover emissions through to subsequent links of the supply chain. For at the point source or upstream in the supply chain. example, electricity suppliers must be able to reflect the carbon price in consumers’ electricity prices in There are several advantages to having the emissions order to incentivize lower consumption, investment in regulated at their point source: energy efficient appliances, or switching to electricity S Ensures that polluters face “visible” incentives to generated by renewable sources. reduce emissions. As emitters see a direct cost to S Monitoring costs are lowest and compliance can pollution, they face a clear incentive to adopt emissions be most easily enforced. The administrative costs of reductions technologies and processes or to change monitoring emissions are lowest at the point where the their consumption choices. Regulating upstream or supply chain is most concentrated since it is easier to downstream relies on the additional costs being passed regulate a smaller number of large entities.84 Energy through into the price that is passed down the supply markets are usually most concentrated upstream, but for chain. If this is not considered likely, for instance due to other sectors this may not be the case (see Figure 3-3). the market power of suppliers, then these incentives will S It is most efficient to deal with issues of carbon be reduced.85 Even where costs are passed through, leakage. To address the risk of carbon leakage, organizational and behavioral factors mean that free allocations or other support measures are often regulating at the point of emissions may be considered provided to emissions-intensive, trade-exposed more effective in incentivizing entities to reduce industries (discussed further in Step 5). Free allocations emissions (see Box 3-1). 84 Only including large emitters might come at the cost of market depth and some increase in market power for large entities trading allowances, but this depends on the relative size of sectors trading and overall liquidity in the market. 85 Kim and Lim 2014. 62 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Figure 3-3 Examples of market concentration across sectors Electricity Transport Agriculture (power generation) (mobile fuel combustion) (livestock emissions) Extractors Refiners Farmers Point & importers & importers (Thousands) source (Tens) (Tens) Upstream Emissions Generators (Hundreds) Downstream Emissions Point Retailers Processors Upstream source (Hundreds) (Tens) STEP 3 SCOPE Retailers (Tens) Downstream Consumers Consumers Consumers (Millions) (Millions) (Millions) Emissions Point source Box 3-1 Technical note: Regulation and behavioral impacts Regulating energy use at the point of emissions is sometimes seen as more effective in incentivizing emissions reduction behavior. Emissions sources (for example, large installations) face identical economic incentives regardless of whether the carbon price is placed directly at the point of emissions, or indirectly through increased fuel prices. However, this theoretical equivalence may not hold in practice because visibility of the regulation — its “saliency” — might be important in its own right. That is, the increase in cost must be clearly and directly associated with carbon pricing to stimulate a behavioral response. However, it is possible to address these behavioral concerns through means other than placing the point of regulation where emissions occur. Direct engagement, technical advice or mandatory reporting, and emission reduction plans can improve decision makers’ understanding of the potential to benefit from mitigation as well as the economic costs of not doing so. These additional measures could help shed light on the opportunities for companies to mitigate at any point in the energy supply chain and could be cheaper than changing the point of regulation to be at the point of emissions. For example, one of California’s complementary policies from the 2008 Scoping Plan required large industrial facilities (for example, refineries, cement kilns, and food processors) to do energy efficiency audits. The policy also required the facilities to assess the GHG and local pollutant co-benefits for energy efficiency measures identified during the facility audits. The policy was designed to encourage facilities, many of which received updated output-based allocation under the Cap-and-Trade Program, to consider GHG-saving measures that could reduce energy and ETS compliance costs. The value of direct regulatory signals in terms of institutional incentives varies by culture and organizational form. STEP 3: DECIDE THE SCOPE 63 S Can better align with allowance allocations and case, upstream entities are also more used to operating other reporting requirements. If company- or in complex regulatory environments, which can reduce facility-level data is required in order to freely allocate administrative costs and increase market efficiency. allowances (see Step 5) or provide other compensation, However, this depends on the specific nature of the then there can be administrative efficiencies from source of emissions, as not all sectors’ supply chains aligning the point of regulation to this level. While will be most concentrated upstream. this can require covering a large number of facilities, S It can enable higher coverage across sectors in some cases existing permitting and licensing and avoid thresholds within sectors. Linked to the regulations can provide an existing source of high- above point, upstream regulation may not require the quality data. For example, in the EU, the 1996 Integrated thresholds often necessary in downstream systems Pollution Prevention and Control Directive established in order to avoid high transaction costs (discussed a set of common rules for permitting and controlling in Section 3.2.3). Thresholds can result in market industrial installations that facilitated regulation at distortions, including intra-sector leakage between the point source of emissions.86 Finally, in some firms on either side of the threshold. As thresholds cases institutional capability to monitor and enforce are based on the amount of firm’s emissions, not compliance may be stronger at the point of emissions, their emissions intensity, they can have the effect particularly if there is a small number of large emitters. of increasing emissions if production moves from a STEP 3 SCOPE S Allows emissions to be measured more accurately. regulated entity to an unregulated entity that is more Measuring emissions at the point source is typically emissions intensive. These problems may be avoided more accurate and nuanced, as it requires fewer by adopting upstream regulation.87 For example, assumptions than estimating emissions upstream. California’s ETS applies to 80 percent of the state’s For example, point source measurement accounts emissions by covering around 350 entities. New for fuels that are extracted but not combusted (and Zealand’s regulation covers 100 percent of fossil fuel therefore do not emit GHGs). This includes natural gas emissions by regulating just 128 firms. By contrast, that can be used as a feedstock rather than as fuel. the EU ETS covers 45 percent of total greenhouse gas Non-combustion emissions in industrial processes can emissions with over 11,500 entities covered.88 only be measured at point source. Systems will often take a mixed approach to the point of regulation, covering some sectors or activities upstream On the other hand, upstream regulation can have some key and others downstream, at the source of emissions. advantages: The California Cap-and-Trade Program and the Québec S Administrative costs can be lower. This is particularly Cap-and-Trade Program both have used a mixed the case in the energy sector, where there are often approach, as discussed in Box 3-2. far fewer entities involved in fossil fuel extraction and commercialization than in final consumption. In this Box 3-2 Case study: Upstream regulation A number of jurisdictions have included upstream coverage of emissions, meaning that emissions are regulated at the point of extraction or distribution, rather than when and where they are emitted into the atmosphere. Upstream emissions coverage can be an effective way to incorporate sectors with many small final emitters without requiring that final emitters actually participate in the ETS. However, the effectiveness and viability of upstream emissions coverage will to some extent be constrained by the ability of upstream entities to pass through the carbon price signal to downstream emitters. New Zealand has chosen a system that is as far upstream as possible for all energy-related emissions, while still dealing with emissions from forestry, waste, and industrial emissions downstream. Fossil fuels, whether for transport, electricity, or direct energy use, are regulated upstream at the point of production or import. In total, the government enforces compliance for 128 entities in the energy, liquid fuel, and industrial sectors, yet covers 100 percent of CO2 emissions from fossil fuel use.89 This can be compared to the other 2,281 entities covered mainly downstream in other sectors of the New Zealand ETS (NZ ETS), the majority of which are for post-1989  86 Directive 96/61/EC, which was subsequently replaced by the Industrial Emissions Directive (directive 2010/75/EU of the European Parliament and the Council on Industrial Emissions). 87 Choosing an upstream point of regulation for energy so that emissions from more sources are covered reduces leakage across firms within and between sectors. See Bushnell and Mansur 2011. 88 There are factors other than whether regulation is introduced at an upstream or downstream point that affect this comparison including whether it is installations or companies that are regulated (see Section 2.4). 89 New Zealand Emissions Trading Register 2019. 64 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION forestry activities. The upstream approach to fossil fuels has allowed for administrative simplicity while ensuring comprehensive coverage. However, a few large downstream firms felt that their upstream fuel suppliers — to whom they are tied because of small markets — were not managing the GHG liabilities efficiently and hence were passing on a GHG cost that was too high. In a few cases, this has been resolved through private contracts that allow the downstream firm to manage its GHG liabilities and provide units to the upstream regulated party as it buys fuel. Moreover, the government has enabled some downstream firms to “opt in” as a point of regulation, avoiding double counting by providing a rebate to the upstream point of regulation for emissions associated with the fuel sold to these downstream firms.90 The systems of California and Québec mix upstream coverage of transportation fuels with downstream coverage for the power and industrial sectors. Upstream coverage of transportation fuels reduces administrative costs by regulating a relatively small number of fuel distributors, while downstream coverage of the in-state power and industrial sectors directly regulates emissions at their source, which aligns better with existing regulatory practices and increases the visibility of the carbon price for these sectors. This approach of “mixed coverage” allows these systems to capture 80 percent or more of the emissions in their jurisdictions. One consideration for mixed stream coverage is to ensure there is no double regulation — for example, no instances STEP 3 where emissions are regulated both upstream and downstream. This can occur where fuel distributors sell fuels to SCOPE downstream industrial facilities that are also covered by the ETS. In this case double counting is avoided through the use of a GHG accounting procedure allowing upstream fuel suppliers to reduce their surrender obligation by the amount of fuel sold to downstream regulated entities. 3.2.3 THRESHOLDS of firms to manage ETS compliance, and the government’s capacity to enforce compliance. Sector-specific issues, In order to minimize administrative and MRV costs while like the market structure, distribution of emissions across maximizing the number of sectors covered in an ETS, entities in each sector, and the range of mitigation options policymakers have tended to introduce thresholds on ETS available to local entities of different scales, also play a participation. This means that entities below a certain size significant role in the decision. The market structure can are not subject to the ETS’s requirements. Thresholds can affect both the number of entities (and thus the level of significantly reduce the number of regulated entities while emissions) covered, and the risk of production leakage excluding a relatively small quantity of emissions sources from covered to unregulated entities. and mitigation opportunities. Thresholds play a particularly important role when energy or industrial emissions are Key considerations for the choice of threshold include: regulated at the point source of emissions. S Number of small sources. If there are many small The size of a regulated entity (and therefore the threshold) sources of emissions then a relatively low threshold can be measured using a number of different indicators, may be needed in order to ensure that, in total, a large including GHG emissions per year, energy consumption proportion of emissions is covered. The benefit of level, production level, imports, or capacity. The Korean including a sector where a low threshold is needed ETS, for example, uses a threshold of 25,000 tons of CO2 must be carefully weighed against the potentially high per year at facility level, or 125,000 tons of CO2 per year administrative cost of including such a sector. at company level. Entities with emissions exceeding these S Capabilities of firms and regulators. If small thresholds are deemed to be within the scope of the ETS.91 firms have limited financial and human capacity, the Similarly, the Mexican pilot ETS has a threshold of 100,000 additional costs of complying with an ETS may be tons of CO2 per year at facility level.92 The EU ETS, on the significant and could influence their decision to operate. other hand, regulates power sector entities with a capacity In this case a threshold set at a higher level (thereby of over 20 megawatts (thermal rated input).93 covering fewer entities) may be preferred.94 S Likelihood of intersectoral or domestic leakage. The appropriate threshold depends on each jurisdiction’s A threshold above which entities are subject to a context, including its specific mitigation goals, the capacity carbon price, and below which they are not, may 90 Kerr and Duscha 2014. 91 Korea Ministry of Environment, State Affairs Coordination Office, Ministry of Strategy and Finance 2020; ICAP 2020d. 92 ICAP 2020d. 93 European Council 2003. 94 While the ETS should result in firms exiting the market if they are not viable when the true cost of their emissions is taken into account, this is generally not a politically or socially acceptable outcome. Furthermore, Betz, Sanderson, and Ancev (2010) find that partial coverage, by excluding firms below a threshold, can reduce social costs while maintaining emissions reductions, compared to blanket coverage. STEP 3: DECIDE THE SCOPE 65 distort competition between the two groups. The 3.2.4 LEVEL OF REPORTING OBLIGATION additional carbon price could lead to substitution away from the covered firms to the uncovered firms A further important design characteristic concerns who is without a reduction in emissions. Choosing a suitable legally responsible for complying with the ETS regulations — threshold therefore requires balancing the potential that is, surrendering to the regulator an allowance for each administrative costs of a lower threshold that enables ton of emissions. Some of the main options might be greater coverage, with the potential competitiveness S a company; impacts of a higher threshold resulting in less coverage. S a company at a specific plant site (called a “facility” or Alternatively, entities that do not meet the threshold for an “installation”), or used for a specific production line coverage under the ETS could also be regulated by a or process; or different form of carbon pricing (for example, a carbon S a specific plant site or facility (which could contain tax) or other climate policy. Under Phase 3 of the EU several processes and/or companies). ETS, small emitters (defined as those emitting less than 25,000 tons of carbon dioxide equivalent (CO2e) The choice depends on which entities can be held legally per year) were able to opt out of the ETS obligations so liable and where data is available and auditable. Often long as they are covered by measures that will achieve these factors depend on existing regulatory structures. an equivalent contribution to emissions reductions.95 STEP 3 SCOPE Inclusion thresholds across a range of selected Regulating a more aggregated unit like a company can jurisdictions are illustrated in Figure 3-4. reduce administrative costs for both the government and S Other market distortions as a result of thresholds. the companies. It allows more flexibility regarding where Related to the point above, a threshold for entity emissions occur within the entity without the need to report inclusion can create an incentive to break up existing or trade units. production facilities into smaller units in order to bring On the other hand, in cases where multiple companies each unit’s emissions below that threshold to avoid interact within one installation, the attribution of emissions compliance obligations. Similarly, firms just below and liabilities to companies can be difficult. These the threshold may choose to stay there, curbing their problems may be particularly pronounced, for example, growth. In many cases this can be dealt with through in highly integrated chemical/fuel production sites, where the reporting obligations discussed in Section 3.2.4. several companies or subsidiaries may be involved in numerous interlinked production processes and where — in Figure 3-4 Variation in thresholds across selected jurisdictions order to improve the overall efficiency (metric tons CO2e/year) of production — different processes may constantly exchange energy (for 140,000 example, in the form of waste heat, 120,000 waste gas, cooling capacity, power) Metric tons CO2e/year 100,000 or products (for example, hydrogen, pre-products, hydrocarbons). 80,000 60,000 The level of reporting obligation is a question of administrative efficiency 40,000 and ease, and independent of decisions 20,000 on coverage and MRV. Reporting and data collection can still be mandated 0 Shenzhen Beijing EU ETS; Chongqing; Québec; Nova Scotia Mexico Republic of or encouraged at a granular level (for Switzerland; Guangdong; Republic Korea Kazakhstan Tianjin of Korea; example, at the installation level), while California; Canada the obligation to surrender allowances is placed at a higher level (for example, Jurisdictions the company level). For example, a ■ Company threshold ■ Installation threshold company might have two installations or facilities — a coal mine and an Note : This figure shows only jurisdictions where the inclusion threshold is measured in tons CO 2 e of in/direct electricity generator, both of which are emissions per year. Inclusion thresholds can vary by sector and type of entity. In Québec, for instance, fuel importers distributing covered under a hypothetical ETS. If > 200L are also subject to inclusion. The same threshold applies to Nova Scotia, where electricity importers and the reporting obligation is placed at natural gas distributors with emissions > 10,000 tCO 2 /year are included. Other systems set thresholds at both the facility and company level (e.g. Korea ETS). With certain exceptions (e.g. Shenzhen pilot), thresholds set at the the company level, the company must company level are usually highest. 95 Directive 2009/29/EC of the European Parliament and of the Council. 66 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION surrender allowances for aggregate emissions produced permitting, licensing, and regulations are focused on at both facilities. It may be asked to report aggregate individual installations. Adopting the same approach for the emissions, or to provide a split between its facilities. On EU ETS means that it is possible to combine the procedures the other hand, if the reporting obligation is placed at the for regulating air pollution and emissions trading.96 It is also installation level, the electricity generator and coal mine consistent with a desire to place the liability at the point must separately surrender obligations. where technical mitigation can be achieved. In Kazakhstan, Korea, and China, the regulated entity is the company. In the case of China, energy statistics have 3.2.5 SUMMARY traditionally been collected at the company level, making Table 3-2 summarizes considerations in relation to each of this approach a logical extension of the existing policy the four aspects of scope design discussed above. framework. By contrast, in the EU existing environmental Table 3-2 Decisions on scope More Fewer STEP 3 SCOPE Sectors/ S Greater opportunity for low-cost reductions S Lower administrative and transaction costs Gases S Avoids risk of leakage between sectors S Less risk of leakage between jurisdictions Covered S Greater ability to align carbon pricing with economy-wide emissions reduction targets Point source of emissions Upstream S Provides direct incentives for polluters to reduce S Can be cheaper and simpler to administer, particularly in the Point of emissions energy sector Regulation S Possible behavioral benefit of regulating at the S Potentially greater coverage with fewer points of regulation point of emission S Can reduce competitive distortions between and within sectors S Can build on existing regulatory frameworks Low High Threshold S Greater opportunity for low-cost reductions S Lower administrative costs Level S Reduces risk of leakage between firms above S Protects smaller firms where administrative and transaction and below the threshold costs might be prohibitive Installation Company Level of Reporting S Can simplify reporting when multiple companies S Allows companies to choose how they manage internal reporting Obligation are operating at the same installation and data collection/management and compliance costs 3.3 SCOPE CONSIDERATIONS IN PRACTICE This section considers the main issues that may arise when is essential that costs can be passed through to deciding on the scope and point of regulation in some key the subsequent stages of the supply chain in order sectors often covered in an ETS. to provide a price incentive for behavior change. This may not always be the case, particularly where electricity markets are strictly regulated (see Box 3-3). 3.3.1 ELECTRICITY GENERATION When cost pass-through is possible and all producers There are three possible options for the point of regulation and importers can be identified and regulated, in the electricity supply chain: this option allows for high-quality, comprehensive monitoring of emissions. By monitoring fuel, it is 1. At fuel source (upstream). This is the approach possible to monitor emissions in the electricity sector used by the New Zealand ETS and involves directly as well as other sectors using those fuels (see Step 7). covering all fuels that are used in electricity generation However, fuels may realize different levels of emissions by regulating them at their source (production, import, depending on their end use, particularly if they are not or distribution). As with any upstream coverage, it 96 European Commission 2000. STEP 3: DECIDE THE SCOPE 67 combusted and are used as inputs in processes like and administrative cost than the fuel source option the manufacture of chemicals. Therefore, assumptions described above. If it is accompanied by thresholds may need to be made on the end use of the fuels to reduce transaction costs on smaller generators, it when regulating emissions at this point in the supply may miss some small generation sources. In California chain. A similar issue may occur if facilities are using the price is also imposed on electricity imported from technologies such as carbon capture, and storage, generators outside the state’s jurisdiction (see Box 3-3). which prevents emissions reaching the atmosphere. 3. Electricity consumers (downstream). Used in China MRV processes can be developed to account for this and the Tokyo and Saitama ETS, this option requires (see Step 7). Furthermore, it is important to cover all electricity consumers to surrender units associated fuel sources to prevent market distortions. Finally, with their consumption of electricity. It provides there may be concerns that regulating a small number incentives for energy efficiency and conservation, and of entities may allow for monopoly power in the tends to focus only on large energy users to avoid high allowance market. These concerns may be addressed administrative costs. Given this weakness, it tends by separate regulation (see Step 5). to be used in cases where emissions costs would 2. Generators (point source of emissions). Used in otherwise not be reflected in electricity prices (for the EU, California, Kazakhstan, and China, this option example, in regulated markets where cost pass-through allows for more accurate reporting of emissions. In is not possible) or where generators are outside the STEP 3 SCOPE some cases, where there are fewer generators than jurisdictional reach of the ETS. fuel sources, it may involve less overall regulation Box 3-3 Case study: Electricity imports in the California Cap-and-Trade Program As a high share of California’s electricity is imported from neighboring states, policymakers decided to include emissions from electricity generated outside of California and sold to Californian electricity consumers within the scope of the California Global Warming Solutions Act, also known as AB 32. The act authorized the adoption of a Cap-and-Trade Program by the California Air Resources Board (CARB) and directed CARB to minimize leakage to the extent possible. The regulators require “first deliverers” of electricity into California to report emissions associated with the production of that electricity and, consequently, to surrender the appropriate amount of allowances in the ETS. Both producers and importers of electricity must account for the emissions associated with electricity consumed in California. When the source of electricity delivered are unknown (for instance when there is no existing power purchase agreement from a specific power plant), importers are required to use a fixed “default emissions factor,” which is roughly equivalent to an older gas-fired power plant. Regulatory characteristics concerning how electricity efficiencies in generation, efficient dispatch and generators dispatch their electricity, how they recover transmission, efficiency in use, and conservation. their operational and investment costs, and how electricity prices are set at the wholesale and retail levels can However, in some regulatory frameworks, electricity prices influence which of these approaches is most attractive. are set (or heavily regulated) by the government, such that emissions liabilities imposed on generators will not be If electricity suppliers are permitted to pass through cost reflected in higher prices downstream. Box 3-4 provides increases to consumers, placing regulation upstream or more detail on the primary barriers to ETS functioning in at the point source incentivizes mitigation throughout the these markets and potential policy solutions. supply chain: fuel switching, investment in renewables, 68 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Box 3-4 Technical note: Emissions trading in jurisdictions with regulated electricity market Emissions trading has typically been designed to operate within liberalized and competitive markets, where the cost of emission allowances can be freely reflected in the price of carbon-intensive goods and economic entities are free to adjust their operations and investment decisions. For the electricity sector, this implies customers are free to choose their electricity supplier; there is unbundling of supply, generation, and networks ensuring competition in wholesale and retail markets; power plants are dispatched based on their economic merit; and independent regulators are assigned to monitor the market.97 Under these conditions, the allowance price drives decarbonization of the electricity sector through several channels. First, where the cost of emissions is internalized through the ETS, low-carbon electricity generation becomes more competitive and a shift away from fossil-based generation technologies is encouraged (production lever [clean dispatch]). Second, carbon-intensive electricity use becomes more expensive, encouraging consumers to increase their energy efficiency or switch to low-carbon sources. Third, low-carbon generation assets generate higher profits, incentivizing their investments. Conversely, high-carbon assets earn lower margins and are faced with declining capacity factors (i.e., amount of running hours), encouraging early closure (decommissioning lever).98 However, the structure and regulation of the electricity sector is important for the impact of carbon pricing. STEP 3 SCOPE Jurisdictions will have different underlying energy mixes and related opportunities to switch between fuel sources, affecting the magnitude of response to a given allowance price. For example, the response to an ETS will be stronger in electricity systems that are dominated by coal but also have access to gas and renewable sources compared to systems that are partially decarbonized through hydropower but are still reliant on fossil fuels for backup capacity.99 Similarly, jurisdictions with older fossil fuel fleets will face fewer stranded assets and therefore lower cost and social resistance to carbon pricing. Electricity regulation may dampen the carbon price signal through the electricity supply chain. The main regulatory practices, their impact on the carbon price signal, and potential solutions are explored in the points below.100 S Wholesale price caps. In many liberalized markets price caps still constrain the ability for electricity generators to increase their bids in wholesale markets at times of excessive demand and rising electricity prices. This can create a barrier to underlying allowances costs being passed through to electricity prices and result in a “missing money” problem with insufficient investment in generation capacity, which is often addressed through the creation of separate capacity markets. Furthermore, price caps can limit incentives for consumers to use electricity more efficiently or to shift their demand patterns. As carbon prices rise, consideration should be given to where electricity price caps are set and the impacts of these caps on the mitigation signal, noting that some consumers can be compensated for increased electricity bills through alternative means.101 S Regulated tariffs. Where electricity prices are set based on a predefined set of rules, the tariff methodology together with the method of allocation of allowances will determine how the allowance price is transmitted to electricity generators. Tariff methodologies may need to be adjusted to ensure that allowance costs are reflected in final tariffs. S Administrative electricity dispatch. In a system with regulated power production, planning agencies instruct electricity dispatch based on predetermined technical, economic, or political considerations or criteria. Under these conditions, an allowance price will affect dispatch decisions only if it is explicitly considered under the administrative dispatching criteria. This type of “climate friendly” dispatch has been trialed in China and is under consideration in Korea. S Regulated retail prices. The incentive for end consumers to reduce their emissions depends critically on the levels and structure of electricity rates. Where little or no pass-through occurs, there is no incentive to reduce electricity consumption or switch to less carbon-intensive goods and services. The regulatory barrier to cost pass-through can be overcome by including electricity consumers within the scope of the ETS, such that large electricity consumers are required to hold and surrender allowances for the indirect emissions from their electricity consumption. This has been the approach in the Korean ETS and the Chinese pilots, where carbon  97 Matthes, 2017; Organisation for Economic Co-operation and Development (OECD)/International Energy Agency (IEA), 2016; Acworth et al. 2018; and Acworth et al. 2019. 98 IEA, 2020; Acworth et al. 2019; and Acworth et al. 2018. 99 Acworth et al. 2019. 100 For a comprehensive overview on aligning ETSs with energy market regulations and policy instruments, please also see De Gouvello et al. 2019. 101 Acworth el al. 2019. STEP 3: DECIDE THE SCOPE 69 costs cannot be freely reflected in electricity prices.102 Under such circumstances, special attention must be given to avoid unintended effects of double regulation. S Regulated electricity investments. Electricity-sector investment and planning are seldom left to the market alone. Where governments centrally plan the expansion of electricity infrastructure, the role for an ETS in guiding low-carbon investments may be more limited. However, in systems with regulated investments, governments could mandate that the planning body consider expected allowance prices when making investment decisions. For example, carbon costs could be included as additional charges or shadow prices (without an actual charge in the cost-benefit analysis that governs investments). In regulated electricity markets, it can be valuable to associated with devalued assets, shield industry against provide incentives for emission reductions through both reduced competitiveness, and protect end-consumers from reducing the emissions intensity of generation and, electricity price increases. However, these measures should separately, reducing the overall consumption of electricity. be designed to preserve the carbon price signal created by Several systems (for example the Chinese pilots and the ETS in order to maintain abatement incentives. STEP 3 Korea), therefore, combine regulations at the point source SCOPE and downstream at the consumer level in order to provide Using an ETS to reduce electricity consumption by end an otherwise lacking incentive to reduce electricity users may need to be complemented by other measures consumption.103 In these cases, combining the regulation to address related barriers to emission reductions. For of generators (so long as free allowances are allocated example, requirements for electricity reduction plans appropriately; see Step 5) with coverage of indirect by landlords and regulation of electricity consumers in emissions by electricity users strengthens the emission Tokyo and Saitama have in part overcome split incentive reduction incentive of the ETS — although it still may not problems in the commercial building sector (see Box 3-5). promote efficient dispatch across generators with different Even systems with deregulated electricity markets do not emissions factors. generally have perfect real-time price (and hence carbon Producers and consumers across the supply chain can cost) pass-through. This suggests a potential role for be compensated for additional costs imposed by the complementary policies to improve emissions cost pass- carbon price. Such measures may help decrease costs through in electricity or directly reducing peak demand. Figure 3-5 Abatement channels under a carbon price signal in liberalized electricity sectors with full cost pass-through Electricity sector abatement under a carbon price with full cost pass-through Short-term abatement options Long-term abatement options Production Levers Consumption Consumption Decommis- (point of Investment Innovation (industry) (households) sioning regulation) Mechanism Carbon price pass-through from electricity generators to electricity consumers Clear and credible (long run) carbon price signal • Fuel switch • Reduce • Reduce • Increase • Reduce the • Innovation Abatement effects consumption consumption net present business case into new • Clean and and increase and increase value of low to maintain products, efficient energy energy efficiency carbon operation of processes and dispatch efficiency investments high carbon technologies • Switch to low assets carbon electricity suppliers Allocation/compensation effects 102 Munnings et al. 2014. 103 This is different from the case in Tokyo where electricity is imported so there is no “direct” point of regulation, only regulation of large energy and heat users. Tokyo only applies a downstream point of regulation. 70 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Box 3-5 Case study: Inclusion of the commercial building sector in Asian ETSs Direct inclusion of the building sector is an important tool to incentivize demand-side abatement for jurisdictions where electricity and heating generation may lie outside the geographic bounds of the jurisdiction or where the power sector faces strict price regulations that limit the potential to pass on carbon costs to consumers. In Tokyo electricity is imported from surrounding prefectures, meaning the Tokyo Metropolitan government has no authority to mandate low-carbon generation. At the same time, heating and electricity consumption by large commercial and industrial buildings accounts for about 20 percent of Tokyo’s emissions. This led the Tokyo Metropolitan government to enact a cap and trade system that includes commercial buildings. In the Tokyo ETSs, building owners have a compliance obligation for their buildings’ indirect emissions. In addition, large tenants (renting spaces larger than 5,000 square meters or consuming more than 6 million kilowatt-hours of electricity on a yearly basis) are required to submit an annual emissions reduction plan and can also assume obligations jointly with or in place of building owners, incentivizing them to invest in demand-side abatement options themselves. The commercial building sector is also covered under the Korean ETS and some Chinese ETS pilots, which require building owners to surrender allowances for the indirect emissions associated with electricity consumption.104,105 Since electricity prices in China and Korea are heavily regulated as part of a broader socioeconomic strategy, STEP 3 SCOPE policymakers there also focus on the demand side to reduce emissions through cap and trade, in combination with incentives to reduce the carbo-intensity of power generation. Electricity consumers could also be compensated for Industrial processes additional costs imposed by the carbon price. Such Except for the Regional Greenhouse Gas Initiative and measures may help decrease costs associated with Massachusetts, all systems cover some form of industrial devalued assets, shield industry against reduced process emissions — the emissions intrinsic to chemical competitiveness, and protect end consumers from processes beyond the combustion of fuels, primarily cement electricity price increases. However, these measures should (clinker), steel, and aluminum. Globally, these industrial be designed to preserve the carbon price signal created by processes cause about 21 percent of GHG emissions.106 the ETS in order to maintain abatement incentives. For process emissions from cement, aluminum, and steel, there is no real choice for point of reporting obligation — 3.3.2 INDUSTRY emissions can only be monitored at the point of emission. Producers are generally large. In ETSs that choose to Stationary energy use regulate emissions from energy use at the downstream As in electricity generation, emissions from industrial level, such producers will generally already be the points of fossil fuel combustion can be regulated further upstream regulation for energy-related emissions. (California/Québec) or downstream (EU, China, and Korea). While in many jurisdictions electricity generators are large Chemical manufacturing can also create process (such that regulating them up- or downstream may involve emissions. Where small industrial facilities are emission a similar number of entities), by contrast, industry typically sources, they are sometimes exempted to avoid excessive features a combination of some large sources and many administrative costs. small sources. If the point of regulation is at the source of emissions, thresholds will often need to be used to keep Finally, some industrial processes emit fluorinated administrative costs manageable. A careful choice of greenhouse gases. While these account for a relatively legal entity between companies and installations is also small proportion of total greenhouse gas emissions, their important. If an upstream point of regulation is chosen, high global warming potential makes them an important these issues are largely avoided. contributor to climate change. Emissions of these gases from industrial facilities are included in a number of ETSs (see Figure 3-1 above). 104 ICAP 2020c. 105 Asian Development Bank 2018. 106 IPCC 2014. STEP 3: DECIDE THE SCOPE 71 3.3.3 TRANSPORT producers or importers. The Transportation and Climate Initiative (TCI), a regional ETS for transport emissions Globally, transport accounts for about 14 percent of in the United States (expected to implement a cap on greenhouse gas emissions. Despite this, a majority of ETSs road emissions starting in 2022), proposes to implement do not cover transport emissions. regulation at the state fuel supplier level. This regulation is upstream of the point of emissions — vehicles — but The perceived limited short-term mitigation potential of downstream of the importer or producer of the fuel (which the sector is one reason for this: for essential travel, the is usually outside its jurisdiction). Germany has introduced behavioral response of drivers to fuel prices is low, meaning an ETS that will cover fuel emissions from the transport a relatively strong change in fuel prices causes relatively and building sectors starting in 2021. These sectors are weak changes to the amount vehicle owners drive and little not covered by the EU ETS, which covers Germany’s impact on the choice of vehicle (for example, choosing power and industry sectors. It also places the regulation to invest in an electric vehicle). However, for nonessential upstream, at the level of fuel distributors and suppliers. travel, price responsiveness may be greater. For freight transport, carbon pricing may stimulate intermodal In contrast, in Korea and in two of the Chinese pilots substitution between, for example, road and rail use. A (Shenzhen and Beijing), emissions associated with the key determinant of the price responsiveness of transport vehicles owned by regulated entities (only public transport STEP 3 SCOPE users to fuel prices is the availability of alternatives, operators in the case of the Chinese pilots) are also covered such as public transport and low-emission options for as part of compliance obligations set at the entity level. transporting freight; these alternatives in turn depend on These systems regulate all energy emissions downstream, longer-term infrastructure developments and innovation so this approach is consistent. However, it carries the risk in electric transport. The effectiveness of carbon pricing of intra-sectoral leakage. For example, if a firm reduces the in stimulating this abatement therefore depends on other use of its fleet cars but switches to (unregulated) private taxi transport policies (see the discussion of complementary use, behavior may change but emissions may actually rise. and competing policies in Step 1). In jurisdictions, like New Zealand, where fuel use is The presence of effective companion policies can be regulated at the producer, domestic aviation and shipping another reason to exclude (road) transport emissions from can be easily covered, although differentiation between the scope of an ETS. In the EU, ambitious vehicle emission fuel sold for domestic and international purposes may standards, high fuel taxes, and other regulations are be required. In sectors where regulation is not upstream, currently used to achieve emissions reductions. Therefore, covering aviation and shipping needs to be separately including vehicle emissions in the cap would have limited considered. Some systems, like the TCI, explicitly exclude additional impact on promoting cost-effective abatement. aviation and shipping. Shanghai, on the other hand, has Other jurisdictions (for example California) use inclusion of included aviation, in part because it is a large contributor transport in the ETS as a backstop for emission reductions to emissions there. Since airlines have detailed energy primarily triggered by efficiency standards, low-carbon fuel consumption records, it is relatively simple to measure requirements, and other transport-specific policies. In other these emissions. The EU ETS covers intra-European cases, it may be preferable to replace existing regulation or Economic Area (EEA) aviation sector emissions and fuel taxes with inclusion of the sector under the ETS cap, in might expand coverage to include other sectors such as order to achieve more cost-effective mitigation and ensure maritime transport, road transport, and direct emissions absolute limits on emissions. from the buildings sector as part of amendments under the European Green Deal. The latter two could be included As transport sector GHGs are emitted by millions of through upstream coverage of heating and transport end users, it is simpler, and less costly, for the point of fuels, either through the existing EU ETS or as a separate regulation to be upstream. In New Zealand, California, ETS combining the two sectors.107 Box 3-6 describes the and Québec, for example, this is done at the point of fuel experience of regulating global aviation emissions. 107 European Commission 2020e. 72 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Box 3-6 Case study: EU aviation and international measures to regulate aviation emissions In 2008, the EU ETS Directive was amended to include the aviation sector in the scope of the EU ETS as of 2012. Airlines operating flights within the EEA as well as international flights to and from non-EEA countries were included in the scope of the system. All such flights were to surrender allowances under the EU ETS, with airlines facing a fine of EUR 100 per ton of CO2 emitted when failing to do so. Persistent offenders faced the possibility specter of being banned from EU airports. When the directive came into effect in 2012, the inclusion of third-country flights faced strong opposition from several developed and emerging economies, including the United States, China, India, and Russia. Despite the European Court of Justice ruling the directive legal,108 these countries met in February 2012 to discuss measures they would take if the EU proceeded with the extension of the scope of Europe’s ETS to international aviation.109 To provide momentum for agreement on a global measure to tackle emissions from aviation in the International Civil Aviation Organization (ICAO), as first called for in the Kyoto Protocol in 1997, the EU agreed on a temporary derogation from including international flights in the EU ETS. This decision, known as the “stop-the-clock” provision, was initially set to apply until the ICAO Assembly in October 2013. In 2013, the ICAO Assembly agreed to develop a global scheme for reducing emissions from aviation through STEP 3 SCOPE market-based measures by 2016 to be implemented by 2020. In response, the EU extended the intra-EEA scope for the aviation sector under the ETS for the years 2013–2016, and in 2017 prolonged the provision to 2023.110 The basic parameters of the ICAO measure were agreed in October 2016 as the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA), which initially aimed at offsetting CO2 emissions of international aviation above 2019 and 2020 average levels through international credits and sustainable aviation fuels. Against the backdrop of decreased aviation emissions following the COVID-19 pandemic, the ICAO Council decided in July 2020 to use 2019 emission levels as the sole baseline year for the pilot phase.111 CORSIA is implemented in several phases: a pilot phase (2021–2023), a first phase (2024–2026), and a second phase (2027–2035). During the pilot and first phases, offsetting requirements apply only to flights between states that have decided to participate, whereas the second phase will apply to all flights between covered ICAO Member States. In all cases, states need to implement national legislation to comply with CORSIA provisions. As of July 2020, 81 states amounting to about 75 percent of international aviation activity expressed their intention to participate in the CORSIA pilot phase starting in 2021.112 Since 2019, airplane operators with international flights producing more than 10,000 tons of CO2 annual emissions from all International Carbon Action Partnership (ICAP) Member States are required to monitor, report, and verify their emissions. Since the scheme is route based, airlines not participating are still required to comply with these obligations. In March 2020, the ICAO Council approved six carbon offsetting programs as eligible for delivering carbon credits to airlines during the pilot phase and decided that carbon credits must come from projects that started operations on or after January 1, 2016. In 2017, the EU agreed that CORSIA implementation would take place through the EU ETS Directive.113 In July 2020, the European Commission announced it would put forward a proposal addressing CORSIA implementation in the EU as well as other aspects of the EU ETS for aviation by June 2021 in the context of the European Green Deal and increased climate ambition.114 EU legislation provides for the European Commission to assess CORSIA’s environmental integrity, including its compatibility with the Paris Agreement, and to consider ways for the provisions under CORSIA to be implemented through the EU ETS. Without amendments to the EU ETS, it would revert to its full scope for aviation activities on January 1, 2024. To ensure the effective functioning of CORSIA, remaining uncertainties will have to be addressed surrounding baseline provisions, the quality of offset units and use of alternative fuels, double counting, and full participation of countries. Brazil, Russia, India, and China, for example, have repeatedly voiced fundamental concerns with the scheme and filed formal reservations and differences on CORSIA in ICAO. 108 Court of Justice of the European Union 2012. 109 ICAP 2019. 110 European Union 2017. 111 ICAO 2020b. 112 ICAO 2020a. 113 European Union 2017. 114 European Commission 2020e. STEP 3: DECIDE THE SCOPE 73 3.3.4 WASTE improved technology and reduction of emissions from new and historical waste streams. The waste sector is usually not directly covered by ETSs.115 It is a relatively small source of emissions in most of the jurisdictions that have currently adopted ETSs, MRV can 3.3.5 LAND USE–RELATED ACTIVITIES be difficult and expensive due to the large number of small Agriculture, forestry, and other land use are together and dispersed sources, and mitigation options can be responsible for just under one quarter of emissions limited if stringent regulation of waste disposal is already in globally.117 Regionally, however, this percentage varies place. For these reasons, to date, only the ETSs in Korea strongly — as does the cost-effective mitigation potential and New Zealand feature design elements that cover parts within each sector. The discussion below focuses on of the waste sector.116 emissions from forestry and agriculture. Emissions from waste, and potential for mitigation, may be much larger in emerging economies. There may be Forestry, land use, and land use change significant emissions, and abatement potential, associated Emissions changes related to land use are largely a result with wastewater disposal, waste incinerators, and of afforestation or deforestation. However, the management landfills — further abatement potential may come from of other types of land (for example savannas and STEP 3 SCOPE reducing the production of waste. For example, emissions peatlands) will also be relevant for some regions. of methane and nitrous oxide from the disposal and anaerobic treatment of industrial wastewater are relatively To date, most ETSs have not covered changes to land straightforward to measure and abate. There may also be use, including it only as a potential source of offsets (see co-benefits with reductions in other pollution associated Step 8). Forestry is an administratively more complex with better overall waste management. Covering these sector to include in an ETS: there are often a large number sectors will require innovation and robust MRV systems, of entities and there is a need for an efficient tracking but might have a considerable benefit in countries where system over the lifetime of a forest to monitor both the waste sector is a significant source of emissions. sequestration (uptake) as forests grow and emissions in the case of harvest. Precise monitoring, to ensure targeted A challenging issue with landfill methane is that emissions incentives requires site-specific information, and/or arise over long periods as the waste decomposes. During detailed Earth observation data from satellite imagery. this period, the technology for managing emissions can change — while it may be attractive in terms of However, as jurisdictions with significant emissions administrative costs to place the emissions obligation at associated from the forestry and land use sectors consider the point and time of waste disposal, the emissions factor ETSs, the benefits from including the forestry sector may not be well aligned with actual emissions, making it could be high. The example of New Zealand described in difficult to apply a price to consumers. Further, applying a Box 3-7 shows that it is possible to include emissions from charge at the time of disposal would provide no incentive deforestation. to reduce emissions from waste already in the landfill. A tailored approach may be needed to incentivize uptake of 115 It may be indirectly covered, if waste is used to generate heat or electricity (as is the case in Sweden). 116 Australia’s former ETS also covered the waste sector. 117 IPCC 2014. 74 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Box 3-7 Case study: Deforestation in the New Zealand ETS Owners of plantation forests that were established before 1990 become compulsory participants in the New Zealand Emissions Trading Scheme if they deforest their land.118 Deforestation is deemed to occur if they clear more than two hectares of pre-1990 plantation forest and convert it to a non-forest use or do not meet minimum replanting or regeneration requirements. They are obliged to either surrender allowances to cover the emissions that deforestation caused, which are calculated using look-up tables to estimate the carbon stock at the time of harvest, or undertake “offset planting” by planting an equivalent new forest on non-forest land. Most pre-1990 forest landowners were eligible to receive an allocation of units to compensate them for the potential loss of land value due to the ETS. Landowners with fewer than 50 hectares could apply for an exemption from the deforestation obligation. Deforestation rates have varied in New Zealand over recent decades. Large-scale deforestation of plantation forests began in the early 2000s in response to the perceived increased profitability of some forms of pastoral farming (particularly dairy farming).119 The anticipated introduction of the NZ ETS saw many forest owners bring their deforestation intentions forward to avoid liability. This resulted in high rates of deforestation between 2004 and 2008. It was expected that the scale of deforestation would fall after the introduction of the NZ ETS in 2008, and indeed, deforestation fell sharply between 2008 and 2011. However, the allowance price went into steady decline starting in 2011, and a combination of high dairy prices and very low carbon prices, further exacerbated by policy STEP 3 SCOPE uncertainty, resulted in higher levels of deforestation than previously expected. The exclusion of international units from the NZ ETS in June 2015, along with planned ETS reforms, has led to a steady increase in the allowance price, strengthening incentives to maintain and increase forest sinks in New Zealand (which allow for the generation of units). Modeling studies from 2016, taking into account external factors such as the price of timber, estimated that a carbon price of NZD 7.00 would slow deforestation, while a price of NZD 15.00 would mostly halt deforestation.120 Agriculture 4. existing policy in some jurisdictions may be focused on No ETS currently covers agriculture’s “biological” increasing agricultural output, whereas a carbon price emissions, primarily nitrous oxide from fertilizer, manure may drive relative reductions in agricultural output, or and livestock, and methane from ruminant animals. changes in composition; however, a carbon price can There are five reasons why these direct emissions from still incentivize a fall in emissions intensity alongside agriculture tend to be excluded from existing ETSs: growing output; and 1. agricultural emissions are a small share of total 5. the carbon price may cause competitiveness concerns emissions in most jurisdictions that currently have an where these agricultural products are traded. ETS; To date, New Zealand is the only country that has 2. actions taken to reduce the intensity of biological attempted to cover agricultural non-CO2 emissions. The emissions from agriculture per unit of product can only New Zealand government recently decided to put a price be measured on-site, and many farms are small and on agricultural emissions starting in 2025; pricing will be remote; at the farm level for livestock and at the processor level for 3. mitigation options are typically limited and are often fertilizer. Key considerations are outlined in Box 3-8 below. poorly understood, meaning that even high mitigation costs may drive only limited changes in emissions intensity; 118 New Zealand Ministry for Primary Industries 2015. 119 Dorner and Hyslop (2014) report that only 0.1 percent of plantation forest was cleared for pasture between 1996 and 2002 and 1.5 percent between 2002 and 2008. 120 Manly 2016. STEP 3: DECIDE THE SCOPE 75 Box 3-8 Case study: New Zealand and agricultural emissions Unusually for a developed country, in 2017 agricultural emissions of methane from ruminant livestock and nitrous oxide from crop fertilizers made up 48 percent of gross GHG emissions in New Zealand. The country’s ETS was intended to be an “all sources, all gases” system but it has struggled to include these biogenic emissions from agriculture. Although legislation was in place in 2008 to include these emissions starting in 2015, their entry into the ETS was suspended in 2009, only to be put back on the political agenda with a change of government in 2018. The recent push for analysis and public consultation on the matter has resulted in New Zealand agreeing on a pathway to full carbon pricing of agricultural (biogenic) emissions by 2025 or sooner, with the framework legislature to be in place in 2020. The agreed approach aims at a mix of ETS coverage and a farm-level carbon pricing instrument based on a levy/rebate scheme that will be only partly integrated into the NZ ETS. Analyses have identified the point of obligation to be a key design hurdle, with a clear trade-off between administrative costs and delivering accurate mitigation incentives.121 Original legislation would have made meat and milk processors and fertilizer manufacturers the points of obligation, not the farms. Administratively, this approach would be less complex and costly, as there are only a few hundred meat and dairy processing plants and even fewer nitrogen fertilizer suppliers to cover, compared to the 20,000 to 30,000 individual farms in New Zealand with a huge range of sizes, types, and productivity levels. Nitrogen fertilizer manufacture is potentially suitable to be brought STEP 3 SCOPE under the NZ ETS, as it is upstream of the farms and the carbon price passed through would incentivize farmers to optimize its use, with a corresponding effect on emissions. However, pricing biogenic methane emissions at the processor level (downstream from the farms) means that livestock farmers would face a carbon price at the point of sale — per kilo of meat or milk and not per ton of CO2e. This would provide incentives to shift farm production patterns away from ruminant livestock but little incentive for farmers to reduce the emission intensity of livestock production.122 The preferred point of regulation, both from the perspective of policy design and in the opinion of New Zealand’s farming community, is at the level of the individual farm. This would allow farmers to apply management techniques and new technologies to reduce the emissions intensity of production, thereby providing incentives for a wider range of mitigation options beyond cutting production. However, this creates challenges in terms of monitoring and compliance, with time and effort needed to build capacity on farms. The challenge is to give farmers the tools to be able to realize abatement options and comply with the carbon price regulation while limiting distributional impacts on farming families and rural communities. In the initial phase, the agricultural sector has been promised 95 percent free allocation (or the equivalent of this under a different pricing mechanism). Any revenues from pricing agricultural emissions are to be reinvested in the sector. Furthermore, a public–private collaboration between the agricultural sector and the government has been established to foster capacity and prepare for farm-level carbon pricing over the next five years. Already in 2022, this readiness will be assessed, and the government has maintained the right to introduce pricing at the processor level in 2025 if progress on farm-level pricing is not made. As a more diverse set of economies, some with significant industry as a result of coverage should be considered. To agricultural emissions, consider carbon pricing, coverage the extent that downstream coverage of emissions at the of agriculture may increase. There is potential to cover food-processor level accurately reflects emissions, this larger operations like intensive feedlots more easily than may prove an attractive means to extend coverage while smaller, dispersed operations practicing open grazing. avoiding these competitive distortions. However, potential competitive distortions within the 121 New Zealand Interim Climate Change Committee 2019. 122 Kerr and Sweet 2008. 76 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION 3.4 QUICK QUIZ Conceptual Questions 1. What are the relative benefits of “upstream,” “point source,” and “downstream” choices in the point of regulation for emissions from the energy sector? 2. What factors should be considered when deciding whether to include sources from an additional sector in an ETS? Application Questions 1. How do existing regulatory frameworks affect price pass-through, especially in the electricity sector? 2. Which emission sources or sectors are likely to be the most important to cover? 3. How strong is the capability of your administrators to manage participation of (and enforce compliance by) additional points of regulation — both new emission sources and small facilities or companies? STEP 3 SCOPE 3.5 RESOURCES The following resources may be useful: S Emissions Trading and Electricity Sector Regulation S Striving to Keep ETS Simple STEP 4: SET THE CAP 77 Step 4 - Set the cap STEP 4 Set the cap At a Glance_____________________________________________________________________________ 78 4.1 What is an ETS cap?_______________________________________________________________ 79 4.2 Considerations for cap setting______________________________________________________ 80 4.3 Data requirements_________________________________________________________________ 85 4.4 Implementing the cap______________________________________________________________ 89 4.5 Managing the cap__________________________________________________________________ 92 4.6 Quick Quiz________________________________________________________________________ 96 4.7 Resources________________________________________________________________________ 96 BOXES Box 4-1 Technical note: Determining the level of ETS ambition____________________________ 81 STEP 4 Box 4-2 Case study: Accounting for uncertainty of emission projections in cap setting CAP for Phase 1 of the EU ETS (2005–2007)_________________________________________ 86 Box 4-3 Technical note: Data considerations under an intensity-based cap_________________ 87 Box 4-4 Case study: Jurisdictions have taken a range of approaches to cap governance_____ 90 Box 4-5 Case study: Australia’s and New Zealand’s cap mechanisms______________________ 92 Box 4-6 Case study: The linear reduction factor for the EU ETS___________________________ 95 Box 4-7 Case study: Ambition and cap design in the California Cap and Trade Program______ 95 FIGURES Figure 4-1 Aligning the ETS cap with overarching emissions target__________________________ 80 Figure 4-2 EU emissions reduction targets and the EU ETS cap_____________________________ 82 Figure 4-3 Top-down and bottom-up approaches to cap setting_____________________________ 83 Figure 4-4 Setting the ETS cap with a top-down approach_________________________________ 87 Figure 4-5 MAC curve plotting abatement options in order of their cost______________________ 89 TABLES Table 4-1 Summary of cap setting approaches___________________________________________ 84 78 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION AT A GLANCE environmentally credible and fair by stakeholders to Checklist for Step 4: Set the cap gain (and maintain) political acceptability. External ✔ Determine the ambition of the cap, type of cap, and stakeholders, particularly international trade and approach to cap setting potential linking partners, are likely to judge the ✔ Create a robust foundation of data to determine the system’s cap ambition in relation to the level of cap mitigation effort and price in comparable jurisdictions. ✔ Choose time periods for cap setting However, system compliance costs should not be so high as to cause disproportionate harm to jurisdiction ✔ Agree upon formal legal and administrative governance arrangements competitiveness and welfare in the context of the broader commitment to addressing climate change ✔ Agree on a long-term cap trajectory and strategy for providing a consistent price signal and achieving other ETS policy goals. Allocation of allowances can help address competitiveness and welfare concerns and is further discussed in Step 5. The emissions trading system (ETS) cap is the maximum quantity of allowances issued by the government over a Policymakers must also consider their approach to cap defined period of time, which limits how much covered setting, depending on economy-wide ambition and sources can add to global emissions. An allowance, jurisdictional circumstances. The two main options supplied by the government, allows the holder to emit one available are: ton of emissions under the cap in compliance with the rules 1. A top-down approach. The government sets the cap STEP 4 CAP established by the program. A “tighter” or “more ambitious” based on its overall emission reduction objectives cap is one that issues fewer allowances, which results in and a high-level assessment of mitigation potential greater scarcity of allowances and a higher carbon price. and costs across sectors regulated by the ETS. This approach makes it simpler to align the ambition of the ETS caps are usually absolute caps, meaning they set an ETS with the jurisdiction’s broader mitigation goals and up-front limit on the quantity of emissions allowed within the contributions from other policies and measures. each compliance period. This is by far the most commonly This is by far the most common approach. used approach and provides certainty on the emission 2. A bottom-up approach. The government bases reductions resulting from the ETS. Some jurisdictions, the cap on an assessment of emissions, mitigation however, have adopted intensity-based caps, which potential, and costs for each sector, subsector, or prescribe the number of allowances issued per unit of participant, and determines an appropriate emission output or input (for example, gross domestic product reduction potential for each. The overall cap is then [GDP], kilowatt-hour of electricity, or ton of raw material). determined by aggregating the emissions/emission The fundamental consideration underlying the ambition reduction potential for those sectors, subsectors, or of the cap is how quickly the jurisdiction wants to reduce participants. This is not a common approach, and thus emissions within the covered sectors.123 This consideration, far has only been implemented in China. in turn, presents three key issues that policymakers should A range of data can help policymakers make informed consider: decisions on the ambition of the cap and adopt an 1. Aligning cap ambition with jurisdictional targets. appropriate approach to cap setting. These include historic An ETS is typically one of several instruments that may emissions data, estimates of future emissions, estimates of be used in reaching an overarching economy-wide, the technical and economic potential to reduce emissions subnational, or even sectoral emissions reduction in covered sectors, and impacts of other existing or target. The ambition of the ETS cap should align with planned policies on emissions. this overarching strategy. 2. Effort sharing between regulated and uncovered Policymakers will also need to consider legal issues and sectors. The decision on how much mitigation administrative processes relevant to cap setting. This responsibility to assign to sectors under the cap includes designating the appropriate government authority should account for the relative capacity of regulated with responsibility for administering and, in some cases, versus uncovered sectors to reduce emissions. setting the level of the cap. The merits of establishing an independent body to provide advice on setting or updating 3. Balancing ambition and system costs. The the cap must also be considered. level of cap ambition will need to be perceived as 123 “Capped” and “covered” are considered synonyms and are used interchangeably throughout the handbook. STEP 4: SET THE CAP 79 In addition, implementing a cap requires: with respect to the ratcheting up of ambition levels of S Designating allowances to be issued. ETSs issue Nationally Determined Contributions [NDCs] under the domestic allowances in units (for example, tons) of Paris Agreement). greenhouse gas (GHG), either carbon dioxide (CO2) or Finally, they must balance the trade-off between providing CO2 equivalent (CO2e). In addition, policymakers need certainty on the cap’s trajectory, given its importance to to decide on whether to recognize external units for establishing price, against the need to preserve flexibility compliance and whether to limit their use in the system. for adjustments. The cap drives an ETS’s total contribution S Choosing the time period for a cap, as well as how far to domestic and international emission reduction efforts. in advance these periods are set. Caps may be defined The stringency of the cap and the time period for reducing on an annual or multiple-year basis. The cap period will it are key elements in determining a jurisdiction’s emissions usually correspond to a time period during which other reduction pathway. The process for setting and updating major program design features do not change. caps should provide sufficient predictability to guide long-term investment decisions while maintaining policy Policymakers must also lay out processes to manage flexibility to help respond to new information and evolving the cap and its interactions with other elements of the circumstances. ETS. They need to consider how to accommodate an evolving scope, how to ensure that methods of allocating Section 4.1 introduces how an ETS cap is defined. allowances are consistent with the cap, whether and how Section 4.2 discusses the fundamental decisions to accommodate shocks to the system that may destabilize policymakers must address when setting the cap: the market, potential interactions with offset credits, and its ambition and associated costs, and the approach how the cap type and ambition will affect potential linking to cap setting. Data requirements are detailed in STEP 4 with other systems. Section 4.3, followed by administrative and legal options CAP for implementing a cap in Section 4.4. Long-term In addition to this, policymakers need to reflect on how cap management of the cap, and its interaction with other ETS setting can be aligned with the potentially dynamic nature design elements, are covered in Section 4.5. of national or international commitments (for example, 4.1 WHAT IS AN ETS CAP? The ETS cap limits how much regulated entities can The ETS cap determines the system’s emissions reduction contribute to global emissions. An allowance, issued by ambition. However, a range of other ETS design elements the government, permits the holder to release one ton will also influence the total amount that regulated entities of emissions under the cap in compliance with the rules are able to emit under the rules of the ETS: established by the program. Because the ETS limits the S the rules determining the extent to which allowances total number of allowances and establishes a market, each can be borrowed from subsequent, or banked from allowance has value (the carbon price). Entities regulated previous, years (see Step 6); by an ETS and other market participants trade emissions S the existence or otherwise of a price or supply allowances depending on the value they attach to the right adjustment measure (PSAM) and the impact this has on to emit. the supply of allowances, particularly whether such a There are two types of cap. The first and most common is mechanism can override the cap (see Step 6); an absolute cap, which sets an upfront limit on the quantity S the approach taken to crediting mitigation activities in of emissions. The second type is an emissions intensity- the uncovered sectors and the potential for tradable based cap. It prescribes the number of allowances issued offsets (see Step 8); and per unit of output or input, such as unit of production or S the rules governing a link with other ETSs and resulting GDP, kilowatt-hour of electricity, or ton of raw material. unit flows (see Step 9). Under an intensity-based cap, the absolute amount of emissions allowed under the cap increases or decreases Given these various features, aggregated emissions within as a function of the economic activity. Some of the Chinese the covered sectors in the jurisdiction may be greater or pilot ETSs use intensity-based caps. less than the amount of allowances established by the cap in a particular year. As a result, decisions on setting the cap should be made in conjunction with decisions 80 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION on these other design aspects. Moreover, it should be crucial element of the cap-setting process. Stakeholders underlined that some design issues related to cap setting may include ETS participants, groups that may be affect not only the general ambition level but also the share adversely affected by or benefit from the carbon price, of emission reductions that take place within the system authorities responsible for policies interacting with ETS, (versus uncovered sectors) and the balance of costs researchers who can help model the impacts of choices, between linked jurisdictions and over time. potential linkage partners, and broader trade partners. These groups can be essential in gathering data, building Given the central role of the cap in determining ambition public confidence in modeling results, and gaining support and the level of the price, engaging with stakeholders is a for the ETS at large. This is discussed fully in Step 2. 4.2 CONSIDERATIONS FOR CAP SETTING Setting the cap requires decisions on two fundamental 4-1: Figure 4-1 Figure Aligningthe Aligning theETS ETScap with cap overarching with overarching issues: the extent of emission reductions that are sought emissions target (cap ambition) and the approach to cap setting (top-down or emissions target bottom-up) that will be used to achieve this goal. This section highlights the issues involved in setting the cap as part of the system’s overall ambition. It also discusses the advantages Emissions trajectory STEP 4 and disadvantages of absolute and intensity-based caps. Emissions CAP target Emissions (MtCO2e) 4.2.1 CAP AMBITION AND COSTS Uncovered emissions The fundamental consideration underlying cap ambition is how far and how quickly the jurisdiction wants to reduce its GHG emissions. This, in turn, breaks down into three key issues that policymakers should consider when setting cap ETS cap ambition: 1. aligning cap ambition with jurisdictional targets, 2. the share of mitigation responsibility borne by regulated and uncovered sectors, and Year 1 Year 2 Year 3 Year 4 Year 5 3. balancing emissions reduction ambition and costs. Years Aligning ambition with jurisdictional targets One of the key objectives of an ETS is to achieve a quantity of abatement consistent with a jurisdiction’s Figure 4-1 shows how a cap can be set in line with a overarching mitigation commitments. If these commitments jurisdiction’s overarching mitigation target. In this example, are considered the long-term environmental targets of the cap is equal to the national target trajectory, less the system, the cap ambition can be thought of as the estimated emissions in uncovered sectors. The European medium-term or interim goals that are required to step Union (EU) adopts a similar approach, implementing toward the target. several policies to reduce emissions but relying on the ETS cap to provide a degree of certainty in reaching its The cap allows ETSs to provide certainty as to the mitigation targets. emissions outcome. Several jurisdictions, therefore, align the ETS cap with their jurisdictional target to provide a The approach to setting an emissions cap should be degree of confidence that the target will be reached and considered an ongoing process rather than a static mitigation obligations met. As the covered sectors would decision. The cap should support increased ambition as be “guaranteeing” the emissions reductions needed to systems mature and, in the case of national targets, are reach the target, this is particularly relevant for jurisdictions ratcheted up in line with the Paris Agreement. Cap ambition that have ETSs with broad scopes and companion policies should be regularly assessed in the context of economy- to reduce emissions in uncovered sectors. wide goals, abatement opportunities, and broader macroeconomic conditions. STEP 4: SET THE CAP 81 Box 4-1 discusses three metrics that can be used to assess responsibility borne by covered and uncovered sectors. how ambitious an ETS is, focusing on quantity and speed of The decision on how much mitigation responsibility to emissions reductions, allowance price, and total cost. assign to covered sectors should take into account the relative capacity of regulated and uncovered sectors to reduce emissions. Box 4-1 Technical note: Determining the level of If marginal abatement costs are relatively low within ETS ambition uncovered sectors, firms could be permitted to access Three metrics may be used to assess program these lower-cost emissions reductions through domestic ambition with regard to GHG reductions:124 offsets, which are discussed further in Step 8. 1. Quantity and speed of emissions reductions. As a practical example, alongside decisions on the caps The primary goal of an ETS is to reduce for the third and fourth phases of the EU ETS (2013–2020 emissions. Consequently, a key measure of a and 2021–2030), policymakers in the EU issued Effort system’s ambition is the amount of emission Sharing Decision legislation that expressly defined the reductions achieved under the cap. This should level of mitigation responsibility allocated to uncovered be considered in relation to the jurisdiction’s sectors across Member States in order to achieve EU-wide broader emissions reduction targets. mitigation commitments.129 Greater mitigation effort was 2. Allowance price. In theory, the allowance required from covered sectors because of the expected price reflects the marginal cost of emitting a lower mitigation costs in power generation (one of the ton of CO2 or equivalent GHG in an ETS. It thus covered sectors) and the effects from companion policies depends on the overall quantity of emission to strengthen the use of renewable energy sources in the STEP 4 reductions achieved up to that point and the power sector.130 Figure 4-2 illustrates the effort sharing CAP cost associated with the next unit of reductions. between the covered and uncovered sectors in the EU. The allowance price indicates the magnitude of the incentive that the ETS is providing to reduce Balancing ambition and costs emissions by an additional ton.125, 126 The fundamental objective of any ETS is to deliver a desired 3. Total cost. Whereas price reflects the cost of level of emission reductions cost effectively. For an ETS to reducing an incremental unit of emissions, total be politically acceptable, relevant stakeholders generally cost reflects the overall cumulative resources need to perceive the level of ambition as environmentally devoted to achieving a certain amount of credible and economically fair. Credibility will depend emission reductions.127, 128 on the level of mitigation required by the cap relative to projections of emissions under business as usual (BAU) and its total expected cost. A more ambitious cap will impose more costs on covered sectors than a less ambitious cap. Effort sharing between covered and uncovered Fairness has both domestic and international dimensions. sectors Domestic stakeholders will consider whether the cap might Linked to the discussion above, in cases where an cause disproportionate harm to domestic competitiveness economy-wide emissions reduction target exists, (including for firms at risk of carbon leakage, as discussed determining the ambition for sectors within an ETS has in Step 5), national income, or welfare.131 External important consequences for the intended mitigation from stakeholders, particularly international trade and potential sectors that are not covered by the ETS. The government linking partners, might judge the system’s ambition in should consider the equity, efficiency, and political relation to the level and cost of mitigation effort and carbon implications of decisions on the share of mitigation prices in comparable jurisdictions. 124 For further discussion of all three, see Aldy and Pizer, 2015. In addition, the Partnership for Market Readiness (PMR) (2015a) provides a practical step-by-step guide for assessing the level of ambition in emissions reduction pathways. 125 Similar price levels do not necessarily imply similar ambition, depending on the historical emissions profiles and abatement options that remain available to the participants in the ETS. 126 Another caveat to using allowance prices as the sole criterion is the fact that ETS prices could be higher due to poor system design. For example, if the market rules impeded the efficient exchange of allowances, higher prices could result. Conversely, lax monitoring, reporting, and verification (MRV) standards could decrease the price. 127 This approach, however, only gives information on the “cost” side, disregarding the “benefit” side. It is important to keep in mind that in a given decarbonization scenario aggregate benefits may equal to or even exceed the costs. 128 For example, where both costs and (co)benefits are considered; see the International Energy Agency’s “Sustainable Development Scenario” in IEA 2017. 129 To achieve a goal of reducing the EU’s 2030 emissions reduction target of 40 percent below 1990 emissions, covered sectors need to achieve a 43 percent reduction below the 2005 level according to the EU ETS Directive, and uncovered sectors needed to achieve a 30 percent reduction below the 2005 level according to the Effort Sharing Regulation, which also distributes the emission reduction efforts for the non-ETS sectors among the Member States. 130 European Commission (2013) and Decision 406/2009/EC. 131 However, it is possible that, depending on the way in which revenues raised from an ETS are redistributed, and depending on the country context, GDP and/ or welfare may rise. 82 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION 4-2: Figure4-2 Figure EU Emissions EU emissions Reduction reductionTargets and targets the EU and theETS EU Cap ETS cap 6,000 5,000 4,000 Emissions (MtCO2e) 3,000 2,000 1,000 0 1990 1995 2000 2005 2010 2015 2020 2025 2030 Year STEP 4 CAP ■ Historical EU GHG emissions ■ Emissions from EU ETS sectors ■ Emissions from uncapped sectors ETS cap ETS cap + ESD/ESR budget Linear decline to European Green Deal target of 55% Note: During the first two phases of the EU ETS (2005–2012) there was no EU-wide cap, but rather country-specific national allocation plans were used to set a cap bottom-up. Starting in Phase 3 in 2013, the European Commission set an EU-wide cap along with targets for sectors outside of the ETS under the Effort Sharing Decision (ESD) and Effort Sharing Regulation (ESR), establishing an aggregate emission reduction target spanning ETS sectors as well as non-ETS sectors. The 2050 long-term strategy first set out the vision for a climate-neutral EU in November 2018, looking at all the key sectors and exploring pathways for the transition. The Communication on the European Green Deal in December 2019 reinforced the ambition to become climate neutral by 2050 and prompted “a process” or “processes” for increasing the EU’s 2030 target from 40 percent below 1990 levels to at least 55 percent. The ETS cap reflects the trajectory that was in place in 2021 but was subject to revision to align with the 55 percent 2030 reduction target. A jurisdiction may choose to maintain the overall ambition However, an alternative way to manage prices is to use of its ETS cap but elect to moderate domestic compliance PSAMs. These measures can keep costs low by injecting costs by giving ETS participants access to units outside the market with an additional supply of allowances when the covered sectors, through domestic or international prices rise above a predetermined threshold (see Step 6). offsets (see Step 8) and linking (see Step 9). If marginal Using PSAMs allows policymakers to have an ambitious abatement costs are low, ETS participants could be cap as the default and only intervene in the market if prices enabled to sell domestic allowances to another system are untenably high, maintaining the opportunity of meeting through linking. Linking does not alter the overall ambitions higher targets. It also leaves open the option of injecting of the linked ETSs, but in this case it would lead to higher allowances from outside the cap (thereby permanently domestic carbon prices and more domestic emissions raising it), or from future compliance periods (leading to reductions. In either case, the jurisdiction needs to decide a temporary raising of the cap followed by an equivalent how much it wishes to direct ETS-related mitigation reduction in the future). investment to achieve reductions within covered (vs. uncovered) sectors and within its borders (vs. globally). Introducing the ETS with a relatively high cap (and therefore lower prices) in earlier periods can also help In the early stages of an ETS with often high uncertainties lower the perceived initial risks to participants and to the on allowance prices, governments might wish to keep economy, reduce competitiveness impacts, and create an prices, and therefore compliance costs, low and place a enabling framework for the necessary learning processes higher priority on getting ETS architecture in place, building for regulators, regulated entities, and other stakeholders.132 support for the system, and starting trading. This can be Over time, as the infrastructure is established, market achieved by setting a relatively high cap (less stringent) participants become more familiar with the ETS in earlier periods, which is then gradually tightened. regulations, and other jurisdictions adopt similar pricing 132 A relatively high cap may also incentivize firms to “bank” their allowances for use in later compliance periods (in systems where banking is permitted). This banking behavior may lead to an oversupply of allowances, which depresses future prices. This issue is discussed in more detail in Step 6. STEP 4: SET THE CAP 83 Figure 4-3 Top-down and bottom-up approaches to cap setting Figure 4-3: Top-down and bottom-up approaches to cap setting Top-Down Bottom-Up Jurisdiction’s emissions reduction target Jurisdiction’s emissions reduction target High-level assessment of mitigation potentials ETS Cap Non-ETS sectors ETS Cap Non-ETS sectors Allocation to installations Free allocation* Auctioning Assessment of emissions and mitigation potentials *Potentially aligned to the ETS cap with an adjustment factor STEP 4 CAP approaches, the system’s ambition may rise (through available (which are illustrated in Figure 4-3) are discussed tighter caps), and regulators may not need to intervene as below: actively as at the earlier stage. 1. A top-down approach. The government sets the cap based on its overall emission reduction objectives and a Moreover, starting with an initially loose cap that tightens high-level assessment of mitigation potential and costs over time can create incentives for long-term low-carbon across covered sectors. This approach makes it simpler investment decisions while, enabling a gradual adjustment to align the ambition of the ETS with the jurisdiction’s to carbon pricing in the short term. This approach must broader mitigation goals and the contribution from other be carefully managed however, to avoid “locking-in” policies and measures. The approach described in low ambition into the system. For instance, continued Figure 4-1 is a top-down approach. investment in emissions-intensive assets could increase political pressure to retain loose caps and result in an 2. A bottom-up approach. The government bases the inability to ratchet up ambition. To ensure the ETS delivers cap on a more granular assessment of emissions, long-term abatement, policymakers may wish to consider mitigation potential, and costs for each sector, incorporating tighter “futures cap” into the initial design subsector, or participant, and determines an of the system and reflecting planned price increases in appropriate emission reduction potential for each. PSAMs. This allows the system to build in the ability to The overall cap is then determined by aggregating ratchet ambition without having to subsequently change the emissions/emission reduction potential for those legislation, which can be a lengthy and difficult process. sectors, subsectors, or participants. The impacts of differing levels of ambition in future A hybrid approach takes elements from both top-down and economic scenarios can be assessed through modeling bottom-up cap setting. Bottom-up data and analysis might exercises. A wide range of information can be collected be used as a basis for the cap, which is then adjusted to inform this process. This is discussed further in to reflect interaction effects between sectors, and the Section 4.3.2. intended contribution of the covered sectors to top-down mitigation objectives. Many ETSs with a more limited scope use these hybrid approaches.133 Some Chinese pilot ETSs 4.2.2 APPROACHES TO CAP SETTING use a hybrid approach. Policymakers thus far have taken different approaches Table 4-1 below provides a more detailed account of the to cap setting, depending on economy-wide ambition caps chosen by different jurisdictions and how they relate and jurisdictional circumstances. The two main options to economy-wide targets. 133 This involves adjusting for the possibility that emission savings in one sector might become easier, or more difficult, if they are also being sought in another sector at the same time. 84 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Table 4-1 Summary of cap setting approaches System Approach to cap setting and cap characteristics Overall approach to cap setting: Top-down 2013: 163 MtCO2e covering electricity and the industrial sectors 2014: 160 MtCO2e covering electricity and the industrial sectors California 2015–20: Cap in 2015 expands to 394 MtCO2e with introduction of transportation fuel and natural gas distributors and declines to 334 MtCO2e in 2020 2021–30: Cap declines from 321 MtCO2e in 2021 to 200.5 MtCO2e in 2030 ETS coverage: ~80 percent of California emissions Overall approach to cap setting: Top-down Phase 1 (2005–07) S Cap based on aggregation of national allocation plans of each EU Member State Phase 2 (2008–12) S Same as in Phase 1, but much stronger coordination and oversight by the European Commission Phase 3 (2013–20) S Cap for stationary sources: 2013–2020: 2,084 MtCO e in 2013 and declining by the linear reduction factor (LRF) of 1.74 2 EU ETS percent/year; coverage expanded S Cap for the aviation sector: 2013–2020: 38 MtCO e per year 2 Phase 4 (2021–30) S Revisions in 2018 to EU ETS Directive such that in Phase 4 ● the LRF for stationary sources and the aviation sector increases to 2.2 percent per year from 2021 onward ● the Market Stability Reserve (MSR) may reduce the cumulative cap starting in 2023 through cancellation of allowances in the MSR that exceed the previous year’s auction volume STEP 4 CAP ETS coverage: For 2018 it was 40 percent of total EU-27 emissions (the Brexit matters) ~45 percent of EU emissions Overall approach to cap setting: Top-down 2013: 147 MtCO2, meaning a stabilization at 2010 levels 2014–15: Cap declines from 155 MtCO2 to 153 MtCO2 Kazakhstan 2016–17: System suspended 2018–20: 486 MtCO2, meaning a 5 percent reduction by 2020 relative to 1990 levels (no yearly cap) ETS coverage: ~50 percent of Kazakhstan emissions Overall approach to cap setting: Hybrid 2020–2022: Cap during pilot determined based on historical emissions of participants as well as Mexico’s NDC and sectoral Mexico targets under its climate change law. This process resulted in an overall cap of 271 MtCO2 for 2020 and 273 (pilot) MtCO2 for 2021, with annual sectoral distributions and three allowance reserves. This is in line with BAU emissions and Mexico’s NDC. ETS coverage: ~40 percent of Mexican emissions Overall approach to cap setting: Transitioning to hybrid 2008–15: Operated under its national Kyoto target without a fixed domestic ETS cap 2015–20: Domestic-only system, still without fixed domestic cap New 2018: Government decided to develop and introduce an auctioning mechanism within an overall cap on nonforestry Zealand sectors; first auctions take place in 2020. These reforms, along with a move toward five-year emission budgets and supply settings, will transition the system toward a hybrid cap-setting approach. 2021-25: Cap declines from 32.8 MtCO2e in 2021 to 29.6 MtCO2e in 2025 ETS coverage: ~49 percent of New Zealand emissions Overall approach to cap setting: Top-down 2019–2022: Nova Scotia set its cap using the federal Environment and Climate Change Canada’s carbon pricing guidance Nova Scotia and its provincial targets. The 2019 cap was set at 13.68 MtCO2e and declines gradually relative to BAU projections to 12.14 MtCO2e in 2022, the last year of the first compliance period. ETS coverage: ~80 percent of Nova Scotia emissions Overall approach to cap setting: Top-down 2013–14: 23 MtCO2e per year covering electricity and the industrial sectors Québec 2015–20: Cap expands to 65 MtCO2e in 2015 with introduction of fuel and gas distributors and declines to 55 MtCO2e in 2020 2021–30: Cap declines from 55.26 MtCO2e in 2021 to 44.14 MtCO2e in 2030 ETS coverage: ~80 percent of Québec emissions Overall approach to cap setting: Top-down 2015–17: 1,686 MtCO2e including a reserve of 89 MtCO2e for market stabilization, of which 84.5 percent was used Republic of 2018–20: 1,796 MtCO2e, including a reserve of 14 Mt for market stabilization, 5 Mt for market makers, and 134 Mt for new Korea entrants and other purposes ETS coverage: ~70 percent of Korean emissions  STEP 4: SET THE CAP 85 Table 4-1 Summary of cap setting approaches (continued) System Approach to cap setting and cap characteristics Overall approach to cap setting: Top-down 2009–11: 188 million short tons per year 2012–13: 165 million short tons per year 2014: By 2012, emissions were 40 percent below the cap, and the 2014 cap was tightened to 91 million short tons. RGGI 2015–20: Reduction of 2.5 percent per year; two interim adjustments have been made to account for banked allowances 2021–30: Cap will decline by 2.275 million short tons per year from 75 million short tons in 2021. The Emissions Containment Reserve (ECR) may reduce the cumulative cap starting in 2021. ETS coverage: ~18 percent of emissions in RGGI states collectively Overall approach to cap setting: Bottom-up 2008–12: Voluntary phase Switzerland 2013–20: Cap declines from 5.6 MtCO2e in 2013 to 4.9 MtCO2e in 2020, a linear reduction of 1.74 percent ETS coverage: ~10 percent of Swiss emissions Overall approach to cap setting: Bottom-up 2010–14: Cap set at facility level and aggregated to a Tokyo-wide cap. Depending on the compliance category, facilities must reduce emissions by 6 percent or 8 percent below base year (i.e., average of any three-year period from Tokyo 2002–2007). 2015–19: Similar to above but 15 percent or 17 percent from base year 2020–24: Similar to above but 25 percent or 27 percent from base year ETS coverage: ~20 percent of Tokyo emissions Note: BAU = Business as Usual, RGGI = Regional Greenhouse Gas Initiative, GHG = Greenhouse Gas, MtCO2e = Megaton of Carbon Dioxide equivalent STEP 4 CAP 4.3 DATA REQUIREMENTS A range of data can help policymakers make informed Verification Systems and GHG Emissions Quantification decisions on the type and ambition of the cap. These are report provides detailed guidance on setting up discussed in this subsection as follows: frameworks for such data collection.135 S historical emissions and economic data, When gathering firm-level data on historical and S projections for emissions under a baseline (for example, anticipated future emissions to establish and project the BAU trajectory), trends, policymakers can consider the following: S technical and economic potential to reduce emissions S Existing firm-level environmental and production in covered sectors, and reporting systems may offer a useful starting point S roles of existing and new companion policies and for emissions data needed to set a cap, but the barriers to mitigation. methodologies applied, or the level of quality control or enforcement, may not be consistent with what is needed for an ETS. 4.3.1 HISTORICAL EMISSIONS AND S If adequate data for cap setting are not available ECONOMIC DATA from existing reporting systems, prospective ETS Historical emissions data play an important role in cap participants could be required to report emissions setting, as they provide an evidence base from which to early so that authorities have those data available when project future emissions in the absence of a cap, thereby determining the cap. establishing a baseline. Data at a jurisdictional level may S The data used to set the cap should predate serious already be available from domestic emissions inventories consideration of an ETS; otherwise, firms may have an or can be obtained from international organizations incentive to exaggerate their emissions, or emit more, in or research institutions.134 The Partnership for Market the hope of a looser cap, particularly if they anticipate Readiness’s (PMR) Guide to Designing Accreditation and 134 Examples include IEA, the Emissions Database for Global Atmospheric Research, the Carbon Dioxide Information Analysis Center, the Climate Analysis Indicators Tool developed by the World Resources Institute, and the PRIMAP-hist dataset from the Potsdam Institute for Climate Impact Research. Methodological differences between data sets should be taken into consideration. 135 PMR 2016, 2020. 86 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION that allocation will be through grandparenting (see As emissions data is often calculated from energy data, Step 5 for more on allocation). the methodological consistency (including the relevant S When using firm-level historical or projected emissions, emission factors) between data calculations for cap setting policymakers should seek an independent assessment and other steps in the ETS design process is of crucial of the firm’s self-reported information and assess it importance. This ensures that estimated emissions are against sectoral, national, and/or international peers. comparable across steps. Aggregate information from national inventories may also While it is still possible to proceed with cap setting even be used to sense-check firm-level data. For example, if historic emissions data is not available or is incomplete, information on the level of emissions from all the coal the specific challenges arising from gap filling need to combusted nationally, which is generally available in be addressed carefully. The experience of Phase 1 of the national records, should be close to the aggregate self- EU ETS, as explored in Box 4-2, illustrates some of the reported emissions of regulated entities (adjusting for problems that can arise. those excluded due to an emissions threshold). Box 4-2 Case study: Accounting for uncertainty of emission projections in cap setting for Phase 1 of the EU ETS (2005–2007) The availability of historic emissions data is critical when determining an ETS cap based on projections or growth rate. Due to the lack of reliable data on industry-wide and company-specific emissions of installations under the EU ETS prior to 2005, the cap was based on a bottom-up estimate of the allowances required by each installation. These estimates were based partly on incomplete data and partly on inconsistent emissions calculation STEP 4 CAP methodologies, while the data collection also allowed for the opt-out of certain years without considering this carefully enough for the calculation of totals. As a result, in mid-2006, after reports for actual emissions in 2005 were published, it became obvious that most Member States had set too generous caps and allocated too many allowances — almost 4 percent more than business as usual emissions, by some estimates.136 When entities found that they could comply fully with the pilot phase obligations without using all their allowances and the remaining allowances could be carried over to the next phase, the price of allowances fell to zero. This led to important accounting and allocation reforms for Phases 2 and 3 of the EU ETS with a move to a centralized cap and allocation process based on historical emissions data, generated by the monitoring, reporting, and verification (MRV) obligations.137 Given that banking was not possible between Phase 1 and Phase 2, any Phase 1 overallocation was not carried over into the next phases. Grubb and Ferrario examined four lines of evidence on emissions forecasting in the context of cap setting in the first phase of the EU ETS: scenario projections, statistical analyses of past forecasts, the process for official emissions forecasts, and the history of allocation negotiations in the EU ETS.138 They recommend that future ETSs should be designed with full recognition of “irreducible uncertainty and projection inflation” and a priority should be placed on improving the reliability and accessibility of data used for setting ETS caps. Such issues have been addressed for subsequent phases of the EU ETS. The elimination of the impact of lobbies at the national level and the addition of provisions for a more significant role of modeling enhanced the stringency and accountability of the EU-wide cap, and recent research has found the cap-setting process to be more efficient now.139 Developing an intensity-based cap requires 4.3.2 PROJECTIONS FOR EMISSIONS macroeconomic or production data in addition to UNDER BUSINESS AS USUAL emissions data. The metrics required will depend on the base of intensity calculations (for example GDP, population, Information on expected emissions without an ETS can kilowatt-hour of electricity, ton of clinker, and so on) also be useful when setting a cap. It can be used as a and must be chosen according to jurisdictional context baseline to compare the potential emission and cost and data availability (see Box 4-4 for more detail). This impacts of an ETS under different emission caps. information is generally available from a range of domestic sources and can also be supplemented by information from international sources such as the World Bank. 136 Egenhofer 2007; US GAO 2008. 137 See European Commission 2012 for MRV regulations. 138 Grubb and Ferrario 2006. 139 See Fallmann et al. 2015. STEP 4: SET THE CAP 87 The type of economic and emissions forecasting used Figure 4-4 Setting the ETS cap with a top-down approach for setting jurisdiction-wide mitigation targets can also be useful for these purposes. Four key options are:140 Historical emissions Future emissions projection 1. Trend extrapolation. Observed historic trends in output (for example GDP, kilowatt-hour of Nationa l emiss electricity use, and so on) and emissions intensity ion s targ et tra j ecto as a function of output are extended into the r y future to define an emission pathway. 2. Extended extrapolation. The extrapolation 2030 target emissions Emissions (MtCO2e) of historic trends is refined by accounting for potential changes in output and/or emissions intensity. 3. Decomposition projection. Trends in a small number of key emission drivers (for example, population, economic growth, energy intensity, 2015 2020 2025 2030 and structural change) are assessed to define an Year emission pathway. 4. Detailed bottom-up analysis. Drivers of  Historical uncovered sector emisions  Projected uncovered sector emissions  Historical covered sector emissions  ETS cap production and emission intensity are analyzed in detail at the sector or subsector level in the context of broader economic projections and the STEP 4 CAP results aggregated to define an emission pathway. Figure 4-4 illustrates how a simple top-down cap can be set using this information. In this example, policymakers However, emissions and economic projections involve a would need to know the trajectory of their jurisdictional high degree of uncertainty associated with emission drivers emissions reduction targets and projections for uncovered operating independently of the ETS (for example, growth sector emissions (which can be forecasted using the of production, sectoral value added or GDP, volatility in techniques mentioned above). The yearly ETS cap is international energy prices, commodity demand, and then simply the target trajectory less the emissions from currency exchange rates). It is therefore useful to develop uncovered sectors. a range of emission and economic projections that can be used for assessing the potential impacts of an ETS. An intensity-based cap reduces the need for policymakers When using company or industrial association data for to develop output projections to predict the cost of projections it should be considered that these projections compliance with the cap. However, they impose the need regularly tend to be overoptimistic for growth assumption to explicitly select appropriate intensity metrics. This is and emission trends.141 discussed further in Box 4-3. Box 4-3 Technical note: Data considerations under an intensity-based cap Intensity metrics can relate to economic and/or commodity outputs. The appropriate choice of metrics will vary according to sector coverage, the availability of data, and the objectives of the ETS. If an ETS covers a single sector whose emissions are strongly correlated with GDP, like power generation, then either a GDP or a commodity metric could be used. When multiple sectors are covered by an intensity cap, then the output metric of GDP may be the easiest to apply universally. Alternatively, a bottom-up multisector cap could be developed using sector-specific commodity metrics. Experience with setting emission intensity reference levels in other contexts, such as average performance standards or best-practice emission benchmarks, has highlighted a number of the technical challenges that can be associated with using bottom-up intensity caps in an ETS. While defining emission intensity reference levels may be relatively straightforward in sectors like electricity generation, it becomes more difficult in sectors like specialized product manufacturing, mining, or chemical production. It is also challenging to develop emission-intensity reference levels for processes like cement, steel, and aluminum production when regional differences in resource and technology availability, process methodology, and fuel mix need to be taken into account.  140 PMR 2015a. 141 Matthes and Schafhausen 2007. 88 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION If, however, substitution of commodities is seen as a significant source of emission abatement (aluminum vs. steel, cement vs. other building materials), the use of metrics related to commodities is obviously not suitable as a basis to define the cap for certain sectors that are to be regulated by an ETS. When emissions-intensity reference levels are used as a basis for a cap across a number of sectors rather than for allocation to specific firms or sectors, simpler reference levels could be used, particularly if the output metric is GDP. 4.3.3 TECHNICAL AND ECONOMIC Importantly, while information on marginal abatement cost POTENTIAL TO REDUCE curves is useful, it is not essential to have comprehensive EMISSIONS information on marginal abatement cost curves before setting an ETS cap. The point of an ETS is to create The magnitude and cost of mitigation opportunities incentives for market participants (consumers and across covered and uncovered sectors constitute a third producers), not regulators, to discover the most cost- key category of information. The cap should incentivize effective mitigation options across covered sectors. Raising innovation and maximize economic mitigation potential to cap ambition gradually and reviewing the cap periodically produce cost-effective abatement. may be sufficient to moderate the risk of excessive prices Mitigation potential can be defined as “the amount by and enable the cap to be adjusted as better information on which it is possible to reduce greenhouse gas emissions marginal abatement cost curves becomes available. or improve energy efficiency by implementing a technology or practice that has already been demonstrated.”142 4.3.4 RELATIONSHIP WITH OTHER STEP 4 Information on technical mitigation potential in key POLICIES CAP sectors is widely available from international research organizations. For example, studies synthesizing In many jurisdictions, a new ETS will interact with information on technical mitigation potential in key sectors other policies to drive change. Estimates of MACs and have been produced by the Intergovernmental Panel projections for relative emissions and price responses on Climate Change (IPCC),143 the International Energy under different cap settings might vary significantly Agency,144 the Deep Decarbonization Pathways Project led depending on the existence and workings of these policies, by the Sustainable Development Solutions Network, and and result in either enhancing, duplicating, or negating the Institute for Sustainable Development and International the impact of an ETS. It will therefore be important Relations.145 However, it is always important to adapt the to document these policies carefully as a first step to findings of such studies to local conditions. explore these interaction effects and hence determine the appropriate type and ambition of the cap. See Step 1 for a Economic mitigation potential can be defined as “the detailed discussion on companion policies. potential for cost-effective GHG mitigation when nonmarket, social costs and benefits are included with In existing ETSs (for example, EU ETS and RGGI), significant market costs and benefits in assessing the options for interactions have been observed between ETSs and other particular levels of carbon prices and when using social policies, particularly those implemented to promote renewable discount rates instead of private ones.”146 Developing energy and energy efficiency. For Phases 2 and 3 of the marginal abatement cost curves for key sectors can help EU ETS these interactions with complementary goals and explain the effectiveness of different mitigation measures policies in the framework of the EU’s 20-20-20 targets for and the overall cost of achieving an emissions reduction 2020 efficiency (20 percent emission reduction, 20 percent target. A marginal abatement cost curve presents the of energy from renewable energy sources, and 20 percent potential emissions abatement and associated cost for a of energy intensity improvements) were subject to broad set of mitigation measures (see Section 1.5.1 of Step 1 for modeling exercises that built a robust reference for a cap further detail). Figure 4-5 provides an example marginal that considered the additional emission mitigation from the abatement cost curve. However, developing accurate complementary policies.147 The 2030 emission reduction target marginal abatement cost curves can be challenging and (40 percent below 1990 levels) was accompanied by an energy may be easier in sectors that are already regulated or efficiency target of 32.5 percent and a renewables target of 32 where technical mitigation options are common across percent. In the framework of the European Green Deal all three countries, so it is possible to draw on others’ experiences. 2030 targets are adjusted to more ambitious levels. 142 IPCC 2014. 143 IPCC, Climate Change 2014: Mitigation. 144 For information on International Energy Agency’s (IEA) low-carbon energy technology roadmaps, see IEA 2020b. 145 Deep Decarbonization Pathways Project 2015. 146 IPCC 2007. 147 See Capros et al. 2008. STEP 4: SET THE CAP 89 Figure 4-5 MAC curve plotting abatement options in order of their cost 150 Annual abatement cost of the mitigation option ($/ tCO2e) Option 9 Option 9 100 Option 8 has the Option 1 has the highest cost lowest cost and should be Option 7 50 undertaken first Option 6 Option 5 Option 4 0 Option 3 -50 Option 2 Option 1 -100 Mitigation options with negative cost -150 STEP 4 CAP 100 200 300 400 500 600 700 Annual abatement potential of the mitigation option (tCO2e) 4.4 IMPLEMENTING THE CAP Once the fundamental design decisions have been made, stakeholders, and representatives of civil society. This could informed by the collection of relevant data and modeling help improve the objectivity, transparency, and credibility of efforts, it is possible to set the cap. As discussed in this the cap-setting process (see Box 4-4). section, this requires: The cap level can be written directly into legislation or, more S agreeing upon the formal legal and administrative commonly, the legislation can establish the process for governance arrangements, setting the cap. Cap levels could then be set in secondary S designating allowances to be allocated under the cap, legislation or similar, which provide sufficient authority but and are more easily amended. Fixing the cap level by law makes S choosing time periods for setting the cap. it harder to adjust, both to water down provisions and also to increase ambition. This certainty may be desirable and allow businesses to plan long-term investment decisions 4.4.1 CAP GOVERNANCE better by providing a credible legal foundation. On the An appropriate authority should be delegated the other hand, the legislative process is complex and time responsibility for setting the ETS cap. It should also ideally consuming. Setting out the process rather than the cap coordinate with the bodies responsible for setting NDC itself provides less certainty but enables more time for targets and other companion policies. The relevant authority data collection and analysis. It could also defer technical may be a regulatory, legislative, or administrative body cap-setting discussions until later — and less political — depending on structures already in place in the specific stages of ETS development. Most importantly, it would jurisdiction. Given the importance of the cap to the costs allow for evolution in the ambition and design of the cap as businesses and society will face, a jurisdiction may also a response to changing circumstances, including political wish to consider the merits of establishing an independent change, ratcheting climate targets, or revision of emissions body to provide advice on setting or updating the cap. For projections (which inherently carry a level of uncertainty example, the body could include technical experts, sector when formulated). The design of PSAMs might also allow for an evolving cap (see Step 6). 90 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Box 4-4 Case study: Jurisdictions have taken a range of approaches to cap governance For the first two phases of the EU ETS, the governance approach for cap setting was left to the Member States. In some jurisdictions (for example, Germany), cap setting was subject to a full legislative process; in other jurisdictions (for example, France) it was done by administrative orders. Member States’ caps were subject to approval by the European Commission as the administrative body of the EU, acting within the legislative framework that defined principles rather than quantitative specifications. In many cases, the commission required changes, in particular to reduce national caps; however, the Member States also challenged these decisions. To avoid the legal uncertainty and safeguard the environmental integrity of the EU ETS, from Phase 3 onward the EU-wide cap is set under EU legislative process. In the case of the California Cap and Trade Program, state legislation (AB 32) set the requirement that California return to 1990 emissions levels by 2020 and charged the California Air Resources Board (CARB) with developing a Scoping Plan for meeting the 2020 target. The initial Scoping Plan, approved by CARB in 2008, provided for development of an ETS. The cap was set through regulation under a process managed by CARB as the primary implementing agency (see Box 4-7 for details on the California Cap and Trade Program caps).148 In Australia, the carbon pricing mechanism (now repealed) required the Climate Change Authority, an independent statutory agency, to make an annual recommendation on where the cap should be set in five years’ time. The government was required to take the authority’s advice and recommendations into account when setting caps and announce these five years in advance. The process for setting caps was outlined in primary legislation with individual caps set in regulations. The Clean Energy Act provided a default cap if a cap was not set. In Korea, the ETS cap was set outside of legislation to enable greater flexibility and efficiency. The legal basis for STEP 4 CAP implementation of an ETS was first established in the 2010 Framework Act on Low Carbon, Green Growth followed by the Emissions Trading Act. Secondary legislation, an allocation plan completed by the Ministry of Environment in September 2014, defined the ETS cap and allocation provisions in alignment with the act. 4.4.2 DESIGNATING ALLOWANCES FOR increase unit supply in the market. Policymakers may DOMESTIC COMPLIANCE choose to place quantity limits on the issuance or use of removal units. As noted above, the government may also Every ETS currently in operation issues its own domestic choose to operate PSAMs that issue allowances beyond allowances in units of tons of greenhouse gas, either the cap in order to provide price protection or hold back carbon dioxide (CO2) or carbon dioxide equivalent (CO2e). allowances for specific purposes (for example, new entrant All existing ETSs use (metric) tons with the exception allocation in the course of a trading phase or allocation of RGGI, which uses US short tons.149 In addition, for price predictability purposes). These may not be made policymakers also need to decide whether to recognize available to the market if not used for the purpose for which external units for compliance. Such external units may they were originally held back. When these allowances are derive from offset mechanisms (see Step 8) the ability to permanently removed from the market it would implicitly buy and sell through linking (see Step 9) or international tighten the cap, which is another way to gradually adjust a trading mechanisms like cooperative approaches cap for real emission trends (see Step 6). developed under Article 6.2 of the Paris Agreement. Parties to the agreement will be able to trade emissions reductions The activities associated with specific domestic allowances in the form of internationally transferred mitigation can be differentiated and tracked, if desired, by assigning outcomes (ITMOs). The principles governing the creation a unique serial number to each allowance at the time and trade of ITMOs remain to be decided by the United of issuance into a central registry. For example, New Nations Framework Convention on Climate Change. Zealand’s government chose to create a single allowance, the New Zealand Unit (NZU), which applied equally to Not all emissions reduction units issued by the government emissions by all sectors and removals by the forestry and may be subject to the ETS cap. For example, the industrial sectors. Some market buyers (both domestic and government may choose to issue units for removals by international) were willing to pay a price premium for NZUs sinks. Removals are environmentally equivalent to lower associated with forest conservation and afforestation, emissions from mitigation, so units are often issued in especially for land under long-term forest covenants. By addition to the cap. In this case, removal allowances would assigning a unique serial number to each allowance issued 148 California Air Resources Board 2008. 149 The short ton refers to a mass of 2,000 pounds or 907 kilograms (as opposed to a metric ton, which refers to a mass of 1,000 kilograms). Its use is confined to the United States. STEP 4: SET THE CAP 91 into the registry and enabling allowance tracking, sellers S The EU ETS set a new cap prior to each multiyear could market the attributes of their NZUs to gain a price phase: 2005–2007, 2008–2012, 2013–2020, and premium and buyers could verify the sources. By contrast, 2021–2030. A feature of the EU ETS is that the caps California and Québec deliberately chose not to publish from 2013 onward include an automatic linear reduction identifying numbers that would distinguish allowances factor that defines the annual contraction of the cap from the two systems because allowances of the two ETS (see Section 4.5.6). markets are fully fungible. S The Tokyo ETS also set a new cap prior to each multi- year compliance period: FY2010–2014, FY2015–2019 and FY2020–2024. 4.4.3 CHOOSING TIME PERIODS FOR S Most Chinese pilots have an ex post de facto cap CAP SETTING depending largely on the benchmarks and the actual Policymakers need to define the period for which the cap outputs/business volumes of the covered enterprises. is fixed under a given set of parameters (referred to here S The Australian ETS proposed to set five years of caps as a “phase”). This will usually correspond to a time period initially and to set the next annual cap on a rolling basis under which other major program design features are also each year so that caps were always set five years in specified. The length of phases can change over time. For advance, as discussed in Box 4-5. instance, the EU ETS sets phases lasting several years. Phase 1 of the EU ETS was three years long, Phase 2 Scheduling formal cap reviews on a periodic basis can was five years long, Phase 3 was eight years long, and enable systematic adjustment of the cap to ensure it Phase 4 will be 10 years long. In addition to the duration remains appropriate while providing certainty about cap of the phase, jurisdictions will need to consider how far in settings between reviews. It can also help ratchet cap STEP 4 advance the phases should be set. This requires balancing ambition in accordance with national climate policy, or if CAP businesses’ desire for certainty with the need to retain mitigation potential is higher than expected while setting flexibility and use recent data for cap calculations. the previous cap. Cap reviews may be conducted as part of a comprehensive ETS review, or as a stand-alone exercise. Policymakers also need to define the period for which When conducting a formal cap review, the government may entities need to surrender obligations (referred to here wish to evaluate: as a “compliance period”).150 The use of banked and S changes in the broader context for an ETS, such as the borrowed allowances across compliance periods makes jurisdiction’s overarching mitigation targets, economic the distinction between each period less relevant (see development trends, the availability of new technologies, Step 6). An annual compliance period is a common choice and the relative ambition of carbon pricing or alternative and often seen as the default. However, decisions on mitigation policies in other jurisdictions; compliance periods should be coordinated with other S how the ETS has performed relative to expectations for aspects of climate change policy and ETS design. For example, expanding the ETS’s scope to incorporate allowance prices, compliance costs, and potential for additional sectors, linking with other jurisdictions, leakage and competitiveness impacts; and and changes in the jurisdiction’s international climate S how much the carbon price has influenced behavior change contributions and emission reduction targets and investment of the regulated entities to reduce will all have implications for cap setting. Transitions emissions, particularly relative to other drivers such as between compliance periods can also be scheduled to international energy prices, commodity demand, and accommodate milestones, like the entrance of new sectors other policies and regulations. or new participants, or the commencement of linking. Reviews of ETS operation are discussed in more detail in Examples of phases and compliance periods from a few Step 10. systems are as follows: S In A relatively simple approach to cap setting applied by RGGI, caps were initially set up front for two 5-year many systems to date is to define annual caps that start phases (2009–2014 and 2015–2020) with a cap review at a designated point and decline at a (possibly linear) and adjustment in 2012. rate that is fixed for each cap period. The benchmark for S In California and Québec, annual caps were set defining the cap’s starting point typically is either actual up front. These were aggregated into a series of emissions in a recent year, average annual emissions over multiple-year compliance periods covering 2013–2014, a recent period, or projected emissions in the starting year, 2015–2017, and 2018–2020. although projected emissions are inherently uncertain and subject to pressure for revision. The cap ending point is 150 Each system may use the terms “phase” and “compliance period” differently, or use different terms altogether. It is important to understand the meaning of these terms in the specific context. 92 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION defined in alignment with the jurisdiction’s mitigation and in each year in between. In other cases, the annual cap may cost objectives for covered sectors (which will require stay constant across individual years within a cap period projections to be made). A straight line is then often drawn but decline in a stepwise fashion over the cap periods. between the starting and ending points to set the cap level Box 4-5 Case study: Australia’s and New Zealand’s cap mechanisms The Australian ETS applied the concept of a rolling cap mechanism. Under the government’s carbon pricing mechanism, which started operation in 2012 but was repealed in 2014, the initial three-year fixed price phase was to be followed by a flexible trading phase that provided for fixed five-year caps that were to be extended annually by one year by the government, with advice from the Climate Change Authority, an independent agency. In the event no decision could be reached, a default cap would align with the government’s national emissions reduction target for 2020.151 This process ensured that businesses had a predictable level of certainty on cap duration, the timing of cap setting, and the default level of ratcheting. The New Zealand government has taken a similar approach in the reforms announced in 2019 to the NZ ETS. The reforms aim to establish a coordinated decision-making process to manage unit supply into the NZ ETS.152 The process aims to set a limit on the number of NZUs that can be released into the NZ ETS market each year via the auctioning mechanism. To do so, it considers a range of factors, such as allowance quantities from auctioning, free allocation, international units, and a cost containment reserve, as well as projected removals from the forestry sector. The annual NZU supply limit will be announced annually five years in advance and extended each year. Based on the advice of the independent Climate Change Commission, the Minister of Climate Change may still STEP 4 CAP decide to adjust supply volumes up to four years after the initial announcement. However, these quantities become fixed one year in advance. The measure is designed to increase the transparency of unit supply decisions and give all participants greater certainty over market developments, while aligning the unit supply in the NZ ETS with New Zealand’s long-term emissions reduction targets and five-year carbon budgets. 4.5 MANAGING THE CAP Once the cap has been implemented, policymakers must ETSs) may provide explicitly for step changes in the cap as actively manage the cap and its interactions with other new sectors enter. In the California and Québec systems, steps in the ETS design process. In particular, they must breaks between phases are aligned with the entry of new make necessary alterations to the cap due to sectors. In the EU ETS, some sectoral scope changes 1. any changes in the scope (see Step 3), were made at the transitions between phases, but aviation entered the system midstream during Phase 2. After the 2. interactions with allocations and allocation further enlargement of the EU in 2007 (when Romania and mechanisms (see Step 5), Bulgaria joined) the cap was adjusted for the ETS-covered 3. market shocks and the operation of PSAMs (see Step 6), sectors in the new Member States in the course of Phase 1. 4. interactions with offsets (see Step 8), While scope has usually been increased, there have been 5. linking with other ETSs (see Step 9), and scenarios where a shrinking scope has necessitated a cap change. In the case of RGGI, the cap was revised downward 6. ratcheting ambition over time (see Step 10). when one of the participating states — New Jersey — withdrew, and then back up again when it rejoined.153 In 4.5.1 CHANGING SCOPE most cases, these kinds of cap changes can be planned and integrated smoothly into cap-setting arrangements. An ETS’s cap will need to be adjusted as sectors enter or exit the ETS, or as participation thresholds change. As well as sectoral changes, individual entities within An operational ETS with phased sectoral entry under an covered sectors can either enter or exit the market during a absolute cap (for example, the EU, California, and Québec compliance period. Further information on accommodating 151 Government of Australia 2011. 152 NZME 2018. 153 See Box 9-6 in Step 9 for more detail on delinking in RGGI. STEP 4: SET THE CAP 93 new entrants and closures during the cap period can be to accommodate the need to surrender two allowances found in Step 5. for each unit of emissions from electricity generation: one upstream and one downstream. 4.5.2 INTERACTION WITH ALLOCATIONS 4.5.3 MANAGING MARKET SHOCKS Decisions on the cap will have central implications for decisions on allocation. It is generally preferable for Under normal operation, an ETS responds to fluctuations discussions on allocation to take place after the cap has in unit supply and demand through changes in allowance been defined in order to separate discussions on overall prices, demand for offsets, banking, or borrowing. When system ambition from discussions on the distribution of systemic shocks (such as major changes in fuel prices or costs. This can also help avoid the problems seen, for economic activity) drive changes in allowance demand or instance, in Phase 1 of the EU ETS where the decision prices that are out of the ordinary and could destabilize on how many allowances to provide for free ended up the market, policymakers may need to consider whether to determining the overall cap, resulting in a total cap that was adjust the supply of allowances available. This intervention above BAU emissions and hence the price falling to zero. can be made on an as-needed basis, but is increasingly implemented using automatically triggered, rule-based However, given political and administrative pressures, PSAMs built into the ETS design to automatically expand decisions on caps and allocation may become interlinked or reduce supply (See Step 6). and iterative, especially in systems that allocate most or all of their allowances for free. In these cases, policymakers Policymakers implementing PSAMs to manage prices will need to ensure that the level of free allocation they must also decide if these adjustments are temporary plan to supply under a given methodology (for example, or permanent in nature. Temporary measures are STEP 4 CAP on the basis of facilities’ historical emissions or emission counterbalanced by corresponding changes to the cap in benchmarks per unit of production) can be accommodated future periods, preserving the long-run emissions reduction by the cap they have set.154 target of the ETS. On the other hand, changes not reflected in future caps result in a permanent adjustment From a procedural perspective, however, a key emerging of the overall ambition. Policymakers may also choose to lesson is that a deep integration of cap-setting and neutralize some, but not all, of the adjustments. allocation procedures tends to inflate the caps as a result of distributional conflicts on (free) allocation. A clear It is important to note that permanent increases in supply separation of the cap setting and the allocation process adversely affect the emission reductions achieved by the should be seen as the preferable model for the procedural ETS and may put the country’s ability to meet its NDC at arrangements around the cap setting. risk. Conversely, permanent decreases in supply allow countries to increase the ambition of their ETS and can be In systems that combine free allocation with auctioning, as a useful mechanism to ratchet up emissions reductions. long as the cap can safely accommodate committed levels See Section 6.3.3 of Step 6 for further detail on the relative of free allocation, the issue is in principle less significant as merits of temporary and permanent adjustments. the amount of auctioning within the cap can be adjusted to accommodate fluctuations in free allocation. Further details Additionally, to improve policy certainty and retain the on the trade-offs between allocation methods are in Step 5. confidence of market participants, policymakers should define clear triggers and/or procedures for unscheduled Special considerations arise for cap setting when the point cap adjustments as part of initial ETS design and set of obligation for surrendering allowances in regard to one parameters around the type of adjustments that could be emission source is applied at more than one point in the made. Cap adjustment triggers could be defined based supply chain. For example, in the case of emissions from on unit supply or unit price.156 Step 6 provides more electricity generation in the Korean ETS, policymakers information about PSAMs. Alternatives to rule-based cap have assigned unit surrender obligations for both direct adjustments would be discretionary mechanisms that could emissions at the point of electricity generation and indirect rely on decisions of specific bodies appointed for these emissions at the point of electricity consumption.155 A key purposes. Such discretionary arrangements have been consideration is the potential for government regulation of subject to conceptual and theoretical debate but are not energy prices to prevent carbon prices from being passed typically used for unscheduled cap adjustments in practice. through the supply chain. The cap in such a system needs 154 In some of the Chinese ETS pilots, the caps are actually determined by the allocation approaches, as caps have not been announced, and the actual total number of allowances in the market constitutes the actual caps. 155 Kim and Lim 2014. 156 Gilbert et al. 2014b. 94 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION 4.5.4 INTERACTION WITH OFFSETS type of cap. Moreover, trading between jurisdictions with absolute and intensity caps may result in an increase in In addition to allowances provided under the cap, overall emissions, relative to the case where no linking is policymakers might also allow the use of offsets for allowed. For this reason, jurisdictions with absolute caps compliance within an ETS, albeit often subject to qualitative may decline to link with jurisdictions with intensity caps. and quantitative limits (see Step 8). Offsets provide credit Indeed, in the example of the US Clean Power Plan, trading for emissions reductions or removal by domestic or between participants in rate-based states (which choose international sources not covered by an ETS and, once intensity targets) and participants in mass-based states accepted, are treated as equivalent to allowances within (which choose absolute targets) was not permitted. Linking the ETS. This widens the pool of sources of emissions is more fully discussed in Step 9. reduction available and generally provides ETSs the ability to achieve the same mitigation outcome at a lower cost. 4.5.6 RATCHETING AMBITION OVER TIME Although they are generally separate from the ETS cap, AND PROVIDING A STABLE PRICE offsets can have an impact on unit supply within the ETS, particularly when there are no quantitative limits, or very SIGNAL generous limits, placed on their use. For example, when As described in Section 4.4.3, it is typical for the period Certified Emission Reductions from the Clean Development over which a cap is set in advance to be between two and Mechanism (CDM) suffered a steep fall in prices as a result 10 years, although in some cases this is even longer (see of the financial crisis, these units flooded the compliance Box 4-6 on the EU ETS). At the transition points between market in the NZ ETS (which placed no limits on their use) cap periods, policymakers have an opportunity to review and the EU ETS. This is one of the factors that led to a and make adjustments to the cap as more information on STEP 4 significant surplus of allowances, and resultant crash in abatement costs, economic fluctuations, and actions by CAP prices, in both systems. While NZ ultimately delinked from international trading partners becomes available. the CDM market, these factors contributed to the EU’s decision to “backload” over 900 million allowances over However, enabling periodic cap adjustments may create the period 2014–2016. The allowances were withdrawn uncertainty among market participants as to the possible from the market and ultimately placed in the ETS’s market long-term trajectory of the cap and the resulting price stability reserve. signal. This may undermine one of the main benefits of carbon pricing, namely, to provide a carbon price signal Offsets also affect the burden sharing between that can incentivize low-carbon investments. uncovered and covered sectors, allowing for the voluntary participation of unregulated entities in the ETS. Some In this context, ETS participants might benefit from having sectors, like waste management, agriculture, or forestry, some additional policy certainty. One option is to define are often excluded from the scope of ETSs due to the a long-term trajectory for the cap. The trajectory could dispersed nature of the market and the difficulty in signal a direction of change and/or a rate of change over quantifying and reporting emissions. However, they time with regard to emission levels and/or carbon prices in represent significant opportunities for emissions reductions alignment with broader long-term mitigation, technology, and GHG removal. Offset markets allow self-selection of or economic transformation targets. Possible approaches entities within these sectors that can reduce and report include setting an indicative cap range or a default pathway emissions into the system. If these uncovered sectors in advance to guide future decision-making while building can deliver significant emissions reductions and removals in flexibility for decision-making by future governments through offsets in the ETS, resulting in excess allowances, (see Section 4.4.3). This was the approach taken by the it may be possible to tighten the cap further and faster. European Commission (see Box 4-6). Achieving cross- party support for a long-term cap trajectory would help further improve policy certainty. PSAMs may also be 4.5.5 LINKING WITH OTHER ETSs used to provide a consistent price signal. Additionally, intertemporal flexibility and bringing forward mitigation If a jurisdiction has intentions to link its ETS to the ETS when prices are low can make it easier to ratchet ambition in one or more other jurisdictions, then this will be made in the future (see Step 6 for a detailed discussion). considerably easier if the linked ETSs have the same STEP 4: SET THE CAP 95 Box 4-6 Case study: The linear reduction factor for the EU ETS From 2013 onward, the cap for the EU ETS has been subject to the LRF. The LRF is expressed as a percentage of the average annual total quantity of allowances issued in accordance with the Member States’ national Allocation Plans for the period from 2008 to 2012 (adjusted for scope changes) and that marks the annual decline of the cap along a linear trajectory, starting in the midpoint of the 2008–2012 period. The LRF was initially set at 1.74 percent. It was explicitly designed without an expiry date and therefore formed part of the binding ETS legislation for periods beyond 2020. In the context of the structural reform of the EU ETS concluded in 2018, the LRF was increased to 2.20 percent from 2021 onward, again explicitly without a date for expiration. While the original LRF at 1.74 percent would have reduced emissions of regulated entities to 70 percent below 2010 levels by 2050, the adjustment to 2.20 percent from 2021 onward leads to a legally binding emissions reduction of 82 percent below 2010 levels by midcentury. This robust long-term emissions reduction commitment is one of the reasons why prices did not fall to zero as a surplus of allowances accumulated in the EU ETS from 2010 onward. Indeed, a liquid carbon market underpinned by a credible long-term emissions reductions commitment can provide a clear informational signal to investors regarding the type of activities consistent with the long-term regulatory environment even when future policy stringency is not yet reflected in the current price signal. Box 4-7 provides an account of how policymakers change the cap over time while still maintaining market managed the challenge of providing a steady price signal confidence and providing a clear price signal to market when setting the cap for the California Cap and Trade participants. The balance between predictability and Program. By identifying clear rules and parameters up front flexibility is relevant throughout the development of an ETS STEP 4 for adjusting caps over time, and signaling future changes and is detailed further in Step 6. CAP well in advance where possible, governing authorities can Box 4-7 Case study: Ambition and cap design in the California Cap and Trade Program The California Cap and Trade Program was designed to help the state achieve its 2020 target to reduce GHG emissions to 1990 levels by 2020 and by 80 percent below 1990 levels by 2050. Strategically, it was designed as a backstop to reinforce outcomes from a large portfolio of mitigation policies and ensure that mitigation incentives reach the parts of the economy that were not covered by targeted policies. Drawing from assessment of mitigation potential and modeling of economic costs, CARB allocated a share of the statewide emissions reduction responsibility to covered ETS sectors, which account for approximately 80 percent of the state’s emissions. Officials defined an absolute cap to start from a projection for actual emissions in 2013 and to decline on a linear basis to meet the designated 2020 endpoint for total emissions from covered sectors, which was more than 16 percent below starting levels. The state’s initial projection for start-year emissions had to be adjusted downward after officials received improved facility-level data under a mandatory reporting regime for industrial sources, fuel suppliers, and electricity importers starting in 2008. The cap was adjusted upward in 2015 to accommodate the entry of new sectors, which were subject to a faster annual rate of decline than earlier entrants. The passage of Senate Bill 32 in 2016 established a 2030 reduction target of 40 percent below 1990s levels, and CARB adopted a cap trajectory for 2021–2030 that aligns with the 2030 goal. The annual rate of decline will average 4.1 percent from 2021 to 2032, reaching 200.5 megatons of carbon dioxide equivalent (MtCO2e). The program design includes quarterly auctions, with a price floor or “auction reserve price” that increases each year. This escalating floor price provides continuous upward price support, while an allowance price containment reserve and price ceiling hold a portion of allowances out of regular circulation and introduce them during periods of high demand at high fixed prices. The allowance price containment reserve (APCR) also includes allowances that remain unsold for eight consecutive auctions. A large share of unsold allowances from the 2013–2020 period have been added to this reserve that will only be available for potential release from the price containment reserve starting in 2021. Starting for 2021 compliance, a price ceiling at which price ceiling units (PCU) can be purchased by compliance entities will be available in addition to the APCR. PCUs can only be used to meet the remainder of compliance entities’ compliance obligation and are available at a fixed price above that of the APCR. The revenue collected from potential sales of the PCUs is used to ensure continued environmental integrity with at least one-for-one emissions reductions. CARB implemented these PSAMs, along with other limits to the number of allowances entities can hold or bank, to help ensure the ETS drives reductions in alignment with the 2030 target157 (for more on the role of PSAMs, see Step 6).  157 California Air Resources Board 2017. 96 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION For additional supply and flexibility beyond the cap, participants can use a limited number of approved offsets to meet a portion of their compliance obligations and access allowances from linked ETSs. Through periodic reviews by CARB, legislative oversight, and mandatory updates to the state’s Scoping Plan for reductions at least once every five years, California creates opportunities to adjust policies as needed to stay on track toward its reduction goals.158 4.6 QUICK QUIZ Conceptual Questions 1. What is the role of the cap in an ETS? 2. What background information is helpful to set the ETS cap? 3. What is the difference between an absolute cap and an intensity cap? Application Questions STEP 4 CAP 1. In your jurisdiction, how much should the ETS contribute toward meeting the overall emission reduction targets? 2. Will your jurisdiction need to design a cap that supports linking to another ETS in the near or longer term? 4.7 RESOURCES The following resource may be useful: S Achieving Zero Emissions Under a Cap and Trade System 158 Center for Climate and Energy Solutions 2014. STEP 5: DISTRIBUTE ALLOWANCES 97 Step 5 - Distribute allowances STEP 5 Distribute allowances At a Glance_____________________________________________________________________________ 98 5.1 Allocating allowances______________________________________________________________ 99 5.2 Auctioning_______________________________________________________________________ 105 5.3 Free allocation____________________________________________________________________ 109 5.4 Comparison of allocation methods_________________________________________________ 117 5.5 Quick Quiz_______________________________________________________________________ 121 5.6 Resources_______________________________________________________________________ 121 BOXES Box 5-1 Technical note: Allocation terminology explained_______________________________ 100 Box 5-2 Technical note: Carbon leakage channels______________________________________ 104 Box 5-3 Technical note: Auction design for ETSs_______________________________________ 106 Box 5-4 Case study: Partial use of consignment in California auctions____________________ 107 Box 5-5 Case study: Auction revenue use_____________________________________________ 108 Box 5-6 Case study: Fixed historical benchmarked allocation in Phases 3 and 4 of the EU ETS____________________________________________________________________ ALLOCATION 112 STEP 5 Box 5-7 Technical note: Impacts of output-based allocation_____________________________ 113 Box 5-8 Technical note: Alternative approaches to carbon-leakage protection_____________ 116 Box 5-9 Technical note: Updating free allocation provisions______________________________ 118 FIGURES Figure 5-1 Possible evaluation of primary allocation method as an ETS matures______________ 119 TABLES Table 5-1 Allocation methods in different ETSs__________________________________________ 101 Table 5-2 Trade exposure and emissions intensity in different ETSs________________________ 115 Table 5-3 Summary of methods of allocation against objectives___________________________ 117 Table 5-4 Summary of performance in reducing the risk of carbon leakage for different methods of allocation_______________________________________________________ 120 Table 5-5 Summary of data requirements for different methods of allocation________________ 121 98 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION AT A GLANCE that a policymaker may wish to manage through the Checklist for Step 5: Distribute allowances approach to allowance allocation. Some relate to the ✔ Match allocation methods to policy objectives distribution of costs and value, including possible ✔ Define eligibility and methods for free allocation loss of asset value (“stranded assets”), undesirable impacts on consumers and communities, and a desire ✔ Define treatment of entrants, closures, and removals to recognize those who have taken early reduction ✔ Set up auctions to play an increasing role over time actions. Additionally, the potential to create windfall while reducing free allocation profits where firms pass on carbon costs to consumers despite receiving free allowances is higher under some An emissions trading system (ETS) creates allowances that methods of allocation, and policymakers can seek to enable the holder to emit a certain amount of greenhouse minimize this risk. Other issues relate to risks such as gases (GHGs), which can then be traded in the market. participants initially having a low capacity to trade or By capping the number of allowances created, the ETS resistance to participation among some companies limits pollution to a level less than would otherwise occur. where institutional capability is weak. This scarcity of allowances creates economic value that S Reducing the risk of carbon leakage or loss of is expressed through the market price of allowances, the competitiveness. Carbon leakage occurs when carbon price. production moves from a jurisdiction with a carbon price to another jurisdiction without a carbon price or The carbon price flows through the economy, leading to with a lower carbon price. This can occur in the near higher consumer prices for emission-intensive goods and term through domestic firms losing market share to services, reducing or increasing the value of assets, and international competitors, and over the longer term potentially benefiting or adversely affecting different groups through firms’ decisions as to where to invest in plants of workers across the economy. Even if the total costs and equipment. These risks present a combination of ALLOCATION to the economy of an ETS are small, there can be large STEP 5 undesirable environmental, economic, and political relative winners and losers. outcomes for policymakers. Avoiding these factors is Creating allowances establishes an asset that must be always one of the most controversial and important allocated in some way, the choice of which ultimately aspects when considering the design of an ETS, and determines how these costs and value are distributed across allocation in particular. There is little empirical evidence society. The allocation method is key to how companies of carbon leakage to date, with most ETSs having taken react to the ETS. It can affect how companies decide on steps to reduce carbon leakage risks. This is likely in production volumes, the location of new investments, part due to low carbon prices thus far, but a wide range and how much of the emissions costs they pass on to of other factors also affect investment and production consumers. This means that, in some circumstances, decisions, and are also likely to have played a role in certain methods of allocation can distort the carbon price limiting carbon leakage. signal and related incentives for emission abatement. S Raising revenue. The allowances created when an Allowances can also be sold, generating revenues for the ETS is established are valuable. By selling allowances, government that can be channeled to a range of different often through auctioning, ETSs can generate significant uses. In these ways, allocation can affect the total costs to amounts of public revenue that can then be used for the economy from the ETS and their distribution. other purposes. S Supporting price discovery in markets. The In practice there are two broad ways that allowances are economic efficiency of an ETS results from price allocated: providing them for free or selling them through discovery by trading allowances. Generally, this occurs auctions. When distributing allowances, policymakers in liquid secondary markets; however, in smaller will seek to achieve some or all of the following objectives markets with lower liquidity, allocation by auctions can (which are not always mutually compatible): play an important role in price discovery by matching S Preserving incentives for cost-effective abatement. supply and demand in the market and providing In attempting to achieve any or all of the objectives, transparent information on market conditions. policymakers must ensure that an integral objective of the ETS is maintained: ensuring covered firms are The distribution of allowances will be a contentious issue, incentivized to abate emissions in a cost-effective and finding a solution that is acceptable to government, manner and as far as possible through the value chain. stakeholders, and the general public is critical to getting S Managing the transition to an ETS. There are started. There are three main methods of free allowance numerous issues involved in transitioning to an ETS allocation, implying four methods in total (auctioning plus STEP 5: DISTRIBUTE ALLOWANCES 99 three free allocation approaches). Each method involves protection from carbon leakage and can still result in trade-offs against achieving one or more of the above windfall profits but provides protection for early action. objectives. This approach is more complex to implement than 1. Selling allowances in an auction. Policymakers grandparenting, given the likely need to collect and create a source of revenue using a method that interpret historical emissions intensity information to set minimizes the chance of market distortion and lobbying domestic-specific benchmarks and the need to have for preferential treatment. Auctioning is a simple and access to historical output data to facilitate allocation. efficient way to get allowances to those who value them 4. Free allocation using output-based benchmarked most. It can provide flexibility in managing distributional allocation (OBA). This also uses product benchmarks, issues for consumers and communities by making but assistance is adjusted to the actual level of use of auction revenues. It also rewards early action, output in a compliance period rather than a fixed as those that have already undertaken significant historical level of output. This option provides stronger reductions will face lower costs of compliance than protection against carbon leakage risk and rewards more emissions-intensive firms that need to buy more early action. However, this can come at the cost of allowances. However, auctioning does not protect reduced abatement incentives. Like fixed historical against leakage and provides no compensation for benchmarked allocation, getting the benchmark losses from stranded assets. correct can be challenging, and maintaining the 2. Free allocation using a grandparenting approach. cap requires additional provisions, as the levels of This provides allowances for free based on historic allocations are not known in advance. emissions. It is a relatively simple method of allocation Many systems have selected a hybrid approach combining that can make it attractive in the early years of an ETS. auctioning with free allocation, where entities in some It provides some compensation for the risk of stranded sectors receive some free allowances, but typically not all. assets but can also result in windfall profits. It provides Often this is a way to ensure that sectors that are at risk only weak protection against carbon leakage, can of carbon leakage can receive the benefits of protection distort the price signal if applied in combination with through appropriate free allocation approaches. Such ALLOCATION updating provisions, and penalizes early action. sectors are usually identified using two main indicators — STEP 5 Given its drawbacks, grandparenting should only emissions intensity and trade exposure; however, these be considered as a transitional approach while indicators may not capture the risk of carbon leakage as building the capacity for auctioning or a benchmarked well as intended. approach to free allocation. 3. Free allocation using fixed historical benchmarked Section 5.1 first explains the four main allocation methods allocation. This uses benchmarks to standardize the before considering the main objectives. Section 5.2 amount of free allocations provided for each unit of and Section 5.3 then break down the advantages and historical output of a particular product, for instance, disadvantages of each allocation method. Section 5.4 per ton of steel. This breaks the link between the discusses how free allocation can be targeted to those that emissions intensity of a given facility and the level of need it most, discussing the different components of free allocation it receives — allocation remains constant allocation as well as how to deal with new entrants and regardless of changes to the facility’s production or closures. emissions intensity. This approach provides only partial 5.1 ALLOCATING ALLOWANCES This section first presents the ways in which allocation is allowances away for free using a variety of methods. This most commonly done before discussing the objectives that chapter considers the following four options: should be considered when deciding between allocation 1. selling allowances in an auction, methods. 2. free allocation using a grandparenting approach, 3. free allocation using fixed historical benchmarked 5.1.1 METHODS OF ALLOCATION allocation, and There are two fundamental approaches to allocation: the 4. free allocation using output-based benchmarked government can sell allowances at auction, or it can give allocation. 100 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION It can be helpful to break this down first into a decision as Free allocation via grandparenting uses historical to whether to sell allowances through auction (Option 1) or emissions to determine the allocation. The historical to provide them for free (Options 2–4). emissions get multiplied by adjustment factors, most commonly the carbon leakage assistance rate and cap Auctioning involves the allocation of allowances through a decline factor. An explanation of assistance rates and cap competitive bidding process, allowing for price discovery decline factors, along with other principles and terms used and strong incentives for carbon abatement. It also creates in free allocation, are explained in Box 5-1. a source of revenue that can then be distributed to a wide range of potential beneficiaries. Free allocation via benchmarking includes fixed historical benchmarked allocation and output-based benchmarked Free allocation provides some proportion of a firm’s allocation. It uses output, for example tons of aluminum emissions for free. Grandparenting, fixed historical produced, scaled by an emissions-intensity benchmark to benchmarked allocation, and output-based benchmarked convert the output into emissions. This is then scaled by allocation are related, and can be expressed as variants of adjustment factors in the same way as grandparenting. The two basic formulae: primary difference between fixed historical benchmarked S Free allocation (grandparenting) = applicable historical allocation and output-based benchmarked allocation is emissions x adjustment factors that the former uses historical output that remains constant S Free allocation (benchmarking) = applicable output x for a fixed period, while output-based benchmarked benchmark x adjustment factors allocation uses current output. Box 5-1 Technical note: Allocation terminology explained Emissions intensity Emissions intensity is a number that provides the quantity of emissions that are released to produce one unit of a product. For example, the emissions intensity of cement could be 0.5 tons of carbon dioxide (CO2) per ton of cement ALLOCATION produced. STEP 5 Benchmarks The benchmark is a numerical value that presents an emissions intensity of the production process. The benchmark can be chosen at different levels, which alters the stringency of the allocation. For example, a benchmark for cement could be the average emissions intensity of firms that produce cement. This would mean that some firms are above the benchmark (they produce more emissions than average so receive a smaller allocation than what they need), while some would be below (they produce fewer emissions than average, so receive a larger allocation than they need). An alternative benchmark could be the average emissions intensity for the top 10 percent of the most efficient firms. This means that most firms would have a free allocation below what they need. In the European Union (EU), the benchmarks are derived from the average emissions intensity of the 10 percent most efficient facilities within a sector. This compares to the New Zealand benchmark (referred to there as an allocative baseline), which is the average emissions intensity of national sectors. Small ETS markets may have too few facilities to calculate a benchmark based on the sector and instead may look to use the emissions intensity at the individual facility level, which is done in Québec for most benchmarks, or look to use benchmarks from other jurisdictions. In general, product-based benchmarks are the preferred option to follow the principle of having one benchmark per product. Benchmarks need to correctly reflect the different divisions of emissions-intensive processes in production to reduce the risk of gaming. This would, for example, entail having sufficient disaggregation in cement benchmarks to distinguish between production with and without the highly emissions-intensive production of clinker. Adjustment factors These are a variety of tools that are used to manage the total level of free allocation that is provided and ensure that the number of allowances allocated for free remains at a suitable level relative to the cap over time. There are several adjustment factors that have been applied in ETSs to date: S Assistance rates: These scale the level of emissions that receive free allocation. The value of the assistance rate can be from 0 percent to 100 percent, with 100 percent representing a maximum rate of assistance. In benchmarking, an assistance rate of 100 percent means that the free allocation is not adjusted downward any further. It does not mean that entities receive all their emissions liability for free, since the benchmark is still applied. The assistance rate often varies between sectors, even within the same ETS. This is to adjust for differing severities of carbon leakage risk, with those at most risk receiving the highest assistance rate. In the  New Zealand ETS as in some other jurisdictions, the assistance rate is referred to as the assistance factor. STEP 5: DISTRIBUTE ALLOWANCES 101 The assistance factor is 90 percent for highly emissions-intensive activities and 60 percent for moderately emissions-intensive activities. S Decline factors: These seek to ensure that the level or rate of free allocation falls over time. For instance, California uses an overall cap decline factor that tightens over time. The cap decline also varies between different activities to reflect the differing levels of carbon leakage risk. S System-wide limits: These establish a ceiling for the total number of free allocations to industry. The EU uses a cross-sectoral adjustment factor to limit the number of allowances it can provide for free. In calculating the level of free allocation, if the total free allocation exceeds the limit for free allocation, the cross-sectoral adjustment factor is applied. The cross-sectoral adjustment factor allows for adjustments to be made to free allocation to reflect the tightening of the cap and the resulting reduction in the number of total free allowances due to increasing ambition of emissions reduction. As a number of systems demonstrate, it is possible to use and free allocation; any of the free allocation methods different approaches for different sectors or firms covered may allocate only a share of the allowances. Table 5-1 by the ETS. It is common to use a mixture of auctions summarizes allocation methods used in each ETS to date. Table 5-1 Allocation methods in different ETSs Free Allocation ETS Free Allocation Recipients Free Allocation Type versus Auction ~50 percent free Emissions-intensive and trade- Output-based benchmarking for industrial sectors allocation (significant exposed (EITE) sectors and other (~12 percent) vulnerable to carbon leakage;159 direct share through industries; electric distribution California allocation to electric distribution utilities and natural gas consignment); utilities and natural gas suppliers suppliers consigned for auction, with proceeds mandated increasing percentage consigned allowances freely on ALLOCATION for benefit of ratepayers and mitigation (40 percent) auctioned behalf of ratepayers STEP 5 Industry and heat sectors and Fixed historical benchmark set at the average of the Mixed: 57 percent EU — domestic aviation; declining free 10 percent most efficient installations in a sector/ auctioned, 43 percent Phase 3 allocation for non-EITE sectors from subsector during 2007–2008; fallback approaches freely allocated 80 percent to 30 percent in 2020 through heat or fuel benchmarks, or process emissions Fixed historical benchmark based on fixed-period Mixed: 57 percent historical activity levels. Activity levels are updated every auctioned, 43 percent five years (2019, 2024) or annually following a change of freely allocated, with Industry and heat sectors, and more than 15 percent in activity levels; benchmark set at EU — declining free allocation aviation;160 free allocation for non- the average of the 10 percent most efficient installations; Phase 4 shares toward 2030 EITE sectors to be phased out by fallback approaches through heat or fuel benchmarks, based on more 2030 or process emissions; benchmarks adjusted for two stringent allocation separate periods, 2021–2025 and 2026–2030, according rules to annual reduction rates varying from 0.2 to 1.6 percent to reflect technological progress 100 percent free Grandparenting or output-based product-specific Kazakhstan All allocation benchmarking (voluntary) Grandparenting, fixed historical product-based 90 percent free Korea All benchmarking (for example cement, refinery, domestic allocation in Phase 3 aviation) Mixed, with ~27 percent EITE activities; free allocation New free allocation for gradually reduced for 2021–2030 Output-based benchmarking Zealand 2021–2025. Auctions and at accelerating rate post-2030 from 2021  159 Industrial allocation is about 12 percent of the total allowance budget, with natural gas and electric utilities accounting for about 40 percent. 160 Article 10c of the EU ETS Directive allows for transitional free allocation to thermal-power generators with the condition that Member States invest the worth of free allowances in modernizing their electricity systems. In Phase 3, eight Member States made use of the derogation. Allowances allocated under this derogation are deducted from Member States’ auctioning volumes; see European Commission 2015b. 102 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Table 5-1 Allocation methods in different ETSs (continued) Free Allocation ETS Free Allocation Recipients Free Allocation Type versus Auction Industrial facilities — Output-based benchmarked allocation based on production intensity benchmark Free allocation, Industrial facilities Nova Scotia for the reference period 2014–2016; fuel suppliers — Nova Scotia auctioning from 2020 Power Inc; fuel suppliers 80 percent free allocation based on previous year’s verified emissions; Nova Scotia Power Inc allocation based on a reduction from business-as-usual projections ~25 percent free Québec allocation; ~75 percent EITE activities Output-based benchmarking auctioned Regional Greenhouse 100 percent auctioned None N/A Gas Initiative (RGGI) 100 percent free Grandparenting based on entity-specific baseline set on Saitama All allocation any consecutive three years in the period 2002–2007 Fixed historical benchmarking using similar methodology Mixed, but mainly freely Switzerland Manufacturing industry to the EU ETS; fallback approaches through heat or fuel allocated benchmarks, or process emissions 100 percent free Grandparenting based on entity-specific baseline set on Tokyo All allocation any consecutive three years in the period 2002–2007 ALLOCATION 5.1.2 OBJECTIVES WHEN ALLOCATING incentives that policymakers will want to preserve when STEP 5 ALLOWANCES allocating allowances: When distributing allowances, policymakers will likely seek 1. Encouraging substitution from high-carbon to to achieve some or all of the following objectives: low-carbon producers. Where the cost of emissions S preserving is internalized in an ETS, it is an intended effect incentives for cost-effective abatement, that carbon-efficient producers (those with a lower S managing the transition to an ETS, emissions intensity) will benefit over less-efficient S reducing the risk of carbon leakage or loss of ones (triggering the optimal level of production among competitiveness, existing and/or between existing and new installations). S raising revenue, and 2. Incentivizing firms to reduce their emissions S supporting price discovery in markets. intensity. Because lower-emitting firms gain a competitive advantage over higher-emitting ones, This section discusses each of these objectives and this should encourage firms to reduce their emissions highlights some of the trade-offs that policymakers will need intensity (triggering technological improvements). to consider. If it is possible, policymakers should first have 3. Promoting demand-side abatement. The method of clear discussions on competing objectives and agree to a allocation should allow the price of emission-intensive balance among them, then choose the type of mechanism(s) goods and services to increase, so that consumers to use and design the specific allocation methodologies are discouraged from buying polluting goods and based on information and data available in the jurisdiction. encouraged to switch toward cleaner ones. Preserving incentives for cost-effective abatement The simplest way to ensure that all of these incentives Ensuring firms and individuals are incentivized to abate for abatement are preserved would be to sell allowances emissions in a cost-effective manner is a fundamental through auctioning,161 but this may not be the best way to objective of an ETS. There are three types of abatement achieve other objectives such as managing the transition to an ETS or addressing carbon leakage risk, both of which are discussed below. 161 This could even be combined with cash-based assistance rather than allowance-based assistance to deal with leakage and/or transitional concerns. STEP 5: DISTRIBUTE ALLOWANCES 103 Managing the transition to an ETS These risks can be mitigated through adopting simple Policymakers may wish to address three key distributional auction design, along with the appropriate period of impacts involved in transitioning to an ETS: preparation. A key part of the preparation is capacity building. This can be done via training or through a pilot 1. Stranded assets. Stranded assets are assets (such phase of the ETS (see Step 10). Building capacity early will as coal mines, generation capacity, coal-fired boilers) help avoid the potential for poor functioning of the ETS in acquired in the past that generated profits before the early stages. Through developing understanding of regulation but now leave their owners with high how the ETS works, resistance to participation may also be emissions that are hard to reduce. They fall in value reduced. Addressing these early issues with large amounts with the ETS as operating costs rise and may become of free allocation may introduce additional problems. For obsolete earlier than anticipated. These losses can be instance, there may be poor price discovery in these early partially compensated for through free allocation. phases of the ETS, which could undermine the operation 2. Recognize early investments in emission of the secondary market and create resistance to reducing reductions. In the time it takes to implement the free allocation in later periods. ETS, firms may be making abatement investments. It is valuable to reward, or at least not penalize, those Reducing risk of carbon leakage or loss of who have already invested to reduce emissions. competitiveness The process by which allowances are allocated can Implementation of an ETS or other mitigation policies can influence this. Auctioning rewards early action. If create the risk of carbon (or emissions) leakage. Carbon allowances are allocated for free, then either using leakage occurs when production and emissions move from an early date for measuring historic emissions under the jurisdiction with a mitigation policy to one without an a grandparenting approach or using benchmarking equivalent policy or a less-stringent policy. This can lead to approaches from the beginning can help reward early an increase in global emissions as production patterns shift. action or prevent delays in emission reductions. 3. Undesired impacts on consumers and communities. There is little evidence of carbon leakage to date, although Emissions costs passed through to consumer prices will empirical ex post estimates are limited.162 It is also possible ALLOCATION have welfare impacts on households. Some value from to use economic models to generate ex ante leakage STEP 5 allowances can be used to protect households’ well- estimates, the results of which are varied, but still find being, particularly poorer households. California uses limited evidence overall.163 This may be because the free allocation (with conditions on how the allocation level of carbon prices to date has not been sufficient to value is used) to protect electricity consumers, while substantively change the relative economics of production RGGI invests most revenue in energy-efficiency facilities, and because carbon pricing systems have adopted measures to reduce electricity bills. policies such as free allocation that have succeeded in reducing the risk of leakage. At low levels a carbon price is Two risks could arise early in ETS implementation: likely to be only a minor factor in determining the location of 1. Companies may have a low capacity to trade production compared to factors like the availability of labor, initially. A transitional concern could be that tax rates, access to markets, or exchange rates. companies, especially small companies, may have a low capacity to trade. Concerns about not being The risk of carbon leakage may decline in the longer term able to access allowances on the market or making with the ratcheting of ambition under Nationally Determined costly mistakes (for example, by failing to comply with Contributions (NDCs) and the expansion of policies such obligations, resulting in fines) are common before an as carbon pricing. Carbon pricing in one jurisdiction is not ETS is implemented. This may lead to a preference carried out in isolation, with at least some form of emissions to provide firms with allowances for free, such that constraints emerging in most jurisdictions through their they may not need to substantively participate in adoption of climate targets, for example through NDCs auctions and trading in order to meet their compliance under the Paris Agreement. This means that any loss in obligations, at least in the early phases of the ETS. competitiveness arising from the ETS will be smaller since trading partners will be implementing measures resulting 2. Resistance to participation. If institutional capability in similar impacts to their industry. The tightening of NDCs is weak early in the ETS, it can make identifying over time means long-term competitiveness will require participants and collecting data from them difficult. If that conventional, high-emitting industries are phased allowances are given for free, this resistance may be out by new low- and zero-emission industries. In this reduced. Free allocation also helps reduce political sense leakage risk is a concern only if domestic firms are opposition among the firms covered by the ETS. 162 The Carbon Pricing Leadership Coalition’s Report of the High-level Commission on Carbon Pricing and Competitiveness assesses the existing literature in depth. 163 PMR 2015g. 104 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION losing market share to a more emissions-intensive firm. expanding production, and instead choose to increase Nevertheless, the risk of leakage presents a combination of production elsewhere in response to the higher costs. undesirable outcomes for policymakers: Importantly, and in contrast to capital leakage, productive S Environmental. Leakage undermines the ability of capacity is maintained, but the quantity of production at an ETS to deliver on its environmental objectives by these facilities may be lower. Because productive capacity causing emissions to rise in jurisdictions beyond the is maintained, the production leakage may be temporary reach of the policy. Leakage is particularly likely to and could be reversed. Production leakage can be occur if production shifts to a jurisdiction that does not expected to occur in the short term because it does not have regulated emissions, for instance if it does not involve large changes in investment. also have an ETS or a stringent NDC. In this case the Capital leakage refers to a reduction in investment in shift in production would not be matched by equivalent either existing or new capital. The higher costs from the additional mitigation effort in the country to which ETS could reduce the profitability of investments and production shifts, leading to a rise in global emissions. thus reduce firms’ incentive to invest in the domestic This issue is less likely to exist over the longer term with jurisdiction, potentially investing elsewhere with less-strict ratcheting ambition and expanded scope of NDCs. environmental regulation. In the long term, with increasing S Economic. The decline in domestic production can proliferation of carbon pricing globally, the scope for affect the balance of trade and lead to structural transferring productive capacity closes; therefore, the change with strategic economic implications. Reduced risk of capital leakage is reduced. Capital leakage can production is likely to be associated with job losses be expected to occur over a longer term than production and stranded assets in the affected sectors. It also leakage and is more likely to be permanent because of the reduces the cost effectiveness of the ETS in achieving large investment costs involved in moving. global emission reductions. Structural changes can act to accelerate the decarbonization of the domestic Carbon leakage represents a transfer of either production or economy and reduce its dependence on emissions- productive capacity, with no decrease in emissions on a net intensive production, but this may have opposing basis. The transfer reduces emissions for the jurisdiction ALLOCATION effects in jurisdictions that see emissions increase due from which the leakage originates, but there will be a rise STEP 5 to carbon leakage. Furthermore, these processes will be in emissions elsewhere. Thus, the transfer of emissions stalled if cheaper fossil fuel-intensive imported products undermines global ambition to reduce emissions if it goes out-compete domestic low-carbon alternatives. to jurisdictions unlikely to raise their climate ambition. S Political. The risk of loss of jobs and asset values can create significant political challenges, particularly as emissions-intensive industries are often clustered in Box 5-2 Technical note: Carbon leakage channels discrete regions. There are three main channels through which This confluence of potentially undesirable environmental, competitiveness can be influenced: two types of economic, and political outcomes means that the risk production leakage, which operate in the short run, and of leakage is always one of the most controversial and a third (capital leakage) that operates in the long run. important aspects when considering the design of an ETS, 1. The domestic markets channel reflects even if leakage is often not realized in practice. the competitiveness of a firm’s production in domestic markets relative to imports from rivals Carbon leakage is thought to occur in two main ways, based in external jurisdictions. through production leakage and capital leakage. Box 5-2 2. The external markets channel is the firm’s explains how leakage through production can be broken competitiveness in external markets to which it down into the domestic and external market channels, and exports. provides further detail on capital leakage. The extent to which each allocation method addresses these channels of 3. The capital channel captures the competitiveness leakage is discussed later in the chapter. of existing productive capacity or new investment that may serve both domestic and external Production leakage refers to shifts in production because markets. of changes to the relative operating costs for firms in The first two short-run channels of competitiveness different jurisdictions. The ETS increases the relative cost will importantly be driven by the short-run marginal of production for emissions-intensive firms when compared cost of production of domestic producers relative to to locations without an ETS. EITE firms are unable to pass their rivals across both markets — which depend, in on their increased costs, while at the same time the cost part, on the design of carbon prices.  savings from producing elsewhere increases. Therefore, firms may decide to reduce production or decide against STEP 5: DISTRIBUTE ALLOWANCES 105 In addition, over the longer run, decisions regarding These new resources can be used to either cut capital investments will be influenced by an (distortionary) taxes elsewhere in the economy; support assessment of long-run cost of production, which other public spending needs, for example other policies, includes the cost of capital. All three channels to decarbonize the domestic economy; support action on matter for carbon leakage, with the domestic health, education, or infrastructure; or reduce government markets and external markets channels key for deficits and/or debts. They can also play a valuable role short-run risk of carbon leakage, while the capital in compensating disadvantaged households that might channel is important for leakage over the longer run. otherwise be adversely affected by an ETS. Over time the importance of the capital channel A more detailed discussion on the use of revenues from increases and options to deal with carbon leakage ETS auctioning can be found in the PMR’s Using Carbon and competitiveness beyond free allocation Revenues report. (typically targeted investment support from auctioning revenues) will be of growing importance, Supporting price discovery primarily for capital-intensive production processes. ETSs with high shares of free allocation increase the risk that an ETS will face low liquidity, because fewer firms are likely to engage actively in the market if their needs Further details on carbon leakage can be found in the for allowances are more or less fully satisfied by free Partnership for Market Readiness’s (PMR) Carbon Leakage: allocation, although other factors such as market size Theory, Evidence and Policy Design report as well as also impact liquidity. In the trading process, companies International Carbon Action Partnership’s report Carbon implicitly disclose their assessment of abatement costs. If Leakage and Deep Decarbonization. trading is inhibited, this will therefore create barriers to price discovery. Organizing allocation mechanisms to encourage Raising revenue taking part in trading or auctioning activities will support The allowances created in an ETS have value. By selling price discovery, improve the overall efficiency of an ETS, allowances through auctioning, policymakers have the and reduce the costs to meet emissions reduction targets. ALLOCATION potential to raise significant amounts of public funding. STEP 5 5.2 AUCTIONING Existing ETSs vary substantially in the extent to which If auctioning is pursued, conducting relatively frequent auctioning is used. At one extreme, RGGI started auctions will help provide transparency and a steady price with high levels of auctioning — about 90 percent of signal to participants and consumers, and can reduce allowances — and individual states could choose how to emissions price volatility. Frequent auctioning means that spend the revenue. In the EU ETS, the use of auctioning the quantity for sale at each individual auction is reduced, has expanded over time, starting with low shares and decreasing the risk of manipulation of the auction itself and introduced primarily to the power sector. About 54 percent making it more difficult for any one participant to gain too of allowances were auctioned or sold in Phase 3 of the much market power in the secondary market. RGGI and EU ETS over the period 2013–2019. In some jurisdictions California-Québec have quarterly auctions. The large-scale where the ETS is relatively new (for example, most Chinese EU ETS auctions are held several times a week. The single- pilots and Korea’s ETS), virtually no allowances are round, sealed-bid, uniform-price auction design is the most currently allocated through auctioning, although Korea commonly used in carbon markets around the world today, and China’s national ETSs do foresee a rising share of due to its simplicity for both users and administrators, and auctioning in the future. its resistance to market collusion.164, 165 Box 5-3 discusses ETS auction design issues in more detail. 164 Lopomo et al. 2011 evaluate leading auction formats and conclude the sealed-bid, uniform-price method is most appropriate for carbon markets, in part because of its relative strength against potential collusion among market participants. 165 Cramton and Kerr 2002 and Betz et al. 2010 discuss detailed choice of auction mechanisms for GHG markets. 106 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Box 5-3 Technical note: Auction design for ETSs In an ETS, allowances are typically sold by the government through multiunit auctions, which are similar to those conducted in other markets such as stocks, bonds, and commodities (for example, energy, flowers, and fish). The key elements of auction design include: Frequency and schedule. In determining the frequency of auctions and the auction schedule, the regulator must strike a balance between ensuring open access and participation, and minimizing the impact of the auction on the secondary market. Frequent auctions may be desirable to ensure a steady flow of allowances into the secondary market at a rate that does not jeopardize market stability. Yet multiple auctions can also increase transaction costs and the risk of low participation. Several auctions are held for EU allowances every week on different trading platforms, whereas Québec and California hold four joint auctions a year. Price determination. Prices at auctions are either pay-as-bid (where successful bidders receive the price they bid, so the price can vary between bidders) or uniform price (where all successful bidders receive the same price, the price at which demand equals supply). ETS auctions adopt uniform price formats for two reasons. First, the existence of the secondary market means that bid prices will not vary much beyond the prevailing market price, reducing the benefits of pay-as-bid auctions. Second, uniform pricing limits strategic bidding, as all successful bidders pay the same market-clearing price and are incentivized to bid up to their highest marginal value for allowances.166 This supports an efficient distribution of allowances and reliable price signals that more closely reflect marginal abatement costs within the economy. Bidding format. Dynamic versus sealed. Today, most ETSs have chosen an auction design in which participants simultaneously submit a single bid without knowing what others are willing to pay (known as “sealed bid”), with the auction winners paying the auction clearing price (uniform price). Participation. Jurisdictions will need to determine who can participate in auctions — whether only liable entities should be allowed to participate or also other market participants. As competitive bidding is fundamental to a ALLOCATION successful auction, in general, the more participation the better, so long as participants are sufficiently creditworthy. STEP 5 In this way, auctions need to balance the importance of keeping the costs of participating low to maximize participation, with the need to ensure the involvement of only serious participants who have the ability and intention to pay. Other rules that policymakers should consider on participation include reporting requirements when submitting bids, rules for participants acting on behalf of clients (for example, entities with compliance obligations), and other provisions that are typical of financial markets. Publication of information. To support transparency and price discovery for the secondary market, winning prices and volumes (and sometimes winning participants) are usually published directly after an auction. Auctions work best when the rules of how they work are known by all participants, and so it is important that all stakeholders are well briefed on how the auction will operate. Market misconduct. Underlying market misconduct laws (for example, regarding collusion) govern auctions and the behavior of participants. Jurisdictions may further more commission independent market monitors to oversee the conduct of the auction participants, identify cases of market manipulation or collusion, and foresee measures to prevent market misconduct (limitations on bids).167 Partially subscribed auctions. When demand for allowances is lower than the amount for sale, auctions may not sell out. ETS jurisdictions apply different rules to such situations. In the EU ETS, the auction is cancelled, and the full auction volume is distributed over subsequent auctions scheduled at the same trading platform. In systems with a reserve price at auction (for example, California, Québec, RGGI, Nova Scotia) the auction clears at the reserve price, and unsold allowances are placed in a holding account to be reoffered in subsequent quarterly auctions. When (or if) these allowances are reoffered to the market will depend on predefined market rules. Allowances that are unsold at joint auctions in the California and Québec trading schemes due to the reserve price are returned to auction after two consecutive auctions result in a settlement price above the auction reserve price.168, 169 166 Lopomo et al. 2011. 167 See Cramton and Kerr 2002; Evans and Peck 2007;, and Kachi and Frerk 2013 for a summary 168 Western Climate Initiative (WCI) 2018. 169 Québec Environment Ministry stakeholders noted that the rate of reintroduction is set to a maximum of 25 percent of the volume of allowances otherwise offered for sale at auction to avoid reintroduction resulting in a temporary oversupply. STEP 5: DISTRIBUTE ALLOWANCES 107 An approach that tries to combine the benefits of portion of free allocation, consignment can help facilitate auctions and free allocation is a consignment auction. price discovery, boost liquidity in the market, and reduce With consignment auctions, eligible entities are allocated differences in access to allowances.170 allowances for free but must return — or consign — them to the jurisdiction for sale at auction. The entities then Consignment has been used in limited circumstances, receive the revenue from the sale of consigned allowances with Box 5-4 discussing consignment allowances from the at auction, but jurisdictions could stipulate how recipients California allowance budget, available at California-Québec spend it. By using auctions as a means of distributing a auctions. Box 5-4 Case study: Partial use of consignment in California auctions California is currently the only active ETS in the world that uses mandatory consignment of some allowances available at auction, though the mechanism was also used earlier in SO2 trading. Specifically, some electrical distribution utilities and natural gas suppliers receive allowances each year that must be sent, or “consigned,” to California-Québec auctions rather than used to satisfy their compliance obligations. After the allowances are sold, the proceeds from the consigned allowances are returned to each utility and supplier with the requirement that the value must be used “for the primary benefit of” ratepayers.171 Uses of the value that satisfy this requirement include measures to reduce GHG emissions and direct compensation to customers. Consignment entities must report annually on how they use the proceeds and spend it within 10 years. Any revenue from consignment that has not been spent within 10 years is automatically returned to ratepayers.172 Among all entities regulated under the California cap and trade system, only investor-owned electrical distribution utilities and natural gas suppliers are required to consign at least a portion of their directly allocated allowances each year. Investor-owned electrical distribution utilities must consign all freely allocated allowances each year, while publicly owned electrical distributors and cooperatives are able to choose how many of their allowances are consigned and how many they hold onto for compliance. Natural gas suppliers are only required to consign a minimum percentage of their ALLOCATION STEP 5 free allocation, which increases 5 percent each year to 100 percent in 2030. Consigned allowances are the first sold at California’s quarterly auctions, before the sale of those owned by the California Air Resources Board. 5.2.1 ADVANTAGES are minimized and build public support for the ETS. Auctions have several advantages: This might include providing assistance to reduce the risk of carbon leakage and associated structural S Raising revenue: Income raised in an auction can be change or mitigating the effects of the ETS on used by governments to support several objectives, disadvantaged consumers and communities. Care with examples from the EU, California, RGGI, and should be taken to ensure that these measures do not Québec provided in Box 5-5, including: undermine the objectives of the ETS in the long term. z Supporting other climate policies: The government S Reducing potential for political lobbying: Auctions may, for example, wish to invest in low-emissions can be administratively simpler than free allocation infrastructure, incentivize industry to invest in energy approaches. They also reduce the opportunity for efficiency and clean energy technology, generate industry lobbying to support specific firms or sectors funding for R&D, or reduce emissions in non-covered (although there may still be lobbying for the auction sectors. proceeds). z Improve overall economic efficiency: Revenues S Facilitating price or supply adjustment measures could support fiscal reform, such as reducing (PSAMs): The majority of PSAMs (see Step 6) are other distortionary taxes in order to improve overall implemented through adjusting the number of allowances efficiency or to lower government debt. that are auctioned. For these mechanisms to be effective, z Addressing distributional concerns and there needs to be a minimum auction volume. generating public support for the ETS: The S Improving price discovery and market liquidity: government could use revenue from the sale of Auctions provide a minimum amount of market liquidity allowances to make offsetting adjustments to the tax and can facilitate price discovery, especially in cases and benefit system to ensure distributional impacts 170 Burtraw et al. 2017. 171 CARB 2018b. 172 See CARB’s overview of consignment allocation, “Electrical Distribution Utility and Natural Gas Supplier Allowance Allocation” 2020b. 108 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION where there is little trade in secondary markets by those 5.2.2 DISADVANTAGES who receive free allowances. S No direct protection against leakage risks or S Reducing risk of distortions: As described further compensation for stranded assets:173 The key below, different forms of free allowance allocation disadvantage of auctions on their own is that they may distort incentives to undertake cost-effective provide no direct protection against carbon leakage abatement. In an auction all entities pay the full cost and do not compensate firms for losses from stranded of allowances, which should lead to cost-effective assets. Firms will face the full financial cost associated abatement. The auction results in an efficient allocation with their emissions liability. While not commonly used of emission rights and a price reflective of the true value to date, revenues from auctioning could also be used to of allowances in the market. directly address these risks. S Rewarding early action: Early actions and early S Concerns over impacts on small firms: There may movers do not face disadvantages and are fully often be concerns that small firms will not be able to incentivized, since with auctions early movers need to easily participate in an auction process, further raising buy fewer allowances, giving them an advantage over costs. One way of reducing potential negative impacts those who do not abate early. on small firms is to have a simple auction design, S Increasing market transparency: In providing reliable as many jurisdictions have adopted with sealed-bid price signals, auctioning also boosts the transparency auctions. An enabling framework for liquid secondary of the market, which in turn supports the development markets could further address this issue, and the of a credible, long-term investment framework for acquisition of smaller numbers of allowances from regulated entities and establishes confidence in the intermediaries might have lower transaction costs than fairness of the market. auction participation in some cases. Box 5-5 Case study: Auction revenue use ALLOCATION Looking across established ETSs, auction revenues are often used to support low-carbon innovation and fund STEP 5 additional climate and energy programs. Between 2012 and 2019, the EU Member States collected a total of EUR 50.5 billion through auctions. While they have the authority to decide autonomously on how they use auction revenues, the ETS Directive instructs them to spend at least 50 percent of revenues on climate- and energy-related purposes. Data for 2013–2018 show that EU Member States used 37 percent of auction revenue for renewable energy, 32 percent for energy efficiency, 17 percent for sustainable transport, and 7 percent for R&D.174 At the EU level, allowances are further set aside and auctioned to capitalize financial support mechanisms aimed at promoting low-carbon innovation and supporting modernization efforts. In Phase 4 of the EU ETS, the Innovation Fund will leverage investment in innovative technologies such as carbon capture and storage or utilization, as well as others targeting industrial processes, renewable energy generation, and energy storage. The Modernisation Fund will support lower-income Member States in modernizing their energy systems, improving energy efficiency, and promoting a socially just transition. These funds replace the NER300 program that supported low-carbon investment in Phase 3. Any unused resources from this program will fuel the Innovation Fund. California and Québec, which operate a linked carbon market with joint auctions, manage their shares of auctioning revenue independently. By the end of 2019, California had raised an estimated USD 12.5 billion (EUR 11.2 billion) in auction revenue through its cap and trade program. California has strict statutory requirements regarding how auction revenues must be spent.175 Auction revenues from state-owned allowances are deposited into the Greenhouse Gas Reduction Fund, which funds state programs in clean transportation, sustainable communities, clean energy, energy efficiency, natural resources, and waste diversion. Through the budget process, the California’s governor and legislature have directed funds to various state agencies on diverse programs including high-speed rail, affordable housing, and climate adaptation programs. In 2018, 79 percent of Greenhouse Gas Reduction Fund funding went to transport and sustainable communities, 14 percent to natural resources and waste diversion, and 7 percent to clean energy and energy-efficiency programs.176  173 This assumes that the revenue raised from the sale of allowances is not used to address these issues. 174 This data is based on the EU Climate Action Progress Report 2019, European Commission 2019. For more information on revenue use, please see the ICAP report: Santikarn et al. 2019. 175 State laws stipulate that revenues be spent on reducing GHG emissions, preferably with cobenefits such as job creation and improved air quality. Thirty-five percent of auction revenue must be used to benefit disadvantaged communities, with 25 percent of revenue to be invested in projects located directly in disadvantaged communities. Sources: California Senate Bill (SB) 1018, see Government of California 2005; Assembly Bill (AB) 32, see Government of California 2006; AB 1532, see Government of California 2012a; SB 535, see Government of California 2012b. The latest requirements, which superseded SB 535, are set out in AB 1550; see Government of California 2016. 176 Santikarn et al. 2019. STEP 5: DISTRIBUTE ALLOWANCES 109 California communicates the use and impact of auction revenues by engaging in partnerships and projects that have clear benefits to local communities (such as housing and clean transport). It places high emphasis on effective communications, with a website177 dedicated to ETS revenue use and a corresponding slogan — “cap and trade dollars at work” — for projects funded through ETS revenue. Semi-annual reports on cap and trade auction proceeds published by the California Air Resources Board include detailed cumulative and project profiles, which are also featured and disseminated online.178 The showcasing of cobenefits of the Cap and Trade Program has played a key role in ensuring political buy-in and overcoming opposition from industry lobbies. In the Québec Cap and Trade Program, auction revenues go to the Québec Green Fund, which supports climate change programs and helps achieve objectives set out in the Climate Change Action Plan. By 2019 Québec had raised an estimated CAD 3 billion (EUR 2.7 billion) in auction revenues.179 Roughly 90 percent of this revenue has been invested in GHG mitigation, 8 percent in adaptation measures, and 2 percent in program coordination. By law, two-thirds of the Green Fund’s revenue must be directed to the transport sector. RGGI, the first ETS in the United States, was launched specifically as a cap and invest program aimed at reducing power-sector emissions and using auction proceeds to support economy-wide energy and climate programs. By the end of 2018, the ETS had generated an estimated USD 3.08 billion (EUR 2.77 billion) in auction revenues. Like the EU ETS, RGGI participating states can decide how they spend their revenues. In 2017, they invested 51 percent of revenues in improving energy efficiency, 14 percent in clean and renewable energy, 14 percent in targeted GHG abatement, and 16 percent in direct bill assistance. RGGI investment proceeds are used to support households and low-income groups, support businesses, create jobs, and reduce pollution. As such, these proceeds play an important role in ensuring tangible cobenefits, which are communicated in a transparent manner through annual investment reports.180 Further details can be found in the PMR’s Using Carbon Revenues report. ALLOCATION 5.3 FREE ALLOCATION STEP 5 Common approaches to free allocation include 5.3.1 FREE ALLOCATION USING grandparenting, fixed historical benchmarked allocation, GRANDPARENTING and output-based benchmarked allocation. The most The rate of assistance under grandparenting is determined appropriate free allocation approach will depend on by historical emissions and the assistance rate. This means the local context. Grandparenting may be appropriate that the amount of allocation received remains independent when jurisdictions lack data to implement benchmarking of future output decisions or decisions to reduce emissions approaches, but should be used as a temporary measure intensity, provided that the firm stays open. In some only until the data needed (particularly output data) cases, periodic adjustments or updates can be made becomes available. Fixed historical benchmarked allocation to take account of large changes in circumstances from and output-based benchmarked allocation both outperform when the initial allocation is made. However, updating grandparenting in most respects (see Section 5.4). allocation introduces further issues and negates some In jurisdictions with a fixed cap, free allocation approaches of grandparenting’s advantages. Prominent examples of might face the need to introduce an additional adjustment grandparenting include the first two phases of the EU ETS, factor (see Box 5-1) that aligns the aggregate free allocation the first phase of the Korean ETS (for most sectors), and to the aggregate cap or the share of the cap that is various Chinese ETS pilots. earmarked for free allocation. This is of special relevance in When implementing grandparenting, it is critical to set the cases where EITE industries represent a larger proportion base year for the data used early on to avoid incentives of total emissions under the cap or where significant for entities to drive up emissions to increase allocation, to amounts of allowances are withheld for free allocation of ensure equitable treatment of facilities, and to minimize new entrants. 177 California Climate Investments, http://www.caclimateinvestments.ca.gov/ 178 For more information, please see CARB 2020c. 179 Québec Ministry of Environment and Climate Change 2019. 180 For more information, please see RGGI 2018. 110 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION lobbying by firms to maximize the benefit to their facilities. respond to the carbon price in the same way as if they Two challenges with this are: had not received the free allowance allocation. 1. Data availability. The data may need to be collected and audited specifically for this process and may not Disadvantages be available for earlier years. However, grandparenting is associated with several 2. Perceived inequity as a result of rapid changes disadvantages: within sectors. Firms that have contracted since that S Updating of grandparenting reduces incentives to date may receive more allowances than their current abate. While grandparenting should maintain marginal emissions. Firms that have expanded will receive incentives to abate, this can be significantly diluted if relatively fewer allowances, but also probably have applied in combination with updating provisions (as fewer “stranded assets” because their investments widely implemented for Phases 1 and 2 of the EU ETS). were made more recently when the regulation may In these cases, future allowance allocation will be based have been anticipated. on updated emission levels. This means that firms that make emission reductions (by reducing either output or Because of the considerable disadvantages of emissions intensity) could receive lower support in the grandparenting, which are discussed in more detail below, future, significantly decreasing the incentive to abate. it should be considered only as a transitional arrangement This is a major distortion of the carbon price signal while collecting data to implement benchmarking or to and leads to less cost-effective emission abatement allow time for capacity building for auctions to take place. from production and investment decisions. It is likely to be addressed only if it is signaled at an early stage Advantages that subsequent allocations will not be based on The key advantages of grandparenting are: grandparenting, as indeed has been the case in several S Relative simplicity. Grandparenting uses a firm’s systems. historic emissions to calculate free allocation and does S Weak impact on leakage risk. Since grandparenting not require data on output. This makes it a relatively does not affect the marginal incentives that firms ALLOCATION straightforward approach to undertake allocation, face under a carbon price, it does not protect against STEP 5 making it a popular method in the initial stages of many production leakage. The risk of capital leakage is only carbon pricing systems. Grandparenting can also be partially protected against. Existing productive capacity simpler for regulated entities, as — unless firms are is maintained by grandparenting when there is a changing rapidly — their free allocation will be close to minimum production requirement; however, investments their level of emissions and less trading may be required into new capital or maintenance of existing capital in early years. may be lower. The higher costs brought about by the S Can partially compensate for stranded assets. introduction of a carbon price presents a risk that a firm One-off grandparenting may be a particularly may reduce investment and/or output (and transfer this attractive approach where there is a desire to provide output to competitors outside of the jurisdiction). transitional support for industries that might otherwise S Windfall profits. Grandparenting can create windfall lose significant value from stranded assets. For profits via different channels: example, the now-repealed Australian carbon pricing z With grandparenting, firms are incentivized to reduce mechanism included a one-off, non-updating allocation emissions to minimize their carbon-cost liability. of allowances to electricity generators to reduce the Firms may be able to invest in low-cost abatement financial impact that they otherwise would have faced. that reduces liabilities by much more than the cost of Firms are also less likely to resist participation if they the investment, therefore reducing the carbon-cost receive free allowances. liability. Any investment has no impact on the number S Maintains marginal abatement incentives. Firms of free allowances it receives. In this case, having a that reduce emissions can sell or bank their surplus high quantity of freely allocated allowances results in allowances; those that increase emissions pay the full a large rise in assets without a comparative increase cost. As with auctioning, grandparenting should, in the in costs. These windfall profits under grandparenting absence of any updating provisions, result in an efficient may be highest for the historically high emitters within allocation of emission rights domestically and a price a sector that have not taken early action; they receive reflective of the true value of allowances in the market. a high rate of free allocations and may still have One of the features of grandparenting is that it is a significant low-cost abatement opportunities available. lump-sum financial allocation to firms — the amount z The additional carbon-cost liability changes optimal that the firm receives is not a function of its current or output decisions; firms may decrease output, leading future output. In the short term, firms should therefore to an increase in prices. Combined, firms may benefit STEP 5: DISTRIBUTE ALLOWANCES 111 from both higher prices and free allowances,181 product-based benchmarks were challenging given data thus prolonging the lifetime of high-carbon assets limitations or heterogeneity in the production process of and leading to higher costs of emission reduction. a single product, fallback benchmarks such as fuel inputs This was seen, for instance, for some electricity were used. Free allowances received by firms/installations generators in Phases 1 and 2 of the EU ETS.182 in the sector are in principle calculated by multiplying Windfall profits could be a wider issue for the the installation’s historic output level by the benchmark. longevity of the ETS, potentially undermining public Once the level of free allowance is set, future changes in confidence in the system, particularly if they persist. installation output have limited impact on the allowances z Without additional provisions, once firms have received by each installation (only if capacity is added). received their free allocation they could close and In this way, fixed historical benchmarked allocation does sell their allowances, creating windfall profits. not have an impact on marginal incentives for abatement, However, some of the revenue generated may cover similar to grandparenting and in contrast to OBA, which any stranded assets. Because of this risk, when does impact marginal incentives. grandparenting is implemented it often requires facilities to maintain operations to some extent to Advantages receive free allocations. The main advantage of this approach is that it provides incentives for substitution within sectors by advantaging S Penalizing early action. Early actions and early more efficient firms: movers would face disadvantages if they implemented S Severing the link between firms’ emissions intensity abatement measures before the period that was and allowances received. Firms that have taken action selected as the base period for grandparenting. before the ETS to reduce their emissions intensity will S New entrants and closures. Firms that wish to enter benefit relative to those with high emissions intensity; a sector may be at a disadvantage because they have early actions are rewarded. In addition, as explained no historic emissions on which to base allocation above, under a grandparenting approach with periodic through grandparenting. In this way, grandparenting updating, firms may be reluctant to reduce their can act as a barrier to entry, which reduces the ability ALLOCATION emissions intensity, as it will reduce the free allowances STEP 5 of the ETS to drive emissions reductions. The reduced the firm is entitled to receive in the future. This challenge competition from this barrier to entry will delay decisions is largely eliminated by this approach; it is the industry- on emissions reductions for existing firms, which may wide benchmark, rather than firm-specific emissions, choose to instead increase emissions since they are able that determines the amount of free allowances to absorb the additional increase in costs. The barrier to received in the future. Firms will therefore profit even entry may also prevent new firms with new, low-emission in the medium to long run from production efficiency technologies from entering the market. Any provisions to improvements that reduce their emissions intensity. adjust for this may be inaccurate or may leave the firm with a lower allocation than other firms. Disadvantages The disadvantages of this method are: 5.3.2 FREE ALLOCATION USING FIXED S Calculation of product benchmarks. This is data- HISTORICAL BENCHMARKED intensive and creates potential for lobbying around the ALLOCATION allocation methodology. Complications arise through issues such as the existence of similar products Fixed historical benchmarked allocation combines two with different production processes and through features. First, in contrast to grandparenting, the degree multioutput production processes. However, the of free allocation is determined by applying a sector-wide successful development of benchmarking approaches process or product-level benchmark emissions intensity in many jurisdictions indicates that these technical to historical output levels. All firms undertaking the same challenges can be overcome. Existing principles and process or producing the same product receive the same methodologies to set benchmarks, for example, from benchmark. The size of a firm’s allocation depends on the EU or from California, could also be used by other the firm’s historical output level but not its emissions. Any systems as a basis for developing their own. adjustment factors are applied to scale the free allocation. S Risk of windfall profits. As the level of allocation is not This is the approach adopted in the EU ETS for those dependent on current output levels, firms that are not deemed to be EITE (see Box 5-6). A series of benchmarks exposed to international competition may raise prices were created for different products under the cap. Where in response to a significant emission cost. While, as 181 CE Delft and Oeko-Institut 2015 present empirical evidence suggesting cost pass-through despite the provision of free allowances in both Phase 2 (grandparenting) and Phase 3 (fixed-sector benchmarking) of the EU ETS, for certain industrial sectors. 182 See Sijm, Neuhoff, and Chen 2006. 112 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION discussed above, this increase in prices might stimulate S Potential for distortions of the price signal. If some demand-side abatement, it can also lead to firms benchmarks are not strictly based on product outputs earning windfall profits from free allowance allocations,183 but instead reflect process, fuel, or other input thus prolonging the lifetime of high-carbon assets and specifics, price signal distortions may arise that are leading to higher costs of emission reduction. comparable with those observed with grandparenting in S Mixed results in mitigating leakage risk. Fixed combination with updating provisions. historical benchmarked allocation has a similar dynamic S New entrants and closures. This requires a to grandparenting: sectors exposed to international policy approach to ensure new entrants are not competition could experience production leakage, cutting disadvantaged compared to incumbents. With free back on production and losing market share to those allocation determined by previous output, the new not facing carbon prices. In other words, it may not be entrant would have to purchase allowances to enter the particularly effective at reducing carbon leakage risk. market and thus would experience higher costs than However, as the historical level of output used to calculate incumbents who received the free allocation. Closures these benchmarks is often updated on a semi-regular may introduce scenarios where firms have large free basis, this provides some incentive to maintain a certain allocations to sell, creating windfall profits. level of production and productive capacity. This would provide some degree of protection for carbon leakage. Box 5-6 Case study: Fixed historical benchmarked allocation in Phases 3 and 4 of the EU ETS Under fixed historical benchmarked allocation, the number of allowances an entity receives is a function of a product- based benchmark combined with installation-specific historic activity levels for a fixed baseline period. Although allocation in Phase 3 is not adjusted frequently to changes in output, the levels are tied to each installation’s historical production and not historical emissions. For Phase 4, the allocation is adjusted based on a 15 percent change of the production level. ALLOCATION STEP 5 The approach to fixed historical benchmarked allocation under the EU ETS Phase 3 did not regularly update the output basis for allocation of free allowances. However, provisions were in place to reflect large decreases in plant activity or changes in capacity. Allocation rules required firms to report activity level changes of at least 50 percent from the period when free allocation rules were set. In the face of declining output associated with the financial and economic crisis, this is considered to have resulted in (1) overallocation to some installations that had reduced their activity levels by less than 50 percent; and (2) creating incentives for companies to spread production over several installations to maintain full issuance of free allowances, leading to inefficient levels of production in some sectors.184 In addition to the above-outlined problems, industry remained concerned that as fixed historical benchmarking would not adjust free allocation provisions for increased levels of production, it would not provide sufficient protection against carbon leakage. Against this background, the free allocation provisions under the EU ETS were adjusted for Phase 4. Specifically, rules that are more flexible have been introduced to better align free allocation with actual production levels. The relevant changes to the ETS Directive are specified in the implementing regulation on adjustments to free allocation of emission allowances due to activity-level changes.185 The main aspects of free allocation provisions for Phase 4 of the EU ETS specify the following: S Free allocation may be updated annually to mirror sustained changes in production (if this change is higher than 15 percent compared to the initial level, on the basis of a two-year rolling average). S Carbon leakage will be assessed against a composite indicator of trade intensity and emissions intensity, with industries considered at risk listed in the Carbon Leakage List. The updated Carbon Leakage List for Phase 4 was adopted in 2019. S Historical activity levels are adjusted twice throughout the phase to ensure free allocation is targeted to production levels. Furthermore, benchmark values account for technological progress, declining at an annual rate between 0.2 and 1.6 percent compared to the Phase 3 benchmark reference. For the steel sector, the lower end of the 0.2 percent annual benchmark update rate applies for the period 2021–2025.  183 CE Delft and Oeko-Institut 2015 present empirical evidence suggesting cost pass-through despite the provision of free allowances in both Phase 2 (grandparenting) and Phase 3 (fixed-sector benchmarking) of the EU ETS, for certain industrial sectors. 184 For example, cement (see Branger et al. 2014). 185 Commission Implementing Regulation, 2019/1842, European Commission 2019a. STEP 5: DISTRIBUTE ALLOWANCES 113 S Freeallocation for sectors deemed not to be exposed to risk of carbon leakage will be 30 percent from 2021 to 2026, reducing to 0 percent by 2030 (except district heating, which will be at 30 percent). S As an additional safeguard for industry, a free allocation buffer of over 3 percent of the cap, initially earmarked for auctioning, will be made available if the initial free allocation is fully absorbed (thereby reducing the likelihood of a correction factor being applied). The revised EU ETS Directive also provided an enhanced data collection framework, which is considered important for attaining robust data. To be eligible for free allocation, installations are obliged to perform a data collection exercise and submit production, emissions, and energy data to their competent authority prior to Phase 4. To facilitate this exercise, the European Commission held technical workshops in eight Member States. These one-day events covered all the details of the free allocation rules, including the National Implementation Measures process; benchmark updates; and monitoring, reporting, verification, and accreditation requirements. In addition, they provided data templates, case studies, and the opportunity for installations to ask specific questions. 5.3.3 FREE ALLOCATION USING that a firm faces. That is, the decision to produce an OUTPUT-BASED BENCHMARKED additional unit of production will lead to both a higher cost ALLOCATION from increased carbon liabilities and an increase in free allocation. Like other forms of free allocation, adjustments OBA is also a benchmarked approach in that it uses are sometimes made to better target free allocation or to predefined benchmark emissions intensities fixed by make total allocation consistent with the overall cap. process or product type to calculate allocations. However, unlike fixed historical benchmark allocations, OBA adjusts Variants of OBA are used in California, Québec, New allocations to reflect the actual level of production in each Zealand, the former ETS in Australia, and some sectors compliance period (rather than a fixed, historical level of in most of the Chinese pilots. A simple example of OBA is production). Because OBA adjusts allocations for changes provided in Box 5-7. ALLOCATION in a firm’s output, it also changes the marginal incentive STEP 5 Box 5-7 Technical note: Impacts of output-based allocation This example illustrates the leakage Output protection and incentive for increasing GHG Unit Firm 1 unit 2 units efficiency of EITE industrial production Firm emissions tCO2e/unit of A — High 1 under OBA. Consider an emissions price intensity output B — Low 0.5 of USD 100 per ton of carbon dioxide equivalent (tCO2e). As high-emissions Benchmark Allowances/ 0.7 intensity Firm A increases output from 1 to unit of output 2 units, its emissions also rise by 1 tCO2e. Allocation tCO2e Both 0.7 1.4 With no free allocation, this increase in A — High 1 2 Emissions tCO2e production would cost USD 100 in terms B — Low 0.5 1 of allowance costs in addition to the direct tCO e 0.3 0.6 Net liability 2 A — High cost of production. That could leave Firm (emissions less USD USD 30 USD 60 A vulnerable to international competition allocation) and cost tCO2e -0.2 -0.4 (price = USD 100) B — Low and risks carbon leakage. By providing free USD USD -20 USD -40 allowances based on a benchmark and the firm’s output, OBA reduces the allowance costs for a firm. In this example, assume the benchmark is set at 0.7 tCO2e per unit of output, and Firm A continues to emit 1 tCO2e per unit. This means that as production increases from 1 to 2 units, Firm A’s emissions increase from 1 to 2 tCO2e, while its free allowance allocation increases from 0.7 to 1.4. Therefore, the allowance cost for the firm is only USD 60, rather than USD 200 in the absence of OBA. In contrast, when low emissions intensity Firm B (with an emissions intensity of 0.5 tCO2e per ton) increases output, the extra free allocation it receives (also based on the benchmark of 0.7 tCO2e per ton) is greater than its extra emissions (0.5 tCO2e) and it receives a production subsidy of USD 20 per unit. This illustrates the way benchmarks give low-emissions-intensity firms a competitive advantage but also illustrates the risks of setting sectoral benchmarks that are too high. If the emissions rate is set above the level of actual emissions per unit of output, perverse incentives to increase output can be created. This is a particular issue in a heterogeneous sector where one rate may be applied to a set of different activities and outputs. 114 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Advantages number of studies that show how important demand-side The advantages of OBA are: abatement and the circular economy will be for achieving net-zero emissions.186 The demand-side abatement can S Strongly targets leakage risks. Under OBA an extra often be relatively low cost (for example, using steel, unit of output (or production by a new entrant) will aluminum, and cement more efficiently in construction). directly result in additional allocations, as opposed If these low-cost actions are not incentivized to occur, to grandparenting and fixed historical benchmarked the cost of meeting a given emission reduction target allocation schemes, where extra output does not may increase. In trade-exposed sectors the reduced cost usually lead to additional assistance. This means increase may not have material effects on demand-side that the short-run risks of production leakage both abatement, as international competition would serve domestically and externally are reduced, as increased to limit price increases in any case. However, there are production leads to increased allocations that may policies that could be combined with OBA such that partially or fully offset additional carbon costs. leakage protections are maintained, but demand-side Further, as benchmarks are used, firms still maintain abatement is better incentivized. For example, jurisdictions incentives to invest in reducing the emissions intensity could apply charges downstream on the consumption of production, including for capacity expansions. For of emissions-intensive goods while maintaining OBA for instance, a glass manufacturer may choose to invest in producers, which would effectively pass on carbon costs a new low-emission furnace that enables it to increase that are blunted through free allocation and incentivize production as any additional carbon costs are offset more efficient use of industrial products.187 through additional allocations received via OBA. S Calculation of benchmarks and measurement of S Maintains incentives to reduce emission intensity. output. OBA, as with fixed historical benchmarked Output-based allocation preserves incentives to reduce allocation, uses historical emissions intensity and emissions intensity. A reduction in emissions intensity output to calculate benchmarks. Benchmarks based reduces emissions liability but has no effect on free on firms’ historical emissions intensity require the allocation. This incentive will be strongest when OBA collection of data on emissions and output. Establishing is used with a stringent product benchmark calculated sectoral benchmarks is data-intensive and creates ALLOCATION across the sector. Product benchmarks encourage STEP 5 potential for lobbying around the methodology. In early mitigation action and allow less carbon-intensive applying a benchmark across a sector, it is often firms to gain a competitive advantage through changing difficult to determine the common output and ensure technologies and processes to lower carbon costs. it fits the sector in question. These issues may be Process benchmarks also encourage efficiency lessened by utilizing international benchmarks. improvements but do not encourage adoption of new S Possible interaction challenges with the overall technologies or processes. cap. Keeping the number of allowances allocated for S New entrants. OBA is the only free allocation method free within the cap may be more difficult to manage discussed that adequately addresses the issue of new under OBA if overall levels of free allocation are high. entrants. New entrants under OBA would be allowed As allocation adjusts with changes in recent output, the the same allocation as an identical incumbent firm; overall level of assistance that firms are entitled to receive hence, new entrants are not disadvantaged compared may not be known when a particular phase of an ETS to incumbents in this respect. starts. If increases in OBA cannot be absorbed by the pool of allowances that would otherwise be auctioned, Disadvantages there is a risk of exceeding the cap, rendering the The disadvantages of this method are: domestic environmental outcome of the ETS less certain. S Demand-side abatement incentives are reduced. This potential challenge raises the need for adjustment OBA provides firms with additional allocations for each factors that align allocation with the cap trajectory. additional unit of production. Tying allocation to current production reduces the marginal costs of production relative to other allocation mechanisms; at the margin, 5.3.4 TARGETING FREE ALLOCATION a firm does not face the full carbon price. The lower Excessive free allocation can reduce the efficiency of increase in costs means a lower increase in prices. A lower carbon markets and the amount of revenue flowing pass-through of costs in turn undermines incentives for to government for use toward other objectives. These consumers to change behavior to reduce consumption trade-offs have led jurisdictions to try to closely target free of emissions-intensive products or substitute for less allocation to the sectors and firms that need it most. Free emissions-intensive alternatives. There are a growing allocation often reduces the incentives for abatement but 186 For example, Material Economics 2018; Rissman et al. 2020. 187 See Acworth et al. 2020 for an overview of consumption charges and demand-side abatement measures. STEP 5: DISTRIBUTE ALLOWANCES 115 often helps with managing the transition to the ETS and between producers in different jurisdictions. Products can reduce the risk of carbon leakage. Jurisdictions with are trade-exposed if the companies that produce them existing ETSs often deem those in most need as the firms compete with foreign producers in either export or import that face the highest carbon leakage risk, as this is often markets. For trade-exposed products, higher production the largest concern of participants. costs because of the ETS cannot be fully passed on to consumers and production may no longer be profitable. The risks of leakage are usually highest for industries that Where factors such as trade barriers or transport costs produce outputs that are both emissions-intensive and make trade unlikely to occur, covered firms are insulated trade exposed: from competition from uncovered competitors and the S Emissions intensity captures the impact that carbon risk of leakage should be small. Trade exposure is often pricing has on a particular firm or sector. An emissions- quantified with trade-intensity indices. intensive product is one for which the additional costs from a carbon price are large enough to substantially In addressing leakage risk concerns, most jurisdictions affect the overall cost of production. combine the two indicators of emissions intensive and trade exposed. They are often used to create separate S Trade exposure is used as a proxy for the ability of a EITE sectors into tiers of leakage risk, with the tier level firm or sector to pass on costs without significant loss of dictating the level of assistance provided. Table 5-2 shows market share and hence their exposure to carbon prices. the different factors that ETSs have used to identify which Trade, or the potential to trade, is what allows competition sectors might be exposed to the risk of leakage. Table 5-2 Trade exposure and emissions intensity in different ETSs Emission Intensity (EI) Trade Exposure (TE) Carbon leakage risk criteria Emission intensity tiers: 1. High: >5,000 tCO2e per million dollars of value added 2. Medium: 1,000–4,999 tCO2e per million dollars of value ALLOCATION added STEP 5 3. Low: 100–999 tCO2e per million dollars of value added California EI = tCO2e/million dollars of value (imports + exports)/ 4. Very low: <100 tCO2e per million dollars of value added (WCI) added (shipments + imports) Trade intensity tiers: High: >19 percent Medium: 10–19 percent Low: <10 percent Both measures combined to determine final leakage risk category of low, medium, or high. Cost intensity used: Direct and indirect cost increase >30 percent; or non-EU trade intensity >30 percent; EU ETS [Carbon price × (direct emissions (imports + exports)/ 188 × auctioning factor189 + electricity or (Phase 3) (imports + turnover) consumption × electricity emission Direct and indirect cost increase >5 percent and trade intensity factor) / Gross value add (GVA)] with non-EU countries >10 percent. Trade intensity * Emissions intensity > 0.2 then considered to be at risk of carbon leakage. {[direct emissions + Trade intensity * Emissions intensity between 0.15 and 0.2, EU ETS (imports + exports)/ (electricity consumption × qualitatively assessed and may be considered at risk of carbon (Phase 4) (imports + turnover) electricity emission factor)] / GVA} leakage. Criteria include abatement potential, market characteristics, and profit margins. Trade exposure is Two tiers: qualitative and based 1. Highly exposed: carbon intensity >1,600 tCO2e per million New EI = tCO2e / million dollars of on the existence of New Zealand dollars of revenue and trade exposed. Zealand revenue trans-oceanic trade in 2. Moderately exposed: carbon intensity >800 tCO2e per million the good in question. New Zealand dollars of revenue and trade exposed. (imports + exports)/ Québec tCO2e / million dollars of value Three tiers for both emissions intensive and trade intensity: low, (imports + domestic (WCI) added medium, high. production) Source: Acworth et al. 2020. 188 Assumed carbon price of EUR 30. 189 Auctioning factor represents the share of allowances the sectors would need to purchase if not on the carbon leakage list in order to cover their emissions stemming from activities eligible for free allocation. 116 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION While these criteria have typically been used in determining This means that the current approach to targeting free sectors exposed to carbon leakage, there are a number of allocation may not measure leakage risk well, particularly important considerations. when carbon pricing diffuses to key trading partners. However, currently there are no clear alternatives that can First, when considering emissions intensity, it is important be applied in broad leakage risk assessment.190 Discussion to take into account the carbon emission costs passed on the potential alternative methods to provide leakage through from the supplying sectors, particularly electricity, protection that aim to address the limits of free allocation as well as the direct carbon emission costs incurred in can be found in Box 5-8. production. This may be important for industries such as aluminum smelting, where most of the impact of a carbon Overall, free allocation to at-risk industries is important. price is indirect cost impacts from electricity prices. However, providing free allocation comes at a large cost in terms of both forgone revenue and reduced abatement. Second, in the academic literature several authors have The caps of ETSs are set to decline in the decades ahead argued that trade intensity, while relevant, is not a stand- as jurisdictions scale up their mitigation efforts, which alone driver of carbon leakage and only has an effect when a means the amount of allowances available for free will sector or firm is also emissions intensive. The same can also decline as well. Therefore, free allocation faces increasing be true of emissions intensity in cases where trade intensity constraints as an instrument to compensate leakage- is not high. An important caveat is that trade exposure will exposed industries for increased production costs of ETS be a useful metric only if a jurisdiction’s trading partners do compliance. This is particularly true for systems where not have a sufficiently high carbon price in place. If trading EITE industries reflect a large proportion of the allowance partners have a carbon price at a similar level, then leakage cap. To achieve the ETS’s objective of reducing carbon is unlikely to occur. Therefore, as carbon pricing expands, emissions, steps should be taken to reduce free allocation risks of leakage are likely to reduce. An additional important over time. This can be done via reducing the assistance consideration is the nature of competition between rates or by recalculating the benchmarks. trading partners. If firms facing a carbon price are able to pass through costs to consumers because of the market ALLOCATION structure, then the risk of leakage is lower. STEP 5 Box 5-8 Technical note: Alternative approaches to carbon-leakage protection Concerns about the limits of free allocation as protection against carbon leakage have prompted discussion in academic and policy circles about alternative approaches. Some of the most commonly discussed ideas are summarized below. S Tiered approaches to free allocation. ETSs have often award sectors deemed at risk of carbon leakage an equivalent or very similar level of assistance, despite varying levels of vulnerability to carbon leakage across sectors. One way to ensure declining budgets for free allowances target sectors that are most vulnerable is to create a tiered approach that categorizes sectors according to their risk and gives different levels of free allocation based on those classifications. Such an approach is planned for Québec post-2020, is done in New Zealand, and was suggested by some EU Member States during deliberations on Phase 4 of the EU ETS.191 S Border carbon adjustment (BCA). BCAs would apply tariffs or other fiscal measures to imported goods based on their GHG content, with or without rebates to domestic exporters to recover their costs of ETS compliance. By leveling differences in carbon costs between domestic and foreign producers, BCAs could offer strong protections against carbon leakage. They could also strengthen incentives to reduce emissions by allowing the jurisdiction to end or limit free allocation to sectors included in the BCA scheme. However, BCAs present challenges in terms of administrative complexity (for example, data availability on the carbon content of imported goods) and the potential for legal disputes under the World Trade Organization. These challenges may also limit the effectiveness of a BCA as a policy response to carbon leakage.192 S Charges on consumption. A charge could be applied at the point of consumption based on carbon content and the price of an ETS allowance in the implementing jurisdiction. Producers would continue to receive free allocation but would be held liable for consumption charges, which they could directly pay themselves or pass to the next purchaser down the value chain. Imported goods would be treated equivalently. Consumption charges paired with free allocation therefore have the potential to protect against carbon leakage while  190 Acworth et al. 2020. 191 California Air Resources Board 2013. 192 Mehling et al. 2019; Cosbey et al. 2019; and Acworth et al. 2020. STEP 5: DISTRIBUTE ALLOWANCES 117 improving incentives for low-carbon intermediate and final consumption, which is a key lever to push for deep decarbonization.193 Given their resemblance to a value-added tax, consumption charges may be simpler to implement. However, extending the charge further downstream to address domestic leakage concerns would also require default values for carbon-intensive imported goods. S Supporting investments in transformative technologies: Especially for production processes with very high capital and low operational costs (including allowance costs), the capital leakage channel is the most significant mechanism for carbon leakage. Targeted low-carbon investment support could be accompanied by a ratcheting down of free allocation such that allowance costs are reduced in line with a reduction in emissions. Policies supporting low-carbon investment include carbon contracts for difference, which offer price guarantees for technologies that yield emissions reductions below a certain benchmark.194 5.4 COMPARISON OF ALLOCATION METHODS This section compares the different allocation methods. 5.4.1 PERFORMANCE AGAINST Section 5.4.1 assesses the performance of each allocation OBJECTIVES method against the objectives identified; Section 5.4.2 No method of allocation performs best across all the discusses the topic of new entrants and closures; and objectives that policymakers may pursue. The different Section 5.4.3 discusses the data requirements for objectives and allocation approaches need to reflect the implementing each allocation method. market environment as well as regulatory arrangements. The rest of this subsection discusses how each method of ALLOCATION allocation performs against the objectives in more detail. STEP 5 Table 5-3 provides a summary of the performance of each method. Table 5-3 Summary of methods of allocation against objectives Objective Method of allocation Preserving Managing the Reducing the risk of incentives for cost- transition to the Raising revenue Price discovery carbon leakage effective abatement ETS Auctioning ● ● ● ● ● Grandparenting ● ● ● (capital leakage) Fixed historical benchmarked ● ● ● (capital leakage) allocation Output-based benchmarked ● ● ● allocation ● High ● Medium ● Low Preserving incentives for cost-effective abatement incentives for cost-effective abatement. This partly relates The ultimate aim of the ETS is to reduce emissions. to the approach that they take to updating allowance Table 5-3 shows that auctioning provides full incentives allocation over time. Updating allowance allocation is for abatement while none of the free allowance allocation discussed further in Sections 5.3.1 and 5.3.2, as well approaches score a “high” against preserving the as Box 5-9 below. Because free allocation reduces the 193 Munnings et al. 2019; Ismer et al. 2016; and Acworth et al. 2020. 194 See Acworth et al. 2020; Richstein 2017; and Sartor and Bataille 2019. 118 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION compliance burden for firms, the full cost of allowances substitution from high-carbon to low-carbon producers is not internalized. Ultimately this disadvantages cleaner may not be fully realized, and any related demand-side alternatives to carbon-intensive goods because emissions abatement driven by price pass-through on emission- from those goods are not fully priced. This muted price intensive goods and services is only partially achieved. signal reverberates across the industrial value chain, As discussed in Box 5-9, incentives for emissions-intensity disincentivizing more efficient intermediate and final reductions, but not necessarily absolute emissions consumption.195 This means that the aim of encouraging reductions, are preserved in OBA. Box 5-9 Technical note: Updating free allocation provisions If allowances are allocated for free, the price signal of the ETS can be distorted and the incentives for cost-effective abatement may not be preserved. A key determinant of the degree of these distortions is the interaction between allocation and different updating provisions, that is, whether and how the allocation of allowances responds to changes in circumstances after the initial allocation is made. If entities know or can predict that a change in circumstances will lead to a change in the allocation approach, then this may distort their behavior. Most existing ETSs update free allocations — for example, in response to plant closures or alternatively large changes in production or capacity levels. This may be done between trading phases (the fixed baseline period benchmark approaches described in Section 5.3.2) or within a trading phase (the OBA approach described in Section 5.3.3). This updating can reduce leakage, but it can also create significant price distortions. Many ETSs also have updating provisions for new entrants and plant closures. These likewise require carefully and consistently designed allocation (benchmarking) features. Due to the possible distortions of price signals, the allowance allocation needs to be not only reflected as a pure distributional issue but also considered an important design feature with regard to the cost-effectiveness of ALLOCATION STEP 5 emissions abatement. Managing the transition to an ETS Benchmarking methods look to provide partial Each allocation method manages the transition to an ETS compensation for stranded assets by rewarding those that to some extent, with no method providing full assistance. have lower emissions intensity with a higher percentage At face value, auctioning provides the lowest assistance of free allocation relative to their emissions level. This in managing the transition because it provides no support means that early investments are not disadvantaged on stranded assets and no protection against potential or disincentivized. With benchmarking providing some distributional impacts on households. However, the percentage of the current allowance burden for free, the revenues from auctions can be used to protect against average cost of compliance is reduced, meaning that cost these disadvantages, and auctioning does reward early pass-through is partially reduced. investments in emissions reductions and facilitates price The introduction of carbon pricing carries an important discovery, which can be important in activating trade in the political dimension and is usually a politically contentious nascent stages of an ETS. process, with significant vested interests often opposed Grandparenting performs strongly where auctioning does to policy reform. However, this is increasingly balanced not, compensating for stranded assets and helping avoid by a constituency of business interests and other negative impacts from cost pass-through. Providing a high stakeholder groups calling for carbon pricing. In a context percentage of allowances in the early stages of an ETS of strong opposition to policy reform, free distribution of will reduce the need for trading, thereby allowing time for allowances provides a visible reduction in the distributional firms to build up the capacity to trade. In addition, this impacts of carbon pricing on some of those who might may reduce opposition to the initial implementation of the be most opposed to its introduction, while still providing ETS. However, grandparenting does not recognize early policymakers with an assurance that a particular emissions investments well, and, as discussed in Section 5.3.1, may reduction target, as reflected in the cap, will be met. provide incentives for an increase in emissions. In cases where demand for strong carbon pricing is high, auctioning is an attractive method because of its preservation of abatement incentives. 195 Branger and Sato 2017; Fisher and Fox 2007; and Acworth et al. 2019. STEP 5: DISTRIBUTE ALLOWANCES 119 Figure 5-1 Possible evaluation of primary allocation method as an ETS matures 100% Auctioning Share of primary allocation Fixed historial benchmarking ■ Grandparenting ■ Benchmarking ■ Auctioning Grandparenting Output-based Note: This graphic is only illustrative of the possible evolution of the primary benchmarked allowance allocation method of an ETS allocation as it matures. Allocation methods do not necessarily need to follow a particular order nor does an ETS necessarily transition through every type. 0% 1 2 3 4 5 6 7 Time 8 9 10 11 12 13 14 15 $ $ $ BENCHMARK BENCHMARK $ ALLOCATION STEP 5 BASE YEAR Time Grandparenting Fixed historical benchmarking Output-based benchmarked allocation Auctioning Many ETSs have initially started with a large majority of produce more, it experiences the full cost of the carbon allowances allocated for free using different approaches, price and therefore may decide to limit production, which then often looked to gradually increase the proportion of could be taken up by firms uncovered by carbon pricing. auctioning over time. This means the capital is preserved but production leakage may occur.196 Reducing the risk of carbon leakage or loss of competitiveness Fixed historical benchmarked allocation provides allocation in line with previous production and thus provides a degree Grandparenting and fixed historical benchmarked of certainty on allocation to firms. Due to its providing allocation provide some protection against capital leakage allocation based on previous production, its protection in the form of avoiding closure of existing production against carbon leakage is similar to grandparenting. Fixed capacity, while output-based benchmarked allocation historical benchmarked allocation protects against existing provides more complete protection against both capital capital leakage, but production leakage could occur. leakage and production leakage. Comprehensive protection may be more important for growing developing In comparison, OBA always adjusts in line with levels economies, since new capital will be more important than of production. If a facility wants to increase production, existing capital. In addition, new investments are also the this will be matched by a proportional increase in free most responsive to leakage pressure. allocation. The full cost of the carbon price is not faced, and the production leakage that occurs in grandparenting Grandparenting provides the facility with free allocation and fixed historical benchmarked allocation does not occur to cover some percentage of its emissions, for example, to the same extent or at all. OBA also protects against 90 percent or 100 percent of historical emissions. Facilities capital leakage, unlike grandparenting and fixed historical experience the full opportunity cost of the allocation benchmarked allocation. OBA protects against leakage immediately. In the short term, if the facility wants to of investment in existing capital and new capital because 196 Production leakage through both domestic and external channels (see Box 5-2). 120 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION increases in production are reflected with the proportional 5.4.2 NEW ENTRANTS AND CLOSURES increase in allowances. With OBA, firms receive the full When deciding on allocation methods, it will be important benefits from reductions in emissions intensities. Since to consider how the system will deal with both new the allocation uses a benchmark for emissions intensity, entrants to, and exits from, the market. the benefits of reductions (either increased selling or decreased purchasing of allowances) against this Under an auction system and OBA, both entry and exit may benchmark are experienced for every unit of production. be accommodated in a relatively straightforward manner. An auction system automatically accommodates new entrants Table 5-4 provides a summary of the performance of and exits — allowances are readily available for purchase. In each method allocation in protecting against the risk of OBA systems, new entrants are treated in broadly the same production and capital leakage. way as an existing source that expands production. When a new entrant reports output, it will receive allowances just Table 5-4 Summary of performance in reducing the risk like existing firms. Similarly, if any firm closes, it produces no of carbon leakage for different methods of output and receives no allowances. allocation In comparison, grandparenting and fixed historical Method of Production leakage Capital leakage benchmarked allocation are less accommodating in allocation risk protection risk protection allowing entry and exit. In terms of closure, to avoid Auctioning ● ● windfall profits from selling allowances, a facility should no longer receive free allowances after closing. However, Grandparenting No/ limited 197 ● this may not be consistent with an intention to provide Fixed historical No/ limited ● allowances as compensation for the loss of stranded benchmarking assets. It may also create an artificial incentive to Output-based preserve production.198 Nonetheless, in most ETSs with Yes ● benchmarking grandparenting, closure is normally associated with the ● Yes ● No loss of rights to free allowances. ALLOCATION STEP 5 In terms of new entrants, the typical approach in systems Raising revenue with grandparenting involves a new entrant’s reserve, which Auctions are a source of revenue (see Section 5.2), while is set aside within the cap to provide free allocation to eligible free allocation forgoes this revenue to achieve other new entrants to the market. In the EU, new entry provisions objectives. Policymakers should consider the extent to are used primarily to avoid leakage of new entrants. which auctioning, in conjunction with targeted revenue use, can achieve the desired objectives relative to free allocation methods. 5.4.3 DATA REQUIREMENTS FOR ALLOCATIONS A more detailed discussion on the use of revenues from The different types of allocation also have different levels of ETS auctioning can be found in the PMR’s Using Carbon complexity that may play into decision-making. Auctioning Revenues report. is the lightest on data requirements since allocation is done via a centralized manner. However, that is not to Supporting price discovery say that auctions are without the need for data capacity. Auctions can support price discovery in the market (see Of the free allocation mechanisms, grandparenting is the Section 5.2). High levels of free allocation inhibit price least demanding since it requires only data on historical discovery because of the lack of trading that occurs (see emissions. Fixed historical benchmarked allocation has the Section 5.3). If free allocation is pursued as the allocation added requirement of emission benchmarks, which may be method, a small amount of auctioning can aid in price harder for policymakers to initially define. OBA requires, in discovery. Alternatively, consignment auctions can facilitate addition to emission benchmarks, current firm output data. price discovery where conventional auctioning is not applied. OBA is not necessarily more complicated to implement than fixed historical benchmarked allocation; for example, firms may not have accurate records of previous emissions/ output, so implementation of OBA using current output would be more feasible than fixed historical benchmarked allocation (which uses historical data), especially in the 197 Grandparented allocations that are updated with more recent historical emissions will provide limited leakage support. “Pure” grandparenting with no updating provides no leakage support. 198 Ellerman 2008 discusses these issues in the context of Phase 1 of the EU ETS. STEP 5: DISTRIBUTE ALLOWANCES 121 initial phases of an ETS. If OBA is to be implemented under Table 5-5 Summary of data requirements for different a firm cap, additional data and procedures will be needed methods of allocation to align the allocation to the cap in case the aggregate allocation exceeds the cap (or a predefined share of the Historical Historical Emission Actual emissions output benchmark output total cap). Regardless of the approach, collecting the required data can be difficult, with companies having Auctioning ● ● ● ● incentives to try to distort the data to reduce their liabilities Grandparenting ● ● ● ● or increase their allocation. Fixed historical benchmarking ● ● ● ● Table 5-5 provides an overview of the data requirements for the different allocation methods. Output-based benchmarking ● ● ● ● ● High ● Medium ● Low 5.5 QUICK QUIZ Conceptual Questions 1. What are the key options for distributing allowances? 2. What objectives can each distribution option help achieve? ALLOCATION STEP 5 Application Questions 1. In your jurisdiction, what activities are both strongly trade exposed (to jurisdictions with no or weak carbon pricing) and emissions intensive? 2. In your jurisdiction, what regulatory arrangements need to be reflected to assess the advantages and disadvantages of different allocation approaches? 3. Would your jurisdiction want an ETS to generate additional government revenue that could be used strategically? 4. Given the local confidence in markets, how willing would firms and regulators be to rely on auctions versus free allocation for distributing allowances? 5.6 RESOURCES The following resources may be useful: S Carbon Leakage: Theory, Evidence and Policy Design S Using Carbon Revenues S The Use of Auction Revenue from Emissions Trading Systems: Delivering Environmental, Economic, and Social Benefits S A Guide to Greenhouse Gas Benchmarking for Climate Policy Instruments S Carbon Leakage and Deep Decarbonisation 122 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION ALLOCATION STEP 5 This page intentionally left blank. STEP 6: PROMOTE A WELL-FUNCTIONING MARKET 123 Step 6 - Promote a well-functioning market STEP 6 Promote a well-functioning market At a Glance____________________________________________________________________________ 124 6.1 Price formation in an ETS__________________________________________________________ 125 6.2 Decide on intertemporal flexibility__________________________________________________ 130 6.3 Promote a functioning secondary market___________________________________________ 135 6.4 Tools to address price variability___________________________________________________ 138 6.5 Quick Quiz_______________________________________________________________________ 148 6.6 Resources_______________________________________________________________________ 148 BOXES Box 6-1 Case study: Banking in Phase 3 of the EU ETS_________________________________ 131 Box 6-2 Case study: Holding and purchase limits in California and Québec________________ 132 Box 6-3 Case study: Allowance borrowing and financial distress_________________________ 133 Box 6-4 Technical note: Vintage allowances and advance auctions_______________________ 134 Box 6-5  Technical note: Compliance, reporting, and phasing_____________________________ 134 Box 6-6 Technical note: Financial products in secondary carbon markets__________________ 137 Box 6-7 Technical note: The impact of PSAMs_________________________________________ 140 Box 6-8 Case study: The Allocation Committee in the Korean ETS________________________ 141 Box 6-9 Case study: RGGI’s PSAMs__________________________________________________ 142 Box 6-10 Case study: Carbon price floor to foster investment in the UK____________________ 143 Box 6-11 Case study: California’s PSAMs______________________________________________ 145 MARKETS Box 6-12 Case study: The EU ETS Market Stability Reserve______________________________ 146 STEP 6 FIGURES Figure 6-1 ETS allowance price formation_______________________________________________ 126 Figure 6-2 Stylized model of banking in an ETS over time_________________________________ 130 Figure 6-3 Case study: Banking in Phase 3 of the EU ETS_________________________________ 131 Figure 6-4 Technical note: The impact of supply adjustment measures______________________ 140 Figure 6-5 Case study: The impact of supply adjustment measures in RGGI_________________ 142 Figure 6-6 Case study: The EU ETS Market Stability Reserve______________________________ 146 TABLES Table 6-1 Advantages and disadvantages of different approaches to PSAMs________________ 147 124 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION AT A GLANCE Economic shocks and market or regulatory failures can Checklist for Step 6: Promote a well-functioning market undermine the pursuit of these outcomes. To ensure the market is performing well and prices are predictable, it is ✔ Establish the rationale for, and risks associated essential to support the market through rules for intemporal with, market intervention flexibility that allow current prices to reflect future ✔ Establish rules for banking and borrowing expectations. Similarly, appropriate rules for participation ✔ Establish rules for market participation in and governance of secondary markets can improve ✔ Identify the role played by a robust secondary market efficiency. market There are three tools available to policymakers to provide ✔ Choose whether to intervene to address low prices, intemporal flexibility: high prices, or both 1. Banking: This allows regulated entities to bank ✔ Choose the appropriate price or supply adjustment allowances from the current compliance period for use measure in future periods. Banking can help boost low prices as well as create a buffer against future high prices. Allowance prices can vary as they balance policymaker- Crucially, banking brings forward emission reductions, controlled supply with demand, which is driven by a making it more likely that short-term targets will be met. complex interaction of economic and firm-level factors. 2. Borrowing: This allows regulated entities to borrow Delivering a well-functioning market is crucial for an allowances from future compliance periods for use in emissions trading system (ETS) to operate as intended, the current period. This provides entities with flexibility to deliver emissions reductions efficiently and provide in determining their compliance strategy. However, by appropriate price signals for long-run decarbonization. reducing mitigation action in the near term, borrowing A well-functioning market will see predictable price can delay emissions reductions needed to achieve adjustments to external events and changes in information ETS caps. As such, most ETSs have either prevented available to market participants, and feature liquid allowance borrowing or allowed it only to a limited extent. markets governed by transparent rules that facilitate price 3. Length of compliance periods: Within a compliance discovery. These markets in turn will deliver emissions period, firms can reduce emissions whenever it is reductions that occur at the right time and use the least-cost most efficient, akin to having unlimited banking and MARKETS STEP 6 mitigation options available to market participants. borrowing within the period. This makes the length of the compliance period an important determinant of Fluctuations in prices are often desirable as they represent intertemporal flexibility. the adjustment of the market to new information about the cost of abatement. However, large changes in price Policymakers must decide on who can participate in can occur because of exogenous shocks, regulatory primary markets (auctions) and secondary markets, as well uncertainty, or market imperfections. Whether large as the institutions that will support market development. fluctuations in price warrant market intervention by Firms that have liabilities under an ETS are a given for policymakers depends on the objectives of the ETS and participation in the market but noncompliance entities, whether the benefits of intervention are judged to exceed particularly from the financial sector, can also play an its risks. If the sole objective of an ETS is the reduction of important role in adding liquidity and providing access emissions cost, at least in the short term, price variability to risk-management products. Including financial- may not be of concern. If, however, the objective is to market players in the operation of an ETS must be realize an efficient abatement pathway over the long term carefully regulated. The degree to which government with high levels of innovation, persistently low prices may itself participates in the market must also be decided. be considered undesirable as they may deter investment. Governments can directly intervene to provide liquidity Policymakers may also wish to contain costs for market in exceptional circumstances; however, repeated participants to ensure political support. interventions should be avoided and may suggest more fundamental problems with market design. A well-functioning market will deliver emissions reductions to support the achievement and strengthening of emission- Even if an ETS has a relatively well-functioning secondary reduction targets. It will also support economic efficiency market, there remain risks of prices being consistently through ensuring emissions are reduced at the right much higher or lower than intended. As such, it is now time (intertemporal efficiency) and ensuring that the right common practice for ETSs to adopt some form of price mitigation projects are occurring (allocative efficiency). or supply adjustment measure (PSAM). PSAMs help jurisdictions achieve a predictable and effective market, STEP 6: PROMOTE A WELL-FUNCTIONING MARKET 125 meaning prices that are not too high, with their associated Most PSAMs focus on avoiding prices that are too high costs, or too low, which may be inconsistent with longer- or too low. Options used to respond to low prices include term decarbonization. the use of auction reserve prices, hard price floors, or the levying of additional fees and charges. Options used to PSAMs work by adjusting allowance supply available for use respond to high prices include the use of cost-containment in response to certain criteria. These measures will differ reserves or hard price ceilings. While less common, PSAMs based on whether they are targeting high or low prices, the can also seek to manage supply by responding to quantity way in which rules to trigger interventions are defined using criteria, like the number of banked allowances. Each price or quantity criteria, and whether they impact the supply approach has advantages and disadvantages, but recent of allowances in a temporary or permanent way. The design trends globally have seen an increasing use of PSAMs to of a PSAM seeks to balance a jurisdiction’s preferences address the risks of both high and low prices by adjusting over the certainty of achieving a given emissions level with supply at auction. the costs of achieving emissions reductions. The operation of these measures, and the decision to make a temporary Section 6.1 discusses the mechanism of price formation or permanent supply adjustment, has clear links with in an ETS and outlines what is required for a predictable cap setting (see Step 4) and the allocation of allowances and effective market. Section 6.2 sets out the options for (see Step 5). PSAMs are typically based on clearly defined providing intertemporal flexibility in a market. Section 6.3 intervention rules that are announced well in advance. outlines options to support a functioning secondary However, in some cases jurisdictions have adopted PSAMs market. Section 6.4 discusses options for addressing price that give regulators some discretion regarding when and variability. how to intervene in the market. 6.1 PRICE FORMATION IN AN ETS This section explains the ways in which prices are 6. the availability of allowances from linked systems formed in an ETS. Section 6.1.1 explains the dynamics of (see Step 9). supply–demand balancing in the market, and how this may MARKETS STEP 6 lead to excessive medium-term price variability that might To a large extent, therefore, supply depends on parameters run counter to some ETS policy objectives. Section 6.1.2 set by policymakers, be it directly by the level at which the introduces the concept of price volatility (short-run variations cap is set, or through the rules for offsets, banking and in allowance prices) and distinguishes it from having prices borrowing, or linking. that are persistently too high or low. Section 6.1.3 highlights the importance of a predictable and effective market to Demand reduce emissions and promote efficiency. By contrast, the total demand for emissions allowances in an ETS depends largely on technology, expectations, exogenous shocks, and profit maximization by market 6.1.1 SUPPLY AND DEMAND participants. The following are important for determining Various factors will affect the demand and supply of allowance demand: emissions allowances in an ETS (see Figure 6-1), and hence S the level of emissions under business as usual (BAU) determine allowance prices and how they evolve over time. (i.e., no carbon price) relative to the cap; Supply S the costs of abating emissions within the covered The total supply of emission units at a given point in time sectors (which are driven by factors including weather, depends on: economic conditions, capital stock, and availability of existing technologies); the level of the cap and the associated amount of S the outcomes of companion policies (such as renewable allowances (allocated freely, through auctions, or through unit reserves) (see Step 4); energy mandates or fuel economy standards) that reduce emissions within covered sectors; 4. any supply of allowances carried over (“banked”) S expectations (and uncertainty) regarding future from previous periods or drawn from future periods (“borrowed”) (see Section 6.2); allowance prices, which determine the demand for banking emissions allowances for use in future 5. the availability of offset units (see Step 8); and compliance and for hedging price risks; 126 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Figure 6-1: ETS allowance price formation Figure 6-1 ETS allowance price formation Drivers of allowance demand Price Allowance Allowance • BAU emissions relative to cap demand supply • Marginal abatement costs • Companion policies • External factors • Expectations regarding future allowance prices • Demand for emissions allowances from linked systems Price range when allowance Drivers of allowance supply demand varies • Level of the cap • Degree of banking/borrowing • Availability and cost of offsets • Availability of allowances from linked systems Quantity S technological change, including that driven by the policy conditions also affect the expected profitability expectation of future stringency of the program and of investments in mitigation projects and research and future demand for allowances; and development in new technologies and processes. S any external demand for emissions allowances from Various system design features enable regulated entities linked systems. to respond to short-lived price volatility. Broad scope, intertemporal flexibility provisions, regularly held auctions, 6.1.2 PRICE LEVELS AND VOLATILITY availability of offsets and allowances from linked systems, and access to derivatives and other hedging products The market will set the price that balances supply and can help reduce the degree of price fluctuations and their MARKETS demand at any one point in time. When the economy is STEP 6 impact. In general, moderate price volatility is not a serious strong and businesses are expanding operations, there will concern for regulated entities and policymakers and can be be higher demand for products and thus higher associated managed if financial market instruments, such as options, emissions. This will put upward pressure on emissions futures, and other hedging products, are available, as they and increase the total amount of abatement necessary are for other commodity markets. to meet a given cap. In an ETS, underlying economic and technological conditions interact with the cap to Promoting financial-sector participation in secondary determine the price. For instance, a faster rate of economic markets is important for managing volatility, as it supports growth will result in higher carbon prices when the set of the development of the financial instruments needed for abatement technologies and other factors are held equal. entities to manage price volatility. The financial sector can Conversely, a lower rate of economic growth under the assist with creating products that regulated entities can use same conditions will lead to a lower price (as discussed to hedge the risk of prices changing, such as options and in Section 6.2.1) and could even reach zero, particularly if futures contracts. This is discussed further in Section 6.3.3. banking is not permitted. In addition to short-term volatility in prices, markets may Expectations about the allowance market also drive price experience price changes that are persistent and systemic. formation. For example, a low-interest-rate environment This is captured by the concept of price variability: a will reduce the cost of purchasing allowances today for divergence between expected and actual prices that future use and increase banking demand; by contrast, persists over the medium to long term. In other words, regulatory uncertainty over the future of the ETS will it means prices being consistently much higher or much temper such demand. Expectations can mean that even if, lower than intended. in the short run, the total demand for emission allowances associated with current production falls below the number For example, a rapid expansion of economic growth and of allowances available in the marketplace (supply), emissions could cause prices to remain unexpectedly emission unit prices may still be nonzero if there is demand high for an extended period. This could create challenges for banking allowances. Expectations of economic and for business competitiveness and may have unwelcome STEP 6: PROMOTE A WELL-FUNCTIONING MARKET 127 distributional impacts if the effects of high prices are borne A robust and rising price level over time can encourage disproportionately by vulnerable communities. On the other early investment in low-cost mitigation, with a gradual hand, a recession, or a faster-than-expected deployment movement to more costly abatement as lower-cost options of renewable energy, could lead to relatively low prices for are exhausted. Designing a market that delivers a robust a prolonged period. It is unlikely that market actors would price signal reduces the price risk faced by investors and be able to completely buffer such medium- or long-term encourages investments that may pay off only if a robust price changes with derivative instruments, which may carbon price is maintained in the longer term. not be available, or available only for relatively short time periods (rarely more than three years). Similarly, banking Similarly, measures that increase governments’ ability to allowances or purchasing future allowance vintages may ratchet up targets can also play a role. Evidence from the not be enough to buffer large, persistent, and unanticipated ETS to date suggests that emissions are often reduced for increases or decreases in prices. a lower cost than first anticipated.200 Given this, policies that maintain prices at a certain level can bring forward cost-effective emissions reductions and make it easier to 6.1.3 A PREDICTABLE AND EFFECTIVE ratchet up ambition over time. MARKET Promote intertemporal efficiency An ETS should be designed so that it achieves its underlying economic and environmental objectives. Good Intertemporal efficiency requires that mitigation happens market design and the use of measures to promote market when it is most efficient. If it costs less to reduce emissions predictability can help achieve this. A well-designed, well- now rather than in the future, then the ETS should support functioning market will deliver three main objectives: this substitution. This means the quantity of mitigation S Reduced must have some flexibility over time. emissions: Delivering emissions reductions to support jurisdictions to achieve, and strengthen, Intertemporal efficiency is driven by forward-looking firms emissions reduction targets consistent with the Paris anticipating and responding to potential future costs. If Agreement. firms expect prices to be higher in the future, then they will S Intertemporal efficiency: Ensuring emissions are be willing to pay more for an allowance today. However, reduced at the right time. due to uncertainty about the future, how much firms S Allocative efficiency: Ensuring that the least-cost are willing to pay is “discounted” downward to reflect mitigation options are being used. evaluation of this uncertainty alongside any borrowing costs. Through this mechanism, current prices reflect Delivering these objectives requires that policymakers take MARKETS expected future prices in carbon markets. STEP 6 account of the quantity of emissions reductions required, as well as provide predictability about the level and As discussed further in Section 6.2, allowing entities volatility of the carbon price that will generate mitigation flexibility over the point in time when they reduce emissions incentives. These objectives can inform the design of and can facilitate cost-effective action on climate change. It operating rules for an ETS. does so in two ways: 1. By allowing individual entities to abate in the Reduced emissions most cost-effective way. The regulator’s timing of An ETS is created to promote numerous objectives but emissions limits and associated allowance allocations ultimately its aim is to deliver reductions in emissions to over time may not match the most cost-effective path mitigate climate change (as discussed in Step 1). for individual regulated entities. Intertemporal flexibility allows heterogeneous firms to determine the most The Paris Agreement codifies the aim to limit warming to cost-effective trajectory for new investments and to well below 2 degrees above preindustrial levels, which is balance these with the optimal management of existing to be delivered through a set of bottom-up targets with assets and infrastructure.201 ambition ratcheting up over time. An implication of this 2. By facilitating investment in new technology. Fully goal is that global greenhouse gas (GHG) emissions should addressing the challenge of climate change over the reach “net zero” by the middle of the century.199 Reaching long term will also require technologies that may not net zero requires that carbon markets provide sufficient yet exist, so time is needed for new investments in price incentives to mobilize investment in new emissions- research, development, and demonstration to pay reduction technologies and processes. off. Intertemporal flexibility can provide sectors and 199 Dietz et al. 2018. 200 Burtraw and Keyes 2018. 201 Kling and Rubin 1997 state that banking will lead to cost reduction and banking while discounting the value of banked units will lead to a convergence of socially optimal and firm optimal costs. Fell, MacKenzie, and Pizer 2012 compare ETSs with and without banking. Their analysis shows that allowing participants to bank allowances significantly lowers expected costs. 128 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION individual firms with the necessary time to invest in costs. Further information on how to promote a well- new technology and R&D. functioning secondary market is provided in Section 6.3. Ensuring predictable prices by avoiding extreme high- or low-price outcomes is important to support intertemporal 6.1.4 MARKET INTERVENTION: efficiency, as predictable prices provide markets with RATIONALE AND RISKS confidence and reduce the cost of investment in abatement In carbon markets operating to date, market dynamics technology. Under a predictable allowance price path, have sometimes resulted in prices being consistently much investment can be planned according to whether the costs lower (or higher)203 than policymakers think is consistent of the project outweigh that of the cost of future avoided with their long-term economic or environmental objectives, allowance purchases, in addition to other savings. This creating the need for market intervention. These high or low consideration becomes much more difficult if prices follow prices have two main drivers: first, the potential for shocks, an unpredictable price path, and with enough uncertainty given underlying uncertainty in carbon and other markets, investments will be delayed or potentially not be made at all. and second, examples of market or government failure. Promote allocative efficiency Allocative efficiency refers to whether the mitigation effort 6.1.5 SHOCKS AND UNCERTAINTY is appropriately split between regulated entities. That is, The world is uncertain, and unexpected shocks can and allocative efficiency ensures that the lowest-cost mitigation do influence the operation of carbon markets. Shocks to options are used to reduce emissions in a given time period. demand or shocks to supply can lead to large and lasting Ensuring broad coverage can support allocative efficiency changes in prices, and it is increasingly recognized that across the economy, as discussed in Step 3. Market design carbon markets need to be robust to these shocks. can also support allocative efficiency in two main ways: by ensuring liquidity and by reducing transaction costs. Demand shocks are unexpected events that change the emissions profile or mitigation costs of entities covered in a Liquidity means that firms that wish to buy or sell carbon market that alter demand for emissions allowances. allowances can do so at any point, enabling trade-in Demand shocks are generally driven by economic factors allowances, which helps ensure the right entity cuts or unexpected technological developments. For instance, emissions. In a liquid market, firms that can reduce their the 2007–2008 financial crisis and subsequent recession emissions at a low cost will do so and can choose to saw industrial activity and emissions fall rapidly, which sell their allowances to those that cannot reduce their precipitated the fall in allowance prices in the European MARKETS emissions. Liquid markets also transmit a clear price signal Union (EU) ETS from more than EUR 20 in 2008 to less than STEP 6 to participants such that they can make informed choices EUR 10 in 2009. On the other hand, the US unconventional regarding their trading strategies. gas boom played a key role in driving the restructuring of the electricity sector in the Northeastern states and led The secondary market for allowances can support to a rapid fall in emissions and demand in the Regional allocative efficiency through reducing transaction costs. Greenhouse Gas Initiative (RGGI). At present, the impacts Both financial and administrative transaction costs can of COVID-19 and jurisdictions’ policy responses have led create barriers to trade-in allowances, which can lead to to a significant fall in economic activity, emissions, and inefficient mitigation outcomes. If transaction costs are high therefore demand for emissions allowances. (for instance, if brokers charge a large amount to facilitate a trade), the firms that are initially allocated allowances may Shocks can affect sectors differently, which should be decide to keep them, regardless of whether they need them considered when deciding the scope of an ETS (see or not. This could mean that firms with higher mitigation Step 3). For instance, the 2007–2008 financial crisis had costs, which would otherwise purchase these firms’ a larger relative effect on emissions from the electricity allowances, are not able to do so. This results in mitigation and industry sectors in Europe, whereas other sectors efforts being split inappropriately across entities. like transport saw far smaller changes in demand and emissions.204 Similarly, the US unconventional gas boom A liquid market with low transaction costs will support trade- primarily drove reduced emissions in the electricity in allowances and help ensure that prices reflect the latest sector, the only sector covered by RGGI. A broader information available to market participants.202 In general, scope generally reduces the risk of a market being greater participation in the secondary market will increase disproportionately affected by sector-specific shocks. liquidity and spur competition that reduces transaction 202 The process of the market integrating new information is known as price discovery. Reflecting information from all market participants — from manufacturers to generators and traders — can ensure that the carbon price acts as a real-time reflection of the expectations for the future and delivers emissions reductions from the least-cost mitigation options. 203 To date, persistent high prices have not been an issue, but these could prove a risk in the future and are a concern of many policymakers. 204 European Environment Agency 2020. STEP 6: PROMOTE A WELL-FUNCTIONING MARKET 129 A rapid expansion in the supply of emissions allowances would lead to prices partly self-correcting after a short-term can also be a type of shock. For instance, this occurred shock. However, if market participants have systematically in the New Zealand ETS and the EU ETS with the rapid higher, less than “ideal” discount rates, or lack the strategic expansion in supply and use of low-cost offsets from the insight or information to value allowances properly beyond Clean Development Mechanism in 2009 –2012. In this case the short term, this self-correction may not take place and the rapid expansion in supply led to a flood of allowances prices will remain low. This can be aggravated by regulatory in the market, greatly reducing the price before further uncertainty, which creates further uncertainty about the strict limits on offset use were introduced to steady the long-term value of allowances. price. This is discussed further in Step 8, Box 8-3. Careful consideration of local context and policy design is needed to support the development of well-functioning 6.1.6 GOVERNMENT AND MARKET secondary markets. For instance, sometimes a hedging FAILURES product may not be available to purchase at a competitive price, despite the existence of demand; this is known as a The potential need for intervention to constrain excessive “missing market.” Missing markets can be caused by policy price variability needs to be balanced against the choices, a lack of financial market development within a possibility that intervention in the market may itself create jurisdiction, or characteristics specific to a given carbon distortions. Allocation through a market-based approach market such as its small size. like an ETS facilitates the cost-effective allocation of emissions-reduction efforts across the regulated There are several factors that affect the development of entities. This can be jeopardized by market distortions or a secondary market. For instance, the lack of liquidity in unintended effects of policy intervention. exchange-based trade in Korea has created concerns for liable firms seeking to access allowances to meet In particular, there is a risk that policy intervention can liabilities. Other jurisdictions, like New Zealand, have active create uncertainty regarding future policy developments over-the-counter trade offered but lack an exchange with that can exacerbate excessive price volatility or standardized contracts. Only the EU ETS has deep and variability.205 Governments will always retain the legitimate liquid exchange-based trade of derivative products that ability to change certain key parameters of an ETS or provide longer-term hedging options for firms, and even adjust the policy mix of which the ETS is a part. These these markets only trade contracts a few years in advance. changes, or anticipation of these changes, can also lead While this lack of access to long-term hedging is also to considerable price changes, as well as uncertainty that typical for other commodity markets, this means that firms increases risks to abatement investments. For example, looking to make investments in projects with long payback MARKETS policy deliberations over postponing (“backloading”) the STEP 6 periods still bear a large degree of risk. auction of allowances to balance the EU ETS’s cap supply and demand accompanied considerable price movements A lack of market information can also lead to imperfect during the third phase of the program.206 outcomes in secondary markets as participants seek to make decisions without the information they need. For instance, in The extent to which PSAMs compound regulatory the Korean ETS prices spiked close to compliance deadlines uncertainty will be limited if the measures are well designed because firms were unsure of underlying demand in the and operate in a predictable manner. At a minimum, they market and became concerned that they would not be able should be transparent, have a long-term horizon, and have to access the allowances they need. This is a particular a clear and targeted remit. If effectively implemented, risk in ETSs with high levels of free allocation, which can PSAMs can reduce regulatory uncertainty and improve reduce incentives for trading. A lack of liquidity can lead to the functioning of an ETS, which may reduce the need for poor price discovery in the secondary market, which can future regulatory changes. A well-planned, predictable be compounded by a lack of clarity on the future stringency approach to the operation of PSAMs can help guide price of the ETS. This can be alleviated by the government expectations rather than add to price variability. providing transparent information on how the ETS operates Market imperfections may persist despite the best efforts and its future direction, but also through financial market of policymakers,207 which may lead to prices being “too intermediation. Intermediaries help match buyers and sellers, high” or “too low,” or otherwise not reflecting all relevant provide markets with risk-management products, and have considerations. For instance, ordinarily it would be expected an incentive to provide market information to increase that a low allowance price would lead to an increase in confidence and facilitate trade. Some jurisdictions, such demand as participants sought to bank allowances now, as California, have managed to support well-functioning which they could use for compliance purposes later. This secondary markets with only limited exchange-based trading, 205 For a discussion of this issue with regard to experience in the EU, see Koch et al. 2015. 206 Koch et al. 2015. 207 Based on a discussion in Neuhoff et al. 2015. 130 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION in part as restricted free allocation has facilitated the growth of liquid markets for over-the-counter trade. 6.2 DECIDE ON INTERTEMPORAL FLEXIBILITY The key decisions that a policymaker needs to make in the design of intertemporal flexibility are how to approach Figure 6-2 Stylized model of banking in an ETS over time banking and borrowing, and, in addition, the length of the compliance period. A decision must be made as to whether CO2e allowances in the current compliance period are allowed Excess reductions = banked allowances for compliance in future compliance periods (banking), and if allowances from future compliance periods can be used in the current period (borrowing). Generally banking is Excess emissions = use of banked allowances considered a valuable, necessary addition to an ETS, while borrowing is deemed too risky to allow apart from in limited cases. The length of the compliance period differs between existing ETSs, with the longer time frames potentially allowing for more intertemporal efficiencies in abatement while reducing the administrative burden. However, long compliance periods expose the ETS to the risks associated Volume of banked with borrowing, which makes it unattractive. allowances Intertemporal flexibility is a prerequisite for intertemporal Commitment period/ Commitment period/ time efficiency, as discussed in the section above, “Promote Phase I Phase II intertemporal efficiency”. Cap trajectory Actual emissions By allowing firms to shift emissions reduction over time, intertemporal flexibility can reduce overall mitigation MARKETS costs and price volatility. By reducing price volatility, 6.2.1 BANKING STEP 6 intertemporal flexibility can also potentially encourage Banking allows regulated entities to save unused allowances low-carbon investment.208 If allowance prices are low, for use in future compliance periods. It enables reductions entities may choose to buy or hold allowances and save in emissions today in exchange for increased emissions later them for later when prices might be higher. This will and is a vital component of all existing ETSs. increase demand for allowances and hence increase prices. Similarly, when prices are high, entities that have Banking can facilitate cost-effective abatement by allowing excess allowances may choose to profit by selling these those that wish to abate early the flexibility to do so to allowances or may bank these allowances for use against prepare for stricter caps later. Moreover, it can reduce price compliance shortfalls at a later point in time. This will volatility by creating additional demand for allowances reduce allowance demand, causing allowance prices to fall. when prices are low and, once a bank is established, providing an additional supply of allowances when prices The net result of these dynamics is that the trajectory of are high. carbon prices over time is smoother than it otherwise would be (see Figure 6-2). Moreover, in contrast to borrowing, banking also can create a private-sector group with a vested interest in the success Under certain circumstances, however, allowing of the system, including an incentive to ensure rigorous intertemporal flexibility will be insufficient to address monitoring and enforcement, as well as tight future targets, volatility and may even exacerbate it. Other market to protect and maximize the value of their carbon assets. management interventions may be needed to ensure price predictability and provide cost containment in the context In general, banking is central to the efficient functioning of longer-term, system-wide market conditions. These are of most carbon markets. Given this, policymakers have discussed in Section 6.4 below. 208 Fell, MacKenzie, and Pizer 2012. Conversely, intertemporal flexibility in the form of banking helps smooth the transition to stricter caps. When long-term targets are credible and anticipated, regulated entities may find it in their best interest to over-comply and save allowances for use later when caps will be stricter and prices can be expected to be higher (Dinan and Orszag 2010; Murray et al. 2009). Fell et al. 2012 also find that allowing temporal flexibility in the form of banking could save significant costs by incorporating some of the benefits of tax policy, allowing quantity to adjust on a short-term basis. STEP 6: PROMOTE A WELL-FUNCTIONING MARKET 131 usually allowed full flexibility on banking across compliance excessively low prices. Without banking, such an imbalance periods within the same phase (see Box 6-5 of this step for would be contained within the current compliance period. a recap on the differences between compliance periods Also, while allowing banking can often reduce volatility, and phases). Across phases, banking has been unlimited there are cases where it can lead to adverse outcomes. In in the EU ETS since 2008, and is also unlimited in the ETS particular, banking means that changes in expectations of in New Zealand and RGGI, while in Korea banking limits future market conditions can feed back to today’s prices, apply at the installation level, and in California and Québec through altering the value of banked allowances. This is banking is allowed subject to purchase and holding limits desirable if future caps are credible and policy signals are at the entity level. clear but can generate volatility in cases where there is a lack of certainty over future policies. This is most likely to emerge Banking can however create some challenges. For one, in cases where there is an oversupply of allowances in the unlimited banking can enable an excess supply of allowances present and so the primary driver of allowance demand is in one compliance period to be carried over into future for future compliance. Box 6-1 describes how this problem compliance periods, potentially prolonging an underlying arose in the EU ETS. “imbalance” between demand and supply, leading to Box 6-1 Case study: Banking in Phase 3 of the EU ETS During Phase 2 and the early years of Phase 3 of the EU ETS, a “surplus” of allowances relative to emissions projections developed (see the figure below). Prices reflected continued market demand for allowances that could be banked, in the expectation that they would be valuable in the future. However, this resulted in speculation over future policies becoming the principal driver of changes in the ETS price during Phase 3.209 This experience emphasized the importance of ensuring that long-term market signals are maintained. To that effect, the Market Stability Reserve (MSR) was introduced. By adjusting the volume of allowances to be auctioned, it aims to maintain a demand–supply balance within the EU ETS (as discussed in further detail in Box 6-7). Figure 6-3 Case study: Banking in Phase 3 of the EU ETS MARKETS 3,000 STEP 6 2,500 Mio. emission units /Mt CO2e 2,000 1,500 1,000 500 0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 ■ Freely allocated allowances ■ Scope correction ■ EUAs sold or auctioned ■ Surrendered CERs and ERUs ■ Placed in the MSR ■ Backloaded allowances Verified emissions + scope correction Source: European Environment Agency 2019. EU ETS data viewer. Note: EUA = EU Allowance; ERU = Emission Reduction Unit; CER = Certified Emission Reduction Backloading refers to a short-term measure the European Commission implemented where 900 million allowances were not auctioned over the years 2014–2016. Initially they were to be auctioned in 2019–2020 but ultimately were added to the MSR in 2019, along with 397.124722 allowances that were withheld from the auction volumes by the MSR. The sum of allowances depicted in the chart for a given year does not equal the cap as allowances from the NER300 program, deviations from the cross sectoral correction factor, and unallocated allowances are not included. 209 Koch et al. 2014; Koch et al. 2015. 132 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION In practical terms, there are several cases where Phase 1 experience shows, if there is excess allocation policymakers have chosen to impose limits on the banking of allowances in the pilot phase, prices can fall to zero, or holding of allowances: as there will be no demand to buy and bank allowances S Banking from trial phases. Prohibiting or limiting for later use. banking is a way to isolate a pilot phase from the S To control the ability of individual entities to acquire subsequent phase. This creates potential for greater market power. If individual institutions can acquire experimentation in the pilot phase without necessarily large numbers of allowances, there may be a concern requiring that the allowances from the first phase that this could be used to distort the market. This may be recognized as valid in the subsequent phases provide a rationale for limiting the amount of allowances (see Step 10). This approach was adopted in relation that entities can hold, including for banking, as the case to Phase 1 of the EU ETS. However, as the EU ETS of California illustrates (see Box 6-2). Box 6-2 Case study: Holding and purchase limits in California and Québec The respective regulations in California’s and Québec’s cap and trade systems impose holding and auction purchase limits to prevent participants from acquiring market power. These regulations affect the number of allowances that can be purchased from auction or held in an entity’s account at any one time, and thereby also limit banking. With regard to purchase limits, all regulated entities are subject to a purchase limit of 25 percent of allowances sold at auction, while nonregulated entities are limited to 4 percent. The California regulator, the California Air Resources Board (CARB), treats a group of associated entities as a single entity for determining compliance with the holding and purchase limits. This is also the case in Québec, where related entities are considered a single entity, which has an overall holding amount that can be distributed among its individual entities. The resulting distribution must be communicated to the regulator. Each regulated entity can make use of a limited exemption in order to be able to acquire sufficient allowances to meet its respective compliance obligation. Allowances acquired through the exemption must be transferred to an entity’s compliance account and can only be used to cover emissions. Holding limits are vintage specific. The current vintage holding limit applies to all current vintage allowances (for example, allowances from the current and previous vintage years) as one group. Thus, in 2020, the current vintage holding limit covers an entity’s holdings of 2013 through 2020 vintage allowances. The holding limit is set with MARKETS STEP 6 reference to a “base” 25 megatons of carbon dioxide equivalent (25 MtCO2e) and an “annual allowance budget,” which is equal to the number of allowances issued for the current budget year, as shown in the following formula: HLy = 0.1 x Base + 0.025 x (Cy – Base) Where: HL = holding limit C = annual allowance budget y = current year 6.2.2 BORROWING However, some of the challenges associated with providing Borrowing allows entities to use allowances they will intertemporal flexibility can be illustrated in the context receive in future compliance periods within the current of borrowing. Private actors are likely to face incentives compliance period. This means regulated entities can emit to delay costs and behave in a short-sighted manner. In more today and make up for this with larger emissions addition, challenges associated with allowing entities to reductions in the future. borrow allowances include:210 S Delay and uncertainty over future targets. Borrowing provides firms with flexibility to meet targets. Depending on the length of the borrowing period, For instance, it allows those that cannot easily abate there will be less certainty over whether domestic or immediately the opportunity to make investments that will international emission-reduction targets will be reached. provide greater abatement in the future. It can also reduce With Nationally Determined Contribution (NDC) goals short-term price volatility; in particular, it helps to provide for emissions reductions, delayed mitigation may be market liquidity in times when allowances might be scarce inconsistent with these obligations. and prices high. 210 Fankhauser and Hepburn 2010; Vivid Economics 2010. STEP 6: PROMOTE A WELL-FUNCTIONING MARKET 133 S Governments may not be able to assess (for instance, Korea calculates an entity-specific limit on creditworthiness. The government may not be borrowing). As prices in ETSs are expected to rise over well-equipped to assess the creditworthiness and time as ambition increases, banking alone is likely to solvency of firms that borrow allowances. Further, there provide sufficient intertemporal flexibility. An example of is likely to be adverse selection, with the firms that are the risks of borrowing is provided in Box 6-3 below. least solvent likely to want to borrow more than the firms that are most solvent. Requiring firms to report In some ETSs, a degree of short-term implicit borrowing net compliance assets and liabilities on their balance is facilitated by offering early access to future allowance sheets is one possible way to promote transparency allocations, prior to the deadline for compliance in and oversight by shareholders. Provision of collateral the current period. For example, in the EU, entities may be deployed to mitigate this risk, but this adds receive allowances for the current compliance year by transaction costs and complexity. February 28, two months ahead of the end of the previous compliance period (April 30). Because there is no vintage S Increases political pressure to delay action. Borrowing associated with the allocation (in other words, there is no allows firms to delay abatement, thus potentially creating “activation” date at which an allowance becomes valid for an active interest to lobby for weaker targets, or even compliance — see Box 6-3) these allowances can be used for scrapping emissions trading altogether, so that their for current compliance and implicitly “borrowed” without debts are reduced or cancelled.211 any limitation or penalty from the next year’s allocation, As a result of these disadvantages, ETSs have either except in the last year of the phase. prevented explicit borrowing or limited it quantitatively Box 6-3 Case study: Allowance borrowing and financial distress During a phase, companies operating under the EU ETS can use free allowances to meet the present or the previous year’s emissions liabilities, a strategy equivalent to restricted borrowing as previously discussed in this chapter. While borrowing allowances from future allocations has some appeal, as it provides increased flexibility for operators to reduce emissions when it is most cost-effective for them to do so, it also faces some challenges as illustrated by two high-profile cases of regulated firms in the United Kingdom (UK) in 2019.212 Flybmi, a regional airline company based in the UK, collapsed in February 2019, citing several difficulties, including recent spikes in fuel and carbon costs. The company relied on borrowing to meet its surrender obligations but ran MARKETS STEP 6 into constraints when free allocation to UK participants for the 2019 trading year was delayed following the then- ongoing Brexit negotiations and safeguarding measures implemented by the European Commission. While aircraft operators’ total allowance costs are estimated to have represented only about 0.3 percent of their total operating costs on flights within the scope of the EU ETS in 2017,213 the inability to borrow allowances from the next year’s allocation was cited as one aspect that resulted in the airline’s collapse.214 Shortly after, similar concerns were raised by another UK company, British Steel.215 Its obligations under the EU ETS, combined with the company’s reliance on borrowing from its future year’s allocation, resulted in UK government support on commercial terms. The EU ETS was reported to be a contributing factor to debts accrued by the company before it collapsed in May 2019.216 It is generally considered that specific borrowing mechanisms provide companies helpful flexibility to meet compliance obligations. However, while these two cases may be specific to the uncertainty surrounding Brexit at the time, they highlight the financial risks to firms that rely on borrowing future allocations for present-year compliance. 211 Kling and Rubin 1997 found that when firms are given complete freedom to bank and borrow, they produce (and emit) more than socially optimal in early periods. 212 See Tietenberg 2010 for a nontechnical treatment on borrowing for which Rubin 1996 and Kling and Rubin 1997 provide the rigorous foundation. 213 European Aviation Environmental Report 2019. 214 Carbon Pulse 2020. 215 Shankleman and Morales 2019. 216 Clark 2019. 134 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Box 6-4 Technical note: Vintage allowances and advance auctions  In some systems, issued allowances are tagged with vintages (dates), before which they cannot be used for compliance. They can only be banked or traded. For example, California and Québec sell a limited number of allowances from vintages up to three years ahead during the quarterly joint “advance auctions.” While putting a vintage on allowances prevents some of the implicit forms of borrowing discussed above, the trading of these allowances provides a forward price signal, revealing market expectations of future prices. This can make it easier for participants in financial markets to design derivatives such as futures and options, which can make it easier for market participants to hedge price risk (as discussed in Section 6.3). 6.2.3 LENGTH OF COMPLIANCE allowances between compliance periods and often across PERIODS phases. However, within a given compliance period, firms can effectively bank or borrow freely, since they A further way to provide intertemporal flexibility is through have intertemporal flexibility for managing emissions and the choice of length of the compliance period; in other compliance efforts. Box 6-5 explains the terms referenced words, over what period of time emissions are calculated in this section. and the surrender obligation is established. Rules for banking and borrowing establish the flexibility to trade Box 6-5 Technical note: Compliance, reporting, and phasing  The length of the compliance period establishes the basic time limit for compliance, with longer periods providing greater intertemporal flexibility for managing emissions and compliance efforts. At the end of each compliance period, regulated entities need to surrender the allowances necessary to cover their emissions in that time frame. The length of the reporting period determines the point at which entities need to provide information on emissions over a given time frame. The reporting period may be shorter than the compliance period. For more information on compliance and reporting, refer to Step 7. The compliance period may fall within a longer commitment period (called a “phase” or a “trading period” in the MARKETS STEP 6 EU ETS), whereby a time frame is linked to a specific emissions reductions target, potentially tied to an international commitment or a contribution under relevant climate policy, and during which allowance allocations and other program features are comparatively fixed. Separate rules may exist for banking and borrowing across compliance versus commitment periods. Longer compliance periods reduce administrative burdens Systems with longer compliance periods may also on regulated entities and provide greater opportunities for require reporting and some “partial” compliance on cost-effective timing of abatement and greater flexibility to a more frequent basis, while still maintaining some of respond to unplanned events. For example, in California the flexibility from a longer period. This helps to ensure the regulator notes that the three-year compliance period regulated entities are making progress toward meeting helps firms respond to low-water years that might affect their obligations. Partial or full compliance on an annual the generation of hydroelectric power. Longer compliance basis could also help align ETS compliance requirements periods may be particularly valuable when it is known that with other normal financial disclosure, tax, and regulatory abatement investments requiring long lead times may be compliance requirements. In most existing and proposed required for some emitters. ETSs, there are some annual compliance requirements. However, except for Kazakhstan, New Zealand, and At the same time, longer compliance periods — and Korea, systems provide flexibility to partially comply each the associated implicit banking and borrowing that year. ETSs with longer compliance periods include RGGI, they allow — raise the same challenges as banking and California, and Québec, at three years, and Tokyo, at five borrowing more generally. years. In addition, in California there is a requirement of partial yearly compliance of 30 percent of annual covered STEP 6: PROMOTE A WELL-FUNCTIONING MARKET 135 emissions.217 The EU effectively has a rolling compliance up to the end of each phase, which provides a form of deadline as allowances from the next compliance period implicit borrowing. can be used to cover emissions during the current period, 6.3 PROMOTE A FUNCTIONING SECONDARY MARKET The secondary market is where allowances are traded purposes. The process of arbitrage can reduce price between firms after they have been auctioned or freely volatility and better align carbon pricing outcomes with allocated. While the trading is done by private actors, fundamental price drivers across multiple markets, policymakers have a large role to play in defining the rules for instance, by ensuring changing prices of energy and structures under which the market must operate. commodities are reflected in carbon prices. All aspects of ETS design will affect secondary market function in some way, but decisions regarding who can Financial market participants and other investors may participate in these markets are particularly important. take longer-term positions in carbon markets if they Firms with liabilities under an ETS need to participate in consider the longer-term price outlook to be too high or the market, but other actors, such as financial market too low relative to current levels. This reduces volatility participants, can play an important role in adding liquidity by narrowing the trading price band, with financial market and providing access to risk-management products. participants buying when prices drop below their long-term price expectation and selling when they rise above it. This This section focuses on the rules, participants, and helps to provide a source of secondary market demand infrastructure that can contribute to a well-functioning or supply to the market, pushing prices up or down and secondary market. Sections 6.3.1 and 6.3.2 outlines how driving intertemporal substitution as liable entities increase existing financial markets and financial service providers or reduce emissions in response to the changing level of can support a robust carbon market, including promoting the carbon price. market liquidity and trade. Section 6.3.3 discusses the role of risk-management instruments, and Section 6.3.4 Broader market design decisions will affect how a outlines approaches to direct intervention by regulators to secondary market develops. This requires a coordinated address volatility or provide liquidity. approach to avoid unnecessary barriers to trade, for MARKETS instance by allowing the banking of allowances that STEP 6 enables mitigation to shift over time. Other design 6.3.1 SUPPORTING MARKETS decisions can also be made with an eye toward secondary Financial markets play a key role in shaping production market development; for instance, registries for emissions and investment patterns across a range of industrial and allowances and auction platforms can be designed to product markets and can play a similarly important role in integrate with secondary market exchanges, enabling trade carbon markets. Financial markets’ participants provide to occur with lower costs and higher participation than liquidity and support information flows, arbitrage price would otherwise be available. Exchange-based trading in differentials across markets, facilitate trade of liable firms, carbon markets plays an important role in providing risk- create products to manage price and volume risks, and in management services and information flows, as discussed some cases take positions regarding future market prices. in Section 6.3.2 below. Traders from banks, investment firms, and related By creating the conditions for secondary markets to entities often engage in arbitrage, which means they take expand and ensuring transparent flows of information, advantage of price differences between carbon markets policymakers can help covered firms understand supply and other markets by buying under-priced instruments and demand dynamics and better manage the risks and selling them at a profit. Traders can take advantage of associated with fluctuating allowance prices. arbitrage opportunities at scale to profit from even minor Policymakers can provide market-relevant information price differentials, providing a source of allowance demand regarding several aspects of market functioning, including: or supply for entities seeking to trade for compliance 217 From CARB’s Initial Statement of Reasons, justifying the three-year compliance period: “A three-year compliance period provides some intertemporal flexibility by allowing regulated entities to manage planned or emergency changes in operations over the short term, as well as to deal with low water years that might affect the generation of hydroelectric power.” And ARB’s justification for partial annual compliance, to address potential adverse selection: “Staff also recognizes that there is a need to require regulated entities to submit a portion of its compliance obligation more frequently to ensure they are making progress toward their obligations. Regulated entities could emit GHGs and then declare bankruptcy or otherwise cease operation before fulfilling their compliance obligations at the end of the three-year compliance period.” 136 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION S the level of emissions and provision of free allowances is higher, as there is a risk that one party will not comply at a sector, firm, or facility level; with the agreed terms of the trade. Similarly, without a S the outcomes of auctions and underlying supply and central entity to identify and report on terms of trade, this demand; approach provides very little information on demand and supply to the broader market. S information on the type, number, and timing of transactions made in the registry; Over-the-counter trade is generally facilitated by specialist S the operation of a PSAM and its impacts; firms acting as brokers and dealers. These brokers will S any evidence of misconduct, for instance, market buy and sell allowances, engage in direct (proprietary) manipulation or noncompliance; and trade, or more commonly act as an intermediary for trades between other firms. Over-the-counter trading cuts S the overall functioning of the market, as discussed transaction costs relative to direct trade because brokers further in Step 10. can more efficiently connect buyers and sellers compared Opening carbon market participation to the financial sector to direct trading. It has the advantage of flexibility, offering and other participants results in carbon markets operating customized provisions for trade based on the needs of more like financial markets and creates the need to expand the buying or selling party. It can also protect against oversight to this new segment of trading. This brings its nonpayment by holding allowances or money paid in a own set of risks, which has led some jurisdictions, like the separate account (in “escrow”) until obligations have been EU, to regulate carbon markets using existing financial met on both sides of the trade. However, because of the market regulatory powers.218 Allowing financial market need to match a seller to a buyer for a customized trade, it participants to trade in emissions allowances or participate can be difficult to efficiently respond to a rapidly changing in auctions can introduce additional complexity into the market environment. The firm acting as the broker for operation of the ETS, requiring greater oversight and an over-the-counter trade largely determines the degree management of a larger number of participants. However, of information it releases on trades, meaning that the existing laws and oversight arrangements for trading information available to the broader market is often sparse. goods and financial products can be used so new rules do This has implications for oversight of the market, as there is not need to be developed. Nonetheless, financial market limited information to assess how the market is functioning. participants are sometimes prevented from trading during Exchange-based trade occurs on platforms, like stock pilot phases or the initial operation of an ETS. These exchanges or commodity exchanges. These platforms issues will be discussed further in International Carbon facilitate trade in standardized contracts, which enables the Action Partnerships (ICAP) and the Partnership for Market participation of a wide range of buyers and sellers trading MARKETS Readiness’s (PMR) forthcoming paper on ETS Governance. STEP 6 identical products in markets that may see thousands of trades an hour. By aggregating buyers and sellers these 6.3.2 FACILITATING TRADE exchanges provide an important source of price discovery, as differences in information are reflected in demand and Trade in carbon markets often occurs through financial supply as willingness to buy or sell at certain values. As service providers, which will often act as brokers for trade such, the market price aggregates the pools of information for liable entities or provide information on market trends and communicates the weighted view of the market on and outlook. There are three ways in which allowances can the value of these allowances, in a transparent carbon be traded: price. In addition to facilitating trade, such readily available 1. direct trade between liable entities, information about allowances prices and volumes supports 2. trade facilitated by a broker (“over-the-counter” trade), oversight by government on the operation of the market. and Exchanges also reduce counterparty risk by requiring 3. exchange-based trade on a given platform. guarantees of payment prior to allowing trades and by using clearinghouses to facilitate settlement of trades. These options differ in terms of their transaction costs, Finally, exchange-based trading supports the development flexibility, and provision of market information. of liquid derivatives markets that can be used for risk management by hedging carbon pricing risks. These Direct trade between liable entities is rare, as the markets are discussed further in Section 6.3.3. These risk- transactions costs involved in identifying potential trading management products provide entities with the confidence partners and agreeing to the terms of a trade can be high. to invest in mitigation by locking in carbon prices beyond Such trades are flexible, because trading terms can be the current compliance period and reducing uncertainty, agreed upon between firms; however, “counterparty risk” despite uncertain market conditions. 218 The Markets in Financial Instruments Directive is the framework of EU legislation for the financial sector. STEP 6: PROMOTE A WELL-FUNCTIONING MARKET 137 6.3.3 RISK-MANAGEMENT their future carbon liabilities. In many sectors, production INSTRUMENTS decisions are made in advance, and firms may wish to have certainty on their costs when they are setting the price for The financial services sector can help liable firms their product. An example of this is the electricity sector, manage risks associated with both trading and changes where a large proportion of electricity generation is sold in emissions over time associated with their production several years in advance, either through long-term power processes — in particular, the development of derivatives purchase agreements, or through forward contracts that products traded over the counter or through exchanges, are typically two to three years in the future. This locks in which enables firms to manage risks by hedging against a large proportion of generators’ revenues, which means future carbon price movements. that to ensure a certain level of profit they may also seek Financial market participants create risk-management to lock in their costs. As carbon liabilities can form a large products that otherwise would not exist. Risk-management proportion of total costs, generators often use derivative instruments called derivatives allow firms to reduce price products to reduce risks of changes in the carbon price. uncertainty using products like futures, forwards, options, These futures markets also provide a channel through and swaps, as outlined in Box 6-6.219 Futures contracts which future price expectations can affect current carbon are commonly used by firms to buy or sell allowances at a prices. Liquid futures markets encourage arbitrage given set price at a contractual point in the future, and normally the clear link between prices for derivatives contracts and trade on derivatives exchanges, like the Intercontinental spot markets. The existence of derivatives can therefore Exchange, or energy exchanges, like the European improve price discovery and lead to a more efficient Energy Exchange. This allows firms to lock in a price for spot market through arbitrage trading. This can help allowances they will buy in the future. drive intertemporal substitution as described above, as it Futures markets and other derivative products provide a provides for the guaranteed sale or purchase of allowances valuable service to firms, which may want to be certain of in the future. Box 6-6 Technical note: Financial products in secondary carbon markets Derivatives are financial products that derive their value from changes in the price of an underlying asset or commodity. There are four main types of derivatives. These are described below, along with their application to carbon markets. MARKETS Futures contracts are standardized exchange-traded agreements to buy or sell allowances or offsets at a STEP 6 S certain maturity date in the future for a certain price. A futures contract can be settled by a payment based on the current market price at the contractual maturity, which is commonly used for hedging. Futures contracts are the most traded form of derivatives product. S Forward contracts are like futures but are nonstandardized agreements to buy allowances or offsets in the future for a certain amount, usually through a specialized over-the-counter broker. A forward contract is usually settled through the physical delivery of the underlying asset. There may be details in the forward contract that fit the exact needs of the buyer or seller that are not going to be common in the market and are therefore comparatively less commonly traded. S Options entail the right, but not the obligation, to buy (“call option”) or sell (“put option”) a certain quantity of allowances at a future date for an agreed price. S Swaps are a nonstandardized exchange or series of exchanges (allowances, offsets, cash flows) at a given time or for a set period at an agreed price. For example, in some trading systems there is a limit placed upon the amount of offsets installations can use for compliance, which can result in a price differential between offset and allowance units. Swaps can be used to exploit this differential. 219 Aki and Michel 2013; Monast et al. 2009; Pew Center on Global Climate Change 2010. 138 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION 6.3.4 DIRECT VOLATILITY AND LIQUIDITY unable to purchase allowances in the event of shortages MEASURES in the market. The Korea Development Bank and the Industrial Bank of Korea were designated as market makers Aside from allowing financial market participation in and can draw on a government-held reserve of five million the ETS secondary market, the government can play a allowances to increase liquidity in the market if needed.220 direct role in managing volatility and supporting liquidity. These interventions can help reduce price volatility and Measures introduced in the Chinese pilot ETSs focus therefore short-term price risk, which may increase on managing market volatility, while the Korean ETS has confidence in the market. Similarly, the market-maker introduced a market-maker function to support liquidity. mechanism in the Korean ETS can help provide liquidity for Several additional measures have been introduced in the liable entities seeking to buy or sell allowances. However, Chinese pilot ETSs to limit price volatility. This includes the these direct interventions also risk introducing distortions, use of “circuit breakers,” which stop trade on secondary driving prices to deviate from those that are implied by markets when a limit is hit regarding the daily increase economic fundamentals, generating inefficiencies, and and decrease of price (typically 10 percent to 30 percent). decreasing confidence in the market. The specific design of these measures varies in each pilot. As a rule, direct intervention to reduce short-term In Hubei, price fluctuations are directly controlled by the volatility or provide liquidity should be an exception rather exchange, which limits day-to-day price fluctuations to than a regular occurrence in an ETS. Effective market 10 percent of the opening price, and intervention is also functioning and price discovery can be ensured by good allowed in the event of supply and demand imbalances or design, including an ambitious cap, regular auctions liquidity issues. Similarly, in the Fujian ETS the regulator can for a large proportion of allowances allocated, and intervene in the market when it judges there are demand allowing participation of a wide range of financial market and supply imbalances, or when liquidity issues arise. intermediaries in secondary markets. Intervention by The Korean ETS introduced a market-maker facility in government should be considered only if other aspects of 2019 to improve market stability and enhance liquidity. market design have been shown to be ineffective. This followed several years of illiquid trading, in part due In contrast, PSAM’s aim to provide greater certainty about to the large proportion of freely allocated allowances. Its long-term prices can play an important role, as discussed main purpose is to provide selling offers to entities that are in Section 6.4. MARKETS STEP 6 6.4 TOOLS TO ADDRESS PRICE VARIABILITY Given the risk of excessive price variability in carbon (see Section 6.4.3), or quantity measures to manage supply markets, it is now common practice for ETSs to adopt (see Section 6.4.4). some form of PSAM.221 PSAMs help jurisdictions to achieve a predictable and effective market (as discussed in Section 6.1.3) that can ensure prices are sufficiently high to 6.4.1 TARGETING MARKET support longer-term decarbonization, but not so high as to INTERVENTIONS result in excessive costs. Targeting high or low prices PSAMs work by adjusting the supply of allowances into the PSAMs can operate by targeting low or high prices in the market in response to certain criteria. Other measures may market, or both. This is generally done by either reducing work to ensure a minimum cost of emissions by “topping supply if prices are too low, or increasing supply if prices up” the costs faced by regulated entities. The manner are too high. By increasing price certainty, PSAMs can through which PSAMs can be targeted to achieve specific help provide bounds on future price expectations. This can outcomes is discussed in Section 6.4.1. support investment in low-carbon technologies and assets. By reducing the bounds of future price expectations, The implementation of a PSAM will depend largely on PSAMs can reduce price risk, which may reduce the its design, but several options are available to enact required rate of return for this investment and thus increase these measures, which can differ depending on whether abatement investment. they target low prices (see Section 6.4.2), high prices 220 ICAP 2020c. 221 In this publication we use price and supply adjustment measure as a generic term for the universe of interventions that alter supply based on market price or balance. This is distinct from the Supply Adjustment Mechanism, which may be introduced under the UK ETS. STEP 6: PROMOTE A WELL-FUNCTIONING MARKET 139 Increasingly, jurisdictions are seeking to manage potential Quantity-triggered approaches manage the number of risks from both high and low prices. The EU ETS, allowances that are in circulation. Given a fixed cap, California Cap and Trade Program, Québec Cap and a quantity-triggered reserve can respond to external Trade Program, and RGGI all have PSAMs that seek to shocks by adding or subtracting allowances from a increase or decrease supply if prices are too high or too reserve and releasing them into the market based on low, respectively. The New Zealand ETS is moving from a predefined triggers, including the quantity of surplus or system that addresses only high prices to one that seeks to banked allowances.222 The advantage of a quantity-based avoid both low and high prices. China’s ETS pilots employ approach is that it retains flexible supply while avoiding a mixture of approaches, with Beijing targeting only high an approach that directly targets the price, which can be prices while Hubei and Shenzhen target both high and low difficult politically. This also makes the impact on prices prices. more uncertain and makes calibrating a quantity-based approach more difficult in achieving a preferred price Determining triggers for price or supply outcome. This characteristic may make it easier to adjustments implement in certain policy environments, especially given Most jurisdictions set out clear rules for the implementation political challenges around agreeing on specific price of PSAMs by deciding whether to adopt a price or quantity trigger levels, but makes it less appropriate for directly trigger. Most systems use a price-based trigger, which targeting specific prices. allows them to directly target the trade-offs between prices Price and quantity triggers can be designed to be “soft” and quantities for the operation of the ETS. However, the EU or “hard.” Soft interventions will increase or reduce supply ETS adopted an approach using a quantity-based trigger. up to a predefined limit, whereas hard interventions may A price-triggered approach helps to keep the market price increase or reduce supply without bounds. For instance, for allowances within a certain range. This has the advantage a cost containment reserve will release allowances at a of providing businesses greater certainty regarding the level given price until the reserve is depleted, whereas a hard and future trajectory of carbon prices. The level of the carbon price ceiling will provide an unlimited additional supply price is important for determining whether an investment of allowances, or compliance units, at that price. A hard is financially viable and for planning future changes in intervention provides greater certainty in keeping the processes that may impact emissions levels. By signaling a market within predetermined bounds, usually based lower price range, businesses can better plan investments, on price levels. This means that it is more effective in and the risk associated with these investments will be reducing price variability. However, hard interventions can reduced if extreme price realizations in the future can be create a barrier to linking and have potentially large fiscal MARKETS ruled out. Disadvantages of a price-based approach include consequences; for example, if prices are at the hard floor STEP 6 that it can be politically difficult to identify the right range, for a long time then governments could face large costs as different industries and interest groups may disagree on from buying allowances. the appropriate trajectory. Further, abatement costs can The way in which hard and soft interventions affect supply significantly change, for instance, following changes in fuel is explained in Box 6-7. prices, which could hold implications for the appropriate choice of price-based triggers. 222 Analysts have suggested a variety of potential triggers for regulating allowance volumes offered at auction, including allowance volumes in circulation as well as changes in production and other economic conditions. These approaches vary in their ability to provide price predictability, respond to shocks, provide certainty of adjustment, reduce oversupply, and prevent potential manipulation. See Gilbert et al. 2014 for a review. 140 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Box 6-7 Technical note: The impact of PSAMs The figure below illustrates the effect of PSAMs on the allowance supply curve, with arrows indicating whether supply is added or withheld from the market. It serves as a general illustration of these measures and thus does not depict their use under specific jurisdictions. Without price controls, allowance supply is perfectly inelastic and does not react to price differences. This is illustrated by the vertical line Qo. An auction reserve price sets a minimum price at which allowances enter the market through auction. Since bids are not accepted below the reserve price, a reserve price at auction sets a soft minimum bound on allowance prices (Pmin). As prices could fall below the auction reserve price in the secondary market, a hard price floor would require government purchases of allowances to defend a minimum price. At the other end of the spectrum, a price ceiling can be introduced into Figure 6-4 Technical note: The impact of supply adjustment an allowance market through the measures regulator committing to make available allowances at a fixed upper price (Pmax). Hard price ceiling: Implementing a price ceiling implies Price • Unlimited number of allowances at ceiling price surrendering control of the allowance Pmax budget (cap) once the ceiling price is reached. PT3 Cost Containment Reserve (CCR): Within these upper and lower bounds, PT2 • Limited number of additional different allowance reserves can be allowances made available from reserve at trigger price(s) Allowance employed to adjust the supply curve. price range By design, a reserve has only a limited Emission Containment number of allowances and as such does Reserve (ECR): not guarantee a certain price outcome. • Limited number of allowances PT1 withheld at trigger price(s) An Emission Containment Reserve (ECR) Pmin withholds a fixed quantity of supply from Price floor (Auction reserve the market when declining allowance price/hard price floor): Allowances available prices trigger the reserve price (PT1). • No allowances available at Q price lower than floor price* However, once this adjustment has been MARKETS made, prices are free to continue to STEP 6 decline. In the face of increasing prices, a Source: Acworth, Schambil, and Bernstein 2020. Cost Containment Reserve (CCR) makes * An auction reserve price only poses a price floor at allowance auctions; therefore, the share of allowances auctioned is important for the overall effect on the supply of allowances and the a limited number of additional allowances resulting price effects for this tool. In secondary markets, prices could still fall below the auction reserve price. available when certain trigger prices are reached (PT2, PT3). However, as the reserve is finite, prices are free to increase once allowances have been released to the market. Multiple reserves at increasing tier prices can also be employed to act as “speed humps” to slow price increases during periods of increasing demand. But ultimately, these reserves can only act as a “soft price ceiling” to the point where demand surpasses the capacity of the reserve to inject additional allowances and prices are again free to rise to the Pmax. Temporary and permanent supply adjustments PSAMs that have a temporary effect on market supply PSAMs alter the allowance supply in the short term through simply smooth the market over time. PSAMs with a increasing or reducing supply; however, there is a question permanent supply response can affect levels of realized as to what to do with the supply that is injected or removed. ambition. Currently, there is a mix of both in use. The decision to make a temporary or permanent supply The California Cap and Trade Program, Québec Cap and adjustment has clear links with cap setting (see Step 4) and Trade Program, and Korean ETS use PSAMs that provide the allocation of allowances through auctions (see Step 5). a temporary supply response as allowances that are PSAMs that offset changes in supply today with changes unsold at auction are returned to the market in subsequent of allowances in future auctions or caps are known as auctions, while allowances in the CCR are sourced from temporary alterations of supply. Permanent alteration of the caps in other years. Since 2021, the California Cap and supply is where some or all the supply change is not offset Trade Program will allow for increases in supply for price by future auctions or under future caps. ceiling allowances that are sold, although revenues from the sale of additional compliance allowances at the price STEP 6: PROMOTE A WELL-FUNCTIONING MARKET 141 ceiling (should it be triggered) are required to be used to including the Korean ETS and some Chinese pilots, have purchase additional ton-for-ton reductions from low-carbon retained discretionary interventions that provide flexibility projects to ensure the environmental integrity of the ETS. regarding when and how they intervene in a market. Box 6-8 outlines the conditions under which Korea’s The EU’s and RGGI’s ECR include a permanent supply Allocation Committee may intervene in its carbon market. change through the invalidation of excess allowances. This effectively increases the ambition of the ETS, which may A discretionary PSAM may identify circumstances under feed through to the jurisdiction-wide emissions target. which intervention could occur and potential methods Conversely, RGGI’s CCR is sourced from allowances of intervention, while not specifying the precise measure outside the ETS cap, and when a release is triggered in of intervention. While providing flexibility, this approach response to high demand and prices, overall emissions can be counterproductive if the lack of clear criteria for increase. While temporary supply responses may be easier intervention creates unpredictability. In recent years to introduce, permanent supply responses may elicit there has been a movement toward greater reliance on greater changes in behavior. rule-based PSAMs with the EU and New Zealand adopting rule-based measures and Korea investigating moving to Permanent supply adjustment has implications for the a rule-based approach. In general, rule-based PSAMs effective ambition of an ETS. For instance, a PSAM that provide more certainty regarding a regulator’s response features a permanent reduction in supply effectively to shocks and unforeseen events, and are therefore reduces cumulative emissions and can act as a ratchet for considered better at managing excessive price variability. ambition. However, a PSAM that allows for a permanent increase in supply could lead to cumulative increases in There have been proposals for delegating management of emissions that could undermine the jurisdiction’s ability the allowance market to an independent carbon authority to achieve its emissions reductions targets.223 Therefore, or a carbon central bank. Researchers have proposed it may be prudent to avoid permanent increases in supply, various models for delegation to independent bodies that but permanent reductions of supply could play a useful role would aim to adjust auctions to ensure proper market in helping countries ratchet up their target ambitions. functioning and liquidity in the short term and, over the medium to long term, potentially change the ETS cap. Discretionary PSAMs However, these have not been used to date. Most PSAMs are rule based, with the requirements for intervention predefined. Some jurisdictions, however, MARKETS STEP 6 Box 6-8 Case study: The Allocation Committee in the Korean ETS The Korean ETS currently operates with an Allocation Committee that is guided by rules on when to intervene in the market, but also operates with a degree of discretion. There are predetermined situations in which the Allocation Committee is authorized, but not required, to intervene in the market. The conditions under which the committee may intervene in the market include the following: S themarket price for allowances has been at least three times the two-year average for at least six consecutive months; or S the market price for allowances has been at least two times the two-year average for at least one month, and the average trading volume for the current month is at least twice that of the same calendar month in the two previous years; or S the average market price for allowances for the last month is less than 40 percent of the two-year average; or S it is difficult to trade allowances due to the imbalance of supply or demand. There are several actions the Allocation Committee may take in any of these situations, including but not limited to releasing allowances from a reserve. The Allocation Committee may also change rules regarding borrowing and use of offsets in this situation as well as establishing a price ceiling or floor. 223 California’s price ceiling includes a requirement to purchase at least a ton-for-ton corresponding emissions reduction to mitigate this risk. 142 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION 6.4.2 MEASURES TO RESPOND TO LOW auction reserves in place, and they are also planned to PRICES be introduced in the New Zealand ETS. The operation of RGGI’s auction reserve price and other PSAMs are Auction reserve prices discussed in Box 6-9. Auction reserve prices place limits on auctions to ensure that they cannot settle below a predetermined Reserve prices are popular in part due to the ease of price. Controls on auction prices flow through to the implementing a PSAM via auction. Because the regulator secondary market as compliance entities and other already operates the auction and defines auction supply market participants seek to source allowances at least and rules (see Step 5), implementing PSAMs through cost. This means that if the supply at auction is reduced these auctions is relatively straightforward. However, if a to ensure the auction settles at the reserve price, this is large majority of allowances are not allocated by auction, likely to be matched in the secondary market, making an then the effectiveness of a reserve price may be limited. auction reserve price an effective means of intervention In this case policymakers can only make relatively small in the broader market. At present, jurisdictions including adjustments to the overall market. Korea, California, Québec, RGGI, and the UK have Box 6-9 Case study: RGGI’s PSAMs RGGI has evolved to include various price or supply adjustment measures. Since inception, RGGI has Figure 6-5  Case study: The impact of supply adjustment measures in RGGI operated with a minimum reserve price at auction, which precludes bids below the predefined reserve price. The 14 reserve price was set at USD 1.86 in 2008 and increased Containment at a rate of 2.5 percent from 2014 onward. The minimum Reserve triggered 12 price was binding between June 2010 and December (5 and 10 million allowances added 2012 when a surplus of banked allowances accumulated respectively) 10 in the RGGI market. This was addressed as part of the Price (USD/Tonne) scheduled 2012 review, where the RGGI cap was revised Binding 8 Reserve Price – downward for the years 2014–2020, effectively cancelling allowances moved the surplus (banked) allowances. Starting in 2021, the to government 6 MARKETS reserve minimum reserve price will be set at USD 2.30 per short STEP 6 ton and continue to increase at 2.5 percent per year. 4 As of 2014, RGGI states created a CCR, where allowances are released to the market when a certain 2 trigger price is reached. The trigger price was set at USD 4 in 2014, USD 6 (EUR 5.40) in 2015, USD 8 in 2016, and 0 USD 10 in 2017. Since 2017 it has increased annually by 2008 2010 2012 2014 2016 2018 2.5 percent. In 2021, as per the 2017 model rule updates, Time the trigger price will be set at USD 13 and will increase by 7 percent compared to the previous year thereafter. Cost Containment Reserve Reserve Price Allowance Price The CCR was triggered in 2014 and 2015, collectively releasing 15 million additional allowances to the market. Source: ICAP Allowance Price Explorer As these allowances are not sourced from within the cap, * RGGI uses short tons; for the purpose of comparability, prices have been triggering the CCR effectively increases the allowance converted into metric tons. cap. It is difficult to assess the impact the CCR has had in terms of price control. While the first intervention likely placed downward pressure on allowance prices, allowance prices continued to rise, albeit at a slower rate than before the CCR was triggered. The CCR was again triggered in 2015, as prices rose marginally above the CCR in the third quarterly auction. The last auction of 2015 saw prices rise 25 percent to an all-time high despite the injection of 10 million allowances from the CCR at the previous auction. Prices declined soon after. The decline in prices has also been attributed to the legal challenge to the Clean Power Plan, a proposed federal program that would have required states to reduce CO2 emissions, which in February of 2016 was stayed following a Supreme Court ruling.224  224 Energy Information Administration 2016. STEP 6: PROMOTE A WELL-FUNCTIONING MARKET 143 The results of the 2017 scheduled review added another element to RGGI’s toolbox of instruments, the ECR. The ECR is an automatic adjustment mechanism that will operate within RGGI starting in 2021. The mechanism automatically adjusts the cap downward in the face of lower-than-expected costs. Should prices drop below USD 6 in 2021 (rising 7 percent per year), participating states will be able to withhold up to 10 percent of their allocation from the auctions. Allowances withheld will not be reoffered for sale, thereby adjusting the cap downward.225, 226, 227, 228 Hard price floors and a given set price. This approach does not affect the A hard price floor can be implemented through direct quantity of allowances in the ETS, but rather combines intervention, in which a jurisdiction buys back an unlimited a fee with an ETS such that a minimum combined cost number of allowances at a predetermined price. This per ton of emissions is maintained for ETS participants. could include providing an open option for firms to sell In this way, it can deliver a high degree of price certainty. allowances at a fixed price or the regulator purchasing However, the exact degree of price certainty depends allowances on the secondary market to maintain that on how frequently the top-up fee changes in response price. These interventions have generally been avoided in to changes in the market prices of allowances. Frequent ETS to date as they introduce unnecessary complexity. updating increases price certainty but can be technically This is particularly the case given the relative ease of challenging to implement (as discussed in the box below). implementing PSAMs through auctions and preferences for An additional fee has been implemented in the UK power lower-risk, softer forms of intervention. sector (see Box 6-10), a subset of the entities covered in the EU ETS. The policy is designed to increase certainty to Additional fees or charges generators and encourage investment in low-carbon power Additional fees and charges have sometimes been used generation. A bill to introduce a similar levy has been when policymakers wish to ensure that firms face a certain introduced in the Netherlands.229 total cost, rather than exclusively the allowance price. A top-up fee or surrender charge on allowances is one way Australia’s ETS was initially designed to include a price of increasing the cost of emissions in an ETS domestically floor implemented through a minimum auction price within a linked or multijurisdictional system and could domestically and a surrender charge on imports of foreign also be used to ensure a minimum cost for emissions in offset credits. The implementation of this surrender charge a stand-alone system. It could also be used to raise the raised a number of important technical challenges given cost of using offsets when these trade at a lower price than the expectation that it would respond quickly to changes in MARKETS allowances. the CER price and the difficulty for the government to know STEP 6 what price was being paid for an offset.230 When Australia Under a surrender charge, emitters are required to pay a entered into linking negotiations with the EU ETS, Australia top-up fee to the government that reflects (either exactly agreed to abandon its price floor (see Step 9). or approximately) the difference between the market price Box 6-10 Case study: Carbon price floor to foster investment in the UK On April 1, 2013, the UK unilaterally introduced a carbon price floor (CPF) within the electricity sector.231 The goal of the CPF was to “reduce revenue uncertainty and improve the economics for investment in low-carbon generation.”232 The price floor was achieved by implementing a carbon price support (CPS), an additional carbon tax levied on all entities that generate electricity using gas (supplied by a gas utility), liquid petroleum gas, or coal and other solid fossil fuels. Rather than operating as a reserve price at auction, the CPS is charged on top of EU ETS allowance prices to ensure that the price of carbon meets a minimum national target. The CPS is paid by entities for each unit of emissions and is additional to any cost of allowances. The obligation to pay the CPS applies when allowances are surrendered. Entities are regulated at the point where gas passes through the meter or, in the case of liquid petroleum gas, coal, and other solid fossil fuels, at the point of delivery at generating stations.  225 As of 2019, Maine and New Hampshire did not intend to implement the ECR. 226 Regional Greenhouse Gas Initiative 2019a. 227 Regional Greenhouse Gas Initiative 2017a. 228 Regional Greenhouse Gas Initiative 2017b. 229 See Rijksoverheid 2019, 2020. 230 See Hepburn et al. 2012. 231 Brauneis et al. 2013; HM Revenue and Customs 2015; HM Revenue and Customs 2014a; HM Treasury and Customs 2011. 232 HM Treasury and HM Customs 2011. 144 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION The CPS was designed to start at £4.94 per ton and to increase stepwise. The value of the CPS is based on the projected gap between the target price in each year and the price of allowances in the EU ETS in the recent past, with a target price in 2020 of £30 per ton, in 2009 prices. Once the CPS is set for a given year, it is not adjusted to actual fluctuations in the EU allowance unit price such that the final price paid by generators may differ from the target price. HM Revenue and Customs expected that this would support £30–40 billion of new investment in low-carbon technology. However, in March 2014 it was announced that the CPS (the UK-only element of the CPF) rate would not exceed £18 per ton of carbon dioxide from 2016–2017 to 2019–2021, due to lower than expected EU ETS allowance prices in the time after the price floor was introduced, resulting in a wider gap between the prices for emissions allowances for other states in the EU ETS and those in the UK. At the time of writing, the CPF is approximately £40 against a stated target of £30 for 2020. This has created concern that the CPS might be damaging the competitiveness of UK industry and leading to undue increases in household energy bills. The UK government analysis of the increased cost burden concluded that the contribution of the CPF to household energy bills was expected to remain small. For energy-intensive industry in the UK, however, the burden could be quite significant. In response, the UK government announced targeted compensation packages for the increase in energy costs of the energy-intensive industry, which were approved by the European Commission under the state aid rules. The higher costs and compensation notwithstanding, the CPF was identified as the main driver for the shift in generation away from coal, reducing its share in UK electricity generation to about 5 percent in 2018 from about 35 percent in 2013.233 6.4.3 MEASURES TO RESPOND TO HIGH is prepared to sell at a given price. This provides some PRICES assurance to the market, but not a guarantee, that the price will not rise above that level. In this way it provides more Cost containment reserves certainty over the quantity of allowances auctioned and A CCR operates like a price ceiling except that the amount resulting emissions levels than it does over the maximum by which auction supply is increased is limited. When these price. Probabilistic modeling can help conduct stress tests reserve allowances are exhausted, the price can therefore and estimate the required size of a reserve to keep prices still increase. within certain bounds, given best available information.234 To provide a source of allowances for injections, an In the case of California, a percentage of allowances from MARKETS STEP 6 allowance reserve is created from allowances that are the cap is set aside each year into an Allowance Price initially withheld from distribution and/or put up for auction Containment Reserve (APCR) (see Box 6-11). So far, market but remain unsold (for example, because the auction reserve prices in California’s ETS have remained below the level price is not met). These allowances are part of the overall at which an allowance release from the APCR is triggered. cap but are offered for sale only at prices above a certain In Québec, a similar system is in place, and the auction level, as a means of helping to contain costs. In order to reserve price and allowance reserve prices are harmonized keep the level constant in real terms over time and to avoid with California. In both jurisdictions, a staggered approach creating unintended speculative opportunities to profit is used, with different quantities of allowances available for from simply holding allowances, the threshold price level is sale at different prices. The RGGI system also implemented usually set to rise over time at a rate comparable with the a CCR in 2014. In contrast to California and Québec, this market rate of return for other investments with similar risk has a single price at which intervention is triggered, and profiles (for example a 5 percent interest rate plus inflation). allowances from the CCR are automatically offered as part of regular auctions if the trigger level is reached. An allowance reserve provides a soft ceiling since there is only a fixed amount of allowances the government 233 DUKES 2019. 234 Golub and Keohane 2012. STEP 6: PROMOTE A WELL-FUNCTIONING MARKET 145 Box 6-11 Case study: California’s PSAMs California uses a comprehensive set of tools to manage the risks of high and low prices in its carbon market. Over the period 2013–2020, California has implemented a three-tiered APCR as well as a reserve price at auction within its ETS. The latter precludes bids below the reserve price being accepted at auction and therefore sets a minimum price bound. The APCR was designed to provide flexibility in responding to increasing prices. When a quarterly auction results in a settlement price greater than or equal to 60 percent of the lowest reserve tier price, CARB will offer allowances through an APCR reserve sale. CARB will also offer the reserve sale immediately preceding the compliance deadline if there is demand from any regulated entity.235 To date, CARB has not held a reserve sale. The APCR tiers were set at USD 40, USD 45, and USD 50 in 2013, increasing by 5 percent plus inflation annually to 2020. Reforms to the cap and trade program approved in December 2018 provided amendments to the price stability mechanisms of 2021–2030. Going forward, California will operate the reserve sale mechanism with a hard price limit (ceiling) set at USD 65 per allowance. The program will maintain its auction reserve price as a price floor. In between the upper and lower price limits will be two “reserve tiers” that, if reached, would result in additional allowances being offered for sale, like the previous APCR. Those levels will be set at USD 41.40 and USD 53.20 in 2021. All reserve prices, including the price ceiling, increase by 5 percent plus inflation each year. Filling the APCR requires removing allowances from the overall allocated budget. If allowances from the APCR are exhausted or a regulated entity does not hold enough compliance instruments, CARB will offer additional allowances at the price ceiling. The sale of “price ceiling units” is limited to entities’ allowance shortage with respect to their compliance obligation due for the next surrender deadline. CARB uses the revenue generated from the price ceiling sales to achieve emissions reductions on at least a one-to-one basis from projects in sectors or regions outside of the cap and trade program. This provision is meant to ensure that the implied increase in the cap from the price ceiling sales would not lead to an increase in emissions. Hard price ceilings As outlined in Box 6-11 California is introducing a hard A hard price ceiling is implemented through direct price ceiling, with “price ceiling units” being made available intervention, in which a jurisdiction supplies an unlimited at the ceiling level for regulated entities that need them to number of allowances at a predetermined price. This meet compliance obligations. The revenue generated from MARKETS STEP 6 could include providing an open option for firms to the price ceiling sales will be used by CARB to achieve buy allowances at a fixed price or the regulator selling emissions reductions on at least a one-to-one basis from allowances on the secondary market to maintain that price. projects in sectors or regions outside of the cap and trade This sets an absolute ceiling on the price that entities program. This provision is meant to ensure that the implied must pay to buy allowances.236 As an unlimited number increase in the cap from the price ceiling sales would not of allowances will be released to defend the price ceiling, lead to an increase in emissions. implementing a price ceiling surrenders some certainty surrounding the overall allowance cap. 6.4.4 QUANTITY-BASED MEASURES New Zealand’s Fixed Price Option acted as an effective The MSR in the EU ETS is a rule-based, quantity-triggered price ceiling, as it allows ETS participants to pay NZD intervention. The MSR is designed to adjust the annual 25 per allowance to the government as an alternative to number of allowances auctioned in the market in certain purchasing allowances from the NZ ETS market. Alberta’s years, based on predefined rules surrounding the level of Specified Gas Emitters Regulation (although this is the allowance surplus. The MSR aims to maintain a certain not a formal ETS) uses a similar approach; entities can supply–demand balance to address the current surplus pay a penalty or other fee to the government in lieu of of allowances in the EU ETS and improve the system’s submitting allowances. These are effective price ceilings, resilience to major shocks.237 By targeting both oversupply which directly substitute a set tax for an ETS when and undersupply in secondary markets, the MSR seeks to prices hit certain levels. Similarly, if the ETS enforcement avoid excessively low or high prices. Further details on the arrangements do not include a penalty set with reference operation of the MSR are provided in Box 6-12. to the price or make good provision (see Step 7), the penalty will also act as a price ceiling. 235 CARB 2019:250. 236 The idea of a price ceiling was originally developed by Roberts and Spence 1974 and applied to the case of climate policy by Pizer 2002. 237 European Commission (EC) 2015d. 146 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Box 6-12 Case study: The EU ETS Market Stability Reserve In 2015, EU policymakers adopted the MSR to Figure 6-6 Case study: The EU ETS Market Stability Reserve address the structural Total Number of Allowances in Circulation (TNAC) = surplus of allowances Allowances Issued minus Verified Emissions and Cancelled Allowances built up in the system and improve the system’s in the MSR to previous year’s auction volumes. Invalidation of allowances to limit their number Excessive Surplus State Allowances Allowances 12% (24% until 2023) resilience to future shocks. to be in the MSR TNAC > 833 million auctioned of TNAC To that effect, the MSR adjusts the supply of From 2023 onward: allowances to be auctioned Neutral State Allowances Allowances when the Total Number of to be MSR is not active in the MSR 400 million < TNAC < 833 million auctioned Allowances in Circulation (TNAC) — a measure of allowances surplus — is Excessive Demand State Allowances 100 million allowances Allowances above or below predefined to be (200 million until 2023) in the MSR 400 million > TNAC auctioned thresholds.238 The MSR was established in 2018 Note: The TNAC is the cumulative number of allowances issued in the period since January 1, 2008, and entitlements to use and began operating on international credits exercised by installations under the EU ETS in respect of emissions up to December 31 of a current year, minus the cumulative tons of verified emissions from installations under the EU ETS since January 1, 2008, any allowances January 1, 2019. cancelled in accordance with Article 12(4) of Directive 2003/87/EC, and the number of allowances in the MSR.242 The MSR functions as follows: when the TNAC is above 833 million, 12 percent (24 percent up to 2023) of the surplus is withheld from auctions. Actual adjustments to auction volumes take place over the subsequent calendar year. When the TNAC is less than 400 million allowances, 100 million allowances (200 up to 2023) are taken from the reserve and added to auction volumes in the subsequent calendar year. The parameters of the MSR are subject to periodic review, with the first review foreseen for 2021 and every five years thereafter.239 As part of the last reform of the EU ETS for Phase 4, it was also agreed that the number of allowances held in the MSR will be limited to the previous year’s auction volume from 2023 onward — allowances in the MSR exceeding this volume will become invalid.240 The European Commission publishes the TNAC before May 15 each year so that market participants understand whether allowances will be placed into or taken out of the MSR.241 MARKETS STEP 6 Excessive Surplus State: TNAC is above the threshold (833 million). Allowances are withheld from auction volumes and placed in the MSR. Neutral State: TNAC is within the upper and lower thresholds. Allowances are not placed in the MSR nor does the MSR issue allowances. Invalidation State: Allowances in the MSR exceed previous year’s auction volume and are therefore invalidated (lightly shaded area above the dotted threshold represents total amount cancelled). This occurs only after 2023. Excessive Demand State: The number of allowances in circulation is below the lower threshold (400 million). Allowances move from the MSR back to the market. 238 EC 2015d. 239 EU 2015. 240 Depending on the emissions forecast assumed, this could result in roughly 2 billion allowances — roughly the allowance cap of one year — being cancelled in 2023. See Weinreich et al. A Resilient System to Support Long-Term Decarbonization, in ICAP 2018b. 241 EC 2019c. 242 EC 2015b. STEP 6: PROMOTE A WELL-FUNCTIONING MARKET 147 6.4.5 SUMMARY OF OPTIONS FOR increase their complexity in a manner that makes ETS IMPLEMENTING A PSAM linking challenging. The implications of PSAM design for ETS linking are discussed further in Step 9. A summary of the advantages and disadvantages of different designs of PSAM is provided in Table 6-1. PSAMs can make carbon markets function better, but they also Table 6-1 Advantages and disadvantages of different approaches to PSAMs Approach to manage market Advantages Limitations Managing low prices Simple to implement if fee does not fluctuate with price. Difficult to implement if fee adjusts with Additional fees and charges Provides hard floor on emissions price faced by entities price. Inhibits efficiency of system if subject to fee. implemented only partially. Relatively simple to implement; increases price certainty Does not guarantee minimum price in the Auction reserve price to underpin investment; can result in higher government secondary market, particularly if there is revenue even if emissions demand is lower than anticipated. only limited use of auctions. Relatively simple to implement; can tighten cap if volumes Financial burden to regulator for Hard price floors not reintroduced. guaranteeing price ceiling. Managing higher prices Provides greater certainty on prices while limiting uncertainty Price ceiling can only be partially Cost containment reserve on emissions (since emissions cannot increase by more than guaranteed. the number of allowances released from reserve). Environmental target will be Hard price ceiling through Guarantees price ceiling for market participants. compromised if rectifying actions are not unlimited supply at fixed price in place. Other approaches Could enhance compatibility of ETS with other energy and May be politically challenging to climate policies, monitor the interactions with international Discretionary approaches implement. Provides less certainty on markets, and add flexibility to balance ensuring target MARKETS response to shocks. STEP 6 quantities with allowance prices. May increase policy complexity and Quantity-based measures Avoids political debates on where the price should be set. uncertainty. 148 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION 6.5 QUICK QUIZ Conceptual Questions 1. What factors determine the supply of, and demand for, emissions allowances and corresponding prices? 2. What are the key policy tools for providing intertemporal flexibility over short, medium, and longer terms? 3. What are the rationales for managing low or high prices? 4. What different design options are there for price or supply adjustment measures? Application Questions 1. What are your priorities for ensuring price predictability on the low and/or high end, and for other goals of market management? 2. What approaches might provide sufficient certainty over prices, emissions, and other market indicators? 3. Are you considering linking your system in the future, and how might this affect your preferred approaches? 4. How confident are market actors likely to be in the future of an ETS in your jurisdiction and how can policy design help provide predictable signals for investment? 6.6 RESOURCES The following resources may be useful: S Market Stability Mechanisms in Emissions Trading Systems S Emissions Trading and the Role of a Long-run Carbon Price Signal MARKETS STEP 6 STEP 7: ENSURE COMPLIANCE AND OVERSIGHT 149 Step 7 - Ensure compliance and oversight STEP 7 Ensure compliance and oversight At a Glance____________________________________________________________________________ 150 7.1 Developing a legal framework______________________________________________________ 151 7.2 Managing the reporting cycle______________________________________________________ 155 7.3 Managing the performance of verifiers______________________________________________ 162 7.4 Designing an enforcement approach_______________________________________________ 163 7.5 Developing an ETS registry________________________________________________________ 165 7.6 Oversight of the market for ETS allowances_________________________________________ 168 7.7 Quick Quiz_______________________________________________________________________ 170 7.8 Resources_______________________________________________________________________ 170 BOXES Box 7-1 Technical note: Legal pedigree and legislative timeline in the EU ETS______________ 152 Box 7-2 Technical note: Legal nature of allowances_____________________________________ 154 Box 7-3 Technical note: Annual emissions monitoring (calculation) in a hard coal power plant______________________________________________________________________ 158 Box 7-4 Technical note: Monitoring emissions from a lime kiln___________________________ 159 Box 7-5 Technical note: Default emission factors for balancing cost with accuracy_________ 160 Box 7-6 Case study: Fraud and cyberattacks in the EU ETS_____________________________ 167 Box 7-7 Technical note: Contracting ETS transfers_____________________________________ 168 FIGURES Figure 7-1 Overarching compliance and monitoring structure______________________________ 151 Figure 7-2 Hierarchy of norms: The normative pyramid____________________________________ 152 Figure 7-3 Legislative timeline of the EU ETS____________________________________________ 153 COMPLIANCE Figure 7-4 MRV in the EU ETS_________________________________________________________ 156 STEP 7 Figure 7-5 Simplified example of annual emissions monitoring (calculation) in a hard coal power plant________________________________________________________________ 158 TABLES Table 7-1 Legal acts resulting in EU ETS design changes_________________________________ 153 Table 7-2 MRV approaches by ETS____________________________________________________ 157 Table 7-3 Penalties for noncompliance with surrender obligations across jurisdictions________ 164 150 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION AT A GLANCE Robust verification of reported data is important for Checklist for Step 7: Ensure compliance and oversight the credibility of an ETS. Further collection, monitoring, reporting, and verification of activity data (for example, the ✔ Identify the regulated entities tons of clinker or steel produced) allows for cross-checks ✔ Manage emissions reporting by regulated entities and provides flexibility to adopt different approaches to ✔ Approve and manage the performance of verifiers allowance allocation. If independent verifiers are used, the accreditation process must be robust. Alternatively, ✔ Establish and oversee the ETS registry auditing and self-regulation backed with credible ✔ Design and implement the penalty and enforcement enforcement and punishment can also provide credibility. approach While international standards for accrediting verifiers ✔ Regulate and oversee the market for ETS emissions can be leveraged, governments may sometimes need allowances to supplement these with additional checks on verifier capacity, especially in the early stage of an ETS. An emissions trading system (ETS) must be governed by Full compliance must be assured through a credible a rigorous system for market oversight and enforcement. enforcement regime with appropriate penalties. Systems A lack of compliance and oversight may threaten the typically rely on a combination of naming and shaming, environmental integrity of the system and the basic fines, and make-good requirements to provide this functionality of the market, with high economic stakes for enforcement. While the reputational implications of all participants. The compliance and oversight systems noncompliance have proven to be a strong deterrent, which ensure emissions covered by the ETS are measured can be reinforced by public disclosure of ETS performance, accurately and reported consistently. Effective market a binding system of penalties is still needed. oversight can enable the market to run efficiently and promote trust among market participants. Registries — systems that record, monitor, and facilitate the creation, trading, and surrender of all allowances within A prerequisite for effective compliance is developing a an ETS system — need to be developed. This requires legal framework and identifying all entities regulated by an assessment of the legal and institutional framework the system. The legal framework consists of the legal in which the registry will be situated, as well as the basis for the ETS, which will usually be adopted by formal identification of its functional and technical requirements. legislation, as well as additional rules and guidelines to Registry data can be made available to market participants enact the ETS. Additionally, interactions with other areas of and the public to allow interested parties to form views on law, such as financial market regulation, play an important the balance of demand and supply. This is a precondition role. The list of entities to be covered by an ETS can be for the emergence of liquid primary and secondary markets COMPLIANCE compiled centrally or based on firms’ self-nominations. for emission allowances with robust price information. STEP 7 This can be made easier by leveraging existing regulatory The registry should provide sufficiently granular data relationships, but it is likely that governments will also need on emissions, allowance allocation and surrender, and to develop a specific process to identify new regulated compliance while ensuring that appropriate standards of entities as the number of firms changes over time. confidentiality and security are maintained. Effective systems for monitoring, reporting, and verification Finally, regulators also need to oversee both the primary (MRV)243 of emissions and other necessary data (for and secondary allowance markets. Market regulation example, for benchmarking or output-based allocation) determines who can participate, what is traded, and where are at the heart of ensuring the environmental integrity of transactions take place, as well as other rules on market an ETS. Different methodologies for monitoring emissions integrity, volatility, and preventing fraud or manipulation. have been used in different systems, but default emissions Instruments for market regulation include clearing and factors are often used in cases where monitored data is margin requirements, requirements for reporting and not available or to keep costs low. Reporting arrangements disclosure of trading positions, position limits, and need to be transparent and can build on existing data participation, registry accounts, and licensing requirements. collected on energy production, fuel characteristics, energy usage patterns, industrial output, and transport. 243 Detailed guidance on reporting can be found in the Guide for Designing Mandatory Greenhouse Gas Reporting Programs. Guidance on verification can be found in the Partnership for Market Readiness (PMR) publication Designing Accreditation and Verification Systems: A Guide to Ensuring Credibility for Carbon Pricing Instruments. STEP 7: ENSURE COMPLIANCE AND OVERSIGHT 151 This step considers the requirements and options for The chapter is structured around six elements. Section 7.1 regulators to oversee and enforce compliance of regulated discusses how to develop a legal framework for the entities with the ETS requirements. While there are different ETS. Section 7.2 outlines key elements of the reporting options that will depend on the design of the ETS and the cycle, and Section 7.3 how to manage the performance specific jurisdictional context, compliance — and sufficient of verifiers. Section 7.4 discusses how to design an trust that there is compliance — is essential for the integrity enforcement approach. Section 7.5 discusses how to and functioning of the entire ETS. Stakeholders and technical develop an ETS registry to facilitate trade, while Section 7.6 experts in areas such as law, IT, and MRV can provide discusses oversight of the carbon market. valuable input in designing an effective compliance system. 7.1 DEVELOPING A LEGAL FRAMEWORK 7.1.1 ROLE OF LAW IN ETS DESIGN AND Each jurisdiction’s constitutional and broader legal IMPLEMENTATION framework will determine how the ETS is legislated, who must be involved, and the timeline for implementation. Legal considerations play an important role in all stages of An ETS imposes constraints on the economic freedom of an ETS. Clearly defined and enforceable rules are vital for regulated entities, which is why its introduction generally the ETS to function properly because the allowances are requires a formal mandate by a legislature or comparable constructed by policymakers and artificially constrained body. A firm basis in statutory law is core to the rule of in supply. A flawed legal framework can undermine law and vital for the exercise of public authority by the the environmental objectives of the ETS and weaken government’s executive branch. ETS design features, such confidence among market participants. This will affect as the rights and obligations of entities covered by the ETS trading behavior and interfere with the integrity and and its core institutional functions, are also often set out in efficiency of the market. A robust legal framework includes formal legislation. an initial mandate authorizing its establishment, the legal operationalization of key design parameters, and the The type of legislation to establish an ETS will differ across enforcement of compliance obligations. Figure 7-1 provides jurisdictions in line with differences in standard legal an overview of how the legal framework relates to the practices. In California, the AB 32 Global Warming Solutions overarching compliance and monitoring structure that is Act of 2006 required California to reduce its emissions discussed in more detail in the rest of this chapter. by around 15 percent by 2020 in the most cost-effective COMPLIANCE way. The AB 32 authorized the adoption of a market-based STEP 7 instrument and required the development of a scoping plan Figure 7-1 Overarching compliance and monitoring to lay out the strategy for meeting the emissions reduction structure goal. The law left the design of the future instrument to the California Air Resources Board (CARB) but put in place some guiding principles, such as ensuring the approach minimized carbon leakage, and did not disproportionately impact low-income communities. The first scoping plan LEGAL FRAMEWORK was approved later in 2008, which recommended the implementation of a California Cap and Trade Program. Thus, the legal basis and objective of the ETS was established in legislation while much of the details on design Monitoring Market and implementation were developed through regulations. and reporting regulation The design features of an ETS that are set out in formal EMISSIONS TRADING statutory law may be more resilient to judicial or political E nfo LIABILITY tio n change but are also more cumbersome to amend. rce ica en Registry and Therefore, legislators need to make a choice about the rif m t Ve trading design elements that should be in legislation and the elements that can go in subordinate instruments like regulations or technical guidelines. 152 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Generally, those details that are more Figure 7-2 Hierarchy of norms: The normative pyramid important to the operation of the system, or that are more politically sensitive, will be defined in legislation, while more technical issues may be set out in subordinate Higher Lower instruments. Figure 7-2 presents a hierarchy of legal norms that can be used to help I. Constitution identify which elements should be included Certainty of design parameters Sometimes limits ETS design in legislation. Where a norm is situated in (e.g., use of revenues) Ease of rule changes this hierarchy will entail different procedural requirements, with ramifications for the II. Legislation Usually includes key design parameters regulatory timeline and extent of stakeholder (e.g., emissions reduction targets, coverage of ETS) involvement. This will impact its flexibility to adjust to changing circumstances and has III. Executive rulemaking implications for the perceived legitimacy Often includes a mix of technical and policy decisions (e.g., benchmarks for allocation, year-to-year caps) and legal certainty it affords. The higher the rank of the norm, the greater the Higher Lower IV. Technical rules resilience against judicial reviews, as well as Tend to include detailed rules important for operation of system amendment or annulment following political (e.g., registry operations, or rules for opening and operating accounts) changes. However, the higher-ranked norms are more cumbersome to adopt or adjust. Therefore, opting for ETS rules situated higher up in the normative pyramid, such of the features of the ETS — for example, the start date as formal legislation, can strengthen the legitimacy and and duration, the existence of an auction system, and the political durability of the ETS, but also tends to result in development of offsets. AB 32 specified that regulation a slower and more cumbersome adoption or amendment must be published with regard to regulated entity subjects process. and reporting requirements. This provides California’s Air Resources Board more flexibility to adjust the precise Since the political context of an ETS and market features of the ETS. fundamentals are in states of constant change, jurisdictions will seek to retain differential degrees of Similarly, in federally organized or supranational flexibility regarding certain elements. The legal basis, jurisdictions, regulators must decide what to regulate which consists of the central parameters of the ETS (such at the central level and what to delegate to regional or as its overarching objectives, general principles, and the local authorities. Greater centralization has the benefit of main rights and duties of regulated entities), are usually allowing for better coordination and helping avoid uneven regulated at a higher, more formal level. Technical guidance implementation across jurisdictions. However, many tasks COMPLIANCE or operational details that require frequent updating (such require knowledge of local circumstances and direct STEP 7 as benchmarks or detailed MRV rules) are commonly contact with compliance entities and may therefore benefit adopted by way of more flexible regulations and decrees. from delegation to local authorities. Box 7-1 illustrates California’s legislation specifies the overall emissions the European Union’s (EU) choices on legal pedigree and reduction target from the ETS and a high-level overview degree of centralization, as well as the timeline for adopting the EU ETS legal framework. Box 7-1 Technical note: Legal pedigree and legislative timeline in the EU ETS For the EU ETS, the regulator opted to set out the main elements of the legal framework in a directive including central features such as scope and coverage, issuance of allowances, and compliance and enforcement.244 Since the initial directive, there have been over a dozen subsequent directives, regulations, and decisions that have made numerous changes to the ETS, including updating the legal framework to reflect new mitigation targets and a link to international offsets, extending the market to new sectors and gases, establishing common infrastructure systems such as the Union Registry, and providing technical guidance and procedural details on design features such as auctioning and MRV. As a result, the legal framework of the EU ETS has evolved significantly over consecutive trading periods. Competences have been centralized in several areas (such as the allocation of allowances and operation of the registry) where implementation at Member State–level proved inadequate. The revisions also added design aspects  244 A directive is a formal legal act comparable to parliamentary legislation in a national jurisdiction. STEP 7: ENSURE COMPLIANCE AND OVERSIGHT 153 not envisioned in the original directive in response to observed Table 7-1 Legal acts resulting in EU ETS design changes regulatory gaps or design Function Norm Level shortfalls (see Table 7-1). Directive 2003/87/EC (as amended) II The EU ETS legal framework Legal Mandate Article 192 TFEU (legislative competence) I has a relatively high degree of formality. This is at least partly due Directive 2003/87/EC (Annexes) II Scope and Coverage Directive 2008/101/EC II to the division of competences EEA Joint Committee Decision No 146/2007 II between the EU and its Member States. Table 7-1 lists legal acts Data Collection and Inventory Directive 2003/87/EC (as amended) II that put key design elements Generation Regulation (EU) No 525/2013 II of the EU ETS into action. The Nature and Stringency of Target Directive 2003/87/EC (as amended) II table indicates the level at which these acts would be situated in Issuance of Units and Definition Directive 2003/87/EC (as amended) II of Benchmarks Commission Regulation (EU) No 1031/2010 III the normative pyramid described in Figure 7-2. Reforms and Directive 2003/87/EC (as amended) II interventions have generally Price Management and Decision (EU) 2015/1814 II necessitated lengthy and complex Compliance Flexibility Decision No 1359/2013/EU II Directive 2004/101/EC II amendment procedures due to the high degree of formality. This is Registry Commission Regulation (EU) No 389/2013 III illustrated in the legislative timeline Directive 2003/87/EC (as amended) II of the EU ETS (see Figure 7-3), Commission Regulation (EU) No 601/2012 III Monitoring, Reporting, with almost five years passing Verification Commission Regulation (EU) No 600/2012 III between the first conceptual Guidance documents and compliance tools IV proposal and the actual start of Directive 2003/87/EC (as amended) II trading. At the same time, the Compliance and Enforcement Directive 2014/57/EU II EU ETS has proven remarkably durable, withstanding, inter alia, Directive 2014/65/EU II several lawsuits aimed against it. Market Oversight and Regulation (EU) No 596/2014 II Regulation Commission guidance on the application of VAT to emission allowances IV Figure 7-3 Legislative timeline of the EU ETS COMPLIANCE STEP 7 2000 2001 2002 2003 2004 2005 2006 Early proposal Formal Basic legal Legislation EU ETS for an ETS legislative framework adopted to link launches with discussed in proposal adopted and to Kyoto project First Training Period consultations submitted in force mechanisms (2005–2007) 2013 2012 2011 2010 2009 2008 2007 Third Trading Period Aviation Reform legislation Second Trading (2013–2020) included in adopted for 2013 Period starts the EU ETS and beyond (2008–2012) 2014 2015 2016 2018 2019 2020 2021 Market Stability Reform Fourth Trading Period Reserve adopted legislation adopted (2021–2030) for 2021 and beyond starts in 2021 First Trading Period Second Trading Period Third Trading Period Fourth Trading Period 154 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Once the appropriate degree of formality and centralization be rooted in the administrative and regulatory system has been determined, a formal notification and stakeholder dedicated to environmental protection. Therefore, the ETS consultation is typically the next step. Inputs obtained can build on that existing body of rules and institutions during this process can also inform subsequent legislative for its implementation, helping lower administrative costs. or regulatory proposals. The regulatory proposal is often However, it may need to be established through entirely accompanied by an impact assessment that evaluates the new structures if existing rules do not suffice. Regulators relative costs and benefits of the proposed measure. The need to be aware of overlaps with other issue areas, such exact procedural and material requirements vary between as the regulation of economic activity or the regulation jurisdictions, often reflecting different regulatory traditions, of energy markets, to ensure the best possible legal as well as constitutional and administrative structures. alignment of the ETS with the broader legal system and minimize the risk of conflicts or judicial disputes. The legal framework also serves to put various elements of the ETS design steps outlined in this handbook into Financial market regulation is often highly relevant action, including the determination of the cap; allowance for emissions trading, influencing the oversight of the allocation; establishment of the registry, including its allowance market (see Section 7.6 of this chapter). It is operating terms and the conditions and fees for account advisable to consider from the outset the treatment of creation; maintenance and closure; rules and procedures on allowances and ETS transactions under other relevant transparency and MRV, including accreditation of verifiers; regimes, for example, taxation and financial accounting the nature and level of sanctions for noncompliance; and — rules, the law of property, contract, obligations, tort, and where the ETS design includes such features — a system insolvency. Clarity on the legal nature and treatment of for offset project approval and credit issuance, and rules allowances and their transaction can help avoid legal governing price or supply adjustment measures (PSAMs). uncertainty, reduce transaction costs, and preempt loopholes that might undermine the integrity of the ETS An ETS will exist within a densely populated context of and the market it engenders (see Box 7-2). existing rules and principles across countless issue areas. As an instrument of climate policy, the ETS will often Box 7-2 Technical note: Legal nature of allowances How allowances are legally defined and treated has a number of important economic consequences for market participants. Such consequences include S whether allowance holders can acquire genuine ownership of allowances, along with the rights that convey with property, or only enjoy possession; S whether allowances are classified as financial instruments and thus fall within the remit of financial market rules; whether and when allowances are taxed, and on what basis; COMPLIANCE S STEP 7 S whether allowances can serve as collateral or security for a loan; and S how allowances are treated in the case of insolvency of their holder. Regulators have not always anticipated these questions and possible outcomes, nor in every case chosen to adopt clear and consistent legal guidance. Hence, the definition and treatment of allowances has displayed significant heterogeneity across systems, often evolving over time and on a case-by-case basis through judicial or administrative decisions, consistent practice of relevant actors (such as tax accountants), and the recommendations of professional bodies such as the International Accounting Standards Board. In California, for instance, allowances are explicitly precluded from conveying property rights, given concerns that regulators might otherwise be unable to specify how much allowance holders may emit. In the EU ETS, meanwhile, some Member States treat allowances like property, while others consider them administrative or “sui generis” rights that afford their holders fewer privileges than full property.245 Likewise, different jurisdictions apply different rules on how allowances are valued in the financial accounts of holders, with some requiring that they be valued at their purchase price and others at fair market value, substantially affecting the taxable basis when allowances are sold. Rules on capitalization and allowance depreciation also vary considerably between jurisdictions. Such differences can result in legal uncertainty and higher costs for market participants and may also increase the risk of abusive practices. For that reason, for instance, value-added taxation of allowances traded in the EU ETS was eventually harmonized to prevent tax fraud, and since 2018 EU allowances are classified as financial instruments under financial market rules. 245 See, for instance, European Commission 2019c. STEP 7: ENSURE COMPLIANCE AND OVERSIGHT 155 Once the ETS has been set up, a new phase in the Leveraging existing reporting frameworks with governance of the system begins: routine operation. This regulated entities phase is focused on exercising institutional functions and Regulators often have existing relationships with, and applying and enforcing rules. These operational aspects frameworks for, entities newly regulated under an ETS, are considered in the remainder of this chapter. which they can build upon when setting up the ETS compliance cycle. For example, fossil fuel power stations may have reporting obligations on production, energy 7.1.2 IDENTIFYING AND MANAGING use, or emissions from sulfur dioxide, nitrous oxide, and LEGAL ENTITIES other pollutants. These (legal) arrangements provide As discussed in Step 3 of the handbook, there is a wide clarity on which legal entity is regulated and support the range of options available for determining the ETS scope establishment of regular reporting cycles and penalty and points of obligation. These decisions will need to be systems. Similarly, large industrial installations may formalized in a set of rules determining which installations, already be subject to a compliance cycle associated with facilities, or operations are covered by the ETS and the maintaining and enforcing licenses to operate. Other nature of the interactions that are expected between helpful relationships may exist between government these entities and the ETS regulator. A regulator will need statistical agencies and regulated entities and/or between to keep track of these arrangements by identifying legal government departments and industry associations. entities, assessing the nature of existing or new regulatory New or expanded rules will become necessary if existing relationships with regulated entities, and updating the frameworks are insufficient to ensure compliance with the list of regulated entities over time, as described in the ETS. Depending on the jurisdictional context, such rules subsections below. may be based on existing powers granted to the ETS regulator or may necessitate new legislation. Identifying the regulated legal entities Legal entities in an ETS are those that are responsible for Managing regulated entities over time emissions and ensuring compliance with ETS legislation. The list of regulated entities changes over time and must The point of regulation might be at the facility level, but be continuously managed and updated. Businesses those that are responsible for the MRV are the legal may open or close, expand, dispose of, or merge their entities, most commonly a corporation but also potentially operations, with implications for the specific legal entities an individual or government entity. There are two main involved and their compliance requirements under an ETS. approaches to identifying the regulated entities within an These changes will not align with the compliance cycle ETS. They may be identified through self-nomination — of the ETS, requiring the regulator to determine rules and consistent with the self-reporting of tax liabilities by liable processes for managing part-year emissions liabilities and entities in many jurisdictions — or identification may be compliance requirements. Most ETS regulators have a based on a regulator’s own research. Often a combination regular cycle for updating the list of regulated entities and of these approaches is used. Once an approach is decided oblige entities to report material changes in their eligibility COMPLIANCE upon, an appropriate list of entities regulated by the ETS or the legal ownership of assets. STEP 7 will need to be drawn up and published to provide clarity and transparency to businesses. 7.2 MANAGING THE REPORTING CYCLE An ETS requires effective MRV.246 Monitoring involves MRV system, in line with the relevant legislative regimes in emissions quantification through calculation or direct the jurisdiction: measurement, which must then be consolidated in an S methodologies for accounting and quantification of emissions report. Typically, these reports are then verified emissions and other necessary data (for example, in the by independent service providers (verifiers) or through context of allocation approaches such as benchmarking similar audit processes. As an illustrative example, or output-based allocation); Figure 7-4 details the EU ETS MRV cycle. As such, a S guidance on monitoring methodologies; regulator must provide the following key elements of an S templates for reports; 246 For more information on creating programs for the monitoring, reporting, and verification of greenhouse gas (GHG) emissions, please refer to the PMR’s Designing Accreditation and Verification Systems: A Guide to Ensuring Credibility for Carbon Pricing Instruments. 156 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION S rules for the accreditation and use of verifiers; Figure 7-4 MRV in the EU ETS and S details on the exchange and management of data. February 28 It is important for MRV requirements to be Allocation of free allowances for established early given the number of components year n March 31 January 1 that must be communicated to stakeholders Start of monitoring Submission of verified annual period for year n and the importance of MRV for implementing emissions report for year n-1 other aspects of policy such as allocations. The provision of detailed methodologies and guidance for regulated entities is key to enhancing compliance with the MRV system. Compliance EU ETS Check verified can be further enhanced if the regulator minimizes compliance report the administrative costs for regulated entities, cycle for example, through establishing information December 31 technology platforms that allow for efficient End of monitoring period for year n transfer of data and compliance reports. -Submission of changes to Regulators may design monitoring guidance in monitoring plan April 30 for year n+1 Surrender of such a way that preexisting monitoring systems, allowances for year n-1 such as process control systems, energy statistics June 30 reporting, and financial accounting systems,247 can Submission of Enforcement also be used for the MRV requirements under the improvement report for year n-1 (sanctions) ETS, lowering compliance costs. Detailed guidance on MRV is provided in PMR publications, including the Guide for Designing Regulated entity Regulator Verifier Mandatory Greenhouse Gas Reporting Programs, Developing Emissions Quantification Protocols for Source: ECRAN, 2014. Carbon Pricing: A Guide to Options and Choices for Policymakers, and Designing Accreditation and Verification Systems: A Guide to Ensuring Credibility for library of detailed methodologies, product and activity Carbon Pricing Instruments. descriptions, emissions factors, calculation models, and relevant assumptions,248 although in some cases they Key points on establishing monitoring requirements will need to be tailored to the specific context of the are provided in Section 7.2.1; on establishing reporting ETS. Table 7-2 gives a brief overview of the approach to COMPLIANCE requirements in Section 7.2.2; and on establishing monitoring (and reporting and verification) in some of the STEP 7 verification requirements in Section 7.2.3. Additional jurisdictions with established ETSs. As also observed procedural considerations are discussed in Section 7.2.4. in Table 7-2, some jurisdictions require installations to have a monitoring plan. This plan outlines the steps the installation will take to monitor its emissions, including the 7.2.1 ESTABLISHING MONITORING site- or company-specific methodologies for measuring, REQUIREMENTS calculating, and reporting data, and are subject to approval Monitoring refers to the process of collecting the data by the regulatory authority. Other approaches used by necessary to quantify emissions. The ETS regulator should jurisdictions specify the monitoring requirements more define the specific monitoring requirements for all emission explicitly in legislation, rules, or guidelines. Regardless of sources included in the scope of the system. the approach to monitoring, the majority of ETSs require annual reporting through an online system. Monitoring guidelines must be available for each sector covered by the ETS. These can draw upon a wide 247 Such as SAP (Systems, Applications, and Products in Data Processing). 248 ICAP 2016g provides links to monitoring approaches used around the world on its website. STEP 7: ENSURE COMPLIANCE AND OVERSIGHT 157 Table 7-2 MRV approaches by ETS Jurisdiction Monitoring methodologies Verification required for Reporting software/platform Both calculation and measurement may be used with specific tier requirements. Monitoring Plan and annual California Electronic Greenhouse California Continuous emissions monitoring (CEM) is required for Emissions Report Gas Reporting Tool (Cal e-GGRT) certain activities. For CO2 calculation (standard methodology, mass balance), direct measurement, fallback approaches, or combinations of approaches can be used. Electronic templates (available EU ETS Annual Emissions Report from European Commission For N2O, direct measurement is required. website) A tier system sets requirements for data quality and accuracy. Calculation with different uncertainty and data Annual Monitoring Plan and National Greenhouse Gas Korea requirements. For some installations CEM, is required. Emissions Report Management System Methodologies for each sector are provided. Generally, the accounting uses activity data on inputs. Emissions factors are specified by the ministry, but entities can apply for unique emissions factor. Emissions reporting via the New Zealand Majority of activities have to use calculation as standard Annual Emissions Report New Zealand Emissions Trading methodology. However, use of continuous emissions Register monitoring is an explicit possibility in the context of the combustion of used/waste oil, used tires, or municipal waste. Entities can choose their calculation methods among those provided by the ministry for each sector. If entities Annual Monitoring Plan and IQÉA (Inventaire Québécois des Québec have measurement instruments, they must use the Emissions Report Émissions Atmosphériques) method associated with the instrument. RGGI uses data from the US Operators of unit combusting any type of solid fuel have Environmental Protection Agency Regional to use continuous emissions monitoring. Clean Air Markets Division Greenhouse database in accordance with Operators of gas- and oil-fired units may use other Annual Emissions Report Gas Initiative state CO2 Budget Trading (RGGI) methods, calculating emissions via daily fuel records with periodic fuel sampling to identify carbon content. Program regulations. RGGI COATS All major GHGs must be monitored and reported: CO2, CH4, N2O, PFCs, HFCs, SF6, and NF3. Large tenants, that is, those with a floor space above 5,000 m2 or over Annual emissions report, Electronic templates (available COMPLIANCE Tokyo 6 million kilowatt-hours electricity use per year, are including emission from Tokyo Metropolitan required to submit their own emissions reduction plan to reduction plans government website) STEP 7 the Tokyo Metropolitan government in collaboration with building owners. The variety of approaches to monitoring across the size of the installation. For example, there could be a jurisdictions shown in Table 7-2 illustrates that different conservative default calculation method, which is relatively monitoring requirements will work best for different sectors easy to apply (and verify) for small emitters, along with a and different GHGs. One approach to monitoring is to requirement for larger emitters to monitor emissions more prescribe different calculation methods depending on accurately (see Box 7-3). 158 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Box 7-3 Technical note: Annual emissions monitoring (calculation) in a hard coal power plant Power plants are a typical example for calculating emissions. This illustration shows a simplified example of the standard methodology to monitor and calculate combustion emissions from a hard coal–fired power plant. In a hard coal power plant there are two inputs: hard coal and Box 7-3: Simplified example of annual emissions monitoring (calculation) carbonate. The hard coal is burned in a hard coal power plant Figure 7-5 Simplified example of annual emissions monitoring to generate electricity, which (calculation) in a hard coal power plant creates a large amount of carbon dioxide and other pollutants, including sulfur dioxide. Carbonate is used to react with the sulfur, thus preventing it from entering Combustion Emissions = Input x NCV x Emission Factor x Oxidation Factor the atmosphere. Both the coal’s Process Emissions = Input x Emission Factor and the carbonate’s emissions will need to be calculated under an ETS. Here, emissions are calculated by means of activity Flue Gas Cleaning Unit data for the two inputs, coal and carbonate, multiplied by Carbonate emissions and oxidization factors. The amount of hard coal and Electricity carbonate is measured via a truck weigh station; for the major emissions source, the steam Hard coal Steam Boiler (1500 MW) boiler, the net calorific value (NCV), and the emissions factor are Input Hard Coal Power Plant Output Grid determined by sample analysis, while for the minor emissions Heating Value Emissions Oxidation Inputs Emissions from the flue gas cleaning unit a (NCV) Factor Factor standard emissions factor can tons Energy GJ/t tCO2/GJ tCO2 be applied. As the currently valid Hard Coal 1,087,387 25.5 0.095 1 2,634,195 2006 Intergovernmental Panel on (truck scale) (sample analysis) (sample analysis) Climate Change (IPCC) Guidelines Carbonate 10,321 — 0.44 1 4,541 (truck scale) (standard factor) work from a basis of complete fuel oxidation, the default value for the Total 2,638,736 COMPLIANCE oxidation factor, calculated from Source: German Federal Ministry for the Environment, Nature Conservation, Building and Nuclear Safety STEP 7 (BMUB/Futurecamp) the carbon content remaining in ash, is set at 1. Determining which installations follow stricter monitoring The differentials in monitoring requirements tries to seek a can be defined using tiers of approaches. The IPCC249 uses balance between a desire to minimize over-rewarding those three tiers, each representing a level of methodological who monitor poorly with a desire not to unnecessarily complexity. The first tier is the simplest, tending to use penalize small sources that may not be able to afford or global standard emissions factors from IPCC. The second have the capability for more accurate methods. An ETS and third are generally considered to be more accurate. may also require that facilities move up the tiers to more Tier 2 tends to be emissions factors at a jurisdiction accurate methods over time as capacity improves. Box 7-4 or more disaggregated level. Tier 3 tends to be direct presents an illustrative example on emissions monitoring measurement or equivalently complex methodologies. requirements for a lime kiln included in the EU ETS. 249 Further details can be found in the IPCC 2019 Refinement to the 2006 IPCC Guidelines for National Greenhouse Gas Inventories. STEP 7: ENSURE COMPLIANCE AND OVERSIGHT 159 Box 7-4 Technical note: Monitoring emissions from a lime kiln Background and context: When Croatia joined the EU in 2013, installations in the power sector and industry had to ascertain whether it would be covered by the EU ETS. A manufacturing plant for dolomitic lime determined that it would be covered because its daily production capacity exceeded 50 tons of lime. The operator of the lime kiln, who had never been required to monitor and report on GHG emissions, was tasked with designing a monitoring plan. The plan, which is required in the EU ETS but not necessarily in other systems, had to be approved by the competent authority. Methods for determining process and combustion emissions: The relevant EU ETS instructions for meeting monitoring and reporting GHG emissions are laid out in the Monitoring and Reporting Regulation (MRR) and associated guidance documents. They specify that monitoring parameters such as activity data and calculation factors have to meet certain quality requirements, so-called “tiers.” To minimize cost burden, minimum tiers are based on the amount of GHG emitted and less rigorous requirements are imposed on smaller emitters. As the plant’s average annual emissions were between 50,000 and 500,000 tCO2, it was considered a mid-size emitter (a “Category B installation”), which determined its options for monitoring methods. When producing dolomitic lime, CO2 is emitted during the chemical reaction that converts the raw material, that is, dolomitic limestone, into the final product ( process emissions), as well as during the combustion of fuel to heat the kilns in which the conversion takes place (combustion emissions). Under the MRR, both the process and the combustion emissions have to be monitored and included in an annual emissions report. To determine emissions the regulation provides a “standard calculation method” that builds, to the greatest extent possible, on data already available to the operator for other purposes, such as process control and financial bookkeeping. Another valid, albeit costlier, option is continuous emission monitoring based on sensor probes that measure CO2 concentrations and volumetric flows in the flue gas stream. Here, the operator chose the standard calculation method as it was deemed that the required investment for installing probes was too costly in 2013. To determine process emissions, the operator had a choice of focusing on either on the quantity of limestone input or the amount of lime output, multiplied by their respective emission factors and a conversion factor reflecting the proportion of unconverted limestone in the final product. The operator chose the second method as appropriate metering equipment was already installed for product quality control purposes. Lime production was determined using a regularly calibrated weighing belt, while various accessible data sources, including sales invoices, inventory data, and financial statements, were then used to corroborate the results and reduce the risk of errors. The vertical annular shaft kiln used in the plant was fueled with natural gas. The operator had to determine whether the existing gas meter complied with the relevant quality requirements, especially regarding measurement uncertainty. The operator successfully demonstrated that the requirement for Tier 3 (± 2.5 percent over the COMPLIANCE reporting period) could be met. Therefore, use of the existing meter was allowed. For the combustion emissions, the STEP 7 calculation required establishing the calorific value of the fuel used to fire the kiln and multiplying it by the emissions factor of the fuel type and the oxidation factor indicating the amount of unburnt carbon. Given that the installation was midsize, the use of standard factors as established by the national inventory was allowed, thereby avoiding the costs for sampling and laboratory analyses. Calculating emissions: An example Under the MRR, process emissions are calculated using the following formula: Em = AD * EF * CFF where Em stands for emissions (in tCO2); AD for activity data; EF and CF for emissions and conversion factors, respectively. The plant’s production data determined AD to be 63,875.25 tons of lime in 2013. On average, the EF was determined to be 0.91 tCO2/t and the CF of limestone to lime in the plant’s kiln was 0.96. Applying the above formula yielded total process emissions of 55,801 tCO2 in 2013. For the natural gas used to fire the kiln, the operator was allowed to use the reference values set out in the national inventory, namely an emission factor of 56.1 tCO2/TJ and a net calorific value of 34 TJ/106m3. Likewise, the rules allowed applying a fixed oxidation factor of 1.  160 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION For combustion emissions, the MRR sets out the following formula: Em = AD * EF * OF where EM, AD, and EF are as defined above and OF is for oxidation factor. Furthermore, activity data of fuels is calculated using the formula AD = FQ * NCV where FQ stands for fuel quantity and NCV for the net calorific value. In 2013 the plant had combusted 7,095,379 m3 of natural gas. Thus, the combustion emissions of the plant in 2013 amounted to 13,534 tCO2. Adding these combustion emissions to the process emissions calculated earlier showed that the plant’s emissions in 2013 were 69,335 tCO2. The regulator needs to balance a desire for accurate and gaming. A stepwise phase-in of more precise monitoring robust data while limiting the potential for gaming. This is and reporting approaches, starting with default factors especially true in the early phases of an ETS when a long followed by a carefully supervised transition to site-specific time series of consistently monitored and reported data sampling and emission factor calculation, may reduce is lacking. This creates uncertainties about site-specific these risks (see Box 7-5). factors that can give rise to significant potential for Box 7-5 Technical note: Default emission factors for balancing cost with accuracy Default emissions factors can be used to provide an estimate for emissions without having to directly measure emissions factors from a particular source. They allow entities to save costs on detailed monitoring procedures and are feasible where emissions sources are similar. In New Zealand, default emissions factors are available for most emission sources unless a participant prefers to obtain a “Unique Emissions Factor” through direct measurement. A default emissions factor should be set to ensure that it provides reasonable accuracy without penalizing sources that may not be able to use more accurate methods (based on costs or capabilities). The use of defaults may also be restricted to smaller emitters and avoid the use of uncertainties related to site-specific emission factors to game the system, especially in the initial and early phases of an ETS. If there is no flexibility to measure emissions other than the default factor, entities will not be incentivized to introduce new and cleaner inputs. Overall accuracy can be improved if flexibility is provided for entities to adopt more accurate approaches than the default, as the information provided by those entities can also be used to improve default factors. COMPLIANCE STEP 7 7.2.2 ESTABLISHING REPORTING z how long records should be kept (typically between 3 REQUIREMENTS and 10 years);251 S standardizing emissions reports to ensure consistency Regulated entities need to report their monitoring data to the regulator in a standardized and transparent form. over time and across reporters; Emissions report timing should be aligned with compliance S aligning timing of emissions reports with existing time frames (see Step 6 for more details about the financial reporting cycles and compliance time frames; frequency of compliance requirements), typically providing and sufficient time after the end of the monitoring period S creating electronic reporting formats to cut down on for reports to be prepared. The regulator can design an processing time and transcription errors, for example, efficient reporting process by250 through web-based reporting platforms that can reduce S providing regulated entities with clear guidance about time demands, easily manage large volumes of data, reporting requirements, including: automatically check for errors, and bolster security. z the type of information to report, When establishing reporting requirements, it is important to z the frequency of reporting, and consider the ETS context. Many jurisdictions already collect 250 Prada 2010. 251 The PMR’s Designing Accreditation and Verification Systems: A Guide to Ensuring Credibility for Carbon Pricing Instruments. STEP 7: ENSURE COMPLIANCE AND OVERSIGHT 161 inputs to the calculations used for emissions reporting, compliance, it may be possible to rely on self-certification such as energy production and consumption, transport and with spot-checking by regulators. However, most ETSs distribution statistics, fuel characteristics, industrial output, require third-party verification, which provides higher levels and transport statistics. Synergies with company process of confidence in reported data. Section 7.3 discusses the control systems and financial accounting systems can different options for regulating such verifiers. help avoid duplication of information flows and ensure that reporting requirements are practical and effective. Given the complexity and site-specificity of many emission reports, some jurisdictions (including, for example, Some types of allowance allocation may require additional California, Québec, and Korea) extend the need for data (see Step 5). Many ETSs require the monitoring, verification to the monitoring plans, which outline the reporting, and verification of activity data (for example, methodologies for measuring, calculating, and reporting tons of clinker or steel produced). Even if these are not data, and are subject to approval by the regulatory authority. needed for allocation initially (for instance, if allocation is done through grandparenting), collecting this data from the outset can help understand emissions intensities across 7.2.4 PROCEDURAL CONSIDERATIONS sectors and help build the capacity and infrastructure that Procedural considerations in the design and facilitates a shift to alternative allocation approaches such implementation of an MRV system include: as benchmarking or output-based allocation in the future. S Phased implementation. Establishing and managing Regulators should map out their data needs in advance, compliance with MRV systems is a time- and resource- identifying what data they currently have access to, and consuming process that requires significant upfront make information requests from regulated entities as investments. Regulators can adopt a learning-by-doing efficient as possible. approach, for example, through implementing MRV systems in stages, starting with major emission sources or simpler methodologies, or incorporating additional 7.2.3 ESTABLISHING VERIFICATION components over time. Continuous changes in MRV REQUIREMENTS systems may, however, be a source of confusion for Regulated entities have an incentive to under-report regulated entities, which should be carefully managed total emissions to pay less for compliance, and in some by the regulator. To allow regulated entities to adapt to situations also to over-report emissions to receive more the new regulatory requirements, jurisdictions including free allowances. Therefore, it is crucial to verify the Korea have used mandatory emissions reporting prior to accuracy and reliability of the information reported by the imposing constraints on emissions. Korea established regulated entities. its MRV requirements before the formal launch of the ETS, which facilitated the introduction of an ETS (for Verification occurs when an independent party reviews an more details see Step 10, the case study on Korea’s emissions report and assesses that the reported information Target Management System). Early data collection is an appropriate estimate of emissions, based on the COMPLIANCE can also be useful for cap setting and for distributing available data.252 Quality assurance used by regulators STEP 7 allowances (see Step 4 and Step 5, respectively). comes in three forms. First, self-certification is where the S Case-by-case technical decisions. Where guidance reporting entity makes a formal assertion of the accuracy of its emissions report, often combined with auditing is inconclusive, decisions will need to be made on a requirements and large punishments for misreporting. case-by-case basis by the regulator. This process of A second option is an external review by program interpretation and technical decision-making can be administrators, to assess accuracy. Finally, third-party supported by a technical panel or advisory committee. verification also provides for external review, but in this case S Managing disclosure of sensitive data. Businesses the review is done by a qualified/accredited third party. may be concerned that the data monitored and collected during emissions reporting may reveal The approach to quality assurance should take into account confidential and commercially valuable information. the administrative costs for the regulator and the regulated The benefits of public disclosure of emissions and entities, the capacity of regulators and verifiers, and the broader (market) transparency in the ETS need to be context of business compliance with other government balanced with the objective to protect commercially regulations in a jurisdiction, as well as the likelihood and sensitive information.253 It is important to consult value of incorrect emissions quantification. In practice, regulated entities on what information will be made many jurisdictions use more than one or even all of these publicly available before the system starts (see Step 2). approaches. When there is a strong culture of regulatory Despite business concerns, it is likely that much of 252 IPCC 2000. 253 The PMR’s Designing Accreditation and Verification Systems: A Guide to Ensuring Credibility for Carbon Pricing Instruments discusses this in further detail. 162 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION the data is often already published by companies and/ emissions data is released at the same time following or business associations. Policymakers should test verification. This alleviates concerns over some entities whether disclosing such information would compromise having early access to the data, which may inform them commercially sensitive information. The timing of the of potential market demand. disclosure could also present issues. In California, all 7.3 MANAGING THE PERFORMANCE OF VERIFIERS As discussed in Section 7.2, MRV in most ETSs require system. This is generally based on detailed guidelines and the use of third-party verifiers. This section discusses the standards from the ETS regulator, including checklists process of accrediting third-party verifiers (Section 7.3.1), and risk registers to establish the levels of compliance and balancing risks and costs in the verification process with the requirements. Verifiers must also use their own (Section 7.3.2). For further reference see the PMR’s professional judgment to understand the regulated Designing Accreditation and Verification Systems: A Guide entity’s key risks of noncompliance, assess compliance to Ensuring Credibility for Carbon Pricing Instruments. with the program requirements, and undertake sufficient investigations so that they have enough confidence to issue their assurance statement. 7.3.1 ACCREDITING THIRD-PARTY VERIFIERS This approach is intended to achieve good risk management. However, there are options that a regulator To ensure the quality of third-party verifiers, the regulator might consider if there are concerns that this might create should establish a verifier accreditation process — either excessive regulatory burden, including internally or involving a domestic or accessible international S allowing or requiring regulated entities to provide quality accreditation body.254 This is useful in providing an independent assessment of the verifier’s technical assurance statements or self-certification for all reports, competence in emissions accounting, calculation, and with legal liability assigned for false reporting; measurement of emissions from specific sources and S assessing only a sample of reports selected by the sectors. It may also help ensure that the verifier can retain ETS regulator for detailed review and/or third-party impartiality while conducting the verification in accordance verification after they have been submitted; with program rules. S focusing reviewing and auditing only on compliance in the areas of high risk that have been identified by the There are internationally recognized standards that a ETS regulator (for a specific regulated entity); and/or regulator can use or adapt for this purpose, such as those COMPLIANCE S reducing the frequency of review or verification. by the Clean Development Mechanism Executive Board STEP 7 and the International Organization for Standardization Regulated entities may have an incentive to avoid (notably ISO 14064-3 and ISO 14065, as well as ISO 17011, compliance to reduce their costs, with auditors potentially which provides general requirements for accreditation allowing this behavior to maintain relations with clients. bodies assessing and accrediting verifiers).255 Therefore, while the approaches to reduce the regulatory burden may reduce the costs that regulated entities need 7.3.2 BALANCING RISKS AND COSTS IN to incur, they also increase the risk that entities fail to THE VERIFICATION PROCESS comply with the ETS requirements, which could undermine the credibility of the system. One solution to minimize costs Typically, verification requires that regulated entities have for regulated entities, as applied in some of the Chinese their reports scrutinized by an accredited verifier who ETS pilots, is to maintain the more rigorous procedures but must confirm that the regulated entity is complying with for the government to fund the verification process.256 all of the requirements of the monitoring and reporting 254 This option is in the European Commission Regulation (EU) No 600/2012: “A Member State that does not consider it economically meaningful or sustainable to establish a national accreditation body or to carry out accreditation activities should have recourse to the national accreditation body of another Member State. Only national accreditation bodies that have undergone a successful peer evaluation organized by the body recognized under Article 14 of Regulation (EC) No 765/2008 should be permitted to perform the accreditation activities pursuant to this Regulation.” 255 ISO 2006, 2007, 2011. 256 SinoCarbon 2014. STEP 7: ENSURE COMPLIANCE AND OVERSIGHT 163 Regulators may choose to establish verification guidelines. In deciding whether to involve third-party verifiers, it is As verifiers need time to form specialist teams and develop important to consider the local context in which the ETS the right tools and methods to perform verification tasks, it is operating. For instance, in some jurisdictions, company is important for the ETS regulator to carefully monitor and financial reporting is regulated through audited self- manage their performance, particularly in the early stages reporting, with civil and criminal penalties for misreporting. of the ETS. In some of the Chinese pilot ETSs, for instance, With robust compliance mechanisms, using a similar some verification reports are double-checked by experts or approach in an ETS could ensure a credible MRV system other verifiers appointed by the regulators. In the pilots, it is that is aligned with common practice in the jurisdiction. only in the case that a verification report is of poor quality Similarly, review by program administrators may alleviate the that verifiers will be asked to revise the report. In addition, need for third-party verification in jurisdictions where there regulators may stipulate a period of time after which is strong infrastructure in place for program administrators. accreditation must be renewed. Considering the efficacy of approaches used in other areas of government regulation can provide guidance on the most appropriate quality assurance options. 7.4 DESIGNING AN ENFORCEMENT APPROACH Effective compliance relies on establishing processes that Penalties should be set at a level that exceeds an entity’s are transparent and well communicated. If information expected benefits of noncompliance. Typically, there are about compliance is easy to understand, accurate, three categories of noncompliance that carry penalties: complete, and accessible, then regulated entities will S emitting in excess of the number of allowances be more likely to comply on time and without errors. surrendered; Appropriate capacity-building measures targeting S misreporting or not reporting emissions and other data regulated entities are key in this regard (see Step 2). In before specified deadlines; and addition, consideration of the local legal frameworks S failingto provide, or falsifying, information to the already in place and the type of enforcement that has worked in other policy areas is key to designing regulator, verifiers, or auditors. a successful enforcement approach. New Zealand’s Some ETS pilots in China also penalize verifiers who enforcement for their ETS uses the pre-existing provide fraudulent information or reveal confidential enforcement framework. New Zealand tax legislation trusts information.259 the liable entity to report correct figures with minimal oversight and self-assessment of figures but has large COMPLIANCE Penalties, which are often used in combination, may penalties in the case of noncompliance.257 STEP 7 include the following: S “Naming and shaming.” The names of noncompliant While well-designed MRV processes can increase compliance rates, to ensure full compliance across the entities can be published. This may be particularly whole of the ETS, a credible enforcement regime with useful in jurisdictions where a company’s reputation appropriate penalties must be developed. These penalties would be significantly affected by such a statement. should be sufficiently punitive to incentivize compliance S Fines. These can either take the form of a fixed amount and should thus incur a substantial additional cost or be set pro rata to the extent of the noncompliance, for compared to the cost of complying with the ETS. The example, per ton of emissions without a corresponding regulator needs to ensure it can enforce penalties and surrendered allowance. The value of the fine can that, in the event of noncompliance with penalties, it can be set by reference to the observed market prices invoke powers to investigate or prosecute through fines for allowances. A fine may be higher for intentional or other civil or criminal sanctions. For example, in New noncompliance than for unintended mistakes. Zealand, the law gives the regulator extensive prosecution S “Make-good” requirements. This can help maintain provisions for noncompliance, which can result in environmental integrity. Installations may have to comply significant financial and criminal sanctions.258 within a certain time period, by buying allowances from 257 New Zealand Environmental Protection Authority 2020. 258 New Zealand Environmental Protection Authority 2013. 259 SinoCarbon 2014. 164 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Table 7-3 Penalties for noncompliance with surrender obligations across jurisdictions the market or borrowing from their future allocation Table 7-3 shows details of penalties for noncompliance (usually at an unfavorable exchange rate). with allowance surrender obligations applied across S Further measures. Ongoing or repeated intentional different jurisdictions, with most jurisdictions requiring noncompliance may call for stronger penalties, including a make-good surrender alongside other penalties. In criminal charges. In addition, or alternatively, penalties general, the more mature ETSs have larger penalties for outside of the ETS might be used. For example, some noncompliance. A range of other penalties are applied of the Chinese pilot systems linked ETS performance in most jurisdictions for other offences relating to MRV with new construction project approvals, performance requirements, such as not reporting on time or withholding evaluation for state-owned companies, eligibility to enjoy information from a verifier. some preferential financial policies, and credit records.260 Table 7-3 Penalties for noncompliance with surrender obligations across jurisdictions261 Jurisdiction Penalties Make-good requirements and fines: Under the Cap and Trade Regulation, if an entity fails to surrender sufficient compliance instruments to meet its obligation, California requires that the entity submit four compliance instruments (only one quarter of which can be offsets) for each instrument the entity failed to surrender. Of these four instruments, one is permanently retired, and three allowances are California recirculated through the auction mechanism. If an entity fails to submit these four compliance instruments, California may institute formal enforcement actions, including seeking penalties. This includes penalties of USD 1,000 to USD 10,000 (EUR 901–EUR 9,008) per day per violation (i.e., per metric ton that remained unsurrendered) for strict liability, and increasing amounts depending on the level of intent. Naming-and-shaming, make-good requirements, and fines: The name of the noncompliant entity is published. European Union Regulated entities have to buy and surrender the equivalent amount of allowances for each tCO2 emitted for which no allowances have been surrendered. A fine of EUR 100 for each tCO2 emitted for which no allowance has been surrendered. Make-good requirements and fines: The noncompliance penalty equals five monthly standard allowances for each ton (approximately KZT 12,625 per tCO2 Kazakhstan [EUR 29.99 per tCO2] in 2019). In 2013 and 2014 penalties for noncompliance were waived. Fines: Korea A fine of up to three times the average market allowance price of the given compliance year or KRW 100,000 per ton (g) (EUR 77.30 per ton) for each tCO2 emitted for which no allowance has been surrendered. COMPLIANCE Other measures: STEP 7 The Mexican ETS pilot is designed to pose no economic burden on regulated entities; however, in case of noncompliance, Mexico entities lose the opportunity to bank unused allowances for the next compliance periods within the pilot. Moreover, noncompliant entities will receive fewer allowances during the operational period of the national ETS (two fewer allowances for each nondelivered allowance during the pilot). Fines: New Zealand An automatic surrender/repayment penalty will apply when an entity has failed to surrender or repay allowances by the due date. Each overdue unit will incur a cash penalty of three times the current market price. Make-good requirements, fines, and other measures: Companies failing to surrender enough allowances to match their emissions have to surrender the shortfall plus three additional allowances for each allowance they failed to remit. Québec Furthermore, depending on the infraction, they can face additional charges varying from CAD 3,000 to CAD 600,000 (EUR 2,064–EUR 382,045) for each tCO2 emitted for which no allowances have been surrendered as well as CAD 10,000 (EUR 6,883) administrative sanction. Fines are doubled in the case of a second offence. In addition, the Minister of the Environment and the Fight against Climate Change may suspend the allocation to any emitter in case of noncompliance. 260 Information about penalties outside the ETS in the Chinese pilots are noted in Hongming 2015. 261 The information about noncompliance penalties in jurisdictions other than California and New Zealand are retrieved from the ICAP website, “Introduction to ETS, MRV and Enforcement”: https://icapcarbonaction.com/en/mvr-and-enforcement. Information about penalties in California are also sourced from California Air Resources Board 2018b and Government of California 2016, while those in New Zealand are sourced from Shaw 2019. STEP 7: ENSURE COMPLIANCE AND OVERSIGHT 165 (continued) Table 7-3 Penalties for noncompliance with surrender obligations across jurisdictions261 Jurisdiction Penalties Make-good requirements and fines: In the case of excess emissions, compliance allowances for three times the amount of excess emissions have to be RGGI surrendered in future periods. Furthermore, regulated entities may also be subject to specific penalties imposed by the RGGI Member State where the entity is located. Make-good requirements and fines: Switzerland Missing allowances and/or international credits have to be surrendered in the following year. In addition, a fine of CHF 125 (EUR 117) for each tCO2 emitted for which no allowance has been surrendered. Make-good requirements, naming-and-shaming, and fines: First stage: The governor orders the facility to reduce emissions by the amount of the reduction shortage multiplied by 1.3. Tokyo Second stage: Any facility that fails to carry out the order will be publicly named and subject to penalties (up to JPY 500,000 [EUR 4,124] and surcharges of 1.3 times the shortfall). 7.5 DEVELOPING AN ETS REGISTRY Regulators must ensure that regulated entities surrender renewable energy trading systems) and providing the correct number of eligible allowances by the relevant information relevant for development of climate change compliance date. To keep track of market transactions and policy design and mitigation strategies. surrendered allowances, an ETS requires a registry where transfers of allowances are recorded and monitored. At the Establishing an ETS registry involves the following steps: end of each compliance cycle, regulated entities can then S Creating the legal framework for a registry. 262 transfer (or surrender) allowances via the registry to the ETS The legal framework for a registry will ideally reflect regulator to meet their emissions liability for the period. the nature, scope, and scale of the proposed ETS. The regulator must establish timelines for drafting, Section 7.5.1 discusses the process of setting up a registry. conducting consultations on, and implementation of, Section 7.5.2 discusses prevention of fraud. Section 7.5.3 this framework. The registry design may need to be discusses how registry data and design can support aligned with other areas of law — such as property, tax market operations. The PMR’s Emissions Trading Registries and accounting, insolvency, and financial laws — and guide has further details on regulation, development, and address these with the bodies responsible for those COMPLIANCE administration of registries. STEP 7 laws. If necessary, external expertise and support should be drawn in. The most challenging legal aspects often relate to the determination of the legal nature of 7.5.1 SETTING UP A REGISTRY the allowances263 and the allocation of responsibilities to Registries are IT databases that assign a unique serial all the bodies involved. These should be identified and number to each allowance and track those serial numbers addressed at an early stage to avoid later disputes. from their issuance onward. Registries contain information S Setting up the institutional framework for on who has been issued allowances, who holds those administering a registry. 264 The regulator should list allowances as well as other allowances, and details on the responsibilities of the registry administrator and surrendered or canceled allowances. Market participants determine the terms of use and fees for registry users, as sign up to the registry and create an account where their well as the size and structure of the budget for registry allowances are stored. In creating a registry, policymakers administration. On this basis, it should decide which may look to use an existing registry used by a different entity is best placed to assume this role. Combining jurisdiction as a template, while still retaining control the registry administrative functions with other ETS of their own registry. The registry can serve a broader public functions may be beneficial for specialization, purpose than just putting the ETS into action, potentially knowledge pooling, and providing a single point of supporting other climate policy instruments (for instance, 262 For more information on creating the legal framework for registries, please refer to Zaman 2015. 263 It is important to decide on the legal nature of emissions allowances, for example, whether they are an administrative grant, license, or property. Where this is not stipulated in law, opportunistic speculation may occur. This is further discussed in a PMR background note on legal arrangements (Zaman 2015). 264 For more information on creating the institutional framework for registries, please refer to Dinguirard and Brookfield 2015. 166 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION contact between government and stakeholders. It should opening of an account, block or close an account, and establish cooperation procedures between the registry freeze or revoke a user’s access to the registry in a flexible administrator and relevant authorities (for example, manner. This requires the continuous supervision of daily market oversight and regulation). transactions by the market monitoring authority to detect S Specifying the functional and technical unusual behavior. In turn, detection of suspicious events requirements for a registry. 265 This includes or transactions and a prompt response mechanism are procurement of the relevant IT systems; identifying crucial. Furthermore, cooperation between the registry and addressing security issues and options; defining administrator and authorities that carry out criminal the data to be managed; estimating the volume of investigations is required to ensure rapid interventions data and number of transactions to be processed; where necessary. establishing traceability procedures including audit In addition to regulatory instruments, specific technical logs, notifications, and messages; formulating the main security measures can be useful in countering fraud or theft business rules and alerts; specifying the main reports of allowances within the registry. These measures include to be produced by the registry; and creating the main S two-factor authentications and session time-outs; pages of the registry website. S limitation of the registry’s opening hours to working hours to facilitate intervention in case of misuse; 7.5.2 PREVENTING FRAUD S password or other protection of sensitive operations (for Robust technical systems and transaction security example, transfers); measures are necessary to ensure the integrity of the ETS S enabling the registry to automatically use emergency registry and to minimize the risk of unauthorized use for stop functions, block accounts, and reverse operations; criminal purposes such as fraud and theft of allowances. and A key function of an ETS registry is the prevention of S performance of independent security audits of registry fraud. Along with the direct losses suffered as a result of fraudulent activity, fraud can compromise the reputation providers. of the system and threaten confidence in the market. If These measures are now common practice for most fraud is discovered, a quick reaction to the events, and the registries, in part due to lessons learned in the context of appropriate strengthening of systems, can help minimize the EU ETS (see Box 7-6). long-lasting damage. Good security practices when setting up a registry provide the registry administrator with the authority to refuse the COMPLIANCE STEP 7 265 For more information on creating the technical infrastructure for registries, please refer to Dinguirard 2015. STEP 7: ENSURE COMPLIANCE AND OVERSIGHT 167 Box 7-6 Case study: Fraud and cyberattacks in the EU ETS During the first two phases of the EU ETS, the sensitivities regarding national sovereignty and the jurisdictional limitations of the European Commission’s mandate resulted in each EU Member State having its own registry system with varying functional and security arrangements. A Community Independent Transaction Log was used for checking and recording transactions of allowances between accounts. In several instances, heterogeneous registry account access requirements enabled cyberattackers to identify and exploit the weakest point of entry in a particular registry to hack and misuse EU ETS allowances. Major cases of fraud and cyberattacks against the registry accounts of the EU ETS included the following: S Phishing (fraudsters impersonating a legitimate and trusted entity to make participants provide access to sensitive data). In January 2010 a handful of account holders in Germany had allowances stolen after responding to a fraudulent email requesting details to access their accounts. S Hacking. In January 2011 several million EU allowance units (EUAs) were stolen from national registries of five Member States: Austria, Romania, the Czech Republic, Greece, and Italy. In response, the EU ETS established the Union Registry, an EU-wide registry system, in 2012 along with the European Union Transaction Log, which replaced the original log. The unified registry system and security protocol made it easier to control transactions and prevent fraud. Some of the new EU ETS registry security measures include S enhanced control for account opening consisting of stronger and harmonized know-your-customer checks; S enhanced transactions security, including a range of security measures like a 26-hour delay at initiation of a transfer, a trusted account list, and better authentication methods for carrying out transactions (application of a “four eyes” principle, whereby transactions must be approved by at least two people); S strengthened registry oversight, including administrator power to suspend registry access and block transfers; S enhanced protection of the good-faith acquirer by acknowledging the holding of allowances in an account in the Union Registry as prima facie and sufficient evidence for title over them, and establishing rules on finality of transactions (rendering them irrevocable); and S serial numbers of allowances became only accessible by administrators. The interaction between the tax treatment of allowances and vulnerabilities within the ETS registry can also be the target of criminal activity. One example is the EU ETS tax regime, which until 2010 treated the transfer of an allowance as a service that attracted value-added tax (VAT) collected by the seller. A number of exchanges offered spot products (exchange-traded products with physical settlement by way of delivery of an allowance within 1–3 days of the transaction date). These products, along with the real-time transfer and settlement capability of EU Registries, allowed multiple transactions to be carried out in quick succession. Criminals exploited this to commit VAT carousel fraud: the acquisition of carbon allowances without paying VAT (because of the cross-border nature COMPLIANCE of the transactions), which were then sold in the same country at a price charging VAT, with the fraudsters then STEP 7 disappearing before the tax was handed over to the tax authorities. Europol estimated that approximately EUR 5 billion was lost to VAT carousel fraud between June 2008 and December 2009. In response, the European Commission adopted legislation in March 2010 that allowed an optional reverse charge mechanism on emissions allowances. This means that the buyer instead of the seller is responsible for surrendering VAT on domestically traded emissions allowances. The reverse charge mechanism is most effective in stopping VAT carousel fraud if all EU members adopt and apply it simultaneously.266 7.5.3 SUPPORTING MARKET OPERATION ensuring that appropriate standards of confidentiality and Some registry data can be made available to market security are maintained. participants and the public to allow interested parties to Registry design can support the design of secondary form views on the balance of demand and supply. This markets and linking with other markets. A well-designed could facilitate the emergence of a liquid allowance market registry can help with the expansion of liquid secondary with robust price information. To this end, the registry markets by facilitating trade. This helps reduce the should provide sufficiently granular data on emissions, administrative burden of trading for both participants allowance allocation and surrender, and compliance, while and administrators (see Step 6). For instance, the EU 266 Adapted from PMR and Forest Carbon Partnership Facility 2016; Kossoy and Guigon 2012; Berrittella and Cimino 2017. 168 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION ETS registry is designed to facilitate automatic transfers with a lower amount of effort by market participants, which of allowances on linked private exchanges if they meet facilitates trade. The adoption of consistent data standards, standards for security and operation. By directly linking the methodologies, and registry design can also facilitate linking registry and secondary markets, trades can be executed between different ETSs, as discussed further in Step 9. 7.6 OVERSIGHT OF THE MARKET FOR ETS ALLOWANCES In addition to MRV of emissions — and the associated These oversight rules need to be set both in the primary surrender of allowances — the market for trade of market (i.e., at the point of initial distribution of allowances) allowances also requires oversight.267 On the one hand, and in the secondary market (i.e., any subsequent under-regulation and a lack of oversight risks fraud and transactions of allowances). The secondary market manipulation; on the other hand, over-regulation may lead relates to both trades in the actual allowances (direct to spiraling transaction costs, restrict entities’ ability to “over the counter” [OTC] trades as well as trades through access financial risk-management tools, and stifle uptake exchanges), and trades in the derivatives of the allowances, of mitigation options. such as contracts for future sales of allowances.268 The experiences of existing ETSs also show that these The scope of ETS market oversight includes oversight rules should be developed from the beginning S who can participate in the market; of any ETS and that compliance with them should be S who is responsible for overseeing the market; rigorously monitored. The legal framework (see Section 7.1) plays an important role in enabling transactions in the S what can be traded on the market; market and balancing the legal rights of buyers and sellers S where transactions may take place; and of allowances through contractual arrangements and S other rules that affect the market’s safety, volatility, provisions on dispute settlement (see Box 7-7). and vulnerability to fraud, including those related to oversight of other financial and commodity markets. Box 7-7 Technical note: Contracting ETS transfers When market participants engage in a transaction to transfer allowances or allowance derivatives, they enter into a contract. In this contract, the parties to the transaction agree on various terms, such as the amount, type, and COMPLIANCE vintage of transferred allowances or allowance derivatives; settlement and payment details, including price, delivery STEP 7 date, and currency; consequences of default, such as liability and termination; and applicable law and dispute settlement. For OTC transactions, each contract can, in principle, be entirely unique and tailored to the specific circumstances and requirements of its parties. In practice, however, market participants tend to rely on standardized contracts issued by professional bodies, such as the International Emissions Trading Association, the International Swaps and Derivatives Association, or the European Federation of Energy Traders. These contracts are typically referred to as “Master Agreements”269 and help streamline the contracting process by clarifying ambiguous regulatory concepts, providing greater certainty to counterparties, and enhancing overall market liquidity by lowering transaction costs for market participants. When allowances or allowance derivatives are traded on exchanges, such as the European Energy Exchange in Leipzig or the Intercontinental Exchange in London, the terms of the transactions are set out in the conditions and administrative procedures governing access to the exchange, as well as — in the case of derivatives — the contract specifications of that financial product. 267 See Kachi and Frerk 2013 for a brief summary of key elements of market oversight. 268 Derivatives are financial products that derive their value from an agreement to buy or sell an underlying asset or commodity for a certain price in the future. 269 See, for instance, IETA 2019. STEP 7: ENSURE COMPLIANCE AND OVERSIGHT 169 As in commodity and financial markets, several measures S Participation and licensing requirements. Regulators can be taken by regulators at various levels to minimize have the option to impose restrictions on who can trade the risk of market misconduct, prevent systemic risk, and on what markets and decide whether licenses for these safeguard against manipulation. In general, approaches activities are required. For example, Korea limited market to reducing risks focus on knowing who is trading in participation in Phases 1 and 2 to regulated entities the market, excluding traders with a history of market and a small number of banks (i.e., market makers). misconduct, ensuring that participants have the financial Since Phase 3 financial intermediaries have been able resources to honor their trades, and limiting the position to participate in the secondary market. Regulators can that an actor can take in the market. Specific strategies to also introduce capital requirements to reduce systemic apply these safeguards include:270 risk and disclosure rules covering business relationships S Supporting exchange-based trading. 271 Transactions with participants registered in the system. Generally, on OTC markets are less transparent than those on having more market participants will create a more liquid exchanges and thereby lead to a degree of systemic market, which is desirable. However, verification of risk. For example, if a single buyer and counterparty identities and previous records for all market participants amass a very large share of transactions and either is is important to reduce the risk of manipulation and fraud. incapable of fulfilling contractual obligations, the result Utilizing existing regulatory tools. Some jurisdictions may be a complete market failure. Exchanges may play have regulated emissions allowances in the same way a regulatory role with their own procedures in case of as financial instruments. Regulating this way allows for violations, such as membership suspension. They may financial market regulatory tools and regulations to apply. also be useful in providing information on prices, volume, The EU classified ETS allowances as financial instruments open interests, and opening and closing ranges. subject to EU financial regulation, including the Markets in S Clearing and margin requirements. While trading Financial Instruments Directive, which regulates financial on exchanges is always cleared (i.e., there is a markets. Given credible financial market regulation, the clearinghouse that becomes the central counterparty EU determined that existing supervisory structures could to the trade), this is not necessarily the case with perform the market-monitoring role. In California, while the OTC trading. Regulators are therefore increasingly auctions are overseen by the environmental regulator Air requiring OTC clearing of standardized contracts. As Resources Board, secondary market activity falls under the clearinghouses require a deposit as collateral to cover financial markets, which could require the involvement of the credit risk until a position is closed (also called both state and federal agencies within the United States. a “margin”), this greatly reduces not only systemic, However, some jurisdictions, like New Zealand, do not but also counterparty risk. Clearinghouses reduce define allowances as financial products but regulation counterparty risk because they ensure that each party governing trade is still based on existing financial has sufficient resources to clear any transaction. This regulation. Not classifying allowances as financial products provides confidence to both parties of the transaction may increase the risk of misconduct.273 and wards off financially unsuitable or fraudulent actors. S Market monitoring reports. These reports review COMPLIANCE S Reporting and disclosure. In the absence of mandatory STEP 7 and evaluate auction and secondary market activity to clearing or exchange trading, trade repositories or a identify potential inappropriate activity and violations central limit order book 272 can function as a registry of regulation. The frequency and detail of these reports for market orders and an archive of trades to provide vary; for instance, RGGI’s market monitor prepares an regulators with information on market movements. annual report that provides a comprehensive summary S Position limits. A position limit imposes a restriction on on pricing trends, participation levels, and market the total number of allowances or derivatives that may monitoring. More frequent and less extensive reports on be held by a market participant or a group of market prices and trade volumes are published each quarter, in participants with business relationships to prevent the addition to monitoring reports after each auction. possibility that they seek to distort the market. Position limits can be enforced through transparency at the registry level, at the central clearinghouse level, or by an exchange. 270 Kachi and Frerik 2013. 271 OTC trades involve a buyer and a seller coming to a negotiated terms of transaction which is represented in a contract. Usually, OTC transactions use standardized contracts particular to that ETS or jurisdiction. 272 Central limit order book (CLOB) are a centralized record of outstanding limit orders. Each limit order specifies to buy or sell allowances at a predetermined (or better) price. 273 Denne, Campbell, and Wright 2015. 170 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION 7.7 QUICK QUIZ Conceptual Questions 1. Why is compliance and market oversight important for an ETS? 2. What methods can be used to identify regulated legal entities? 3. How can ETS registry data be used to support market operation? Application Questions 1. In your jurisdiction, are there existing environmental, tax, legal, and market administrative or regulatory processes that could be replicated or used for the ETS? 2. What type of legislation would be used to establish an ETS in your jurisdiction? 3. What are the benefits of a stand-alone MRV phase ahead of compliance requirements? 7.8 RESOURCES The following resources may be useful: S Developing Emissions Quantification Protocols for Carbon Pricing: A Guide to Options and Choices for Policy Makers S Designing Accreditation and Verification Systems: A Guide to Ensuring Credibility for Carbon Pricing Instruments S Emissions Trading Registries: Guidance on Regulation, Development and Administration S Greenhouse Gas Data Management: Building Systems for Corporate/Facility-Level Reporting COMPLIANCE STEP 7 STEP 8: CONSIDER THE USE OF OFFSETS 171 Step 8 - Consider the use of offsets STEP 8 Consider the use of offsets At a Glance____________________________________________________________________________ 172 8.1 What are offsets?_________________________________________________________________ 173 8.2 Using offsets: Advantages and challenges__________________________________________ 174 8.3 Sourcing offsets__________________________________________________________________ 180 8.4 Offset control measures___________________________________________________________ 186 8.5 Quick Quiz_______________________________________________________________________ 188 8.6 Resources_______________________________________________________________________ 188 BOXES Box 8-1 Technical note: Offsets and ETS______________________________________________ 173 Box 8-2 Technical note: Negative emissions technologies as offsets______________________ 175 Box 8-3 Technical note: Buyer and seller liability_______________________________________ 177 Box 8-4 Case study: International offsets and imported risk_____________________________ 178 Box 8-5 Case study: From Kyoto to Paris – market mechanisms in the international climate regime_____________________________________________________________ 181 Box 8-6 Case study: Offset use in the Chinese ETS pilots and China’s national ETS________ 187 FIGURES Figure 8-1 International offsets and imported risk_________________________________________ 179 Figure 8-2 Sources for offsets for an ETS________________________________________________ 180 Figure 8-3 Offset programs around the world____________________________________________ 181 Figure 8-4 The general process for project registration and credit issuance__________________ 185 TABLES Table 8-1 A simple illustration of offsetting in an ETS_____________________________________ 174 Table 8-2 Key considerations for reliance on externally administered crediting mechanisms___ 183 Table 8-3 Aspects of standardization of methodologies___________________________________ 184 Table 8-4 Bottom-up versus top-down approaches to developing offset methodologies______ 185 OFFSETS STEP 8 172 STEP 8: CONSIDER THE USE OF OFFSETS AT A GLANCE the ETS by expanding the set of mitigation opportunities Checklist for Step 8: Consider the use of offsets available. It also supports investment flows into those ✔ Outline the potential role of offsets within an ETS sectors and allows entities with the required capacity and ✔ Decide on the type of offsets allowed within the willingness in uncovered sectors to “opt in” to emissions system (both geographical scope and governance reduction activities. By lowering compliance costs and of program) creating a new, supportive political constituency for the ✔ Weigh costs of establishing a domestic crediting ETS in the form of project proponents,275 allowing offsets mechanism versus making use of an existing may make an ETS more attractive to the private sector. This crediting mechanism may in turn allow policymakers to set a more ambitious cap ✔ Decide on qualitative criteria and quantitative limits and may support policy stability. Crediting mechanisms on the use of offsets can also be designed to target specific policy goals including improved air quality, restoration of degraded land, and better watershed management. Finally, crediting Carbon crediting is the process of issuing tradable mechanisms can also support low-carbon investment, emission reduction units to actors implementing approved learning, and engagement among uncovered sources. emission reductions or removal activities. Emissions trading systems (ETSs) may allow for these carbon credits At the same time, the acceptance of offsets in an ETS to be used as “offsets,” and used for compliance in place presents potential challenges. Offsets represent a risk of allowances to compensate for (i.e., offset) emissions by to environmental integrity if they are not additional (for a regulated entity. Allowing offsets in an ETS is an option example, if an actor would have undertaken an activity even that brings a range of benefits and challenges but is not in the absence of the crediting mechanism), not real (for required for an ETS to operate. Nonetheless, some form of example, if the emissions reductions did not occur), or not offsets is accepted to some extent in most existing ETSs. permanent (for example, if they are reversed and released into the atmosphere at a later stage). The inclusion of For offsets to be credible it is essential that any credited offsets, if not designed properly considering both domestic emissions reductions or removals are “additional,” that and international climate commitments, may also create is, these reductions or removals would not have occurred perverse incentives for jurisdictions to implement lax climate if the crediting mechanism274 did not exist. Offsetting commitments in offset-generating sectors and sources, works by allowing emissions from covered sources to weakening global environmental outcomes. Furthermore, increase to a level above the ETS cap so long as additional there might be potential for double counting of offsets (for emissions are compensated for by emissions reductions or example, if the emission reduction benefits are claimed by sequestration elsewhere. This means that offsetting would both the host and buyer jurisdictions). This highlights the have no net impact on the overall emissions outcome, as need for robust and transparent accounting measures. long as carbon credits represent real, permanent, and additional emissions reductions. Systematic approaches to manage these challenges include the use of additionality tests, mandating Offsets may differ in two main dimensions: the geographic conservative baselines, requiring guarantees by the host scope of mitigation activities and the governance of the jurisdiction, or setting aside a portion of the credits issued crediting mechanism. The crediting mechanism may by every project in a common pool to act as insurance OFFSETS STEP 8 be limited to crediting emissions reduction or removal against the risk of reversal, leakage, or lack of additionality. activities within the same jurisdiction or may include offsets generated outside the ETS jurisdiction. The The use of offsets may also result in governance challenges. program itself may be designed and governed by a By providing flexibility in terms of mitigation opportunities, domestic administrator, or it may rely on existing crediting offsets can reduce prices and therefore dampen incentives mechanisms to varying degrees. to invest in abatement technologies in covered sectors. The use of offsets can also carry high transaction costs for both Crediting mechanisms broaden the carbon price signal administrators and participants of the crediting mechanism. to uncovered sectors and provide an avenue to generate The shifting of mitigation effort between sectors may also abatement incentives in sectors that are difficult to include raise distributional concerns. Offsets may create challenges in the scope of the ETS for technical, political, or other for expanding ETS coverage over time as offset-generating reasons. This can increase the economic efficiency of 274 Crediting mechanism refers to initiatives that issue tradable credits to actors that voluntarily implement emission reduction or removal activities that are additional to business-as-usual operations. Other sources may use “crediting program” or “offset program” to describe the same initiative. 275 Project proponents are the entities responsible for implementing the emission reduction or removal project. Other sources may use the terms “project developers,” “project owners,” or “project designers” to describe the same entities. STEP 8: CONSIDER THE USE OF OFFSETS 173 firms resist the change from receiving offset revenues to careful consideration is required when deciding which incurring a liability for emissions. crediting mechanism, geographic regions, gases, sectors, and activities generating carbon credits to accept into an To promote the integrity of carbon credits, it is important ETS. Qualitative criteria for accepting carbon credits, for to ensure that they are generated in accordance with example, may be based on environmental integrity or the robust rules and methodologies, either by using an existing jurisdiction of origin. For carbon credits that are classified crediting mechanism for sourcing reductions domestically as eligible, quantitative limits may also be used to control or internationally, or by creating a new crediting mechanism the inflow of low-cost offset credits and the relocation of to achieve a set of specific domestic policy objectives. mitigation co-benefits. Ensuring the credibility of carbon credits also requires adopting a process for project registration and credit Box 8-1 highlights some questions policymakers should issuance, and determining liability in case of reversal ask themselves when considering allowing offsets within of emissions reductions. Integrity concerns mean that their ETS design. Box 8-1 Technical note: Offsets and ETS Policymakers should consider the following questions when determining whether, how, when, and from whom to allow offsets. S Which sectors are not covered by the ETS? What is the potential for inclusion of these sectors in the ETS? Is there potential to manage the sectors through offsets? S What should be the contribution of these uncovered sectors to national goals over time? How can this contribution be incorporated into offset design, for example through baselines? S What role does the ETS play in the jurisdiction’s long-term decarbonization trajectory and what role could removals play in the ETS? S Is the recognition of offsets from outside the jurisdiction consistent with the goals of the ETS? S How can it be ensured that offsets do not undermine the environmental integrity of the ETS? S Will offset use be unlimited, or will it face restrictions? S What approaches are most feasible for managing reversals and other risks? This chapter provides an overview of offsets and the role advantages of using offsets and potential challenges. they can play within an ETS. Further detail on designing Section 8.3 explains the types of offsets and how they crediting mechanisms to meet jurisdictional objectives may be sourced. Section 8.4 sets out an approach to can be found in the Partnership for Market Readiness’s applying qualitative criteria to the use of offsets — i.e., the (PMR) Guide to Developing Domestic Carbon Crediting geographic origin, types of gases, sectors, time periods, Mechanisms. and types of activities eligible for carbon credit generation. It also discusses quantitative criteria. Section 8.1 explains what offsets are and how they affect emissions in an ETS. Section 8.2 elaborates some of the OFFSETS STEP 8 8.1 WHAT ARE OFFSETS? Carbon crediting is the process of issuing tradable credits The use of offsets typically allows for emissions from to actors implementing approved emissions reductions covered sources to increase to a level above the ETS cap or removal activities. ETSs may allow for these carbon so long as additional emissions are compensated for by credits to be used as “offsets,” for compliance in place of emissions reductions or sequestration elsewhere. This allowances to compensate for (i.e., offset) emissions by a means that the overall emissions outcome is unchanged regulated entity. (assuming that the emissions reductions or removals represented by the offsets are real, permanent, and additional). Carbon credits should only be awarded to 174 STEP 8: CONSIDER THE USE OF OFFSETS activities that are driven by the incentive provided by most crediting mechanisms to date have been designed the crediting mechanism, that is, if they demonstrate to operate, each carbon credit represents an emissions additionality. If an actor would undertake an activity even in reduction equivalent to exactly one allowance.277 Covered the absence of the crediting mechanism, the activity is not sources can purchase these carbon credits and increase additional and the emissions reductions or removals should their emissions by 10 MtCO2e (i.e., to 110 MtCO2e). Total not be recognized by the crediting mechanism. emissions of the covered and uncovered sources remain unchanged through the use of offsets, but overall costs Offsets may be sourced domestically from uncovered fall if the abatement costs of sources under the crediting sectors,276 or from outside the jurisdiction. Offset mechanism are lower than the abatement costs of sources generation may be governed by the same authorities as covered by the ETS. the ETS, or by a regulator outside the ETS jurisdiction or a third-party private operator. The options for the geographic scope of offsetting activities, and the governance of the Table 8-1 A simple illustration of offsetting in an ETS offset program, are discussed further in Section 8.3. No offsets With offsets Table 8-1 provides a simplified illustration of how an ETS with access to offsets operates. It considers the case Sources Before After (MtCO2e) trading trading where the carbon credits are generated by entities in (MtCO2e) (MtCO2e) the same jurisdiction, and the crediting mechanism is governed by a domestic regulator. Without offsets, entities Covered emissions 100 100 110 covered by an ETS cap can emit 100 megatons of carbon 10 Uncovered dioxide equivalent (MtCO2e). The regulator has created a 200 emissions (before offset 20 10 crediting mechanism in which uncovered sources (which within crediting program there currently emit about 20 MtCO2e) can obtain carbon credits mechanism is no distinction for emission reductions. Sources under the crediting between these Other uncovered categories) 180 180 mechanism choose to implement practices to reduce their emissions emissions by half and sell these reductions totaling 10 Total emissions 300 300 300 MtCO2e to covered sources. In this example, typical of how 8.2 USING OFFSETS: ADVANTAGES AND CHALLENGES 8.2.1 ADVANTAGES uncovered sectors to “opt in” to emissions reduction There may be several advantages to using offsets: activities. By lowering compliance costs and creating a new, supportive political constituency for the ETS in S Broadening the carbon price signal to uncovered the form of project proponents, allowing offsets may sectors. Crediting mechanisms provide an avenue OFFSETS make an ETS more attractive to the private sector. This STEP 8 to generate abatement incentives in sectors that are may in turn allow policymakers to set a more ambitious difficult to include in the scope of the ETS for technical, cap and also may support policy stability. It could also political, or other reasons. This increases the economic provide incentives for investing in negative emissions efficiency of the ETS by expanding the set of mitigation technologies, as discussed in Box 8-2. Finally, crediting opportunities available.278 Crediting mechanisms also mechanisms may build capacity in uncovered sectors, support investment flows into those sectors, and allow making it easier to eventually include them within the entities with the required capacity and willingness in scope of the ETS. 276 In theory it would be possible to have covered sectors (but uncovered sources within those sectors, e.g. from facilities/installations under the participation threshold) generating offsets. This, however, is not implemented in any system and is likely to exacerbate the competitive distortions. 277 Some parties, however, including France, decided to deliver only 90 percent of the emissions reductions achieved in their territories as carbon credits to the project participants, creating a net benefit for the compliance of the host party with its international commitments. 278 The US Environmental Protection Agency’s economic analysis of the national cap and trade proposal in the US Senate in 2010 provides a case in point. It estimated that including domestic and international offsets (mostly from forestry and agriculture mitigation) would cut allowance prices by more than 50 percent and have a larger effect on compliance costs than the deployment of key technologies such as carbon capture and storage or nuclear power. See US Environmental Protection Agency, Office of Atmospheric Programs 2010. STEP 8: CONSIDER THE USE OF OFFSETS 175 Box 8-2 Technical note: Negative emissions technologies as offsets In order to meet the Paris Agreement targets, the Intergovernmental Panel on Climate Change’s Special Report on Global Warming of 1.5°C highlights the need for significant action in both reducing global greenhouse gas (GHG) emissions and removing GHGs from the atmosphere. Such removals take place through technologies and practices often referred to as “negative emissions technologies” (NETs). Many of the scenarios considered in the report rely heavily on removals from NETs, particularly in the second half of the twenty-first century. Despite this, NETs, especially those that involve deployment of emerging technologies, have scarcely been discussed in the context of emissions trading. The common and distinguishing feature of NETs is that they remove GHGs that are already in the atmosphere due to past emissions. In other words, they reduce the GHG concentration in the atmosphere. This is in contrast to most traditional emissions reduction credits used as offsets, which stop emissions that would have otherwise occurred, preventing a rise in the GHG concentration. Most prominent NETs focus on carbon dioxide (CO2) and cover a wide spectrum of techniques including reforestation and other agriculture, forestry, and other land use (AFOLU) practices; bioenergy with carbon capture and storage (BECCS); direct air carbon capture and storage (DACCS); and enhanced weathering, which leverages the natural properties of minerals that consume CO2 when they dissolve by pulverizing and distributing them using industrial infrastructure. The costs of removing CO2 from the atmosphere using NETs also vary widely. Typically, forestation practices are on the lower end of the spectrum with costs lower than allowance prices observed in many existing ETSs in 2019, while the costs of some enhanced weathering techniques are about double the highest allowance prices in 2019. At the higher end of the range are BECCS and DACCS, which are still emerging technologies and remove CO2 at a cost many times the highest allowance prices ever observed.279 Many of the advantages and challenges associated with negative-emission AFOLU practices as offsets are similar to those identified in Sections 2.1 and 2.2, not least because several existing offset programs are built around AFOLU practices. The higher cost of technology- and capital-intensive BECCS, DACCS, enhanced weathering, and other techniques implies that they cannot currently help with cost containment but also will not put downward pressure on prices. Therefore, the recognition of these NETs as legitimate offset generators could be viewed as an R&D subsidy mediated through emissions trading, which may support the NETs’ development and upscaling. This in turn can provide cost containment services in the second half of the twenty-first century when residual emissions with extremely high marginal abatement costs need to be compensated for (in addition to the large-scale removal of GHGs from the atmosphere required for achieving the Paris Agreement targets).280 That said, as with conventional offset programs, policymakers may require assurance on quality and permanence of removals by NETs and consider placing quantity limits on NETs to ensure co-benefits from emissions abatement are not compromised. S Ability to target specific policy goals. Crediting domestic sectors not currently covered by the ETS mechanisms can target specific economic, social, and international jurisdictions. It can lead to innovation and environmental co-benefits, including increased and learning about carbon pricing instruments, and air quality, restoration of degraded land, poverty pave the way for these sectors to be covered by the OFFSETS STEP 8 alleviation, and better watershed management. When ETS. Internationally, this learning process can support this aligns with policy priorities, for instance in relation the adoption of carbon pricing instruments in the host to international cooperation or improving livelihoods countries. More than half of carbon credits generated in rural, agricultural, or forested areas, allowing by the Clean Development Mechanism (CDM) to date offset use in an ETS will be an advantage. While all originate from China — reviews suggest this extensive instruments that incentivize mitigation activities produce experience is likely to have played a role in China’s co-benefits, a crediting mechanism can be design to decision to implement an ETS.281 However, in both cases target specific benefits more easily by focusing on key sectors may resist the change from getting revenue activities or geographical locations. from abatement activities (under an offset scheme) to S Increase capacity for implementing carbon pricing incurring a liability for emitting (under an ETS). instruments. A crediting mechanism can engage both 279 Fuss et al. 2018. 280 Dietz et al. 2018. 281 CDM Policy Dialogue 2012. 176 STEP 8: CONSIDER THE USE OF OFFSETS 8.2.2 CHALLENGES AND OPTIONS increase production to generate more carbon credits, TO ADDRESS THEM resulting in a net increase in emissions compared to the counterfactual without the crediting incentive. In There are several potential challenges that must be another scenario, activities reducing the harvest of addressed when considering the use of offsets. These timber from forests could incentivize the use of more can be grouped into two broad categories: environmental emissions-intensive products such as steel in buildings. integrity and governance. S Environmental integrity of climate commitments. Environmental integrity Carbon credits generated outside the jurisdiction of an ETS bear the risk of being counted against both the Ensuring environmental integrity is paramount for crediting host and the buyer jurisdiction’s climate commitments mechanisms to achieve credible emissions reductions. The if thorough and transparent accounting procedures are main challenges to environmental integrity are around: not followed. This puts the environmental integrity of S Establishing additionality. An activity is considered the climate commitments (for example, NDCs) at risk. additional if it would not be implemented in the absence Furthermore, the revenue generated through selling of the crediting mechanism, holding all other factors carbon credits internationally may incentivize the host constant.282 Additionality is an essential element to country to set lax climate commitments, as tightening of ensure carbon credit quality. However, determining the commitments in the host country may reduce their additionality can be challenging as it requires an ability to earn revenue for mitigation activities.285 assessment against a counterfactual (that is, what would have happened in the absence of the crediting However, many of these issues can be addressed by mechanism). The difficulty of the assessment can vary building certain preemptive approaches to addressing across different project types. Good practice is to use these challenges into the design of a crediting mechanism. informed assumptions and ensure there is sufficient This can include: evidence to have a high level of confidence in a S Additionality tests. Crediting mechanisms use a proposed project’s additionality. Crediting mechanisms variety of tests to assess additionality. These include use a range of tests to help determine whether an assessments of whether the activity is required or activity is likely to be additional, as discussed below.283 mandated by other relevant laws, regulations or S Reversals. Some project activities generate carbon requirements; the financial viability of the activity; credits through carbon sequestration or carbon barriers that may prevent the implementation of the capture and storage. However, there is a risk that activity; the market penetration of the activity; and abatement achieved from such activities could later various performance tests (for example, assessing be unintentionally or intentionally reversed and provide whether the activity meets emissions benchmarks only temporary (“nonpermanent”) climate benefits. For or leads to lower emissions than well-established instance, a forest planted to sequester carbon may technologies). Additionality tests may be applied to be harvested prematurely or burned down and not individual activities (such as through eligibility criteria) or replanted, releasing the credited carbon. Similarly, a at the program level, such as automatically classifying field that has been converted to no-till cropping may types of activities, practices, or technologies as be turned back into conventional tillage, releasing soil additional (for example “positive lists”); or conversely carbon. excluding certain project types deemed unlikely to be S Carbon leakage. Crediting mechanisms can additional. In practice, crediting mechanisms typically use a combination of tests to provide a robust method OFFSETS generate carbon leakage through shifting activities STEP 8 or through market leakage.284 Shifting activities may for assessing additionality. The different types of occur, for example, in avoided deforestation and additionality tests are described further in the PMR’s forest degradation projects: paying to protect one A Guide to Developing Domestic Carbon Crediting part of a forest does not necessarily protect other Mechanisms. areas, and may result in deforestation shifting to S Conservative baselines. Crediting mechanisms unprotected areas. Market leakage may occur if the require each project to establish a baseline scenario. crediting mechanism skews market dynamics toward This is important because baseline scenario emissions a higher emissions outcome — for instance, if an are compared to project emissions (that is, emissions entity that is selling carbon credits has an incentive to from the project activity once the project has been 282 Gillenwater 2008. 283 The new context of the Paris Agreement, where all countries have mitigation targets Nationally Determined Contributions (NDCs), can complicate additionality and other assessments. NDCs, the policies to achieve them, their accounting aspects, and, possibly, the progression of the targets over time, may need to be taken into account in such assessments. 284 Leakage could also occur through investment leakage, where offsetting leads to investment relocations from covered jurisdictions to jurisdictions where the company could benefit from baseline-and-credit mechanisms. However, this will only rarely be plausible. 285 Schneider and La Hoz Theuer 2019. STEP 8: CONSIDER THE USE OF OFFSETS 177 implemented) to quantify abatement. For this reason, atmosphere (for example, if a forest is burned down it is critical that the baseline scenario emissions are and not replanted, or if it is discovered that emissions conservative — baseline scenarios should err towards reduction would have occurred even in absence of the underestimating emissions. Overestimating baseline crediting incentive). scenario emissions would inflate calculated abatement, S Host-country guarantees. This is a guarantee at the undermining environmental integrity. This is the case national level, where the country hosting an emissions even if a crediting mechanism has determined the reduction project guarantees these emissions reductions project activity to be additional. against its own nationwide emissions reduction targets. S Buffers and reserves. A portion of the carbon credits This would ensure that even if there are issues with issued by every project is deposited in a common additionality or reversal, the country hosting the project pool, which acts as a general insurance against the will make good any emissions reductions needed risk of reversal, leakage, or lack of additionality. The through actions to drive additional emissions reductions credits in the buffer pool cannot be traded (at least elsewhere in the economy. This has, however, been for a predetermined amount of time). The amount set difficult to implement and enforce in practice. aside can be based on a project-specific assessment (for example, 10 to 60 percent under the Verified Systems also often establish rules that assign responsibility Carbon Standard), or can be common for all projects.286 to the buyer or the seller in case the safeguards identified Credits in the buffer pool can be used to “cover” for above fail and the credited emissions outcomes are not projects where stored emissions are released into the achieved. This is discussed in detail in Box 8-3. Box 8-3 Technical note: Buyer and seller liability Crediting mechanisms may need to assign liability for achieving the underlying environmental outcome as a final safety net — for instance, in cases of emissions reversals, if the monitoring, reporting, and verification (MRV) process uncovers that, retrospectively, carbon credits have not met the required quality standards, or that there have been acts of fraud. There may be no liability assigned (in which case the environmental outcome suffers) or, in some cases, a legal process may be followed to assign liability. However, crediting mechanisms establish rules that assign responsibility to either the buyer or the seller:287 S With buyer liability, it is the responsibility of the purchaser to take action if issues with the quality of the acquired credits are identified. In this case, regulated entities in possession of invalid carbon credits would have to buy new credits or allowances as a replacement. Buyer liability may be acceptable if there is reason to believe that the buyer is more capable than the seller to manage and insure against associated risks, including through selection of less-risky project types, diversifying offset purchases, or buying third-party insurance. Additionally, in some jurisdictions legal liability can only be assigned to buyers. An example of buyer liability is in California, where rules allow the regulator to invalidate a carbon credit up to eight years after the end of the reporting period and the liability for replacing this offset is placed on the buyer. S With seller liability, project proponents are required to reimburse the regulator in case carbon credits submitted for compliance are later found to fall short of mandatory conditions: for example, in the case of an intentional reversal. If it is not considered appropriate to adopt buyer liability, it can be better for the regulator to impose liability on sellers and seek redress in the event of reversals or where sellers are later found to have OFFSETS STEP 8 violated mandatory standards. This places an additional burden on regulators, however, and can be especially challenging for offsets generated outside the jurisdiction of the ETS, which is why some existing crediting mechanisms favor buyer liability. Seller liability may be preferable if the project proponent can be made a legal participant in the ETS with obligations to monitor and report on their level of carbon storage. However, this may be difficult to enforce, particularly in an international context, and may not be appropriate if sellers are not able to readily pool their risks or otherwise manage their liability.288 Even where buyers are liable for replacing units (i.e., offsets or allowances) in case of invalidation or reversals, buyers can shift liability to sellers on a private contractual basis, with commensurate increases in transaction costs. It is also possible for regulators to create a tiered system of liability where sellers are primarily liable but, ultimately, if the seller’s liability cannot be enforced, buyers become liable.  286 For example, the former Australian Carbon Farming Initiative applied a 5 percent automatic deduction for sequestration activities. The Gold Standard applied a 20 percent deduction. 287 Liability could also be allocated to the third-party validator and/or verifier. 288 See PMR 2015f and Murray et al. 2012. 178 STEP 8: CONSIDER THE USE OF OFFSETS Approaches to managing these liabilities tends to take two main forms: S Commercial insurance. Participants may secure additional private insurance for the environmental integrity risks associated with a project or projects. This could be purchased by either the buyer or the seller, depending on liability. Such insurance could serve in place of a buffer or reserve account or provide additional insurance in the event other mechanisms are insufficient. S Compensatory activities by project developer. The project proponent (in the case of seller liability) compensates for the carbon that is released back into the atmosphere through implementing extra activities; for example, replanting of areas where reversals occurred, or planting new areas. Furthermore, jurisdictions may place qualitative restrictions S Pressure on allowance prices. While the inclusion on the type of offsets that can be used for compliance in of offsets can reduce business compliance costs, it their ETS (see Section 8.4.2). This can be useful for carbon also reduces incentives to cut emissions and to invest credits coming from nondomestic programs, or programs in mitigation technologies in the covered sectors (see not managed by the ETS authority where policymakers Step 6 for a discussion of the problems associated with do not have control over what systemic risk mitigation volatile and low prices).289 In the European Union (EU) approaches are built into the design of the crediting ETS, the availability of low-cost offsets from the CDM mechanism. has contributed to low prices and the accumulation of an excess supply of allowances, which policymakers Governance risks have subsequently sought to reduce to increase scarcity General governance risks include challenges in in the system (see Box 8-4). These impacts on prices establishing or operating a crediting mechanism, or in its can be addressed through the use of price and supply interaction with the ETS. These risks include: adjustment measures (see Step 6) and/or quantitative limits on offset use (see Section 8.4.2). Box 8-4 Case study: International offsets and imported risk Upon establishing their systems in 2005 and 2008, both the EU and New Zealand sought to use the potential of the Kyoto Protocol flexibility mechanisms. The New Zealand ETS (NZ ETS) was initially designed to be nested within the international Kyoto cap and, therefore, operated without a domestic cap, allowing for the unlimited use of international credits for compliance. The system started with a New Zealand Unit (NZU) price around 20 New Zealand dollars (EUR 8.11), but once Certified Emission Reduction (CER) prices began to fall in 2011, the NZU prices also declined dramatically. This resulted in negligible incentives for domestic mitigation. New Zealand regained control of its carbon price only when it announced in 2013 its intention to restrict the use of international Kyoto units, including CERs (qualitative limits on international units from certain project types had applied since 2011). However, this created a divergence of prices between 2013 and 2015, as NZUs (with unlimited banking) became more valuable than international credits (with a sunset date). The result was a range of technical problems related to arbitrage opportunities and stockpiling of NZUs. The NZ ETS subsequently became a domestic- OFFSETS STEP 8 only system as of June 1, 2015. While the low price may have protected the NZ ETS from political pressure, it also shook investor confidence in future carbon prices and public confidence in the system. The EU ETS also allowed the use of CDM and Joint Implementation (JI) credits for compliance but capped offset use through national and EU legislation for the period 2008–2020. In addition, offset eligibility was subject to a number of qualitative restrictions: land use, land-use change, and forestry projects and nuclear activities were excluded, while specific requirements were established for large hydropower projects. As in New Zealand, the availability of a large volume of low-cost units generated under JI and CDM between 2008 and 2012 led to a substantial surrendering of such credits for compliance in the EU ETS. This, along with declining emissions due to the 2008–2009 global economic downturn, contributed to low European Union Allowance prices. As a consequence, during Phase 3 (2013–2020), the EU imposed additional restrictions on offsets and limited  289 See, for example, Szolgayová, Golub, and Fuss 2014; Koch et al. 2016. STEP 8: CONSIDER THE USE OF OFFSETS 179 the use of international credits generated post-2012 to those originating from least developed countries, and excluded industrial gas (hydrofluorocarbon [HFC] and nitrous oxide [N2O] from adipic acid production) projects. Figure 8-1 International offsets and imported risk 30 25 20 EUR/Ton CO2 15 10 5 0 2008 2009 - /2010 - /2011 /2012 /2013 2014 2015 2016 2017 2018 - 2019 Time EUAs NZ Allowance Price in Euros ECX CER Emission Futures, Continuous Contract Note: EUA = EU Allowance; NZ = New Zealand, ECX CER ECX contracts (EUA and CER futures, options, and spot contracts) are standardized exchange-traded CERs (certified emissions reductions). Source: ECX CER Emissions Futures 2019 and OM Financial 2019. The EU does not foresee the use of international credits in Phase 4 of the EU ETS (2021–2030), having committed to a domestic-only overall EU climate target for 2030. New Zealand, on the other hand, has committed to an NDC based on both domestic and international abatement. The NDC is based on relatively limited domestic emission reduction potential and high abatement costs due to an already clean electricity mix and high emissions from land use. New Zealand is considering options for reopening its ETS to high-quality international carbon markets, but has initially set no provision for international credits when auctioning begins in 2021. S High transaction costs. The transactions costs the importance of designing crediting mechanisms to associated with a crediting mechanism may be have low costs, for example by using positive lists or high for both administrators and participants. For preapproved rules for eligibility, making validation and example, project proponents face relatively high MRV verification as administratively simple as possible. costs, while program administrators face a range of S Distributional issues. Crediting mechanisms may OFFSETS STEP 8 implementation costs, such as those associated with give rise to distributional concerns over resource confirming project eligibility (which can be complex and transfers to uncovered sectors, whether domestic or resource intensive), registering projects, accrediting international. As noted above, this transfer of resources auditors, and certifying and issuing credits. The high and of potential co-benefits may align with other policy costs for both regulators and businesses of covering objectives, but it can be a disadvantage in cases smaller and potentially difficult to measure sources are where there is misalignment. This misalignment can be often the reason policymakers elect to not cover these exacerbated if resources are transferred abroad, also sources under an ETS in the first place (see discussion compromising international competitiveness. There are of emissions thresholds and scope considerations for also equity issues where certain sources are included different sectors in Step 3). However, while costs can within an offset program, effectively receiving a subsidy be high, project proponents are able to self-select into for reducing emissions, while other sources covered by the crediting mechanism and will participate only if an ETS incur a cost for emitting. it is cost-effective for them to do so. This means that S Subsidy lock-ins. If an ETS intends to expand its costs are not spread equally across a sector and actors coverage over time, allowing the generation of offsets facing relatively high transaction costs can choose to before sectors are covered could make it more not participate in the offset market. This also highlights 180 STEP 8: CONSIDER THE USE OF OFFSETS difficult to subsequently extend the coverage. That is, without adequate protections forest communities may businesses in these sectors would prefer to receive be adversely affected by policies seeking to comply revenue from abatement activities rather than incur a with reforestation guidelines to generate offset revenue. liability for emitting. If the ETS allows offsets generated Policymakers should require social safeguards to abroad, policymakers should seek to manage seller ensure crediting mechanisms cause no harm. jurisdictions’ expectations around the revenues from offsets. Abrupt changes to the demand for offsets (for One way that jurisdictions have managed these impacts is example, by disallowing them in the ETS) may affect through the imposition of quantitative limits and qualitative host countries negatively. criteria on offset use (see Section 8.4). In addition, costs and supply of offsets may be challenging to anticipate, and S Adverse effects in host countries. If not well when information has been collected, there may be a need designed, crediting mechanisms might also lead to for a review of any quantitative limits. perverse incentives in the host country. For example, 8.3 SOURCING OFFSETS Policymakers must decide on the type of crediting projects based on bilateral agreements (for example, mechanism they wish to include in their ETS. Crediting Japan’s Joint Crediting Mechanism). The choice mechanisms differ across two primary dimensions: the regarding the scope of outside-jurisdiction coverage geographic scope of mitigation activities (Section 8.3.1) will largely depend on how policymakers wish to and the governance of the offset program (Section 8.3.2). balance enhanced cost-effectiveness (which will favor a broad geographic scope) versus attainment of other policy objectives (which may favor a narrower scope 8.3.1 GEOGRAPHIC SCOPE OF OFFSETS to direct the subsequent financial flows toward certain ELIGIBLE FOR ETS USE recipients), taking into account the environmental The geographic scope of offsets eligible for ETS use integrity of carbon credits from a particular location. refers to the permitted location of potential projects or Figure 8-2 illustrates the geographical sources of offsets activities.290 This can include activities: and Figure 8-3 provides examples of the sources of offsets S Within the jurisdiction, comprising emissions used in different ETSs globally. reductions and sequestration activities that occur within sectors not covered by the ETS in the same subnational jurisdiction, country, or supranational entity. Accepting Figure 8-2 Sources for offsets for an ETS offsets only from within the jurisdiction may be preferable if domestic emissions reductions are a key priority and ETS jurisdiction Outside ETS jurisdiction can also ease compliance monitoring and enforcement concerns. Additionally, any co-benefits of mitigation are ETS covered sectors kept within the jurisdiction. In the California Cap-and- Trade Program, for example, for compliance obligations Offsets OFFSETS STEP 8 starting with 2021 emissions, at least half of the offset Eligible sectors usage limit must come from activities that provide direct environmental benefits to the state. S Outside the jurisdiction, comprising emissions Offsets reductions and sequestration activities that take place outside the subnational jurisdiction, country, or supranational entity. Accepting offsets from outside the jurisdiction expands potential sources of supply Eligible sectors and offers more low-cost abatement opportunities. Crediting mechanisms may target a wide range of countries (for example, CDM), certain regions (for example, the Mexico Forestry Protocol within the Climate Action Reserve), or specific sectors and Note: Sectors need to be deemed eligible by the ETS jurisdiction. 290 Note that offsets may be sourced from a crediting mechanism that has a different geographical scope than that allowed within the ETS. ETS policymakers may only allow a subset of carbon credits from external crediting mechanisms by applying different qualitative criteria (described in more detail in Section 4.1). Note: Sectors need to be deemed eligible as a crediting mechanism by the ETS jurisdiction. STEP 8: CONSIDER THE USE OF OFFSETS 181 8.3.2 GOVERNANCE OF OFFSET Figure 8-3 Offset programs around the world PROGRAMS In considering the governance of crediting mechanisms, policymakers first need to decide whether to make use of an externally administered crediting mechanism (such as the CDM and any other future United Nations NOVA SCOTIA5 Framework Convention on Climate Change [UNFCCC] 2 GERMANY SWITZERLAND crediting mechanisms, offsets from other jurisdictions, NO OFFSETS and/or voluntary market programs; see Box 8-5 for details) MASSACHUSETTS EU ETS2 and if so, how and the level of reliance (see “Reliance on externally administered crediting mechanisms” below). NEW ZEALAND3 If policymakers choose to set up a domestic crediting QUÉBEC 1 RGGI mechanism, a host of further decisions will need to be CHINA & Market PILOTS made (described in “Designing a domestic crediting regulation 1 CALIFORNIA DOMESTIC INTERNATIONAL mechanism” below). The rules governing the crediting OFFSETS OFFSETS REPUBLIC mechanism will need to be developed by the relevant OF KOREA4 TOKYO domestic authority (which may or may not be the same as MEXICO the ETS authority) to meet the needs of that jurisdiction. SAITAMA KAZAKHSTAN 1 - California and Québec allow offsets mutually sourced from linked jurisdictions 2 - The Swiss and EU ETS no longer use offsets from 2021 3 - New Zealand may readmit international offsets contingent on access to high integrity sources 4 - Korea allows domestic credits as well as international CDM credits developed by Korean companies 5 - Nova Scotia's cap-and-trade legislation includes provisions for an offset program, however as of 2020 the program is not yet operational Box 8-5 Case study: From Kyoto to Paris – market mechanisms in the international climate regime Under the Kyoto Protocol, actions to reduce emissions by countries with mitigation commitments could be supplemented by three flexibility mechanisms. These were designed to create an interlinked system of tradable units among nations and facilitate the transaction of emissions/mitigation units. The three flexibility mechanisms were: 1. International emissions trading. Countries with mitigation commitments under the Kyoto Protocol could acquire emissions units called Assigned Amount Units from other countries with mitigation commitments under the protocol and use them to meet part of their targets (Article 17 of the Kyoto Protocol). 2. The Clean Development Mechanism. The CDM allows emissions reduction (or emissions removal) projects in developing countries to earn CER credits, each equivalent to one ton of CO2 equivalent. These CERs could be traded and used by countries with mitigation commitments under the Kyoto Protocol to meet part of their obligations under the protocol. The mechanism gives countries with mitigation commitments some OFFSETS flexibility in how they comply with their emissions reduction targets, while stimulating emissions reductions STEP 8 in other countries. The projects qualify through a registration and issuance process designed to ensure real, measurable, and verifiable emissions reductions that are additional to what would have otherwise occurred. The mechanism is overseen by the CDM Executive Board, answerable ultimately to the countries that ratified the Kyoto Protocol (Article 12 of the Kyoto Protocol). 3. Joint Implementation. A country with a mitigation commitment under the Kyoto Protocol could participate in an emissions reduction (or emissions removal) project in any other country with a commitment under the protocol and count the resulting units toward meeting its Kyoto target. This project-based mechanism was similar to the CDM, but only involved parties with commitments under the Kyoto Protocol. The CDM was the first and remains the largest international crediting mechanism. Overall, it has fostered USD 304 billion of investment in GHG-reducing activities in developing countries. Entities regulated under the EU ETS were able to reduce the costs associated with 2 billion tons of emissions reductions by buying CERs to meet their compliance obligations.291  291 UNFCCC 2018. 182 STEP 8: CONSIDER THE USE OF OFFSETS The size, scope, and operation of the CDM have drawn some criticism. In particular, some stakeholders have questioned the environmental integrity of some CDM projects, such as those generating CERs from the destruction of industrial gases like HFCs, which accounted for approximately 70 percent of CERs issued in 2009 and 2010.292 Prices on the CDM market have dropped dramatically in recent years, from over USD 20 per unit before the 2008 recession to USD .25 per unit in November 2019. The price decline was likely driven by a number of factors, including the drop in emissions caused by the 2008–2009 financial and economic crisis and the resulting oversupply of compliance units in the EU ETS (also in the context of a large supply of offsets); Japan and New Zealand declining to participate in the second commitment period of the Kyoto Protocol; and a strong reduction in the allowable use of international offsets in some ETSs, in part also due to environmental integrity concerns. As the world transitions from the Kyoto regime into the Paris regime, the CDM finds itself in a phase of uncertainty, with countries still at odds on whether and how the mechanism should be transited to the Paris Agreement. Countries will begin to implement their NDCs and are in the process of negotiating the rules for the two market mechanisms established under Article 6 of the Paris Agreement. This includes developing guidance for cooperative approaches (Article 6.2) and the modalities for the new centralized mechanism (Article 6.4). In the international negotiations under the Paris Agreement, countries are working to define what elements of CDM governance, rules, projects, and credits will be transitioned into the Paris era through Article 6.4. A key area of contention relates to the so-called carryover of CDM credits generated for emission reductions prior to 2020 toward the post-2020 targets under the Paris Agreement. At the same time, as negotiations under Article 6 remain deadlocked, countries diverge on whether and how the CDM should continue to operate and whether and how its credits could be used under the Paris Agreement. Reliance on externally administered crediting for those looking for a quick and cost-effective way to mechanisms include offsets in their ETS. Externally administered crediting mechanisms are run S Gatekeeping. As with full reliance, but with the by institutions or governments external to the jurisdiction ETS regulator placing qualitative and/or quantitative implementing the ETS. They are often recognized by restrictions on the activities generating carbon credits multiple jurisdictions (for example, a body within an in existing crediting mechanisms that can be used international organization, or a nonprofit organization). The for compliance. This allows for more control over the rules are clearly defined for all participating jurisdictions, quantity and quality of offsets in the ETS but requires and the credits are sourced from multiple sources and sold more capacity on the part of ETS policymakers. This across multiple markets. The Kyoto Protocol’s project- approach is discussed in more detail in Section 8.4. based mechanisms — the CDM and JI — are examples of S Outsourcing. Under this approach, the responsibility international crediting mechanisms (see Box 8-5). Article for certain design elements is “outsourced” to 6.4 of the Paris Agreement introduces a future mechanism existing crediting mechanisms. This could include, for which rules and guidelines have yet to be developed but for example, using methodologies developed by is expected to draw on the example of offset mechanisms other mechanisms, or the accreditation framework for developed to date. validators and verifiers. There is, however, a domestic review and approval of projects. Moreover, domestic OFFSETS STEP 8 There are four main scenarios by which ETSs may draw institutions generally retain responsibility for oversight upon externally administered crediting mechanisms:293 and enforcement, including issuance of credits. This S Full reliance. International crediting mechanisms approach provides policymakers with a higher degree are responsible for credit generation, oversight and of control over the crediting mechanism and more enforcement of process, and review of projects. The transparency on the projects being credited than the ETS policymaker chooses which international crediting gatekeeping option, but correspondingly requires a mechanism to include and oversees retirement of higher level of capacity and financial resources. international carbon credits for ETS compliance. This S Drawing examples and lessons learned (indirect option is the least complex and easiest to implement reliance). Externally administered crediting from the point of view of a policymaker designing an mechanisms provide examples that inform development ETS, but cedes control over crediting mechanism of a domestic crediting mechanisms. Domestic design. It may be suitable for jurisdictions with limited institutions are responsible for developing rules capacity to develop their own crediting mechanism, or 292 Cames et al. 2016. 293 PMR 2015f. STEP 8: CONSIDER THE USE OF OFFSETS 183 and methodologies, issuing credits, oversight and Ultimately, the level of reliance and the specific aspects enforcement, and review of projects (see “Designing a relied upon will be based on a range of factors. Table 8-2 domestic crediting mechanism” below). This is the most summarizes the key aspects policymakers need to involved approach in terms of capacity and financial consider when determining the level of reliance on resources required, but provides the greater control externally administered crediting mechanisms. over the crediting mechanism. Table 8-2 Key considerations for reliance on externally administered crediting mechanisms Consideration Preferred offsetting approach Importance of alignment with domestic A greater need for alignment means that it will be more beneficial to develop domestic priorities crediting mechanisms. Current technical and institutional The greater the concern over domestic capabilities to administer a crediting mechanisms, the capacity more reliance might be placed on externally administered crediting mechanisms . Financial resources available for the Developing a domestic crediting mechanism will be more expensive than alternatives that rely offset program more heavily on externally administered crediting mechanisms. If alignment with international practices is desirable (for example, to help facilitate future Importance of aligning with international export of credits), then there is an increased need for integration with the relevant international practices crediting mechanisms. Importance of building domestic If this a priority, then a domestic crediting mechanisms might be preferred. capability (for example MRV, registry) If low-cost abatement is a priority, it may be preferable to source credits from crediting Importance of cost containment mechanisms that cover a wide range of sectors, activities, and regions. Importance of near-term offset Greater reliance on externally administered crediting mechanisms will likely expedite access to generation offsets, especially if a domestic crediting mechanisms needs to be established. If there is a desire for a strong level of control, then this may suggest the establishment of a Importance of retaining policy control domestic crediting mechanism. Designing a domestic crediting mechanism These issues are discussed briefly below. Additional detail If policymakers decide to create a new, domestic crediting on these and other issues is provided in the PMR’s Guide mechanism, there is a range of further considerations. to Developing Domestic Carbon Crediting Mechanisms. One of the most important is developing the rules and procedures to ensure that the crediting mechanism is only The degree of standardization crediting projects that are delivering genuine and additional Crediting mechanisms can develop methodologies that emissions reductions and removals. These rules and employ either a project-specific approach that relies on procedures also ensure that offsets are consistent with the analysis of an individual project’s characteristics and jurisdiction’s objectives, including its emissions reductions circumstances, or a standardized approach where key targets. They set out detailed policy settings, which can components (additionality and the baseline scenario and OFFSETS STEP 8 include project eligibility, demonstration of additionality, emissions) are uniformly assessed or determined for quantification of GHG emissions, safeguards against specific classes of project activities. Where possible, a environmental or social harm, and project monitoring. standardized approach is preferable because it can reduce These rules are referred to as methodologies.294 transaction costs for project proponents by simplifying project development and auditing. However, standardized The rules can be defined along two dimensions: their approaches can be resource intensive to establish and overall degree of standardization and how methodologies maintain for program administrators and are not suitable are developed — whether they are bottom-up or top-down. for all project types. Also, in order to ensure credibility and Finally, policymakers must also put in place a procedure for environmental integrity standardized approaches must be registering projects and issuing credits. more restrictive and be designed in a more conservative manner. 294 The legal definition of what is covered by a methodology is decided by the specific crediting mechanism. For example, some programs may only consider the setting of baselines and emissions quantification as part of the methodology, and other rules on eligibility, additionality, social safeguards, and so on to be supplementary. 184 STEP 8: CONSIDER THE USE OF OFFSETS Standardized and project-specific approaches are not binary tests (as well as project-specific approaches) but have alternatives — policymakers may incorporate a combination project-specific requirements associated with baseline, within a methodology and/or different methodologies across monitoring, and quantification methods. the crediting mechanism. Existing crediting mechanisms typically use a combination of both. For example, some CDM Table 8-3 lists different elements of methodologies that methodologies employ at least some standardized baseline could be standardized. Elements of methodologies that and quantification assumptions, while still prescribing are commonly standardized include default parameters to project-specific additionality determinations. Conversely, measure emissions reductions and the use of sector-wide methodologies used by programs such as California’s performance standards to assess additionality and set the Compliance Offset Program apply standardized additionality baseline. Table 8-3 Aspects of standardization of methodologies Standardized approach Definition Examples Terms or conditions applied across multiple S “Not mandatory by law” Common criteria methodologies S “Does not generate non-carbon related revenue” (As part of additionality language) Emissions factors, default value, and S Avoided electricity emissions module used across CDM Common methods, estimation methods used to address common methodologies factors, and equations circumstances in a consistent fashion across S Denitrification-Decomposition model used to estimate multiple project types methane emissions from rice cultivation projects Project-specific default Used to calculate baseline/project emissions; S 90 percent N2O destruction as baseline for adipic acid values only applicable to a specific project type JI projects Performance standard: Baseline emissions rate (emissions per unit of S Emissions rate: X tons of CO2 per ton of cement emissions intensity output, input, or throughput) S Average of top 20 percent (often used in CDM) benchmark (Applied to baseline/additionality determination) Market share of current production sales or S Market share: < X percent of current sales Performance standard: cumulative market penetration rate (of existing S Cumulative penetration rate: technology in use at market penetration rate stock) of a technology or practice < X percent of all installations (Applied to additionality determination) Technology-specific list that deems all projects of S Specific project types (for example, agricultural that technology additional methane destruction, solar photovoltaics) might be Positive lists automatically eligible — no additionality assessment required Standardization of requirements for baseline and S Prescription of minimum accuracy of measurement Standardized monitoring project monitoring across project types equipment S Tools for determination of boiler efficiency Source: PMR 2015d. OFFSETS STEP 8 Bottom-up and top-down methodology administrator. Often methodologies will draw on development similar methodologies developed in existing crediting Methodologies can be incorporated from existing crediting mechanisms. Project proponents who want to generate mechanisms (see “Reliance on externally administered carbon credits must comply with the standards set in crediting mechanisms” below) or developed from scratch, the relevant methodology for their project type. via either a top-down or a bottom-up process. Crediting mechanisms can also use a mix of bottom-up S In a bottom-up approach to methodology development, and top-down methods, with both project proponents and third parties (usually project proponents) submit a policymakers actively developing methodologies. There are proposed methodology to a program administrator for also a set of intermediate options that combine elements of approval. If approved, that methodology can then also bottom-up and top-down approaches. Table 8-4 provides be used by other projects that meet the requirements of an overview of the advantages and drawbacks of both the methodology. approaches. S A top-down approach leaves the development of methodologies to policymakers or a program STEP 8: CONSIDER THE USE OF OFFSETS 185 Table 8-4 Bottom-up versus top-down approaches to developing offset methodologies Bottom-up Top-down Typical qualities Crediting mechanism has broader coverage Crediting mechanism has more selective coverage Clean Development Mechanism Clean Development Mechanism Joint Implementation California Compliance Offset Program Verified Carbon Standard Québec Compliance Offset Program Examples Gold Standard Climate Action Reserve Voluntary Program Chinese Certified Emission Reduction Program Alberta Emission Offset System Allows for quick start Provides more certainty to project proponents Pros Once developed, may be used by others Provides policymakers with greater control over Greater consistency in approaches and applications of criteria prioritizing project types and methodological choices Potentially costly for project proponents and administrators Requires more up-front time and public resources to Cons develop Source: Adapted from information in PMR, 2015d. Figure 8-4 The general process for project registration Project registration and credit issuance and credit issuance To complete the process of carbon credit creation, projects must be registered, activities implemented, and Project design the appropriate carbon credit issued. This is known as the (project proponent) project cycle — it sets out the actions a crediting project must undergo from conception to credit issuance to Stakeholder consultation (project proponent) project closure. The decisions on the elements included Project registration in a project cycle involve balancing program rigor against Validation regulatory burden and administrative costs. Figure 8-4 (third-party auditor) depicts the steps involved, providing examples of “full” and “streamlined” project cycles. Dashed lines refer to actions Completeness/consistency check that some, but not all, crediting mechanisms include. As (program administrator) highlighted in Figure 8-4, many crediting mechanisms require a validation step to allow project registration. In Review (program administrator/executive body) most cases projects must undertake regular monitoring and some form of verification and checks by third-party [Preliminary] registration auditors and the program administrator to enable credit (program administrator/executive body) issuance. Once credits are issued, there might also be a process of continued monitoring to identify and address Projects are eligible to generate credits under potential invalidation and any reversals (see Section 8.4). the program they were approved under OFFSETS STEP 8 Monitoring (project proponent) Project implementation and carbon credit issuance Verification (third-party auditor) Review of verification (program administrator/executive body) Approval/rejection of issuance (program administrator/executive body) Credit issuance Note: The colors of the boxes differentiate steps according to the responsible Dashed box borders indicate steps that are skipped by some of the entities.  examined crediting mechanisms. Source: Adapted from PMR 2015d. 186 STEP 8: CONSIDER THE USE OF OFFSETS 8.4 OFFSET CONTROL MEASURES Policymakers may decide to put in place qualitative criteria (for political and environmental sustainability reasons) (Section 8.4.1) or quantitative limits (Section 8.4.2) to and industrial gas destruction (because of additionality mitigate some of the risks involved in using offsets, or the concerns). Further, the EU has not accepted temporary impact of offsets on the operation of the ETS. credits295 issued under the CDM, thereby excluding credits from certain projects for afforestation and reforestation, which the CDM treats as only temporary. Although New 8.4.1 QUALITATIVE CRITERIA Zealand has a domestic program to reward forestry It will generally be preferable to include industries, sectors, sequestration, it also did not accept temporary CERs gases, or activities when they have: based on the argument that it could not control the risk of S mitigation potential (to ensure that the inclusion of reversals outside its borders. offsets has an impact); Qualitative restrictions can also be seen as a positive S MRV capacity (to ensure that emissions reductions can incentive for the types of projects that are accepted. Projects be measured, reported, and verified); that are deemed likely to lead to learning and transformation S low mitigation costs (to promote cost-effectiveness); could be bolstered by becoming eligible offset categories. S low transaction costs (to promote cost-effectiveness); For example, the Shenzhen Pilot ETS targets particular clean energy and transport projects as well as ocean carbon S high likelihood of additionality, permanence, and sequestration. The EU ETS, since 2013, accepts only new absence of leakage (to ensure environmental integrity); projects from least developed countries, as access to S environmental and social co-benefits (to allow these mitigation finance is most restricted there. opportunities to be realized); and S potential to encourage investment in new technologies Some systems have also chosen to use offsets to (so that offsets can provide an appropriate incentive). recognize early action before the ETS is implemented, given the learning benefits and reduced risk of lock-in to To give effect to these considerations, many ETSs require high-emission technologies that such early action provides. the credits they accept to meet certain qualitative criteria. The Chinese pilots accept mitigation credits accruing from These criteria typically reflect assessments of co-benefits the early action that some participants have had with the and distributional implications, as well as additionality, CDM generated under China’s GHG Voluntary Emission leakage, and reversal risk. Both Europe and New Zealand Reduction Program. Other goals included ensuring blocked the use of credits from large hydro projects environmental quality, reducing programmatic compliance costs, and producing co-benefits (see Box 8-6).296 OFFSETS STEP 8 295 Temporary certified emission reductions (tCERs) are units issued under the CDM (Article 12 of the Kyoto Protocol). Unlike CERs, tCERs expire at the end of the commitment period following the one in which they were issued. 296 Margolis, Dudek, and Hove 2015. STEP 8: CONSIDER THE USE OF OFFSETS 187 Box 8-6 Case study: Offset use in the Chinese ETS pilots and China’s national ETS China’s GHG Voluntary Emission Reduction Program was established in 2012 by China’s national climate authority. The emission reductions generated under that program are called China Certified Emission Reductions (CCERs). The program was established mainly for the purpose of providing authoritative information regarding China’s domestic voluntary mitigation market to avoid possible negative consequences caused by the fragmented market and imperfect market information. Rules and procedures of the program are very similar to those of the CDM; a large part of the technical standards used in the program were specifically adapted from those under the CDM. For example, 151 of the approximately 200 currently available methodologies used in the program have been translated directly from the CDM methodologies, with minor revisions when necessary, mainly removing those provisions that are not applicable to China, and the remaining methodologies have been developed and approved specifically for the program, mostly in the forestry sector. Although the program was not developed specifically to serve China’s ETS, it has played an important role in the pilot systems as a cost containment measure and as a mitigation incentive to uncovered sectors. The program also supplies offsets to the Chinese national ETS since its operational launch in 2021. The program is also expected to supply offsets to the forthcoming national ETS. For the national ETS, the limit is 5 percent. In all of China’s seven pilot ETSs, the regulated entities are allowed to use CCERs, besides some local credits which are of much smaller scales, to offset a certain amount of emissions, usually up to 5 percent or 10 percent of the verified emissions or the number of allowances freely allocated to the entity. Besides the quantitative limitation, there are also other restrictions on the use of CCERs toward offsetting purposes, including project types, geographical origination, vintage of credits, and project boundary. In some pilots, CCERs generated from hydropower, industrial gases (HFCs, perfluorocarbons, N2O, and sulfur hexafluoride) mitigation, fossil fuel–based power generation, and heat supply projects are not allowed. With regard to geographical location of the eligible CCER projects, several pilots require that a minimum ratio of the CCERs used for offsetting purposes should come from projects located in their own jurisdiction or jurisdictions that have signed cooperation agreements with them, varying from 50 percent to 100 percent. In terms of credit vintage, some pilots require that the underlying emission reductions have happened after a certain time point, for example, 2013, when most of the pilots started their operation. In order to avoid double counting, none of the pilots allows the use of CCERs generated within the boundary of covered installations. For the national ETS, CCERs from projects in renewable energy, carbon sinks, methane utilization, and others will be admissible; details were still pending at the time of writing. The International Civil Aviation Organization Council recently unconditionally accepted the CCER program to supply the pilot phase of the global aviation offset system Carbon Offsetting and Reduction Scheme for International Aviation. 8.4.2 QUANTITATIVE LIMITS The most straightforward and commonly used quantitative Policymakers generally limit the use of offsets in an ETS to limit is to restrict the share of entities’ compliance meet particular policy goals. For example, quantitative limits obligation that can be met with offsets. In the Republic OFFSETS STEP 8 may assist in realizing local mitigation and co-benefits. of Korea, for example, each regulated entity can only While carbon credits used as offsets are equivalent to use offsets to cover up to 10 percent of its compliance allowances for the purpose of compliance, they often obligation. In addition to limits on the share of compliance trade at a lower price than allowances when quantitative obligation for regulated entities, the use of international limits are binding. If firms use their full allocation of offsets, offsets was limited to 50 percent of estimated aggregate these units can no longer be used for compliance, which emission reductions in Phases 2 and 3 of the EU ETS. leads demand and prices to fall relative to the price of Saitama also uses a limit relative to emission reductions allowances. Quantitative limits on offsets can also be used and further differentiates limits by entity, allowing factories in conjunction with price or supply adjustment measures to use more offsets for compliance than offices. (see Step 6) as a price management tool. 188 STEP 8: CONSIDER THE USE OF OFFSETS 8.5 QUICK QUIZ Conceptual Questions 1. What are the benefits of allowing offsets into your ETS? 2. What are the potential challenges from including offsets? Application Questions 1. What are the primary motivations for including offsets in your system and how might they affect the type of offsets you accept? 2. Does your jurisdiction want to use existing units or reward early action by sources that will be covered in your ETS? 3. How could your jurisdiction manage the challenges of allowing offsets? 4. Do you have the administrative capability and mitigation potential among uncovered emissions sources to make it worthwhile to create your own offset program? 8.6 RESOURCES The following resources may be useful: S Establishing Scaled-Up Crediting Program Baselines under the Paris Agreement: Issues and Options S A Guide to Greenhouse Gas Benchmarking for Climate Policy Instruments S A Guide to Developing Domestic Carbon Crediting Mechanisms (forthcoming) OFFSETS STEP 8 STEP 9: CONSIDER LINKING 189 Step 9 - Consider linking STEP 9 Consider linking At a Glance____________________________________________________________________________ 190 9.1 Different types of linking___________________________________________________________ 191 9.2 Benefits of linking_________________________________________________________________ 194 9.3 Risks posed by linking____________________________________________________________ 197 9.4 Balancing the advantages and challenges of linking_________________________________ 198 9.5 Alignment of program design______________________________________________________ 200 9.6 Formation and governance of the link______________________________________________ 203 9.7 Quick Quiz_______________________________________________________________________ 210 9.8 Resources_______________________________________________________________________ 210 BOXES Box 9-1 Technical note: Gains from trade via linkage____________________________________ 194 Box 9-2 Case study: EU-Switzerland linkage___________________________________________ 202 Box 9-3 Case study: Linkage between California and Québec based on the design recommendation developed through the WCI__________________________________ 204 Box 9-4 Case study: Australia and the EU: Learning about alignment_____________________ 205 Box 9-5 Technical note: ETS links and accounting under the Paris Agreement_____________ 207 Box 9-6 Case study: De-linking in RGGI and WCI______________________________________ 209 FIGURES Figure 9-1 Types of linkages___________________________________________________________ 192 Figure 9-2 Illustration of gains from trade in a bilateral linkage______________________________ 194 Figure 9-3 Chronology of WCI linkage events____________________________________________ 204 TABLES Table 9-1 Past, present, and future of linkages between ETSs_____________________________ 192 Table 9-2 Benefits and risks of linking__________________________________________________ 198 Table 9-3 Summary of factors to be considered in linking_________________________________ 203 LINKING STEP 9 190 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION AT A GLANCE flows may also be politically challenging for governments Checklist for Step 9: Consider linking to defend. In addition, there is a risk that linking transmits ✔ Identify potential linkage partners shocks from one system to another that otherwise would ✔ Determine the type of link have been restricted to a single jurisdiction’s ETS, with potentially undesirable effects. ✔ Identify the benefits and risks associated with the link To address these potential disadvantages, jurisdictions ✔ Discuss compatibility of key program design should choose linking partners carefully and consider features safeguards, such as restricting the extent to which they link ✔ Form and govern the link or defining conditions under which the link is terminated. These restrictions will reduce the cost-effectiveness of an ETS but may be useful if there is a need to trade off some of Linking occurs when an emissions trading system the advantages of linking with a reduction of potential risks. (ETS) allows regulated entities to use allowances from one or more other systems for compliance purposes. Clearly identifying the objectives of linking can help in the A jurisdiction can consider various types of linkages, search for an appropriate linking partner. Given the close along two dimensions of choice — the direction of flow cooperation required to run a linked market, linking with of allowances and whether there are restrictions placed a partner that the jurisdiction already trusts and has a on allowances from the linked system. Linking can be relationship with may be preferable. In some cases, ETSs bilateral (or multilateral), where all systems recognize the were designed from the outset to link with a larger market allowances of the other system(s), or unilateral, where the or operate as a multi-jurisdictional system. flow of allowances goes in only one direction. Additionally, systems may or may not place qualitative or quantitative When a jurisdiction has identified a potential linking partner restrictions on allowances from the linked system(s). or partners, an in-depth review of the respective systems helps identify the design elements that need to be discussed There are several economic, environmental, political, and possibly aligned. Linking requires clear understanding and administrative benefits to linking. First, it reduces and acceptance of the current and future levels of ambition, aggregate compliance costs: allowing two systems to standards for environmental integrity, strategies for trade allowances increases efficiency in the same way as stabilizing prices, and direction of future ETS policy in trade between two companies. The larger the difference in partnering jurisdictions. Specific design features that require allowance prices between the systems prior to linking, the compatibility include the voluntary or mandatory nature greater the potential for economic gains from trade. Linking of the system, the type of cap, price or supply adjustment also increases market liquidity and depth, promotes price measures (PSAMs), the use and environmental integrity of stability, and can reduce the risk of carbon leakage. Linking offset credits, rules on borrowing and banking allowances, can increase the political momentum for climate action, and the potential for linking with further systems. allowing jurisdictions to demonstrate climate leadership on a global level and build domestic support for mitigation Certain key design features require not strict compatibility, policies. It may also help lock in the ETS, making it more but rather confidence that the linking partner or partners’ politically challenging for subsequent administrations to ETS designs will deliver comparable outcomes. This undo carbon pricing policies or walk back climate ambition. includes the stringency of the cap, the robustness of Finally, the lower aggregate compliance and administrative monitoring, reporting, and verification (MRV) systems, costs resulting from linkage may also help with the political capacity of regulators to manage risks of misconduct in sustainability and durability of an ETS. the secondary market, the administration of registry and tracking allowances, and ability and willingness to enforce LINKING STEP 9 However, for linkages to work, jurisdictions may need to ETS rules. Coordinating on and understanding other design find compromises to make their systems compatible and to elements such as the system’s scope, point of regulation, guarantee the environmental integrity of allowances across allowance allocation methods, or the length of commitment systems. If prices differ significantly between jurisdictions periods may improve the functioning of a link or address prior to linking, their subsequent convergence can be political considerations, but are not strictly necessary. challenging — either because high-price jurisdictions will be concerned that their climate ambition is being Jurisdictions must also consider the timing of the link, the diluted and co-benefits are reduced, or because low-price legal instrument by which to implement it, and institutions jurisdictions will be concerned about the higher prices they and processes for governing the link. Further, arrangements will experience. The associated financial and allowance should include a contingency plan for de-linking. STEP 9: CONSIDER LINKING 191 Section 9.1 explains the different types of linking. the degree of linking. Section 9.5 considers the extent of Sections 9.2 and 9.3 consider the benefits and risks of design and regulatory alignment required by linking. This linking. Section 9.4 examines how jurisdictions might look chapter concludes with a discussion on the formation and to balance these benefits and risks through both their governance of the link in Section 9.6. choice of linking partner and the possibility of limiting 9.1 DIFFERENT TYPES OF LINKING A jurisdiction can consider various types of linkages, acceptance of Certified Emission Reductions (CERs) with two dimensions of choice — the direction of flow of generated under the Clean Development Mechanism (CDM). allowances and the restrictions placed on allowances from the linked systems. Additionally, systems may place qualitative criteria or quantitative limits on allowance flows from the linked The direction of flow of allowances can be system(s). S Unilateral. Under unilateral or one-way linkage, a S Full or unrestricted linkages. Allowances from all system accepts allowances from one or more other systems are mutually recognized and equivalent systems, but not vice versa. One-way linkages may for compliance purposes without any restrictions, represent the starting point for a potential two-way link. effectively creating a unified market. Norway had a one-way link with the European Union S Restricted linkages. Limits are placed on the flow (EU) (where Norwegian entities could buy EU allowances of allowances from the linked system. These may be but not vice versa) as a first step to a two-way link. A quantitative or qualitative, similar to the limits most similar staged accession was planned for the intended ETSs have on the use of offset credits (see Step 8). link between the EU ETS and the Australian ETS. S Bilateral or multilateral. Allowances from one or more While not a formal link, collaboration among systems may markets are eligible for use in the others and vice versa. be an important step along the way to full linkage — or may Linkages may be bilateral or multilateral. An example of be considered desirable in itself. By coordinating on and bilateral linkage is that between California and Québec. promoting alignment of program objectives, enforcement The Regional Greenhouse Gas Initiative (RGGI) launched mechanisms, or other features, systems can share as a multilateral linked system of almost identical ETSs, information and best practices, increase comparability of each enacted at the state level, but operating from the effort, provide political support, reduce competitiveness and beginning as a single, unified system.297 leakage concerns, and simplify administrative procedures for companies operating across the systems. Collaboration Indirect linkages may also be created when two separate can also be an opportunity for an established ETS to share systems (A and B) each link to a common, third system (C). information with a new system, streamlining technical, legal, Although they are not formally linked, activity in system A and administrative burdens and lowering costs while also could then impact the market in system B and vice versa smoothing the potential path toward eventual full linkage.298 through impacts on the allowance price in the common shared partner system, C. Linkages to C could be one- or These interactions between systems are summarized in two-way. An example of this is New Zealand’s ETS, which Figure 9-1, with some examples of linking ventures to date was linked indirectly to the EU ETS through their mutual summarized in Table 9-1. Further details on linking ETSs can be found in the International Carbon Action Partnership’s LINKING (ICAP) Guide to Linking Emissions Trading Systems. STEP 9 297 There is a legal and theoretical difference between a uniform ETS that covers many jurisdictions, and a set of highly aligned but separate, linked ETSs. However, in practice, cases are often on the boundary and difficult to put into one category or another. For example, the EU ETS is a multi-jurisdictional system in which the EU and the Member States have rule-making and executive functions, and in which the implementation across Member States differs in certain details (for example auctioning and revenue use, definition of installation, etc). RGGI is likewise a multi-jurisdictional system in which the jurisdictions set rules and implement them at the collective level (for example Model Rule, RGGI, Inc.) and individually (state legislatures, state administrations), and in which the implementation across states differs in certain details (for example, revenue use). Allowances in both systems are common, not distinct but fungible. They key distinction between the systems is that EU Member States cannot choose to join or opt out, whereas RGGI states can. For the purpose of this document we therefore refer to RGGI as a system of linked ETSs and discuss the EU ETS as a single system. Further discussion of these borderline cases can be found in Mehling 2016. 298 Burtraw et al. 2013. 192 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Figure 9-1 Types of linkages System System Unilateral A Allowance flow B System System Bilateral A Allowance flow B System C Multilateral System System A B Allowance flow Allowance flow Allowance flow System C Indirect System System A B* *The valve illustrates qualitative and/or quantitative restrictions imposed by System B on allowance inflows from System C. This is illustrative and without loss of generality because restrictions can be imposed in any type of linkage and in multiple systems simultaneously. Table 9-1 Past, present, and future of linkages between ETSs Systems involved Main characteristics Key events S Two-way link California and Québec adopt design 2011 —  California and S Separate caps recommendations of Western Climate Initiative (WCI) Québec California and Québec independently adopt regulatory 2013 —  S Similar design features (current) changes to recognize each other’s programs S Joint auction and registry system 2014 — California and Québec programs link S Linked and then de-linked with California and Linking agreement reached between all three 2017 —  California and Québec jurisdictions Québec with S Separate caps Link becomes operational (linkage occurred from 2018 —  Ontario January–June 2018) S Similar design features (past; active only Ontario withdraws from linked market following 2018 —  S Joint auction and registry system during the first election of new provincial government, but new half of 2018) linking agreement remains valid for California and Québec LINKING STEP 9 S Eventual two-way link beginning with one-way Agreement to enter negotiations on eventual two-way 2012 —  link in which Australian entities could use EU link starting 2018 EU and Australia allowances Australia repeals its Carbon Pricing Mechanism 2014 —  (past; planned but S Separate caps (CPM), which ends discussion of possible EU link never took effect) S Some design features were in process of alignment  STEP 9: CONSIDER LINKING 193 Table 9-1 Past, present, and future of linkages between ETSs (continued) Systems involved Main characteristics Key events S Began as a one-way link with Norway accepting 2005 — One-way link starts EU and Norway EU Allowances (2005–2007) and evolved into a Agreement reached on two-way link 2007 —  two-way link (2008–2012) (past; active 2008 — Two-way link starts between 2005 and S Common cap Directive establishing third phase of EU ETS (2013– 2012 —  2012) S Similar design features 2020) incorporated into revised European Economic S Separate auctions and registry systems Area agreement, making Norway part of the EU ETS S Two-way link Negotiations on linking agreement formally begins 2011 —  EU and S Separate caps 2017 — Linking agreement signed Switzerland S Similar design features after Switzerland 2020 — Link enters into force (current) undertook actions to align its ETS with the EU S Separate auctions S Multilateral link among participating states Agreement reached among original seven signatory 2005 —  S Set of participating states evolves over time as states states join/leave Model Rule establishing regulatory framework 2006 —  RGGI published S Common cap (current) Operations begin in 10 states 2009 —  S Similar design features S Joint auctions 2017 — Model Rule for 2021–2030 published S Same registry systems S De-linked and then re-linked with RGGI New Jersey is among the original signatories to RGGI 2005 —  RGGI and New S Common cap 2009 — RGGI operations begin Jersey S Similar design features 2011 — New Jersey exits RGGI under new governor (current) S Joint auctions 2019 — New Jersey passes legislation to rejoin RGGI S Same registry systems 2020 — New Jersey rejoins RGGI S In the process of designing regulation with Executive order by Pennsylvania governor requests 2019 —  intention to link with RGGI from 2022 development of ETS regulation proposal aligned with RGGI and S Common cap RGGI Pennsylvania S Similar design features Pennsylvania proposes first draft ETS regulation 2020 —  (under aligned with RGGI with the aim to link from 2022 consideration) S Joint auctions S Same registry systems S Adopted legislation to link with RGGI from 2021 Virginia proposes ETS regulation aligned with RGGI 2017 —  S Common cap with aim to link by 2020 S Similar design features 2018 — Virginia releases revised and final ETS regulation RGGI and Virginia Virginia adopts ETS regulation incl. RGGI linkage by 2019 —  S Joint auctions (current) 2020; state legislature adopts budget blocking RGGI S Same registry systems linkage Newly elected state legislature adopts ETS legislation 2020 —  including RGGI linkage from 2021 S Two-way link Link is operational immediately at the launch of 2011 —  Tokyo and S Separate caps Saitama’s ETS Saitama S Similar design features (current) S Separate allocation mechanisms and registry system LINKING STEP 9 S Currently finalizing a memorandum of Subset of TCI jurisdictions announce development of 2018 —  understanding (MoU) to establish a multilateral carbon pricing mechanism for transport sector Transportation link among participating states from 2022 Subset of TCI jurisdictions propose draft framework 2019 —  and Climate Initiative (TCI) S Common cap and draft MoU for transport sector ETS (under S Similar design features consideration) S Joint auctions S Same registry systems Note: This table covers only links between ETSs. It does not include links to offset systems, government-level only links (for example under Kyoto), or indirect links among ETSs caused by offset systems (i.e., as existed between the EU ETS and the New Zealand ETS due to prior link to CDM and other Kyoto units). 194 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION 9.2 BENEFITS OF LINKING Linkage can provide economic, political, and administrative Lowering aggregate compliance costs benefits that help support the design objectives of an ETS. Allowing two systems to trade allowances enables This section identifies some of the most important benefits. efficiency gains in a similar way to trade between two companies (as described in Step 1). The system with higher prices overall will be able to buy allowances from the 9.2.1 ECONOMIC BENEFITS system with lower prices, reducing the cost of achieving The economic argument for linking is based on lowering its cap. Net sellers will have to emit less but benefit from compliance costs, increasing market depth and liquidity, the increased revenues from exporting allowances. Thus, improving price predictability, and reducing leakage linkage can reduce costs while keeping total emissions concerns. Each of these benefits is discussed in the unchanged, assuming caps in both systems are robust and subsections below. compliance obligations are enforced (see Box 9-1). Box 9-1 Technical note: Gains from trade via linkage To illustrate the sources of the economic gains from trade via linkage, consider the simple and stylized setup with two identical jurisdictions labeled 1 and 2 in the figure below. These jurisdictions have business as usual emissions of 100 units. Their marginal abatement cost (MAC) curves are represented by blue and green respectively. The emissions from Jurisdiction 2 decline moving from left to right along the horizontal axis and its MAC increases as depicted by the green MAC curve. The emissions from Jurisdiction 1 decline moving from right to left along the horizontal axis with analogous implications for its MAC shown in blue. Suppose each jurisdiction caps emissions at 50 units, issues 50 allowances, and allows domestic regulated entities to trade allowances freely among themselves. Since the jurisdictions are identical, the market-clearing price of these allowances will be the same. This price is denoted P A in the figure where A is for autarky because only domestic firms can trade. In each jurisdiction the total cost of complying with the cap is equal to the blue and green shaded areas. In this setup, if the systems were linked, there would be no allowance trades between jurisdictions. This is because when the prices, and therefore MACs, are equal, there is no incentive to trade between jurisdictions and so no gains from trade via linkage. However, there would be an Figure 9-2 Illustration of gains from trade in a bilateral linkage incentive to trade if there MAC1 MAC΄1 MAC2 is a difference Price Price between the autarky prices in the two P1A jurisdictions. Such a difference A A = Jurisdiction 1’s PL gains from linking would emerge if the MAC curve in B B = Jurisdiction 2’s gains from linking Jurisdiction 1 is given by MACʹ1. LINKING B + C = Total value STEP 9 PA of allowances In this case, C exchanged regulated entities in Jurisdiction 1 place a greater value on the allowances because P1A > P A . 100 50 30 0 Jurisdiction 2 emissions A linkage between 0 50 70 100 Jurisdiction 1 emissions the two systems 20 would incentivize  STEP 9: CONSIDER LINKING 195 trades that transfer 20 allowances from entities in Jurisdiction 2 to those in Jurisdiction 1 at the price of P L where L is for linking. This implies that the abatement effort in Jurisdiction 2 ramps up from 50 to 70 (and its emissions decline to 30) and declines from 50 to 30 (and its emissions increase to 70) in Jurisdiction 1. The region outlined in red and divided into areas A, B, and C provide additional insights regarding this reallocation of abatement effort and helps pin down the gains from trade. The value of the financial transfer from Jurisdiction 1 to Jurisdiction 2 is equal to the area B+C. It is greater than the increase in the total costs of Jurisdiction 2 for increasing its abatement effort, which is given by area C. Therefore, Jurisdiction 2 has a net gain of area B via linkage. The cost savings in Jurisdiction 1 from reducing its abatement effort is given by the area A+B+C but it only pays B+C for the allowances. Therefore, Jurisdiction 1 has a net gain of area A via linkage. In fact, the total cost of meeting the aggregate cap is lower by precisely the sum of individual jurisdictions’ gains from trade via linkage, namely the area A+B. While this clarifies the magnitude of the gains from trade via linkage, the discussion is silent on the source of the gains, that is, the reason for the difference between MAC1 and MACʹ1. The latter curve could be the result of relatively higher cost abatement options being available in Jurisdiction 1. In this case greater effort is required to comply with the cap and the resulting gains from trade via linkage are due to enhanced effort sharing between the jurisdictions. Alternatively, the difference can be interpreted as the difference between the expected (at the time the system is designed) and realized (at the time the system is in operation) MAC curves in Jurisdiction 1. This can be the result of those changes in economic and technological conditions that are difficult to forecast.299 Linkage between ETSs may also be a strategic step toward Improving price predictability a more integrated global carbon market and the resultant Another advantage of linking is that a larger, deeper market cost savings. As a case in point, the European Commission with a variety of participants from different sectors and cites supporting global cooperation through the bottom-up geographies can reduce price volatility, as shocks to any creation of a better functioning and more cost-effective one system are spread across the broader linked network. network of markets as one of the major reasons to consider Larger, more diverse systems will be able to better absorb linkage of its system.300 day-to-day, company-, industry-, or jurisdiction-specific shocks, as it is less likely that all actors in the linked Increasing market depth and liquidity market will be simultaneously hit by the same economic Linkage can improve market function by increasing the shock. This is particularly the case if linking partners have number and diversity of market participants. In turn, this economies that are not closely correlated. will improve market liquidity — how easy it is to buy or sell allowances — and market depth, that is, the number Reducing concerns around leakage and and volume of buy-and-sell orders at each price. This has competitiveness several benefits, including Linkage can help reduce leakage, particularly among close S improving the market’s ability to form prices; trading partners. When two systems link bilaterally without S restricting the potential for market manipulation as a any restrictions, prices will converge. As long as vulnerable result of buyer or seller power; and sectors are covered in both jurisdictions, there should thus be little (carbon price related) incentive for shifts in S encouraging the provision of services by market production/emissions between the linking jurisdictions intermediaries, making market functioning smoother (for (unless they can get other benefits, such as free allocation). example making it easier to trade in a timely and low-cost manner through electronic exchanges, greater access Linking may also ease the concerns of market participants to financial and risk-management instruments such as and other stakeholders around the competitiveness futures and options, and easier negotiation of trades). impacts of an ETS. These concerns, often a political LINKING STEP 9 challenge in the implementation of carbon pricing, will be Similarly, linking provides smaller economies that may reduced if neighboring jurisdictions’ and trade partners’ not have a diversity of emitting sectors, or the required carbon prices are similar, as would be the case with a depth of market players, an opportunity to join a larger linked market where prices converge. market. Examples include Québec’s linkage with California; Switzerland’s linkage with the EU; and where individual US states have created the joint system RGGI. 299 Ranson and Stavins 2016 and Zetterberg 2012 develop these ideas informally and provide a broad overview of linking in practice. Doda and Taschini 2017 and Doda et al. 2019 analyze gains from trade formally in the context of bilateral and multilateral linkages. 300 European Commission 2015c. 19 6 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION 9.2.2 ENVIRONMENTAL BENEFITS While linking can go some way in solidifying commitment to achieving environmental targets set out in the ETS, Linking lowers the cost of mitigation through a deeper, implementing an ETS remains a political decision that can larger market, as well as the cost of operation through still be undone by subsequent governments. For instance, administrative synergies. In theory, these cost savings both Australia and Ontario were unable to retain their could allow policymakers to ratchet ETS ambition further ETSs due to changing governments, despite agreed and or invest in other climate policies, such as support for operational links to the EU ETS and California-Québec research and development of mitigation technology.301 systems, respectively.304 Furthermore, it may be more politically feasible to The lower aggregate costs resulting from linkage may also increase climate ambition as part of a linked system help with the political sustainability of an ETS and hence including multiple members, as compared to an individual create greater confidence in the durability of the system. jurisdiction. For example, each of RGGI’s program reviews These considerations will depend on the particular political (2012 and 2016) has lowered the regional cap, tightening circumstances but, for example, participation in a linked the annual reduction factor in each of the successive market with California appears to have helped build support phases (2.5 percent through to 2020 and around 3 percent for the carbon market in Québec, and this dynamic seems for 2020–2030 respectively).302 to be potentially extending to other states in North America. 9.2.3 POLITICAL AND ADMINISTRATIVE Increasing administrative efficiencies BENEFITS Linkage could bring efficiencies and cost savings from joint market operations. This might be particularly relevant Linking may also offer political benefits such as increasing for subnational jurisdictions, developing countries, or the momentum for climate action and delivering small countries with greater resource constraints. For administrative efficiencies, as discussed in the subsections example, California and Québec conduct joint auctions below. through an auction platform administered by WCI, Inc. (a nonprofit corporation that provides cost-effective Increasing momentum for climate action technical and administrative support to participating Linking provides an opportunity for jurisdictions to member jurisdictions) to reduce program costs and demonstrate climate leadership on a global level and to streamline operations. Nova Scotia, which is operating build domestic support for mitigation policies. For example, an independent carbon market, also relies on WCI, one of the goals of the WCI is to foster greater market Inc. infrastructure for auctioning. The Pacific Alliance development for reducing greenhouse gas (GHG) emissions jurisdictions (Chile, Colombia, Mexico, and Peru) are through regional collaboration, including linkage, of cooperating in a range of areas, including MRV, registries, subnational jurisdictions in the United States and Canada. information platforms, standards, and accreditation, which may simplify future linking of carbon markets. Linkage can Linking may also help lock in the ETS, making it more also simplify ETS operations and administrative procedures politically challenging for subsequent administrations to for multinationals or other companies operating across undo carbon pricing policies or walk back climate ambition. systems if each recognizes the same allowances and uses This was identified as a key driver for the EU and Australia similar reporting procedures. in pursuing linking of the EU ETS with the former Australian ETS.303 LINKING STEP 9 301 See IETA 2019, IETA, University of Maryland, and CPLC 2019, and Piris-Cabezas et al. 2019 for a discussion on how global markets could enhance environmental ambition. 302 ICAP 2018a. 303 Evans and Wu 2019. 304 Both these systems were relatively new, and it can be argued that the agreements would have been harder to pull out of had the systems had time to produce environmental results and raise revenues. STEP 9: CONSIDER LINKING 197 9.3 RISKS POSED BY LINKING While the discussion above highlights some of the key The potential for asymmetric market oversight may also be benefits of linking, this section discusses the economic, a major concern from the perspective of financial regulators, environmental, and political risks that stem from linking. especially in cases where the respective regulations and institutions of a linking partner are considered significantly less robust than the domestic context. The secondary 9.3.1 ECONOMIC AND ENVIRONMENTAL market for emissions allowances operates as part of a RISKS complex financial system, and can be subject to various The economic and environmental risks from linking include types of misconduct, which may have impacts across challenges from price convergence, the potential for borders in the context of linked ETSs. Misconduct can importing shocks or misconduct from linked jurisdictions, undermine the efficiency and integrity of an ETS and create and the potential for resource transfers to incentivize operational challenges, for instance through the suspension low environmental ambition, as discussed in the three of registry operations. Therefore, robust financial market subsections below. regulation and established processes for cooperation between relevant regulators is needed to reduce these risks. Challenges from price convergence Potential for resource transfers to incentivize low Full linking converges prices between the linked systems, environmental ambition with the higher mitigation cost/higher allowance price jurisdiction seeing a decrease in price, and the system Financial flows from high-cost to low-cost systems may with the lower mitigation cost/lower allowance price seeing incentivize jurisdictions that expect to be net sellers to set an increase in price. Although this reflects the gains from looser caps (or baselines in the case of crediting systems) in trade generated by linking, it can also cause challenges. order to sell more allowances internationally. Some buying jurisdictions could be tempted to support this so they For jurisdictions in which linking leads to a significantly would be able to purchase low-cost allowances and/or may lower carbon price, linking may undermine the incentive to not tighten their caps in light of available cost savings.305 reduce emissions. The fall in carbon price could depress Conditioning the choice of linkage partners on a willingness incentives for domestic innovation; the deployment of to take on acceptable levels of program ambition, as newer, low-carbon technologies; and the delivery of discussed in Section 9.4 below, is thus an important way co-benefits associated with domestic emissions reductions for both systems to take advantage of potential gains from (see Step 1). Indeed, such concerns have been one of the linkage while guarding against perverse incentives. main reasons for limiting the number of international offsets that can be used for domestic compliance purposes. The new, lower price will also lead to a reduction in revenues 9.3.2 POLITICAL RISKS raised by the ETS; this is discussed further in the section The political risks from linking include concerns around below, “Concerns around distributional impacts.” Linking distributional impacts, the risk of transfers of resources partners may wish to consider the implementation of price and co-benefits abroad, and the potential loss of domestic and supply adjustment measures (such as price floors) control over decisions on ETS design, as described in the to stop prices from falling too low (see Section 9.6 in this subsections below. chapter and Step 6). Concerns around distributional impacts Risk of shocks or misconduct being imported from The increase in price in the previously lower-cost linked jurisdiction(s) jurisdiction may create political challenges for the ETS While linking can improve price stability, it also means as there may be large distributional and competitiveness that shocks from one system may be imported into any LINKING implications for individuals and companies; for instance, STEP 9 system with which it is linked, leading to the possibility of in low-income households due to rising energy costs. A a dramatic move in price due to external factors. Shocks related distributional challenge is that auction revenues originating in one system — such as boom-and-bust in high-cost/high-revenue jurisdictions will fall, potentially cycles or ETS policy changes — will likely affect all the jeopardizing domestic initiatives funded through those linked systems. Smaller systems are particularly vulnerable revenues. These may need to be addressed with additional to such “imported risk,” as the impact of activities in the policy measures including identifying other sources of larger, linked system will be relatively more significant. funding for the initiatives. 305 Green, Sterner, and Wagner 2014. 198 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Concerns around transfers of resources and Loss of domestic control over decisions on ETS co-benefits abroad design If the financial and allowance flows across linking While an ETS is developed in light of national jurisdictions are significant, this could also cause political circumstances, linking requires partners to coordinate on challenges. In particular, the recipients of the financial ETS design features to ensure compatibility, especially flows will be those in jurisdictions with lower costs/prices; in cases where a full link is being established. Each party in cases where these low costs/prices are the result of participating in the link will need to be satisfied with the lower policy ambition, this could be seen as rewarding environmental integrity of the allowances used in the other low-ambition jurisdictions or “outsourcing” of emissions system, as after linking these allowances could be used reductions overseas. across all linked systems. Jurisdictions may be reluctant to revise ETS design elements to increase compatibility at As emissions reduction shifts from the high-cost the expense of domestic circumstances. This is explored in jurisdiction to the low-cost jurisdiction, the location- greater detail in Section 9.5. specific co-benefits of these abatement actions will also shift to the lower-cost jurisdiction. This may be The discussion above highlights a series of benefits and challenging for policymakers to accept, especially in cases risks associated with (different forms of) linking. These are where co-benefits like reductions in air pollution and job summarized in Table 9-2. generation are important carbon pricing objectives. Table 9-2 Benefits and risks of linking Benefits Risks Lowers aggregate compliance costs across systems + Can increase domestic emissions and reduce - + Increases market liquidity and depth environmental and social co-benefits Can reduce leakage and competitiveness concerns + Can attract external resources for reducing emissions + Economic Can promote price stability, although it can also import price volatility from abroad ± Can prompt significant financial transfers ± May create administrative efficiencies: pre-linkage negotiations and possible program modifications can be costly, ± while linked systems may lower administrative costs through pooled resources May strengthen domestic ETS legitimacy and durability + May create domestic political concerns over distributional - through reduced costs and international collaboration impacts and resource transfers abroad + May increase potential for raising ambition Political Can help shape and build momentum on global climate action, but also decreases independent control over program ± design and ambition Can encourage policymakers to adopt a more ambitious + Linking to a system that is not equally robust can - Environmental target given the cost-efficiency gains from linking incentivize weak reduction targets 9.4 BALANCING THE ADVANTAGES AND CHALLENGES OF LINKING LINKING STEP 9 This section discusses three issues that will be important 9.4.1 CHOOSING LINKING PARTNERS to policymakers in trying to maximize the advantages While the primary goal when choosing a linking partner of linking while minimizing the effects of challenges it is to ensure environmental integrity is maintained and presents. Specifically, Section 9.4.1 discusses the choice environmental ambition is increased, jurisdictions need to of linking partner and Section 9.4.2 discusses the options manage a tension between for qualitative and quantitative limits on linking. S linkingwith jurisdictions with similar economic characteristics (which will often be geographically STEP 9: CONSIDER LINKING 199 proximate), something that may be politically and political considerations including the prestige associated institutionally easier; and with leading on climate action and exerting influence on the S linkingwith jurisdictions that have very different direction of global policy may also play a role. economic characteristics, which may be more Some institutional factors can also facilitate linking economically advantageous. between two jurisdictions. These include shared cultural How jurisdictions choose to trade off this tension will factors like language and norms, which may ease depend, in part, on the objectives they have for linking. communication; close geographic ties, which enable strong political and business links; and compatibility of On the one hand, economic similarities and geographic institutional frameworks of existing ETSs (see Section 9.5 proximity often imply close political and trade ties. These for more detail).308 Figure 9-3 summarizes both the factors will provide preexisting working relationships that may that drive linking and characteristics that facilitate the facilitate a link, including agreement on acceptable levels process. The examples of linkage through the EU ETS, of program ambition.306 Linking between trade partners will Regional Greenhouse Gas Initiative (RGGI), California- also be more effective in addressing leakage concerns. Québec, and the Tokyo-Saitama link suggest that most jurisdictions have linked with systems where there is some On the other hand, if the economic attributes of a degree of geographic proximity, existing economic and prospective linking partner are different, and this is reflected political ties, and relatively similar environmental ambition in an abatement cost differential, then the opportunity as well as economic and abatement cost profiles.309 to realize gains from trade and achieve lower aggregate compliance costs will be greater (see Section 9.2.1).307 Such differences are more likely to prevail between developed 9.4.2 RESTRICTIONS and developing country systems, between systems that are A further way to manage the benefits and risks of linking subject to different shocks at different times, or between is to consider restricted linking as either an initial or more economies that have different sectoral structures and hence permanent option. This will be less cost-effective than have different abatement opportunities. unrestricted linking but may be useful if there is a need to trade off some of the advantages of linking against some This suggests that the choice of linking partners depends of the risks, especially around the desire to preserve on how much weight jurisdictions place on different incentives for domestic emission reductions. It may also benefits and risks. If the primary purpose of linking is make de-linking easier if conditions change and the linkage to increase market liquidity and depth, and if there is is no longer beneficial. also a concern about the accompanying effects of price convergence, then linking with economically similar (and Quotas or quantitative limits can be applied, limiting the geographically proximate) jurisdictions may be preferred. If use of external allowances to a certain percentage of an the focus is more on lowering aggregate compliance costs entity’s compliance obligation, or to a certain system-wide or addressing leakage risk, then dissimilar linking partners aggregate number of allowances per year, which can then may be preferred. be applied as an entity-level percentage limit. While they would have featured in the proposed Australia-EU link, Supporting greater climate ambition through regional and quotas have not been applied to date in the context of international cooperation is often the underlying rationale linking across ETSs, although they have often been included for linking, with jurisdictions looking to ensure that linking in links to offset programs, such as the CDM (see Step 8). partners take on a fair share of mitigation effort. Domestic political considerations can also play an important role One-way linking, as described in Section 9.1, can also be in the decision to link. For instance, reducing the (real or used to manage risks and requires less coordination than perceived) cost of climate policy or risks of carbon leakage full linking. Asymmetrically trading allowances through may be a key driver for linking. Further linking may be used trading ratios or exchange rates has also been proposed in to try to cement carbon pricing policies and prevent future the past, but these options are currently not being used in LINKING STEP 9 governments from rolling back on ambition. International any jurisdiction.310 306 This can be seen in the linkages of Norway, Lichtenstein, and Iceland with the EU under the European Economic Area; the link of Tokyo and Saitama subnational governments in Japan; and the linkage of California and Québec (and the announced planned link of Ontario) under the Western Climate Initiative. 307 Doda and Taschini 2017. 308 Evans and Wu 2019. 309 Ranson and Stavins 2015. 310 Trading ratios implement a conversion factor that dictates the quantity of foreign units or offsets that must be surrendered to replace one domestic allowance. Exchange rates are a special case of trading ratios that operate symmetrically, akin to an exchange rate for currencies. See Schneider et al. 2017 and Quemin and de Perthuis 2019 for details. 200 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION 9.5 ALIGNMENT OF PROGRAM DESIGN One of the key aspects of linking is that it requires a degree over the other. On the other hand, some differences in of compatibility between different systems in order to design may incentivize a higher level of mitigation. ensure equivalent environmental integrity of allowances and a well-functioning emissions market. Systems may already be compatible or may require adjustments to 9.5.1 DESIGN FEATURES REQUIRING design features in one or more systems. Where systems COMPATIBILITY are being designed with potential future linking in mind, Mutual trust between systems is a precondition for conversations around compatibility of design should be successful linking. Without this overarching confidence had as early as possible. This section provides guidance in each other’s design and governance processes, it is on identifying the design features where alignment is difficult to enter into discussions on specific questions needed to enable successful linking. regarding system compatibility. Aligning design features does not mean that they need to Policymakers must assess the compatibility of key ETS be identical across systems. In fact, design features fall design features, particularly those relating to the ambition along a spectrum of alignment. Some elements require and environmental integrity of emissions reductions. a high degree of compatibility to make linkage work Incompatibility on these features leads to significant (Section 9.5.1), others require only that design features challenges and, potentially, failure to successfully establish result in comparable outcomes (Section 9.5.2), and or maintain a link. finally, some would benefit from coordination and mutual understanding, but do not strictly need it (Section 9.5.3). There are six key design elements that need to be However, while the alignment of some design elements is compatible to enable linking. In addition to these features, optional in principle, alignment may be necessary politically communication regarding future changes to ETS policy and or because linking will lead to the effective transmission of ambition is also essential. Once linked, a clear process for design features across the linked system.311 policy changes should be established, and expectations on communication defined early in the process of linking. While this section provides a generalized hierarchy of S Participation. Bilateral or multilateral linking requires importance for compatibility, each linking arrangement is systems to align on whether participation is voluntary unique and will require policymakers to make decisions or mandatory, without which linking is not viable. on the relative importance of the ETS design features For example, Switzerland redesigned its ETS from a based on their jurisdictional circumstances. ICAP’s Guide voluntary opt-in system to a mandatory ETS as part to Linking Emissions Trading Systems provides a more of preparations to link with the EU. A voluntary system detailed analysis of the implications of a lack of alignment might, however, seek a one-way link where it is able to of each design feature on three factors:312 buy allowances. S System robustness. Linking partners must be certain S Cap type. Linking a system with an absolute cap with a that the combined market is robust enough to deliver system with an intensity-based cap (indexed to output the emissions reductions necessary and to comply with or gross domestic product, for example) is theoretically the combined cap. possible, but practically very challenging. Intensity- S Environmental ambition. Linking partners should be based targets are often perceived as less stringent than confident their partner’s ETS will drive a certain level of absolute caps (though this technically depends on relative mitigation. As the environmental ambition of the system economic growth rates). This may lead to challenges in is largely determined by the cap, the stringency of that reaching agreement over whether the ambition in the cap and the reduction pathway it sets out will be critical two systems is sufficiently similar which, as discussed in factors for consideration. Section 4.1, can often hold back linking.313 LINKING STEP 9 S Possible side effects. This includes any additional S PSAMs. Full bilateral or multilateral linking effectively positive or negative effects of differences between provides all market actors with access to the most linking systems. For example, differences in design may economically favorable price anywhere within the give rise to competitiveness or fairness issues if one system, affecting the efficacy of PSAMs. For example, system is perceived to confer a competitive advantage a price floor in one system will no longer be effective if there are enough allowances below that price in the other 311 See Kachi et al. 2015. 312 ICAP 2018a. 313 PMR 2014a. STEP 9: CONSIDER LINKING 201 system. Similarly, a hard price ceiling in one jurisdiction regard to achieving comparable levels of ambition and could compromise the cap for both jurisdictions.314 In environmental integrity. It is essential to understand a general, when a small ETS links with a much larger ETS, linking partner’s process for cap setting and to have PSAMs in the smaller system will become ineffective as trust in its system’s environmental integrity when this the larger ETS will dominate. ETSs of similar size may be differs across systems. While there may be greater able to maintain independent PSAMs, but alignment is gains from trade when there are differing degrees preferable to avoid these measures operating in contrary of ambition, there are likely to be significant political directions or driving large flows of funds. Careful difficulties from extensive asymmetries. management of these interactions is therefore needed to S Robustness of MRV systems. Confidence in the avoid perverse outcomes.315 robustness of the linking partners MRV systems S Offsets. The robustness of rules for offsets dictates is critical to ensuring comparability in terms of the the quality of allowances in the system and must be environmental integrity of allowances. aligned to ensure environmental integrity. While different S Stringency of enforcement. If systems are not able offset types need not be an intrinsic problem (and to effectively enforce regulation at a comparable level could potentially even improve cost-effectiveness and (due to lack of ability or willingness, or due to wholly liquidity), understanding a potential linking partner’s different legal enforcement structures), environmental rules on quality is important. As for quantitative limits on integrity in all linked systems will suffer. Penalties for offset use, alignment will benefit market functioning as noncompliance should also be comparable; otherwise, offset limits in one system can be undermined by more noncompliance will happen mainly in the system with lenient limits in the other system. less-stringent penalties. S Borrowing and banking. If one system allows S Registry and tracking. While systems can be borrowing to a greater degree than the other, and if theoretically linked without a direct registry connection, prices rise upon linking, entities in the former system having comparable registry systems can greatly may be incentivized to borrow more. They could then facilitate the creation of a linked market. The proposed sell those borrowed allowances (or the present-day link between Australia and the EU raised issues that vintage allowances they replace) to the second system, other jurisdictions will have to address when linking even though entities in that system may not borrow registries, for instance identifying protocols for approving for themselves. Most jurisdictions in a linked system transactions across registries and ensuring sufficient therefore allow banking but highly restrict borrowing. protections for the security of transactions and user S Linking with other ETSs. It is essential for partners information. An example of successful linkage between within the linked system to have compatible views registries is the Kyoto Protocol’s International Transaction on if and how the linked system will grow, and what Log (ITL). In order to trade Kyoto Protocol units (such the decision parameters for including another system as CERs) with one another, jurisdictions (and the CDM are. This could include the environmental integrity of registry) must go through the ITL. The ITL verifies the allowances and the overall ambition level of the other trades in real time, checking that national registries ETS, in order to ensure meaningful mitigation outcomes are recording unit holdings correctly and making sure and a consistent policy signal. transactions are in alignment with Kyoto Protocol rules.316 S Financial market regulations. Regulators in jurisdictions considering linking must have confidence 9.5.2 DESIGN FEATURES REQUIRING in the ability of their counterparts to contain and COMPARABLE OUTCOMES minimize risks of market misconduct that can Some design features do not need to be identical or highly undermine the efficiency and perceived integrity of an compatible; instead, ensuring that comparable outcomes ETS. Robust financial market regulation and established are achieved despite differences in design features may processes for cooperation between relevant regulators be sufficient for successful linking. These design features will reduce these risks. It also ensures comparably LINKING STEP 9 will affect the linked system and therefore need to be smooth facilitation and enforcement of trades between considered carefully by policymakers. the systems. Aligning the content and timing of publicly S Stringency of the cap. Linking partners should find the disclosed market-sensitive information can also ensure stringency of others’ cap acceptable, particularly with equal treatment across jurisdictions. 314 These types of dynamics have meant that the design of price and supply adjustment measures have been a focus of linking negotiations in the past. For instance, Australia agreed to remove its price floor as part of negotiations to link its former carbon pricing mechanism with the EU ETS, while California and Québec operate harmonized price and supply adjustment measures implemented through each system’s cost containment measures and joint auctions. 315 This is discussed in detail in Vivid Economics 2020, which lays out a framework to investigate the effects of linking between carbon markets with different design aspects and characteristics. In particular, it assesses the impact of linking ETS with PSAMs to other markets, including offset markets. 316 For more information on the ITL, see the United Nations Framework Convention on Climate Change’s (UFCCC) webpage on the subject (UNFCCC 2014) as well as Wabi et al. 2013, which details the more technical aspects and requirements of the ITL. 202 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION 9.5.3 OTHER DESIGN ELEMENTS S Allocation methods. Different allocation methods THAT WOULD BENEFIT do not affect environmental integrity as long as the cap is fixed. However, they could present political, FROM COORDINATION AND competitiveness, and distributional challenges for UNDERSTANDING linking. If a system with free allocation links with one Other ETS design features do not need to be aligned for that auctions allowances, industries might view their a link to function, but could benefit from coordination. competitors’ free allocations as being unfair. The However, in practice policymakers may prefer a higher EU and Australia identified provisions to preserve degree of coordination than is strictly necessary for competitiveness in sectors subject to carbon leakage efficient market functioning. These design elements include as one of the issues to be negotiated (see Box 9-4). S Scope. Linked systems need not have exactly the same Also, linking can change the distribution of auction scope and, in fact, linking systems that contain different revenues across systems, creating a potential need for sources of emissions reductions can be a key economic agreement on a division of auction proceeds. rationale for linking. On the other hand, linking systems S Phases. Aligning time horizons across systems is not that cover trade-exposed sectors can help address necessary, but may play a role in reaching agreement competition and potential leakage issues. For example, on programs’ ambition, as well as in improving market the European Commission considered expanding the functioning. Asynchronous phases could produce coverage of the Swiss ETS to domestic aviation as uncertainty over the future reduction targets of the essential for its link with the EU ETS in order to address system with the shorter compliance time-horizon. For potential carbon leakage issues (see Box 9-2). example, the linked ETS programs of California and S Point of regulation. Different points of obligation are Québec both currently run through 2030 (see Box 9-3). not necessarily barriers to linking, but they will require S Compliance periods. Equivalent compliance periods careful accounting adjustments. For example, if one for entities could facilitate joint program administration. system regulates emissions at the point of electricity However, different compliance periods are also generation and another system at the point of electricity possible, and could in fact be beneficial, as they may consumption (for example, industrial facilities or improve liquidity. residential buildings), there would need to be accounting adjustments where electricity is traded across the Box 9-2 provides more detail on the discussions between borders of linkage partners in order to ensure coverage the EU and Switzerland surrounding consistency and and avoid double counting of emissions. convergence of the design of their ETSs. Box 9-2 Case study: EU-Switzerland linkage The road to linking the Swiss and EU ETSs has been long, with the process beginning in 2011 after the former launched its ETS in 2008. In fact, the Swiss government signaled its intention to link to the EU ETS before finalizing its own ETS to help build support for the market-based instrument within the Swiss business community. This forward-thinking approach was motivated by the anticipated small size of the Swiss ETS, the importance of the country’s trading relationship with the EU, and the expectation of access to lower-cost allowances from the EU for compliance by Swiss entities.317 Exploratory talks began in 2008, followed by formal mandates to enter negotiations issued by the Swiss Federal Council in December 2009 and the Council of the EU in December 2010. Formal negotiations ran in seven rounds from 2011 to 2016 and covered key elements of regulatory alignment and technical details, including the scope of emissions trading, handling of auctions, and registries. The two parties completed and signed a linking agreement in November 2017. After both sides ratified the agreement and Switzerland finalized the regulatory changes that were necessary to ensure alignment with the EU ETS, the link entered into force in January 2020. LINKING STEP 9 The early intention to link the Swiss and EU systems, combined with years of direct engagement between the two jurisdictions, has aligned the design of the Swiss system broadly with that of the EU. In line with the EU ETS, the link resulted in an expansion of coverage in the Swiss ETS to include aviation and power, albeit nominal in the case of power because Switzerland does not have any fossil fuel–burning installations. The inclusion of aviation in the Swiss ETS has required data collection, setting up of new administrative systems, and overcoming industry opposition. While the Swiss have maintained their quality criteria on offsets, they aligned with the EU in some keys ways, including limiting CERs to those from least developed countries and excluding offsets from land use and forestry.  317 ICAP 2018a. STEP 9: CONSIDER LINKING 203 Some notable differences were not considered essential for full alignment and will continue. For instance, the Swiss are not adopting the EU’s Market Stability Reserve, an instrument that automatically adjusts auction volumes for over- or under-supply of allowances. However, in the Swiss ETS another PSAM is implemented as of January 1, 2020, and will be reviewed for the 2021–2030 period. The two sides will also continue to run separate auctions partly due to legal restrictions, but allowances from both systems will be acceptable for compliance. Table 9-3 presents a summary of factors to be considered those requiring comparable outcomes, and elements regarding linkage, including those requiring compatibility, where coordination and understanding is preferred. Table 9-3 Summary of factors to be considered in linking Requires Requires comparable Coordination and Step compatibility outcomes understanding preferred Greater alignment Less alignment Step 3: Scope Scope of coverage Mandatory versus voluntary participation Point of obligation Step 4: Cap setting Type of the cap Stringency of the cap Compliance period Step 5: Allocations Allocation methods Step 6: Markets PSAMs Financial market regulation Banking and borrowing Step 7: Compliance Enforcement stringency Robustness of MRV Registry operation Step 8: Offsets Use of offsets Step 9: Linking Linking with third parties Step 10: Implement and improve Phases 9.6 FORMATION AND GOVERNANCE OF THE LINK Establishing the required governance arrangements 9.6.1 TIMING OF THE LINK is a crucial step in the linking process. This involves considering the timing of the link (Section 9.6.1), choosing Whether linkage occurs alongside the launch of an ETS or the linking instrument (Section 9.6.2), identifying institutions afterward may depend on several considerations, including LINKING STEP 9 to govern the link (Section 9.6.3), and preparing a S Objectives for linking. In cases where linking is sought contingency plan for de-linking (Section 9.6.4). mainly to provide depth and liquidity, early linking may be desirable to promote the viability of trading within the ETS. By contrast, if linking is pursued to minimize costs, then immediate linkage may not be as critical. Other features like free allowances in the early stages of the ETS will tend to keep costs low to smooth the transition into the system. 204 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION S Possibility of significant change in design features. in a multi-year collaborative process through WCI The history of ETSs, notably the EU ETS, suggests that discussions, and later bilaterally, to develop a various design features tend to evolve in the early years framework to harmonize their respective emissions of the system. This is consistent with the discussion trading programs before formally enacting regulatory in Step 10 regarding pilots. In cases where there is a amendments to link the two programs in 2014 reasonable probability that design features may be (see Box 9-3). By contrast, the proposed EU and subject to change or evolution, it may be better to delay Australia link would have occurred between ETSs a formal link, as it is more challenging to refine the that formed independently, without an initial intent to design of an ETS when it is linked. link; in this case a two-step approach was proposed, S Level of preexisting compatibility. The timing of with a unilateral and then bilateral linkage in order to the link also depends on the extent to which systems provide sufficient time for the negotiation process and are pre-aligned. California and Québec engaged subsequent coordination (see Box 9-4). Box 9-3 Case study: Linkage between California and Québec based on the design recommendation developed through the WCI Both California and Québec have set GHG reduction targets to 2030 that align with a steadily declining cap on emissions, making emissions trading one of the pillars of achieving their climate goals. From an early stage in the development of their respective ETSs, the jurisdictions intended to eventually link their systems. The two systems officially linked on January 1, 2014. Both jurisdictions built their climate policies on the design recommendations of the WCI, a group of US and Canadian states and provinces that worked together to design a cap and trade reference model. However, only Québec and California went ahead with implementing their own system based on that design and linked their markets in 2014.318, 319 Before linking their two programs through their independent regulatory processes, they embarked on a process of regulatory harmonization by systematically comparing their regulations and identifying which provisions needed to Figure 9-3 Chronology of WCI linkage events 2007 2008 2010 WCI is set up by 5 QE, ON, and other states and 2nd WCI states, including CA provinces join; WCI issues 1st recommendations recommendations on regional ETS issued 2014 2013 2012 2011 Official link CA & QE both start Work on administrative CA & QE adopt WCI between CA & operating ETS and sign aspects begins recommendations QE commences linking agreement LINKING STEP 9 2018 2018 2018 2019 ON links with ON withdraws Nova Scotia Nova Scotia CA & QE after 6 months joins WCI launches ETS  318 Purdon et al. 2014. 319 WCI 2015. STEP 9: CONSIDER LINKING 205 be exactly the same (or have the same effect) and which could differ. In the end, the provisions that were completely harmonized included coverage and arrangements for auctions, floor price, an allowance price containment reserve, banking (with enforced holding limits), and multi-year compliance periods. Design features on which they allowed for differences include offset methodologies and recognition of early emissions reductions. After launching its own ETS in 2017, Ontario joined California and Québec in January 2018. The three jurisdictions adopted regulatory provisions recognizing each other’s programs, as well as developing a linking agreement in September 2017 following an extensive history of collaboration, as all three were involved in the WCI at some point. Ontario’s ETS was also designed with the advice and support of California and Québec.320 However, the link lasted only six months: a newly elected provincial government that opposed emissions trading withdrew Ontario abruptly from the joint market in July 2018. California and Québec took firm and immediate action in response and prevented transactions with entities in Ontario. This intervention was successful and prevented market instability. Ontario formally ended its ETS in October 2018 with the passage of the Cap and Trade Cancellation Act of 2018 (Bill 4).321 For more information on Ontario de-linking, refer to Box 10-3. Despite Ontario’s abrupt exit from the linked market, both California and Québec remain open to new linkages. Box 9-4 Case study: Australia and the EU: Learning about alignment In August 2012, Australia and the EU agreed to negotiate and finalize a full two-way link between the EU ETS and the Australian CPM following nearly a year of bilateral discussions. Unlike the systems in California and Québec, the EU and Australia ETS were not designed with an expectation of eventually linking with each other. The Australian Government had designed the CPM with linking envisioned as a potential long-term option, but without identifying a specific system or linking partner. Full linking between two independently designed systems is possible. Once the necessary adjustments have been identified, partners can choose to implement the required changes before fully linking or adopt a multistage approach where design differences are gradually reconciled.322, 323 In the case of the EU and Australia, the latter approach had been chosen: the linking agreement was to be implemented in stages to analyze, negotiate, and implement any changes to either system that would need to occur in order to facilitate full linking. The 2012 announcement had envisioned two stages of future linking and included changes to the Australian CPM that were enacted shortly thereafter: a repeal of the price floor and applying a limit on the use of Kyoto offsets. The first stage entailed a one-way link through which Australian entities would have been able to use EU allowances to cover 50 percent of their compliance starting at the end of Australia’s fixed price period on July 1, 2015. A full bilateral link was planned to commence on July 1, 2018, in the second stage and would have made EU and Australian allowances interchangeable. However, a change in government in Australia following elections in September 2013 led to the repeal of the CPM and, thus, the link with the EU ETS was abandoned. Although evidence from the negotiators involved suggest that substantial design differences were likely to persist between the two systems, the abandonment of the link makes it impossible to gauge them accurately and assess the extent of further changes that may have been negotiated by the jurisdictions.324, 325 9.6.2 CHOOSING THE LINKING allowances. Important questions to consider regarding a INSTRUMENT linking arrangement include LINKING STEP 9 S Should the arrangement be legally binding or not? Bilateral or multilateral linking arrangements may include formal treaties, nonbinding agreements, and MoUs, while S If a linking arrangement is nonbinding, how can each unilateral links may only require action by one government, linking partner find assurance that the other partner will as long as the selling jurisdiction enables the sale of not unilaterally initiate changes that might negatively affect the operation of the link and of the linked ETS? 320 Carmody 2019. 321 Legislative Assembly of Ontario 2018. 322 Burtraw et al. 2013. 323 ICAP 2018a. 324 World Bank 2014. 325 Evans and Wu 2019. 206 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION S How will the arrangement be designed to provide 9.6.3 ESTABLISHING INSTITUTIONS TO sufficient certainty about the link’s longevity? SUPPORT LINKAGE S How will the linked parties continue collaboration? How A well-functioning linkage requires institutions to help will design changes, including revisions to the cap and administer, or in some cases, oversee its governance. This the potential to de-link, be addressed in future? may include a market service provider and a transparent S Which institutions should be established or designated system for design changes, among others.328 by the instrument to govern the link, and which S A single provider for market services and oversight. governance procedures need to be established to California and Québec, and (separately) the RGGI enable a stable and functioning link? states, have set up a not-for-profit entity that provides program administration services. These services The answers to these questions will depend on the include administering an allowance tracking system, particular legal context in the respective linking administering auctions, and contracting for third-party, jurisdictions. To date, only the EU–Switzerland link has independent market monitoring analysis. This creates been formalized via a treaty, although the EU–Australia link administrative efficiencies and reduces costs.329 Joint would have also used that mechanism had linking gone auctions can also help harmonize carbon price across ahead. In the case of California and Québec, the linkage linked markets. became operational through their respective regulations, S A transparent system for ETS design changes and and the jurisdictions also signed a nonbinding agreement. Each partner’s ability to create a binding linking agreement dispute resolution. Coordination on design features was limited by its subnational status. In the United and the future direction of linked systems requires States, treaty-making is solely reserved for the federal a transparent process and a procedure for dispute government and federal law restricts states from entering resolution. This is especially important for linked systems into certain other types of binding agreements with other with nonbinding linking instruments that retain complete jurisdictions. Thus, both California and the RGGI states sovereignty for each participant, such as the link use nonbinding agreements that, when coupled with their between California and Québec. Both these jurisdictions regulatory processes, provide a sufficiently transparent and have regulatory processes that require notice and reliable approach to linkage.326 Subnational jurisdictions opportunity for public comments before changes are not formal parties to the Paris Agreement and may are adopted. They specifically recognize the need to therefore face further limitations or additional procedural continue harmonizing their ETS design and to provide requirements regarding the legal recognition of their adequate notice of any changes.330 RGGI, working with mitigation cooperation.327 a larger collaboration of states, relies on a Model Rule, a set of proposed regulations, that is reviewed every three Regardless of the legal nature of the linking arrangement, years.331 States adopted individual regulations based on the process of developing these arrangements allows the original model rule and can update their regulation as all parties to lay out transparently what they would like the overarching Model Rule changes. to achieve through a collaborative information sharing process. Furthermore, all arrangements should establish Other forms of cooperation are also possible. In the case the framework for the linked market. This includes the of linking between national jurisdictions, respective rules linking objectives, design mechanisms agreed at the and governing institutions are likely to be established current phase of the link, procedures for coordination as through linking treaties. Like trade agreements, these the systems evolve, and Nationally Determined Contribution linking agreements could establish various forms of (NDC) accounting arrangements where applicable. delegation of responsibility or decision-making processes. Further details on governance and management of a linked market, as well as on stakeholder engagement with respect LINKING STEP 9 326 The legal forms of linking arrangements are discussed further in Mehling 2009. 327 For example, even though Québec and California are transferring emission reductions across the Canada-US border through their linked carbon market, they will not be able to authorize internationally transferred mitigation outcomes under Article 6.3 of the Paris Agreement by themselves. Only their national governments can authorize the use of this mitigation toward their own NDCs. However, the jurisdictions have developed their own accounting program for transparently allocating emissions reductions toward their subnational targets. Article 8 of the 2017 linking agreement between California, Québec, and Ontario, which is still in place for the first two jurisdictions, provides for the development and implementation of an accounting mechanism based on transparent and data-driven calculations attributing to each Party its portion of the total GHG emission reductions achieved jointly through the linked cap and trade programs. These emission reductions can be applied to assess progress toward meeting each jurisdiction’s subnational emission reduction target, provided there is no double counting. 328 Further detail on institutional governance can be found in the German Emissions Trading Authority’s guidance on designing institutions to promote linking. It suggests that structures must be put in place to manage routine operation, to handle adjustments to this operation, to manage periodic reviews, and to handle unforeseen or extraordinary developments (Görlach et al. 2015). 329 Kachi et al. 2015. 330 Government of Ontario and Government of Québec 2017. 331 RGGI 2014. STEP 9: CONSIDER LINKING 207 to linking, can be found in the ICAP’s Guide to Linking Rules governing the linked system’s interactions with Emissions Trading Systems. international mechanisms and agreements must also be established. Box 9-5 discusses how linking affects countries’ climate commitments under the Paris Agreement. Box 9-5 Technical note: ETS links and accounting under the Paris Agreement332 Linking ETSs supports the ability of jurisdictions to achieve their aggregate mitigation targets at lowest cost. This affects the emissions balance of the jurisdictions involved: importing allowances from Jurisdiction B into Jurisdiction A allows the regulated entities in Jurisdiction A to emit more. As a result of the link, emissions “shift” between jurisdictions; in our schematic example, emissions from ETS sectors in Jurisdiction A would be higher than the initial ETS cap. When ETSs link internationally, this shift in emissions can affect countries’ progress in achieving their individual NDCs: if the shift in emissions is not accounted toward countries’ (individual) NDCs, linking ETSs could make it more difficult for the importing country (Jurisdiction A) to achieve its NDC. The same may hold for subnational jurisdictions that use ETSs to achieve jurisdictional mitigation goals. Similarly, international transfers among subnational jurisdictions may affect the ability of countries to achieve their NDCs. Jurisdictions could pursue different options to ensure that internationally linked ETSs are appropriately reflected in formulating and accounting for NDCs and other jurisdictional mitigation goals: S They could decide simply not to account for the link; for example, where the shift in emissions from linking is very small in relation to the countries’ total emissions. S Alternatively, countries with a linking agreement or a joint ETS could communicate a single NDC or communicate two targets in their NDC: a common ETS target and separate targets for their non-ETS sectors. S Finally, they could account for linking ETSs under Article 6.2 of the Paris Agreement, by translating the shifts in emissions into internationally transferred mitigation outcomes (ITMOs) and effecting corresponding adjustments in order to avoid double counting. The Paris Agreement outlines general principles for international transfers under Article 6.2, such as sustainable development, environmental integrity, transparency, and robust accounting. At the time of writing, however, countries under the UNFCCC are yet to agree on the rules for the operationalization of Article 6, such as the definition of an ITMO. Consequently, no accounting methods under Article 6.2 exist for calculating ITMOs and effecting corresponding adjustments related to ETS links. Ideally, the number of ITMOs would exactly correspond to the shift in emissions that occurs in each jurisdiction as a result of linking. A key challenge is that the actual shift in emissions cannot be empirically observed: once two systems are linked, it is impossible to determine the counterfactual emissions scenario had the link not occurred. Policymakers from both jurisdictions therefore need to identify and agree on methods to estimate the shift in emissions. Schneider et al. identified four methods to estimate this shift: (a) comparing emissions with caps; (b) net transfers of allowances; (c) surrender of allowances; and (d) combined information on transfer and surrender of allowances.333 Each method yields a different estimate, with different advantages and disadvantages (such as the treatment of allowance holdings). Nevertheless, approaches based on the number of allowances surrendered by the regulated entities seems to be the most robust method. In this case, ITMOs would represent the net result rather than individual movements of ETS allowances.334 LINKING STEP 9 332 This box is based on Schneider et al. 2018. 333 Schneider et al. 2018. 334 Paragraph 77(d)(ii) of the “Modalities, procedures and guidelines for the transparency framework for action and support referred to in Article 13 of the Paris Agreement” (Decision 18/CMA.2) states that corresponding adjustments are to be undertaken “by effecting an addition for internationally transferred mitigation outcomes first-transferred/transferred and a subtraction for internationally transferred mitigation outcomes used/acquired,” which would be compatible with this approach, especially if ETS allowances are not regarded as ITMOs. The suitability of this approach thus depends on the ongoing Article 6 negotiations and how countries choose to apply Article 6 provisions to internationally linked ETSs. 208 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION 9.6.4 PREPARING A CONTINGENCY event. For example, political changes in New Jersey PLAN FOR DE-LINKING led the state to withdraw from RGGI, and similar political changes saw Ontario withdraw from its link There are four issues to consider when structuring a linking with California and Québec (see Box 9-6). Under some agreement, to ensure any potential de-linking in future is circumstances (for example, a temporary enforcement non-disruptive: issue), a temporary suspension of a link, rather than 1. Adjustment of the cap. If one system de-links from a complete de-link, might be desirable. A clear exit the other(s), this will affect prices in all previously linked strategy will make negotiation of the inevitable changes systems. Policymakers may wish to consider in advance to adapt to new conditions easier and will minimize whether such a development would require a change in problems if de-linking is necessary. This is especially the cap or other market features. See Step 10 for more critical for links between jurisdictions that do not have a discussion on responding to evolving circumstances. close history of interaction on other issues. 2. Treatment of allowances from another system. 335 4. Enforcement of de-linking rules and procedures. To protect the environmental integrity of the market, The legal form of the linking arrangement plays a role jurisdictions may need to consider steps to suspend in enforceability. A nonbinding arrangement, such as or revoke linkage, including by limiting transfers of a MoU, relies on mutual trust and good will but lacks instruments in or out, if official action is taken by a legal enforceability. Jurisdictions cannot be compelled system to suspend its ETS or de-link. If allowances to follow procedures laid out to ensure an orderly exit. from another system can be identified as such and By contrast, linkage based on a treaty agreement are no longer valid after de-linking, any speculation would be considered binding law and can generate about de-linkage will cause prices of allowances in the more accountability. A binding agreement reduces linked systems to diverge. The cheaper allowances will the likelihood of jurisdictions violating the de-linking be used as much as possible before de-linking and conditions and process laid out in the treaty. It also valuable allowances will be banked.336 opens the door for judicial action in case of violation 3. Process for de-linking. De-linking may occur due to (such as sanctions or compensation claims). a buildup of issues over time or a sudden (political) LINKING STEP 9 335 See Comendant and Taschini 2016, which includes a discussion of how to deal with such “contaminated” allowances. 336 See Pizer and Yates 2015 for an analysis of the impact of different treatments of banked allowances under de-linkage. STEP 9: CONSIDER LINKING 209 Box 9-6 Case study: De-linking in RGGI and WCI Experiences with de-linking are rare, but two cases in North America provide insights on the implications of departures from an integrated carbon market: the withdrawal of New Jersey from the RGGI and that of Ontario from its linkage with California and Québec. RGGI was originally made up of 10 Northeastern and Mid-Atlantic states in the United States that joined together to collectively reduce GHG emissions in their electricity sectors. The RGGI MoU set the overall cap and each state’s share of the cap for each three-year compliance period. In May 2011, New Jersey’s governor at the time, Chris Christie, announced that his state would withdraw from RGGI ahead of the second commitment period (2012–2014) by activating the relevant clause of the MoU under which a state “may, upon 30 days of written notice, withdraw its agreement to [the] MOU and become a Non-Signatory State.”337 The RGGI cap had to be modified to consider the fact that 40 previously regulated emitters from New Jersey would be leaving the system. The only guidance given in the MoU was that, in the event of a state’s withdrawal from the system, “the remaining Signatory States would execute measures to appropriately adjust allowance usage to account for the corresponding subtraction of units from the Program.” New Jersey’s withdrawal from the system reduced the cap from 188 million to 165 million short tons of carbon dioxide for the second compliance period.338 New Jersey completed the first compliance period before officially withdrawing. When New Jersey left, it had already sold approximately 300,000 carbon dioxide allowances for 2014 and as RGGI allows unlimited banking and was significantly over-allocated for the first compliance period, some of New Jersey’s allowances remained in circulation and available for use. Consistent with RGGI’s commitment to allow unlimited banking of allowances by market participants, the other RGGI Member States decided to recognize all outstanding New Jersey allowances for compliance purposes.339 While the cap was adjusted to compensate for the withdrawal, other states may have lost some revenue as a result of New Jersey’s action. In this case, de-linking was actually part of a complete dismantling of the cap and trade system in New Jersey. Notably, the impacts on the broader RGGI program were minor, and the experience established a method by which an orderly withdrawal of a linked state could occur at the end of a compliance period. After completing the de-linking process, New Jersey decided to rejoin RGGI in 2018. This meant making its ETS rules consistent with the 2017 RGGI Model Rule and adopting final regulations. The linkage is operational as of January 2020. In contrast to the process of New Jersey’s exit from RGGI, the Canadian province of Ontario’s abrupt departure from its linkage with California and Québec required swift action to ensure the environmental integrity and stringency of the linked market. In January 2018, Ontario, California, and Québec had linked their respective systems, but Ontario withdrew six months later following the election of a provincial government that was set on repealing its own cap and trade program. The move ran counter to the terms of the nonbinding linking agreement requiring parties to provide one year’s notice of withdrawal and to time it with the end of a compliance period. Ontario’s exit risked an overflow of allowances from regulated entities in the province that were no longer required to comply with the ETS. Thanks to the regulatory frameworks underlying the California and Québec systems, both jurisdictions had the authority to intervene. They directed WCI, Inc. in its administrative support capacity to modify the joint registry to prevent compliance instruments belonging to entities in Ontario from being traded with those in California and Québec. However, California and Québec continued to recognize all of Ontario allowances already in the accounts of entities in California and Québec before Ontario’s withdrawal. California and Québec subsequently assessed how many allowances would need to be retired from their own allowances to compensate for Ontario allowances that remained in circulation to ensure the environmental integrity of their respective caps. To that end, they cancelled more than 13 million allowances in 2019. Before this LINKING STEP 9 cancellation, the California Air Resources Board included provisions in its 2018 regulatory reform strengthening its authority to cancel allowances to guarantee the environmental integrity of the program in the event of further episodes of de-linking in the future.340  337 RGGI 2005. 338 RGGI 2016. 339 RGGI 2011. 340 California Air Resources Board 2018b. 210 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION 9.7 QUICK QUIZ Conceptual Questions 1. What are the main advantages of linking and what risks or downsides could this bring, taking into account economic as well as political and strategic factors? 2. What are different ways to link ETSs? 3. What program design features will require coordination under a link, and which ones would benefit from alignment? Application Questions 1. How important may linking be for your jurisdiction’s ETS? 2. What goals might different approaches to linking achieve for your ETS? 3. Who would be your preferred linking partners, and why, and when and how might you pursue linking discussions? 9.8 RESOURCES The following resources may be useful: S A Guide to Linking Emissions Trading Systems S Accounting for the Linking of Emissions Trading Systems Under Article 6.2 of the Paris Agreement LINKING STEP 9 STEP 10: IMPLEMENT, EVALUATE, AND IMPROVE 211 Step 10 - Implement, evaluate, and improve STEP 10 Implement, evaluate, and improve At a Glance____________________________________________________________________________ 212 10.1 Timing and process of ETS implementation_________________________________________ 212 10.2 Gradual implementation___________________________________________________________ 217 10.3 ETS reviews and improvement_____________________________________________________ 219 10.4 Quick Quiz_______________________________________________________________________ 228 BOXES Box 10-1 Case study: Korea’s Target Management System_______________________________ 213 Box 10-2 Case study: Mexico pilot ETS________________________________________________ 214 Box 10-3 Case study: Chinese regional ETS pilots_______________________________________ 215 Box 10-4 Case study: Lessons learned from Phase 1 of the EU ETS_______________________ 216 Box 10-5 Case study: China ETS construction phases___________________________________ 218 Box 10-6 Case study: Structural reviews of the EU ETS__________________________________ 221 Box 10-7 Case study: Comprehensive review of RGGI___________________________________ 222 Box 10-8 Case study: Review processes in the New Zealand ETS_________________________ 223 FIGURES Figure 10-1 ETS pilot design____________________________________________________________ 215 Figure 10-2 Phases of ETS implementation_______________________________________________ 219 Figure 10-3 Types of ETS reviews________________________________________________________ 220 TABLES Table 10-1 Timelines of significant changes in five long-lived systems_______________________ 225 EVALUATION STEP 10 212 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION AT A GLANCE sectors. Major design features of the ETS may be phased Checklist for Step 10: Implement, evaluate, and improve in over time, such as increasing coverage or increasing the stringency of the cap or monitoring, reporting, and ✔ Decide on the timing and process of ETS verification (MRV) regulations. implementation ✔ Decide on the process and scope for reviews Policymakers should design their ETS policy and institutions as an evolutionary process to facilitate change ✔ Identify why the design of the ETS may need to change over time over time in a predictable and constructive way in order to respond to changing circumstances and to incorporate ✔ Evaluate the ETS to support future improvement lessons learned from operating the ETS. Reviews of ETS performance are important to enable this Moving from design to operation of an emissions trading continual improvement and adaptation. Targeted reviews system (ETS) requires that government regulators and can be used to look at specific aspects of the ETS covering market participants assume new roles and responsibilities, more technical details. Comprehensive reviews look at the embed new systems and institutions, and launch a ETS at a higher level, such as whether the ETS has met its functional trading market. objectives and how its fundamental design elements can Every existing ETS has required an extensive preparatory be improved. Early planning can help ensure reviews are phase to collect data and develop technical regulations, successful. For instance, starting data collection before guidelines, and institutions. In addition, some jurisdictions reviews are scheduled and making this data available to have used explicit ETS pilot periods. These allow all parties the public can facilitate successful reviews and evaluations, to test policies, systems, and institutions; build capacity; as existing data sets and systems may not be sufficient. and demonstrate effectiveness. However, if the pilot Any possible changes resulting from these reviews need reveals challenges, it runs the risk of undermining public to be balanced against the risks of policy uncertainty. confidence in the ETS before it fully commences. If a pilot The latter can be mitigated by establishing transparent is considered desirable, policymakers will need to carefully and predictable processes by which ETS changes are determine the scope and length. On the one hand, pilots communicated and implemented. need to give policymakers a clear understanding of the This chapter looks at the process of implementation, market and policy, but costs and complexity should be evaluation, and review. Section 10.1 considers how kept low and in line with the objectives of the pilot phase. a full-scale ETS can be gradually rolled out and how An alternative or addition to pilot periods is to gradually program features can be designed to evolve over time in phase in some design features of the ETS. This will allow a predetermined manner. Section 10.2 examines how the learning by doing, easing the burden on institutions and ETS can be evaluated and reviewed, as well as how policy adjustments can be managed over time. 10.1 TIMING AND PROCESS OF ETS IMPLEMENTATION The implementation of an ETS requires a wide number of have helped inform the development of its national system. timing and process decisions. Often policymakers start Kazakhstan similarly had a formal one-year trial phase.344 with a trial or pilot ETS period to test and confirm the By contrast, California launched its full ETS with no appropriateness of some of their design decisions. For formal pilot or testing phase except for a practice auction; EVALUATION STEP 10 instance, Phase 1 of the European Union (EU) ETS served however, it phased in some elements such as coverage of as a sort of trial phase, while China’s eight regional pilots certain sectors and the share of allowances auctioned.345 344 See Sergazina and Khakimzhanova 2013. 345 See California Air Resources Board 2014. STEP 10: IMPLEMENT, EVALUATE, AND IMPROVE 213 Pre-implementation phases that set out measures to collect jurisdiction. In Korea, the Target Management System (TMS) data, establish MRV procedures, or create the necessary formed the basis for the ETS, as discussed in Box 10-1. institutional arrangements can also build capacity and readiness in the lead-up to the ETS, for example the Korean Target Management System (see Box 10-1). Incentive Box 10-1 Case study: Korea’s Target Management structures are important and even highly technical elements System of an ETS need to be tested. As the design and operation of an ETS is likely to change following a pilot phase, Korea’s TMS was introduced in 2012. It involved methodologies and procedures tested in initial phases or both mandatory reporting and firm-specific emission pilots may still require modifications once the ETS is fully reduction targets, applied to the same parties that operationalized, highlighting the importance for continual were expected to be regulated by the Korean ETS. review and improvements over time. The TMS smoothed the transition into the ETS by developing the necessary MRV processes. It also This section discusses measures required before helped define the scope and the points of obligation, implementation; the objectives of and design choices to be while the data collected provided the government made when starting with an ETS pilot; and the objectives with a basis for determining free allocation and and elements of gradual implementation. the total cap for the ETS. For companies, the TMS yielded insights into how emissions/abatement costs can be reduced, further facilitating the 10.1.1 BEFORE IMPLEMENTATION implementation of the Korean ETS. It is crucial to allocate sufficient time before implementation to ensure the key infrastructure of an ETS is in place and to build capacity for policymakers and regulated entities as However, while mandatory reporting and related initiatives needed. Considerations that should be planned to be done can yield important insights, in many cases, experience before implementation include and capacity can be derived only from pilots or (phased) implementation of an ETS itself, including the respective S expert advice; incentive structures. These are discussed in the following S development of ETS regulations, legal framework, and two sections. guidelines; S designation or establishment of supporting institutions (such as the regulatory entity, or independent advisory 10.1.2 STARTING WITH A PILOT bodies that may review the success of the pilot phase); A pilot is a mandatory program that is explicitly framed S establishment of registry and trading platforms; as a testing or learning period with a clear end date, and S capacity for which the regulator clearly signals that the system building among regulators, ETS participants, could significantly change after the pilot ends. The focus trading entities, and other service providers or of the pilot is often on gathering data, testing systems, stakeholders (see Step 2); and and facilitating learning for both government and business S public education about the system. stakeholders. As such, it might explicitly have design characteristics that are not intended to persist beyond the Before compliance or trading begins, it is necessary pilot, for example a more lenient cap. This section outlines to ensure there are adequate MRV measures in place, the objectives of pilots before discussing their implications including data collection. As discussed in Step 3, pre-ETS for appropriate design. MRV measures can S improve the quality of data used for setting the cap and Pilots have three main objectives: in distributing allowances; 1. To test ETS policy, methodologies, systems, S support capacity building by both participants and and institutions. Pilots can help identify problems regulators as well as legislators; and and facilitate learning related to, for example, data S testgovernment administrative and compliance collection, data reporting, database management, mechanisms before allowances must be surrendered. conflicts with existing legislation, the need for new legislation, or the need for improved market oversight. Most existing ETSs had mandatory reporting (see Step 7) in They can highlight current policies and systems that EVALUATION STEP 10 place before ETS obligations. New Zealand phased sectors should be adjusted to effectively implement an ETS. into the ETS by having one year of voluntary reporting and, Box 10-2 describes how Mexico used a pilot ETS for most sectors, one year of mandatory reporting prior to phase to develop the infrastructure and policy for full the introduction of the ETS unit surrender obligation. The ETS implementation. political and economic feasibility of introducing mandatory 2. To build capacity. Pilots, in contrast to ETS reporting before deciding to introduce an ETS will vary by simulations or voluntary trading (see Step 2), require 214 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION actual implementation of ETS legislation, systems, and 3. To demonstrate effectiveness. As jurisdictions face the institutions that will support the ETS. If the pilot is different circumstances, pilots can be useful to test successful, the institutions and infrastructure built for outcomes and demonstrate overall ETS impact within the pilot can usually be used in the full ETS. In addition, the jurisdiction. Pilots are also valuable if the jurisdiction pilots can help build the capacity of regulated entities is introducing design features that differ from existing and regulators, as well as build advisory capacity by ETSs or is fine-tuning ETS design elements. As a result, training ETS consultants, verifiers, and intermediaries. they can support implementation during subsequent phases, as policymakers can draw on practical experiences in addition to theoretical models. Box 10-2 Case study: Mexico pilot ETS The Mexican ETS pilot started operating on January 1, 2020. Mandated by Provisional Article 27 of the July 2018 reform to the “General Law of Climate Change” and implemented through its 2019 regulation, the pilot ETS will help test system design and will run for two years, plus one year of transition to the full operational ETS. It aims to enhance the quality of emissions data, test system design, and build capacity in emissions trading for regulated entities, ultimately improving the design of the operational period of the ETS, which will commence in 2023. Together, the pilot phase (2020–2021) and the transition phase (2022) constitute the test program of the Mexican system. The pilot covers direct carbon dioxide (CO2) emissions from stationary sources (combustion and industrial process) from entities in the energy and industry sectors generating at least 100,000 tons of carbon dioxide (tCO2) per year. Around 300 entities are covered by the pilot, corresponding to ~40 percent of national emissions. According to the law, the Mexican pilot is designed to pose “no economic impact” on regulated entities during the pilot years. However, in the case of non-compliance, entities will lose the opportunity to bank unused allowances into the next compliance periods within the pilot. Moreover, noncompliant entities will receive fewer allowances during the operational period of the national ETS (two fewer allowances for each nondelivered allowance during the pilot). The Mexican Ministry for Environment and Natural Resources (SEMARNAT) announced regulations on the cap for the pilot, the annual sectoral distribution of allowances, and three allowance reserves at the end of 2019. SEMARNAT has also been working on different infrastructure elements for the ETS, including the system registry, offset methodologies, and the auction platform. Regulations for the transitional phase have not yet been published. The focus is on operationalizing primary and secondary carbon markets in preparation for the transition to the operational period of the ETS. Pilot design cover only large entities, fewer sectors or, as in China, There are several choices policymakers must make when have a more limited geographic scope (see Box 10-3). designing the pilot, summarized in Figure 10-1: A narrower scope allows key policies and institutions to be tested without imposing the same costs (on both the S Length: When choosing the length of the pilot period, government and regulated entities) as a broader pilot. it is important that the time frame chosen is consistent However, there is a risk that the pilot is not representative with its objectives. If the principal aim is to collect data, if it does not cover all market participants. then a short pilot period of perhaps one year may be S Allocation approach: The pilot presents an sufficient, and the first compliance phase can begin immediately after the end of the trial phase. However, if opportunity to test the allocation approach to be used the objective is to build capacity and test systems, then in the full ETS. Efforts during the pilot should focus on a longer pilot phase of several years may be required. gathering the required data needed for allocation (for For example, the pilot phase for the Mexico ETS is three instance, defining benchmarks for free allocations) and years, with the aim to improve the quality of data and building the capacity of regulated entities to be able to build capacity. An interval prior to full implementation report this data. S Cap stringency: Some jurisdictions have decided to EVALUATION may also be needed to review the pilot’s performance STEP 10 and make changes to systems. impose a less stringent cap in the pilot period. They S Coverage: Policymakers can choose to design a choose to do this because it will not directly influence system-wide pilot that covers as many entities as are the functioning of the market in the long term if the pilot due to participate in the full compliance period. The first is a self-contained testing period. However, the benefits phase of the EU ETS, while not officially framed as a pilot gained from this approach must be balanced against phase, followed this model. Alternatively, the pilot might the downsides of lower incentives, a slower start to STEP 10: IMPLEMENT, EVALUATE, AND IMPROVE 215 full market operation, and lower initial ambition. Lower Figure 10-1: ETS Pilot Design Figure 10-1 ETS pilot design stringency in a pilot period may also create a path dependency and generate expectations, making it more difficult to transition to a significantly more ambitious 1. Length • Align the length of the pilot ETS once the pilot ends. with its objectives. S Enforcement: During the pilot, enforcement may be 2 Coverage less strict than in the full ETS. Enforcement can focus • Determine how broad or narrow the scope of the ETS pilot on educating businesses about the ETS rather than should be. imposing punitive measures for noncompliance. Clearly 3 Allocation signalling the pilot as a learning phase can help avoid • Test the allocation approach to expectations of this enforcement being carried over to see if it effectively reduces carbon leakage, raises revenue, and the full ETS. preserves abatement incentives. S Carryover of allowances: A decision also needs to • Use the pilot to gather the necessary data. be made whether allowances from the pilot may be banked into the full-fledged ETS. As discussed in 4 Cap stringency Step 6, restricting banking from a pilot to later phases • Determine the stringency of the cap and consider how it may can reduce the risk that undesirable market features in affect participant expectations the pilot carry over into the full implementation phase. for full implementation. Restricting banking will also avoid carrying over lower 5 Enforcement levels of ambition if the pilot cap is less stringent. • Determine the stringency of enforcement measures. However, restricting banking increases the likelihood • Use pilot enforcement measures that allowance prices fall precipitously at the end of the as an opportunity for covered entities to learn about the ETS. pilot period, potentially undermining public support for the ETS. 6 Carryover of units • Determine whether units from the pilot may be banked into the full ETS. Box 10-3 Case study: Chinese regional ETS pilots The operation of eight subnational pilot systems has been a key step in building capacity and knowledge in the lead-up to a national ETS in China. In 2011, China’s National Development and Reform Commission (NDRC) issued a notice to establish ETS pilots, with the purpose of implementing the 12th Five-Year Plan’s requirement to gradually establish national carbon trading markets and promote market mechanisms to achieve China’s 2020 goal of controlling greenhouse gas at a low cost.346 The pilot approach is based on the Chinese tradition of shìdiǎn ( ), wherein prior to launching a large government program it is considered prudent to first test different variations of the proposal in multiple regions that feature different socioeconomic circumstances. This learning-by-doing approach allows policymakers to simultaneously avoid risks inherent in a one-size-fits-all policy, discard those approaches that have proven to be inadequate, and discover approaches that are particularly appropriate to China’s diverse and unique circumstances. The pilot regions include the cities of Beijing, Chongqing, Shanghai, Shenzhen, and Tianjin, and the provinces of Hubei, Guangdong, and Fujian.347 Collectively these areas have a population of approximately 300 million. The first pilot (Shenzhen) was launched in June 2013; the last (Fujian) was launched in December 2016. There is substantive variation across the different pilots, as they differ in location, scale, and sector coverage among other details. Some of the pilots are in China’s densest cities, such as Beijing and Shanghai; some are in provinces, such as Fujian; and some are in regions, such as Hubei. Allocation methods vary from free allocation based on grandparenting, such as in Chongqing and Shenzhen, free allocation based on benchmarking, such as in Hubei and Shanghai, and some level of auctioning, as in Guangdong. Sector coverage also varies, as all of the pilots cover the power and industry sectors, and some pilots also regulate domestic aviation (Shanghai, Guangdong, EVALUATION STEP 10 Beijing, and Fujian), buildings (Shanghai and Beijing), and public transport (Shenzhen and Beijing). Trading activity across markets also differs but is significant overall: by December 31, 2018, the accumulated trading volume of the allowance spot market in all the pilots had reached 282 million tCO2, with a total value of CNY 6.2 billion.348  346 NDRC 2011. 347 Zhang et al. 2014. 348 ICAP 2019. 216 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION The design of the national ETS builds on the experience and lessons learned from the pilots, specifically the results of different approaches to sector coverage, allocation, and MRV (see also Box 2-9 on capacity building for China’s ETS). The Chinese government also relies on the pilots to provide some of the key infrastructure for the Chinese national ETS. Hubei was selected to lead the development of the national ETS registry and Shanghai is responsible for developing the trading platform. Initially, the pilots were scheduled to run for three years, though they have continued to run through 2020. Policymakers in the central government have thought carefully about the transition from the pilots to a national ETS. In the short term, as the national pilot covers only the power sector, the existing ETS pilots are operating in parallel to the national market, covering the non-power sectors. Over the medium to long term, many are likely to cease operations as the sectors are integrated into the national ETS. Some may continue operations in sectors not covered by the national ETS. Limits of pilots In addition, if ETS pilots are viewed as unsuccessful, While well-designed pilots can achieve many of the they risk losing public support and damaging the public’s objectives outlined above, the lessons they hold for perception of emissions trading. While the first phase of policymakers in terms of effectiveness of ETS design are the EU ETS brought a wealth of market and operational nevertheless limited. For example, they are unlikely to experience for governments and companies, it culminated in run long enough or be ambitious enough to trigger large a sharp allowance price decline, which had a negative impact investments that drive major emission reductions. on public perception, as discussed in Box 10-4. Clearly communicating and managing expectations regarding a pilot phase will be important to mitigate such risks. Box 10-4 Case study: Lessons learned from Phase 1 of the EU ETS Phase 1 of the EU ETS ran from 2005 through 2007 as a three-year pilot in preparation for effective functioning in Phase 2. In this learning-by-doing period, both regulators and regulated entities were able to gain experience with emissions trading. As stipulated in Article 30 of the ETS Directive, a full review of the EU ETS was then mandated before the end of Phase 1.349 Banking allowances for Phase 2, however, was not allowed. Phase 1 was successful in creating a functioning market for allowances and putting a price on CO2 emissions so that, for the first time in Europe, emissions became a concern for the financial controllers/accountants and not just the environmental and production staff. However, overallocation of allowances during this trial phase ultimately led to a steep decline in carbon prices, with negative repercussions for the public perception of the EU ETS. Based on the experience in Phase 1, the working group charged with the review assessed possible policy options to improve the system going forward. In particular, they identified four major issues: S The process by which Member States determined free allocation through the National Allocation Plans tended to overestimate emissions projections, allocating regulated entities more allowances than needed and leading to low prices. This weakened the incentive to invest and innovate. S The lack of harmonization across Member States in their approach to determining National Allocation Plans distorted competition across EU jurisdictions. S Firms in some sectors that received free allocation passed through the market value of allowances by increasing prices for consumers, leading to windfall profits, with negative distributional impacts. S The approval of National Allocation Plans was complex and created some uncertainty about the overall cap of the EU ETS.350 The first phase was valuable in that it allowed these issues to be identified and addressed in subsequent phases.351 In Phase 3, both the cap setting process and the free allocation method were centralized and harmonized at the EU level. Additionally, only sectors considered at a risk of carbon leakage receive free allowances.352 EVALUATION STEP 10 349 European Council 2003. 350 See European Commission 2008a; reports of all Working Group meetings are contained in Annex 1. 351 European Council 2009. 352 The power sector receives no free allocation in Phase 3 as it is considered capable of passing on the cost of carbon to consumers and industry. The rules for Phase 3 also include possible adjustments in the free allocation from year to year, depending on whether there were substantial changes in activity level at the covered installations, whereas in Phases 1 and 2 no ex post adjustment was allowed. STEP 10: IMPLEMENT, EVALUATE, AND IMPROVE 217 10.2 GRADUAL IMPLEMENTATION In addition to — or instead of — a pilot, policymakers may 10.2.2 ELEMENTS OF THE TRANSITION wish to consider gradually implementing aspects of the Gradual implementation lets policymakers gradually scale ETS. Gradual implementation may envisage an end design up different components of an ETS to improve functioning of the ETS from the outset, but phase in some of the design over time. Some of the key design features where a gradual elements. It will generally apply the intended policy design implementation approach might be adopted include but look to manage complexity by building capacity over S Coverage and scope: An ETS might start with a time, staggering implementation by sectors and managing limited number of sectors and with thresholds that potential political challenges from covering some sectors. target the most significant emitters and those that are This contrasts to a pilot that focuses on gathering data, relatively straightforward to include, as in the case of testing systems, and learning. China discussed in Box 10-3. It can then expand to This section outlines the objectives of such a transition, include additional sectors and/or a larger number of its benefits, and its key elements, as well as challenges participants over time. stemming from this approach. A gradual approach to S Cap stringency: Gradual implementation can allow implementation can help embed an evolutionary approach ambition, and associated costs to participants, to grow to ETS design, with policy changes and improvements more slowly. The cap on emissions may be set at a made as circumstances change. This reflects the less ambitious (more generous) level at the outset and processes of change in most ETSs operating to date, increase in ambition over time. which have seen a mixture of ad hoc and planned revisions S Free allocation: Levels and methods of free allocation to design over time. could transition over time. A share of grandparenting for stranded asset compensation to prevent carbon leakage may be necessary at the start of an ETS. 10.2.1 OBJECTIVES OF GRADUAL However, even if major trade competitors do not adopt IMPLEMENTATION comparable carbon pricing mechanisms, taxpayers The objectives of gradual implementation are: may not be willing to support trade-exposed sectors S To build capacity. Gradual implementation builds indefinitely (see Step 5), and continued free allocation capacity both inside and outside of government. It may be incompatible with long-term climate objectives. also builds confidence in effective ETS operation Therefore, free allocation methods may be reduced before obligations apply more broadly or with greater or phased out. Regardless, if grandparenting is stringency, or before more complicated rules are used, there should be a shift to more sophisticated introduced. approaches (such as benchmarking) over time to avoid S To test systems. Gradual implementation provides the drawbacks of grandparenting (see Step 5). If free an opportunity for early review of the first stages of allocation is reduced, the introduction of large-scale implementation and to alter plans for later stages auctions needs careful testing and upscaling. accordingly. S Price or supply adjustment measures (PSAMs): The S Early implementation of a carbon price. Gradual government may also wish to provide a higher degree implementation puts a carbon price in place more of certainty at the outset of an ETS, when public and immediately than if the ETS implementation is delayed financial institutions needed for trading are at a nascent until all elements are ready. stage. The system may then transition toward greater liberalization as the market matures and linking to other S To reduce upfront costs of implementation. markets becomes feasible. The Australian ETS was Introducing an ETS is a complex process, and the an example of where the government had intended to perceived risks and costs of failure can be high gradually relax price control features to allow time for (environmentally, economically, socially, and politically). the market to mature (see Step 6). By moving gradually, policymakers can mitigate some S Linking: Some ETSs may launch as linked systems with of these risks and complexities. other jurisdictions from the beginning. However, in other S To enable time for adjustments in interlinked cases, policymakers may want to preserve options EVALUATION regulatory frameworks. An ETS introduces a STEP 10 for future linking in early phases and ensure their new commodity into the market, with far-reaching own ETS is robust before establishing formal linking ramifications for other regulatory frameworks, such arrangements (see Step 9). as energy market regulation, competition policy, and financial market oversight. Not all interlinkages will be discovered fully ex ante or during a pilot phase. 218 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Box 10-5 Case study: China ETS construction phases In January 2021 China published a series of key policy documents353 and announced compliance obligations for covered entities, operationalizing its national ETS. Given the immense challenge of building and implementing an ETS of this scale and complexity, the Chinese government used a phased approach to ETS construction, drawing also on extensive experience from the ETS pilots in eight subnational provinces and cities with diverse economic and industrial profiles. The step-wise approach to the development of the national ETS was formally laid down in a roadmap endorsed in 2017 by the country’s highest administrative body, the State Council. The first phase of the roadmap was to focus on the development of market infrastructure. Phase 2 was to test market operation covering the power sector only. The third phase should focus on deepening market implementation and expanding it towards a broader sectoral coverage. Since 2017, the Chinese government consequently worked on various fronts to advance the preparation for the national ETS, including: reporting and verification of historical emissions data from eight energy intensive sectors; development of the national registry and trading infrastructure; development of the legislative and regulative framework; as well as a major effort to build capacity. As laid out in the roadmap, the national system started operating covering only the power sector. It regulates over 2,200 companies emitting more than 26,000 tCO2per year. In the coming years, the ETS is then to gradually expand to further sectors including iron and steel, cement, chemical and papermaking. 10.2.3 CHALLENGES ASSOCIATED WITH there may be an incentive to bring forward emissions GRADUAL IMPLEMENTATION from the future to an earlier point in time, to reduce their future liability. For example, actors downstream Jurisdictions should consider whether the benefits from from the point of obligation could have an incentive gradual implementation outweigh its costs. The Partnership to stockpile high-emission fuels or products to avoid for Market Readiness’s Carbon Pricing Assessment: future price increases. In New Zealand, even though A Guide to the Decision to Adopt a Carbon Price also forestry was the first sector covered, once it was known provides further information on capabilities and readiness. that forest clearing would be covered in the ETS as of S Reduces ETS impact. The overall environmental impact January 1, 2008, actors increased forest clearance to of the ETS may be lower if fewer emissions are covered reduce future liabilities (see Step 3). initially. Cost-effectiveness will also be reduced relative S Political expectations. A high initial cap risks low to a broader market. As a result, the overall emissions prices that may harm system credibility and may reduce goals and cap need to be adjusted to account for lower expectations for longer-term prices. Market participants coverage (see Step 4). Policymakers need to factor in may not be confident that the government will the long-term trajectory and goals when implementing implement more ambitious caps in later stages. Clearly the ETS, given the need to ratchet up the ambition of signalling the long-term emissions trajectory, with more climate targets and Nationally Determined Contributions ambitious caps once the ETS is fully implemented, can (NDCs) in accordance with the Paris Agreement. ameliorate this issue. S Carbon leakage risk. A second related concern S Stakeholders resistant to change. There is a potential is the potential for leakage between covered and for initial market design to create lock-in effects by uncovered sources and sectors. This is likely to be making stakeholders resistant to subsequent change, only a short-term risk if the uncovered sources will be making it more difficult to move to the long-term desired entering the system in the medium term. In this case, design. For example, sectors that are excluded initially long-term investment decisions should not be affected. may find it easier to continue to resist entry (for example However, the extent to which this holds true depends the agricultural sector in New Zealand (see Step 3). on the substitutability between covered and uncovered Early and ongoing stakeholder engagement is important sources and sectors. to reduce or manage this resistance (see Step 2). S Perverse incentives. If sources are excluded from the EVALUATION STEP 10 initial stages of the ETS, but expect to be covered later, 353 National Measures for the Administration of Carbon Emission Trading (Trial) http://www.mee.gov.cn/xxgk2018/xxgk/xxgk02/202101/t20210105_816131.html. 2019–2020 National Carbon Emission Trading Cap Setting and Allowance Allocation Implementation Plan (Power Generation Industry) https://www.mee.gov. cn/xxgk2018/xxgk/xxgk03/202012/t20201230_815546.html. List of covered entities 2019–2020 https://www.mee.gov.cn/xxgk2018/xxgk/xxgk03/202012/ W020201230736907682380.pdf STEP 10: IMPLEMENT, EVALUATE, AND IMPROVE 219 10.3 ETS REVIEWS AND IMPROVEMENT This section examines the rationale for reviewing an ETS, design that will need to be considered. New Zealand the main types of reviews, data requirements for reviews removed the use of international offset units after and evaluations, and processes for responding to a review. observing its ETS prices were strongly linked to the price of offset units (see Step 8). S Responding to administrative and legal issues. An 10.3.1 REVIEWS AS A DRIVER OF POLICY ETS is complex and interacts in complex ways with EVOLUTION other laws and regulations. Review may be needed Reviews and policy evaluations provide crucial opportunities to respond to the changing legal environment. In to assess the impacts of policy and make improvements. order to manage the administrative burden of the ETS A successful review will feature an efficient and politically policymakers may also want to review the system for acceptable process to respond to new information on possible simplification options. program performance and to respond to changing local and S Reflecting the evolution of the energy and climate global circumstances. Figure 10-2 depicts a stylized model policy mix. An ETS may interact with other energy and of an ETS policy cycle, including the stages of review and climate policies. These interactions need to be analyzed subsequent adjustments of the policy. and reflected on a regular and systematic basis. This may have numerous effects — for instance, a policy The main reasons why reviews are necessary are that alters a sector’s ability to pass through costs to S Changes in external conditions. For example, an consumers could affect mitigation costs and the way in economic shock or new technologies could alter the which markets behave. cost of meeting a given cap, requiring reassessment. S Changes in domestic and international climate Policy reviews recognize that ETS design is dependent on policies. For example, policy developments might a jurisdiction’s circumstances and must evolve to reflect require an increase in cap ambition to reflect ratcheting changes in circumstances over time. Ideally, ETSs need up of climate targets or offer new linking or offsets to be “predictably flexible”354 — a robust and predictable opportunities. process for review provides flexibility for making policy S Correct changes at a predefined point. Other aspects of ETS errors and unintended consequences. It is design can support predictability outside of the review virtually impossible for policymakers to know exactly process — for instance, introducing rules-based how businesses operate and exactly how they will approaches to address price variability in the long term respond to the new regulation, meaning some mistakes (see Step 6). Similarly, as discussed in Step 3, introducing and unintended consequences will be realized. complementary policies can help increase perceived S Learning from ETS experience. Issues will arise from political commitment to attaining climate targets. lessons learned about emissions trading since the initial Figure 10-2: Phases of ETS implementation Figure 10-2 Phases of ETS implementation Pilot ETS implementation Full ETS implementation ETS Review Policy adjustment preparation (Pilot) Phased implementation EVALUATION STEP 10 354 World Bank 2010 defines “predictable flexibility” as allowing “for timely revision when the underlying social and political circumstances have changed” while being “explicit in defining the conditions under which its terms should be revised.” Similarly, among many others, Stern 2008 notes the importance of predictably flexible policy in order to provide long-term planning while being flexible enough to adapt to changing circumstances. 220 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Figure 10-3: Types of ETS Reviews 10.3.2 TYPES OF REVIEWS Figure 10-3 Types of ETS reviews Clearly defined objectives are critical to any effective review. Often, new policy objectives — or the need to create a new balance among them — can justify a review in Stakeholder Data the first place, regardless of the effectiveness of the ETS in input collection meeting its original goals. Evaluation There are two main types of review: 1. comprehensive reviews, which consider fundamental aspects of the ETS; and 2. targeted reviews, which consider administrative or technical aspects. Scheduled Unscheduled review review Each review type serves a different purpose, summarized in Figure 10-3. Comprehensive reviews are generally Comprehensive Targeted Targeted scheduled reviews done toward the end of an ETS phase and may set in motion structural reform. Targeted reviews generally focus on the performance of particular aspects of an ETS and can be scheduled or unscheduled. In general, both types of review look to perform three roles: 1. to identify program features that are working well; 2. to inform redesign of elements that may not be Design change working as well as they could; and 3. to assess the future role of emissions trading within the climate policy mix. look to assess the ETS as a whole. Some of the key issues that might be explored during a comprehensive review In assessing the performance of the ETS, reviewers include the following: often will want to isolate the impact of the ETS. Different S systematic cap adjustment to account for the broader components of the review will look to answer different context, including any change in the jurisdiction’s questions, such as: overarching mitigation targets (for example ratcheting S Environmental effectiveness: Are emissions lower up of NDC targets), economic development trends, than they would be otherwise? the availability of new technologies, and the relative S Cost-effectiveness: Are costs acceptable and lower ambition of carbon pricing or alternative mitigation than they would be with alternative policies? policies in other jurisdictions; S Fairness: S evaluations of how the ETS has performed relative to Do some groups, especially vulnerable ones, bear excessive costs? expectations for allowance prices, compliance costs, and potential for leakage and competitiveness impacts; and When considering who should undertake a review, S how much the emission price has influenced behavior policymakers should use the range of stakeholders and investment to reduce emissions, particularly relative interested in finding out the impacts from the ETS. Ideally to other drivers such as international energy prices, researchers in academia or NGOs will be able to make commodity demand, and other policies and regulations. use of data from the review to independently explore their own research questions. Transparent evaluation and Reviews also offer an opportunity to engage with consultation with stakeholders and vigorous academic stakeholders and to refresh and refine stakeholders’ and discussion will improve the quality of the work and facilitate officials’ understanding of how an ETS can most effectively its use to effectively revise the ETS. operate, helping to protect core features. Step 2 discusses the types of stakeholders that could be considered. Comprehensive reviews An effective, comprehensive review process is likely to Comprehensive reviews partly assist in resolving the EVALUATION involve individuals and institutions who are respected for STEP 10 predictability–flexibility trade-off discussed above. their competence, objectivity, and integrity. They should Scheduling comprehensive reviews at planned intervals bring a wide range of perspectives and should ideally be creates an expectation that fundamental changes will politically independent or bipartisan. The process needs occur only at specific times, providing predictability to be well resourced both financially and in terms of between review periods. The scheduling of these reviews is time frames, giving enough time for input, analysis, and sometimes included in ETS legislation. These reviews will deliberation. STEP 10: IMPLEMENT, EVALUATE, AND IMPROVE 221 The EU ETS is an example of how comprehensive reviews short-term circumstances. As a result, in practice, the between different phases can allow for the design of design elements of the EU ETS have been reviewed and an ETS to evolve over time, as explained in Box 10-6. changed within phases. These unscheduled reviews are However, this experience also illustrates that such planned equally discussed below. reviews can provide less flexibility to respond to changing Box 10-6 Case study: Structural reviews of the EU ETS Opportunities for reviewing and reforming the EU ETS were planned from the outset and provisions to that effect were included in the ETS Directive.355, 356 In its subsequent version, the ETS Directive specified which elements of the ETS should be reviewed, what questions the review should answer, and also that the European Commission would submit a report on these matters including proposals for amendments of the Directive as appropriate. Article 3 of the Decision to establish the Market Stability Reserve (MSR)357 also includes a timeline and general guidance for a review. When first reviewing the system, the European Commission gathered information through a survey circulated to participants and stakeholders and established a Working Group consisting of representatives of Member States and sectors. This Group discussed scope, compliance, and enforcement, further harmonization and increased predictability, and linking with other ETSs.358 Directive 2009/29/EC amended the original ETS Directive to take into account lessons learned from Phase 1 through this review process. Updates included changes to coverage, cap setting, and allocation. Outside of planned reviews and the associated amendments to EU ETS legislation, the EU has made additional changes to the system in response to changing circumstances. Since 2009, a large surplus of allowances accumulated in the EU ETS, amounting to 2.2 billion at its peak in 2013. The resulting imbalance between supply and demand placed downward pressure on the allowance price, which went from EUR 30 in January 2008 to below EUR 5 in January 2013, where it remained for the next four years. The large surplus and low price triggered an intense debate on the orderly functioning and long-term credibility of the EU ETS. In response, the European Commission released the EU Carbon Market Report in 2012, putting forward options for measures to address the structural supply–demand imbalance of allowances. After broad consultation, two measures were taken. As a short-term measure to respond to excess supply in the market, the European Commission postponed the auctioning of 900 million allowances until 2019–2020, changing the distribution of auction volumes over Phase 3. The auction volume was reduced by 400 million allowances in 2014, by 300 million allowances in 2015, and by 200 million allowances in 2016. This “back loading” of auction volumes was implemented through an amendment to the Auctioning Regulation in 2014. As a long-term intervention, the MSR was implemented in 2018 and operationalized in 2019 to increase system resilience to major shocks by adjusting the supply of allowances to be auctioned (see Step 6). The EU ETS was last revised in 2018 to ensure the system would be well placed to deliver on the 2030 Climate and Energy Framework. The revision focused on three main areas: strengthening the EU ETS, ameliorating protection against carbon leakage, and fostering low-carbon investment. Agreed provisions included a steeper pace of annual emissions cap reductions and better targeted free allocation, as well as new financial support mechanisms to promote low-carbon innovation and to support modernization efforts in the industry and the power sectors of lower- income Member States. As part of Phase 4 revisions, the MSR was also reinforced. Between 2019 and 2023, surplus allowances will be placed in the MSR at the double rate of 24 percent, before the regular feeding rate of 12 percent is restored in 2024. In addition, from 2023 onwards, allowances held in the MSR exceeding the previous year’s auction volume will be invalidated. Finally, the revised ETS Directive includes provisions for Member States to invalidate a portion of allowances to reflect additional policies in the energy sector; for example, a coal phase-out. As a part of the European Green Deal, the EU ETS will undergo its next revision and modernization cycle. The Commission is expected to present proposals to revise and possibly expand the EU ETS in mid-2021.359 EVALUATION STEP 10 355 European Council 2003, Article 30. 356 European Commission 2008a. 357 European Council 2015, Decision (EU) 2015/1814 of the European Parliament and of the Council of 6 October 2015 concerning the establishment and operation of a market stability reserve for the Union greenhouse gas emission trading scheme and amending Directive 2003/87/EC. 358 See Ellerman et al. 2007 and Ellerman et al. 2010 on review and reform processes in the EU ETS. 359 European Commission 2020f. 222 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION Box 10-7 details the review processes of RGGI, whose review system through ongoing evaluation and periodic design has looked to implement more flexibility in the reviews. Box 10-7 Case study: Comprehensive review of RGGI The Regional Greenhouse Gas Initiative (RGGI) system was designed as a “living system,” meaning that the system regulations and the MoU among participating states provides for periodic comprehensive system review and program evaluation. The original RGGI MoU called for a comprehensive 2012 review. Over the course of two years, the review process considered five primary issues: program success, program impacts, additional reductions, imports and carbon leakage, and offsets. In addition to the empirical analyses undertaken by numerous outside organizations, the review incorporated extensive regional stakeholder participation. The participating states held 12 stakeholder meetings, webinars, and learning sessions for the regulated and nonregulated communities, environmental nonprofits, consumers, and industry advocates. The two major findings of the review were that there was an excess supply of allowances and that the cost control mechanisms in place at the time were ineffective. As a result, the number of allowances was reduced from 165 million to 91 million, and a Cost Containment Reserve (CCR) was also created.360 Some other minor adjustments were made concerning offsets, reserve price, and the retirement of unsold allowances. The amendments to the program were captured in an update to the Model Rule and through changes to the RGGI Regional CO2 Allowance Budget. These documents then served as the basis for participating states in their respective statutory and regulatory processes to update their respective CO2 Budget Trading Program regulations. The 2012 Model Rule amendments included a statement committing participating RGGI states to conduct ongoing program evaluation to continually improve RGGI and to begin another comprehensive program review no later than 2016. The second review program review commenced in late 2015 and was completed in late 2017, resulting in the 2017 Model Rule. Program reviews were conducted through a series of nine stakeholder meetings and substantive economic analysis. The review process considered six primary issues: potential changes to the RGGI cap, incorporating and improving RGGI flexibility mechanisms, RGGI regulated sources, complying with the Clean Power Plan, broadening the RGGI market, and improving the RGGI CO2 Allowance Auctions and Tracking System. The resulting 2017 Model Rule outlines major program elements that will guide the program between 2020 and 2030. A key element is an additional 30 percent cap reduction between 2020 and 2030, more than 65 percent below the RGGI cap set in 2009. Other key elements include the creation of an Emissions Containment Reserve (ECR), modifications to the CCR and adjustments to cap to account for excess unsold allowances that were banked up to 2020.361 The 2017 Model Rule amendments also include a statement committing participating RGGI states to conduct ongoing program evaluation to continually improve RGGI and to begin another comprehensive program review no later than 2021. Targeted reviews engage with stakeholders, learn from their experiences, Targeted reviews are complementary to comprehensive and build understanding and acceptance of emissions reviews. They tend to be more administrative or technical trading. Yet they also have their limits — the limited in nature and can be either scheduled or unscheduled. amount of data available may not be sufficient to draw Targeted reviews focus on a specific aspect of the ETS, robust conclusions about the functionality of the system. for instance the operation of a PSAM or offset system, or In many cases, early perceptions of effectiveness are the appropriateness of allocation methods, in contrast therefore unlikely to be an appropriate basis to make to comprehensive reviews, which look at the system at fundamental changes to the design of an ETS. a higher level. For both types of review there are clear S Unscheduled reviews may arise in response to guidelines as to how the reviews are conducted. unexpected or unpredictable developments, including S Scheduled reviews of an ETS let policymakers assess cases such as the following: EVALUATION STEP 10 basic functionality and make any necessary changes z anurgent problem is leading entities to face to the system design to improve that functionality. noncompliance despite their best efforts; Early reviews, in particular, provide a good chance to z laws or regulations are found to be in conflict; or 360 RGGI 2013b. 361 RGGI 2017c. STEP 10: IMPLEMENT, EVALUATE, AND IMPROVE 223 z there appears to be a loophole in the regulations that New Zealand has two types of reviews: mandatory and market actors are exploiting. discretionary. It uses the latter to flexibly review aspects of the ETS should the need arise between mandatory reviews In contrast to comprehensive reviews, technical or as a type of unscheduled review. Box 10-8 describes the administrative issues can be managed largely through review process in the New Zealand ETS. processes run by officials and regulators. These reviews will benefit strongly from input by stakeholders, who can provide practical insights on challenges and potential solutions. Box 10-8 Case study: Review processes in the New Zealand ETS The New Zealand ETS has undergone several reviews, with different processes applied at different points in time. The 2008 legislation establishing the New Zealand ETS (NZ ETS) provided for two types of review processes:362 S a mandatory review conducted by an independent panel appointed by the Climate Change Minister, before the end of each international commitment or five-year period. The results of these reviews would be made publicly available; and S a discretionary review of ETS operation and effectiveness that could be initiated by the Climate Change minister at any time and conducted through any means. The passage of the NZ ETS legislation was immediately followed by a change of government; the new government launched a discretionary review of the NZ ETS in December 2008. The review was carried out by a special, cross- party Parliamentary select committee with the objective of revisiting New Zealand’s climate change policy objectives and deciding whether to proceed with an ETS. After this review, the new government chose to retain the NZ ETS with substantial amendments363 to moderate its expected impact on the economy. The first mandatory NZ ETS review was conducted in 2011 by a panel of seven nongovernmental experts under the government’s terms of reference. It included a six-week consultation period with public submissions and the preparation of expert reports. The panel publicly released an in-depth review report that the government took into consideration in its 2012 proposal for amendments to the NZ ETS.364 The government ultimately chose to accept some — but not all — of the panel’s recommendations. The process helped influence the government’s decisions and build public understanding of the system. In its 2012 legislative amendments, the government changed the NZ ETS review process. Reviews are now optional at the discretion of the minister, no guidance is provided on the scope of the terms of reference, and there is no requirement to use an independent panel. If no panel is involved, the minister must consult with stakeholders and representatives of Maori/iwi (indigenous people) who are likely to have an interest. This change reflected the perception that the initial review provisions were resource intensive and resulted in a very lengthy process. The new review provisions reflect a trade-off between less onerous responsibilities for government and less certainty about the review process for stakeholders. The second review of the NZ ETS was undertaken in 2015–2016, following the government’s July 2015 announcement of New Zealand’s post-2020 target. The review began with the government releasing a discussion document for broad public consultation, along with several supporting documents. The review was conducted in two stages. The first looked at immediate reforms of the transitional measures, and resulted in the phase out of the 1-for-2 policy, a measure that allowed non‐forestry participants in the NZ ETS to surrender one unit for every two tons of emissions (a 50 percent surrender obligation in 2016).365 The second stage focused on the broader design and operation to the NZ ETS and its alignment with New Zealand’s Paris Agreement commitments. Agriculture was excluded from the scope of the review. Results showed that the NZ ETS had been ineffective in driving domestic abatement. The review resulted in a series of decisions to reform the system, to enable unit supply to be better managed, to set a cap on emissions in line with national budgets, to restrict international credits, to introduce auctioning and a cost containment reserve, to begin the phase-out of free allocation, to simplify forestry accounting, and to improve the technical operation of the system. Following further public consultation, the decisions were confirmed in 2018–2019 EVALUATION STEP 10 and came into force with the passing ratification of the Climate Change Response (Emissions Trading Reform) Amendment Bill in mid-June 2020 and the commencement of unit auctioning in early 2021.  362 New Zealand Government 2011. 363 New Zealand Ministry for the Environment 2009. 364 New Zealand Ministry for the Environment 2017. 365 New Zealand Government 2015. 224 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION 10.3.3 GATHERING DATA FOR REVIEWS can help identify potential causes of perceived poor AND EVALUATIONS outcomes and suggest further empirical questions to avoid misinterpretation and enrich interpretation of When designing an ETS, policymakers must also consider data and results from its analysis. the data needs for completing reviews and evaluations, as well as options for gathering it. 10.3.4 MANAGING THE EVOLUTION OF AN Data requirements ETS Much of the relevant data for conducting reviews and ETS policy will inevitably need to develop over time. evaluations is already collected for other purposes; for Changing an ETS can have implications for prices, asset example, energy prices and use, firm activity, impact values, and perceptions and attitudes. Changes can assessments (economic and environmental), revenue and strengthen or undermine predictability, depending on their profits, wages and employment, product prices, patents, drivers and on how they are decided and implemented. and weather or land use. Other data will be generated These implications need to be anticipated and included in by MRV and compliance systems, the registry recording the decision-making calculus when considering whether trades, and through the allowance allocation processes. and how to implement change. Table 10-1 shows how ETS policy has evolved over time in five different contexts. However, some studies will require fresh data. These might include administration costs for government and regulated Fundamental changes to an ETS following a comprehensive entities, emissions from otherwise similar entities not review may have far-reaching political, legislative, and covered by the cap, interview information on new business economic consequences. Given the potential impact practices, investments, revenue generated, and innovations. of the reviews, the scheduling of reviews is often built into legislation (see Step 7). These processes will be To yield robust insights, these data need to be available jurisdiction-specific and may follow existing legislative to authorities and other researchers in a timely way and review timelines. Both the EU and New Zealand have with adequate documentation. The aggregate data that is reviews built into legislation and have policy departments generally released publicly is of limited value in addressing carrying out their ETS reviews. New Zealand’s Climate key questions of effectiveness and impacts; robust, Change Commission has review responsibility regarding a detailed studies will require data on specific participants. range of issues that pertain to the NZ ETS. Data gathering methods ETS legislation should establish policy and processes as In addition to publicly available data, there are two to how the decision maker, typically the government, will methods of gathering information for a review or evaluation: respond to a review. It may specify 1. Reporting by firms: Data on firms’ commercial S the process for sharing findings of a review with other and emissions trading activities are generally kept parts of the government and with stakeholders. For confidential. Special provision will often need to instance, some governments use green paper and white be made for confidential data to be provided to the paper processes to socialize and invite comment on entity undertaking the review and/or evaluation. potential changes; This normally requires that the entity maintain the S the time frame to announce changes; for example, this confidentiality of the data, while using the data to could use movements between phases of an ETS as a inform its findings. In the EU, data that do not have waypoint to make policy changes; and to be published by law are treated as confidential S the minimum notice period for major changes. if the operator marks them as such; if there are requests for disclosure, the operator has the right By establishing a transparent process, policymakers can to prevent disclosure. In some cases, for example help both ensure balance and build trust in the quality in New Zealand, these data can be made available of decisions. Governance processes will be locally in an anonymized form to trusted researchers (for specific and depend on local political culture and existing example in universities and ministries) under strict institutions; however, at a minimum these processes should confidentiality and data security conditions. Data may provide transparency, predictability, and an opportunity for be available to policymakers from impact assessments stakeholders to offer input into decision-making. developed as part of standard government processes. EVALUATION STEP 10 2. Qualitative information: Surveys, interviews, or consultations with participants and other stakeholders can complement analysis of quantitative data. They STEP 10: IMPLEMENT, EVALUATE, AND IMPROVE 225 Table 10-1 Timelines of significant changes in five long-lived systems Regional Greenhouse Gas Initiative Date Event/Changes Made 2005 MoU to set up a joint cap and trade system signed by the governors of Connecticut, Delaware, Maine, New Hampshire, New Jersey, New York, and Vermont. Model Rule outlines the framework for an ETS. 2006 Signatory states publish Model Rule after substantive amendments made in response to public comments. 2007– States codify Model Rule in state-specific legislation and/or regulation. 2008 2008 First auction held. 2009 First compliance period begins. 2011 New Jersey announces intention to withdraw. 2012 First system review: cap reduced to 165 million short tons of CO2. New Jersey withdrawal effective. 2014 Updated Model Rule released after first system review that (1) reduced cap to 91 million short tons of CO2, (2) introduced CCR, and (3) established interim control period to ensure regulated entities comply with allowance purchases in a feasible manner. 2015 Second system review begins. 2017 2017 Model Rule released after second system review: further reduction of emissions cap, creation of an ECR, and modifications to the CCR. 2019 New Jersey adopts final regulations to rejoin RGGI in 2020. Virginia finalizes final regulations to join RGGI in 2020. 2020 Virginia adopts final regulations to join RGGI starting in 2021. Pennsylvania adopted draft regulations to join RGGI in 2022. European Union Emissions Trading System Date Event/Changes Made 2005 Start of Phase 1. 2008 Start of Phase 2. ETS expanded to include European Economic Area countries (Iceland, Liechtenstein, and Norway366). Member States could auction up to 10 percent of allowances. Nitrous oxide (N2O) emissions from production of nitric acid included in scope. Penalty for noncompliance increased to EUR 100/ton. 2008 First revision process of the EU ETS begins. 2009 Directive 2009/29/EC amended the original ETS directive; changes for Phase 3 included (1) a cap set at EU level, decreasing at the linear reduction factor (LRF) of 1.74 percent per year; (2) post-2012 Certified Emission Reductions from the Clean Development Mechanism no longer accepted (except from the LDCs); projects involving the destruction of HFC-23 and N2O excluded regardless of the host country; (3) higher percentage of auctioned allowances — auctioning became the default allocation mechanism for the power sector; (4) more sectors and gases included in the scope; and (5) free allocation determined by EU-wide, harmonized allocation rule. 2012 Aviation sector included based on Directive 2008/101/EC. 2013 Start of Phase 3. Rules for Phase 3 decided in Directive 2009/29/EC begin to apply. 2014 Structural reform process begins. EVALUATION STEP 10 Backloading decision finalized to move 900 million allowances from 2014–2016 auctions to 2019–2020. Commission proposed establishing the MSR to reduce the number of excess allowances (total number of allowances in circulation [TNAC]). 366 Norwegian ETS subsumed by EU ETS. 226 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION 2015 Decision adopted by the European Parliament and EU Council to establish the MSR. Revision process for Phase 4 of the EU ETS begins. 2018 Council of Ministers formally approves the revision of the EU ETS for Phase 4 (2021–2030); changes for Phase 4 include367 (1) LRF increased to 2.2 percent from 1.74 percent from 2021 onwards; (2) the pace at which surplus allowances are removed from the auctions and placed in the MSR is doubled to 24 percent of the TNAC until 2023; (3) backloaded allowances and unallocated allowances from Phase 3 placed in the MSR; from 2023, allowances in the MSR above the previous years’ auction volume will be invalidated; (4) better targeted carbon leakage rules and a gradual phase out of free allocation toward 2030 for less exposed sectors; and (5) funding of low-carbon innovation and energy sector modernization through the newly created Innovation and Modernization Funds. 2019 MSR starts operating. As of August 2020, almost 1.4 billion allowances have been placed in the MSR.368 2020 European Commission announces European Green Deal, including proposals to revise and potentially expand the EU ETS. Québec Cap-and-Trade Program Date Event/Changes Made 2008 Québec joins the Western Climate Initiative (WCI). 2011 Regulation respecting a cap and trade system for greenhouse gas emission allowances announced. Amendments made to the regulation to bring the cap and trade system in line with the rules adopted by the WCI. 2012 Amendment to the cap and trade regulation to set operating rules of offset system and to allow for linking with other systems. Annual allowance caps for the 2013–2020 period are established. 2013 Systems first compliance period begins. 2014 Program links with California’s. 2014 First joint auction with California. 2015 Second compliance period begins. Upstream fossil fuel distributors, suppliers, and first deliverers of electricity added to the program. 2017 Draft regulations setting the cap trajectory for the period 2021–2030 are published and adopted. Cap trajectory regulations adopted. 2018 California and Québec cap and trade programs link with Ontario. Ontario revokes cap and trade Program, severing link with California and Québec cap and trade programs. 2019 Industrial installations that declare annual emissions of more than 10,000 tCO2e but less than the threshold of 25,000 tCO2e can voluntarily register for the cap and trade system. New Zealand Emissions Trading System Date Event/Changes Made 2008 Forestry sector enters the ETS with one-time allocation to pre-1990 forestry. One-time allocation granted to fisheries; free allocation granted to emissions-intensive, trade exposed (EITE) facilities with gradual phase-out. System opened to international trading and accepts Kyoto units for compliance. 2009 NZ ETS discretionary review. Changes include (1) 1-for-2 surrender obligations introduced; (2) phase out of EITE free allocation scheduled but deferred to 2016; EVALUATION (3) stationary energy and industrial processes scheduled to enter but deferred to mid-2010; and STEP 10 (4) agriculture deferred to 2015 (originally scheduled for 2013), but subject to reporting obligation. 367 ICAP 2018b. 368 European Commission 2020c. STEP 10: IMPLEMENT, EVALUATE, AND IMPROVE 227 2010 Liquid fuels sector enters. Stationary energy and industrial processes enter. 2012 NZ ETS first mandatory review. Agriculture entrance into the ETS deferred indefinitely. Fixed price ceiling of 25 NZD introduced. 1-for-2 surrender obligations extended. 2013 Waste sector enters. 2015 ETS stops accepting international Kyoto units for compliance. 2015– NZ ETS Second mandatory review commences. 2016 Stage 1 of review ends May 2016; decision to remove the one-for-two surrender obligation. Stage 2 of the review ends in four made-in-principle decisions that require further work and consultation before they are implemented (1) introducing auctioning of units to align the NZ ETS to the country’s climate change targets; (2) limiting participants’ use of international units when the NZ ETS reopens to international carbon markets; (3) developing a different price ceiling to eventually replace the current fixed price option of 25 NZD; and (4) coordinating decisions on the supply settings in the NZ ETS over a rolling five-year period. 2019 Improvements to the ETS are announced based on Stage 2 of the second mandatory review, including (1) phasing-down industrial allocation from 2021, (2) averaging accounting in the forestry sector, (3) introducing auctioning, and (4) transitioning from a Fixed Price Option to a Cost Containment Reserve. Agreement made with agriculture sector to plan for pricing instrument (or to enter ETS) by 2025. 2020 Climate Change Response (Emissions Trading Reform) Amendment Bill passes through Parliament in mid-June including all amendments determined by the second review. Korean Emissions Trading System369 Date Event/Changes Made 2010 Framework Act on Low Carbon, Green Growth goes into force, establishing a legal basis for the ETS. 2012 Act on Allocation and Trading of Greenhouse Gas Emissions Allowances goes into force. Mandatory GHG and Energy TMS launched. 2014 Allocation Plan goes into force. 2015 Korean ETS launches (covers power, industry, building, public, waste, and transportation sectors). 2016 Allocation Committee doubles the borrowing limit to 20 percent and an additional 9 million allowances auctioned at a reserve price of USD 14.72. Release of basic National Roadmap for Greenhouse Gas Reductions by 2030. Amendments on Framework Act on Low Carbon, Green Growth. 2018 Second phase starts: expansion of benchmark-based allocation, introduction of 3 percent auctioning, new banking rules, permitted restrictive use of international credits, > 97 percent free allowances, < 3 percent auctioned. Allocation Committee makes 5.5. million allowances available from the MSR. 2019 Allowance auctioning started by the Korea Development Bank and the Industrial Bank of Korea (named as market makers). Reforms for coming third phase announced, including (1) stricter emissions cap, (2) use of auctions, EVALUATION (3) move from basing free allocation on grandparenting to sector-specific benchmarking, and STEP 10 (4) opening the secondary market to noncompliant entities. 2020 Phase 3 Allocation Plan approved; Allocation Plan will take effect in 2021 and run until 2025.  369 ICAP 2020c. 228 EMISSIONS TRADING IN PRACTICE: A HANDBOOK ON DESIGN AND IMPLEMENTATION 10.4 QUICK QUIZ Conceptual Questions 1. 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