REPORT PREPARED FOR MARCH 2022 THEPMR.ORG PMR AND ICAP GOVERNANCE OF ETS ICAPCARBONACTION.COM PMICLIMATE.ORG WORLDBANK.ORG Governance of Emissions Trading Systems 2 GOVERNANCE OF ETS ICAP & WORLD BANK GOVERNANCE OF EMISSIONS TRADING SYSTEMS This work is a product of the staff of the World Bank and adelphi, representing the International Carbon Action Part- nership (ICAP), with external contributors. 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 in- cluded in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank nor ICAP concerning the legal status of any territory or the endorsement or acceptance of such boundaries. The World Bank does not guarantee the accuracy, completeness, or currency of the data included in this work and does not assume responsibility for any errors, omissions, or discrepancies in the information, or liability with respect to the use of or failure to use the information, methods, processes, or conclusions set forth. The boundar- ies, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of the World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Nothing herein shall constitute or be construed or considered to be a limitation upon or waiver of the privileges and immunities of the World Bank, all of which are specifically reserved. Rights and Permissions The material in this work is subject to copyright. Because the World Bank encourages dissemination of its know- ledge, this work may be reproduced, in whole or in part, for noncommercial purposes as long as full attribution to this work is given. Attribution – Please cite the work as follows: Partnership for Market Readiness; International Carbon Action Partnership. 2022. Governance of Emissions Trading Systems. World Bank, Washington, DC. © World Bank. All queries on rights and licenses should be addressed to the Publishing and Knowledge Division, The World Bank, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2625; e-mail: pubrights@worldbank.org. © 2022 International Bank for Reconstruction and Development/The World Bank 1818 H Street NW Washington DC 20433 T. 202.473.1000 www.worldbank.org GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 3 EMISSIONS TRADING CONTINUES TO EXPAND AS A FLEXIBLE POLICY RESPONSE TO CLIMATE CHANGE. Acknowledgement The development of this report was led by Michael Mehling (MIT Center for Energy and Environmental Policy Re- search). The World Bank and the ICAP Secretariat jointly oversaw the report, including providing inputs and ma- naging the project. The World Bank team consisted of Timila Dhakhwa with support from Fabiano De Andrade de Corrêa under the guidance of Daniel Besley and Harikumar Gadde. The ICAP Secretariat team consisted of Stepha- nie La Hoz Theuer, Emma Krause, William Acworth and Lina Li. The report was peer reviewed by Nicholas Menzies (World Bank) and Benjamin Görlach (Ecologic Institute). The team is very grateful to representatives of various ETS jurisdictions that provided valuable input in developing case studies for the report. We would like to thank representatives from the following jurisdictions: Jane Wardlaw (Australia), Rajinder Sahota and Rachel Gold (California), Qian Guoqiang (Sinocarbon), Polona Gregorin and Julia Ziemann (EU), Alexander Handke (Germany), Aiman Esekina (Kazakhstan), William Space (Massachusetts), Matt- hew Cowie and Scott Gulliver (New Zealand), Jason Hollett (Nova Scotia), Jean-Yves Benoit and Thomas Duchaine (Quebec), Chris Hoagland (RGGI), Takuya Ozawa (Tokyo) and Chris Shipley (UK). We wish to thank Katie Kouchakjii (KKE Communications) for her careful editing and proofreading of the report. Report design and layout was done by: Hitman Creative Media Inc. (hitmanmedia.com) This report was supported by the World Bank’s Partnership for Market Readiness (PMR) pro- gram and the ICAP Secretariat. The PMR, which concluded after a decade, has now transitioned to the Partnership for Market Implementation (PMI) program. 4 GOVERNANCE OF ETS ICAP & WORLD BANK CONTENTS Executive Summary 06 1 Introduction 10 2 What Is Governance, and Why Does It Matter? 12 - 2.1 Defining Governance 13 - 2.2 Why Governance Matters 13 - 2.3 How Governance Occurs: Actors, Tools and Processes 14 - 2.4 Successful Governance: Guiding Principles 17 3 Governing Emissions Trading Systems: An Overview 19 - 3.1 Emissions Trading and the Governance Challenge 20 - 3.2 Governing an ETS: Actors, Tools and Processes 21 - 3.3 Governing an ETS: The Phases of Emissions Trading 25 - 3.4 Principles of Successful ETS Governance 28 4 First Phase: Establishing the ETS 31 - 4.1 Political and Legal Process 32 - 4.1.1 Engaging Stakeholders and Building Consensus 32 - 4.1.2 Adopting a Robust Legal Basis 34 - 4.1.3 Conducting a Regulatory Impact Assessment (RIA) 38 - 4.2 Institutional and Regulatory Framework 39 - 4.2.1 Assigning Institutional Functions and Responsibilities 39 - 4.2.2 Determining the Level of Centralization 42 - 4.2.3 Embedding the ETS in the Existing Legal Framework 42 - 4.3 Technical and Administrative Capacity 44 5 Second Phase: Operating the ETS 47 - 5.1 Governing the Routine Operation of an ETS 48 - 5.2 Overseeing the Compliance Cycle 48 - 5.3 Overseeing the Market for Emission Units 51 - 5.4 Ensuring Transparency 57 - 5.5 Resolving Conflicts 60 6 Third Phase: Reviewing and Amending the ETS 62 6.1 - Reviewing Performance 62 6.2 - Managing System Change 65 Bibliography 66 GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 5 List of Tables Table 1: Principles of Successful ETS Governance 08 Table 2: Governance Functions during the Operation of an ETS 09 Table 3: Principles of Successful Governance 18 Table 4: Actors in ETS Governance 23 Table 5: Examples of Policy Tools Used in an ETS 28 Table 6: Governance Functions during the Establishment of an ETS 26 Table 7: Governance Functions during the Operation of an ETS 27 Table 8: Governance during the Review of an ETS 27 Table 9: Principles of Successful ETS Governance 30 Table 10: Formality of Design Elements in the EU ETS 36 Table 11: Steps in an RIA 38 Table 12: Transparency Measures in the California ETS 59 List of Figures Figure 1: Governance Phases and Contexts of an ETS 07 Figure 2: Dimensions and Channels of Governance 15 Figure 3: The Policy Cycle 17 Figure 4: Phases of Emissions Trading and the Policy Cycle 25 Figure 5: Governance Phases, Contexts and Functions in an ETS 28 Figure 6: The Normative Pyramid 34 Figure 7: Timeline of the Legal Basis for the EU ETS 35 Figure 8: The Compliance Cycle in the EU ETS 50 List of Boxes Box 1: Stakeholder Engagement in Existing ETSs 33 Box 2: Legal Bases of Emissions Trading in Existing ETSs 37 Box 3: Example of an RIA: The U.S. GHGRP 39 Box 4: Role of the Lead Executive Agency and ETS Administrator 40 Box 5: Use of Private Entities in ETS Governance 41 Box 6: Level of Centralization in ETS Governance 43 Box 7: Legal Nature of Emission Units 44 Box 8: Capacity Needs of Public Authorities in Existing ETSs 46 Box 9: The Compliance Cycle in the EU ETS 49 Box 10: Governance of Offset Crediting Systems 51 Box 11: Market Segments, Units and Derivatives in an ETS 54 Box 12: Market Access Rules in Existing ETSs 55 Box 13: Preventing Fraudulent Activities in Existing ETSs 56 Box 14: California and Québec’s Approaches to ETS Transparency 58 Box 15: Examples of Conflicts in an ETS 61 For a complete Box 16: Performance Review in Existing ETSs 63 List of Abbreviations Box 17: Independent Advisory Bodies in New Zealand 64 see page 71. Box 18: Managing System Change in Existing ETSs 65 6 GOVERNANCE OF ETS ICAP & WORLD BANK EXECUTIVE SUMMARY Emissions trading continues to expand as a flexible policy response to climate change. Its implementation raises complex governance challenges, however, and calls for robust institutional, regulatory and procedural frameworks. Unlike aspects of technical design and implementation, the governance of emissions trading systems (ETSs) has found less extensive treatment in the available knowledge base. However, existing systems offer valuable insights into the successful governance of emissions trading from the initial establishment and routine operation of an ETS to the review of its performance and the management of change. This report draws on such experiences to provide guidance on the governance of an ETS across all stages of its evolution. Governance relates to the ways in which authority is Premised on an artificially constrained supply of channeled at multiple levels and through a variety of emission units created via policy decision, ETSs actors to manage social affairs. Research has shown pose unique governance challenges at every stage the relevance of governance for successful policy of their design and implementation. With an design and implementation, including in the context of incentive structure that differs from more traditional climate change. Governance functions are exercised by markets and with traded units that are intangible public and private actors, such as the three branches and instantly transferable in significant quantities, of government – that is, the legislative, executive, ETSs can be susceptible to strategic and fraudulent and judicial branches – as well as non-governmental market behavior. Sound governance of an ETS and the organizations (NGOs), market service providers, market it engenders is therefore key to manage and and the media. These carry out their roles through prevent such risks. As with governance more generally, different tools and processes, including policies that the governance of an ETS relies on the activities of influence individual or collective behavior. Successful various actors and recruits a number of tools and governance tends to be characterized by a high level processes. Some actors, such as the public agency of participation, transparency, and accountability, mandated with administering the ETS, are specific adherence to the rule of law, efficiency, and fairness. to emissions trading, while others, such as financial Although these are not principles in a formal sense, intermediaries and trading platforms, can also be they can guide governance decisions. found in other markets. GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 7 Overall, an ETS follows the same cycle as other ETS proceeds to the elaboration of its institutional policies, from its initial establishment through its and regulatory framework, it requires defining routine operation to its review and amendment. institutional responsibilities, deciding on its level Each phase in this cycle is characterized by a distinct of formality and centralization, and embedding it set of governance contexts. For instance, when in the existing legal system. Governance of an ETS establishing an ETS, aspects related to governance also requires ensuring sufficient capacities – such already emerge during the preceding political and as technical expertise, professional staff, and financial legal process and extend to the creation of a legal resources – of relevant authorities and stakeholders, and institutional framework, as well as the provision including compliance entities. of technical and administrative capacities. Routine operation of an ETS, in turn, gives rise to governance functions in the context of compliance and market Governance relates to the oversight, transparency, and conflict resolution. Finally, reviewing how an ETS performs is its own ways in which authority is governance context, and can result in system channeled at multiple levels changes. Figure 1: Governance Phases and Contexts of an ETS below illustrates the governance contexts and through a variety of actors encountered in each phase of an ETS. to manage social affairs. Each of these governance contexts entails different governance functions, with their own actors, tools, and processes. When establishing an ETS, governance Once the ETS has been established, the phase functions that need to be met in the preceding of routine operation begins, which introduces new political and legal process range from engaging governance contexts and needs. In this phase, gover- stakeholders and building consensus to adoption nance functions relate to compliance oversight, which of a robust legal basis and performing a regulatory includes oversight of emissions reporting, collecting impact assessment. As this inception phase of an and managing emissions data, and performing accre- Figure 1: Governance Phases and Contexts of an ETS PHASE ESTABLISHMENT OPERATION REVIEW ADMINISTRATIVE TECHNICAL AND TRANSPARENCY INSTITUTIONAL PERFORMANCE CONTEXT COMPLIANCE RESOLUTION FRAMEWORK OVERSIGHT OVERSIGHT AND LEGAL AND LEGAL POLITICAL CONFLICT CAPACITY PROCESS CHANGE MARKET SYSTEM REVIEW 8 GOVERNANCE OF ETS ICAP & WORLD BANK ditation and oversight of verifiers; market oversight, Such a review will often be mandated at periodic which includes determining conditions of market intervals in the legal framework, but it can also be access and participation, regulating market activities discretionary, for instance in response to unforeseen as well as traded units and financial products, and developments. If the review culminates in a decision implementing safeguards against market manipulation to modify the ETS, many of the governance functions and fraud; transparency, which includes disclosure already encountered during its initial establishment of emissions data and information about ETS perfor- acquire relevance again. Managing system change mance and market activities to selected stakeholders can range from minor design recalibrations to more or the broader public; and conflict resolution, inclu- fundamental changes, such as the expansion of an ding in the event of judicial proceedings. ETS to new sectors and activities, the establishment of a link to another ETS, or finally, the termination Finally, at certain points in its evolution, an ETS of an ETS. Table 1 below maps governance functions will face the need for a review of its performance in each governance context, based on the relevant and potentially for adjustment or modification. governance principles. Table 1: Principles of Successful ETS Governance Transparency Transparency Disclosure of Emissions and Market Data Compliance Oversight Oversight of the Compliance Cycle Market Oversight Oversight of Market Actors and Activities Accountability Compliance Oversight Oversight of the Compliance Cycle Market Oversight Oversight of Market Actors and Activities Conflict Resolution Resolving Judicial Disputes or Mediation Rule of Law Political and Legal Process Creating a Robust Legal Basis Defining Institutional Responsibilities Institutional and Regulatory Deciding the Level of Formality/Centralization Framework Embedding in the Broader Legal Framework Conflict Resolution Resolving Judicial Disputes or Mediation System Change Managing Modifications to the ETS Effectiveness and Political and Legal Process Regulatory Impact Assessment (RIA) Efficiency Technical and Administrative Capacity Needs of Public Authorities Capacity Capacity Needs of Different Stakeholders Market Oversight Oversight of Market Actors and Activities Performance Review Assessing the Performance of the ETS System Change Managing Modifications to the ETS Equity and Fairness Political and Legal Process Regulatory Impact Assessment (RIA) GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 9 Table 2: Governance Functions during the Operation of an ETS Phase Governance Context Governance Function Stakeholder Engagement and Consensus Building Political and Legal Creating a Robust Legal Basis Process Regulatory Impact Assessment Establishment Defining Institutional Functions and Responsibilities Institutional and Regulatory Framework Deciding the Level of Formality and Centralization Embedding in the Broader Legal Framework Technical and Capacity Needs of Public Authorities Administrative Capacity Capacity Needs of Regulated Entities and Other Stakeholders Compliance Oversight Oversight of the Compliance Cycle (MRV and Enforcement) Operation Market Oversight Oversight of Market Actors and Activities Transparency Disclosure of Emissions and Market Data, Information on Revenue Use Conflict Resolution Resolution of Judicial Disputes or Mediation Review Performance Review Assessing the Performance of the ETS and the Need for Modifications System Change Managing Modifications to the ETS, including Linking and Termination Unlike aspects of technical design and implementation, the governance of emissions trading systems (ETSs) has found less extensive treatment in the available knowledge base. 10 GOVERNANCE OF ETS ICAP & WORLD BANK 01. Introduction Emissions trading has seen growing popularity as a flexible policy response to climate change, although its implementation gives rise to complex governance challenges. Unlike technical design and implementation, the governance of emissions trading systems (ETSs) has found less extensive treatment in the available knowledge base. This report draws on experiences in existing systems to offer guidance on the governance of an ETS across the various stages of its evolution. GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 11 Emissions trading is a policy instrument based on relative to a particular output, such as the carbon tradable units that allow covered entities to emit intensity of a unit of product. Some cover only one a specified amount – usually a metric ton – of GHG sector or activity, while others aim for comprehensive emissions over a specified period of time. By enabling coverage of all major sources of emissions across the trade in such units, an ETS creates a market in which economy. There is thus no single template for an ETS, the opportunity cost of emissions is revealed by the and the design will invariably reflect the circumstances forces of demand and supply, resulting in an explicit in the implementing jurisdiction. What all ETSs have in price on carbon. It offers compliance flexibility by common, however, is that they raise a complex set of decentralizing the decision about where and when to governance challenges. abate GHG emissions and incentivizes abatement whe- re it is cheapest. By levelling the cost faced by covered Sound governance is critical entities for each ton of emissions, this approach helps achieve climate policy objectives at the lowest overall to ensure a functioning ETS, cost (Fischer and Newell 2008). placing high demands on the institutional, regulatory, and Given these benefits, emissions trading has enjoyed growing popularity as a scalable and cost-effective res- procedural frameworks within ponse to climate change. Following earlier experiences which it operates. with emissions trading for air pollutants and inclusion of an international mechanism for emissions trading Sound governance is critical to ensure a functio- between states in the 1997 Kyoto Protocol (Cole 2016), ning ETS, placing high demands on the institutional, it has seen substantial uptake at the regional, national regulatory, and procedural frameworks within which and subnational levels. European countries introdu- ced the first domestic systems for GHG emissions, it operates. Reflecting the foregoing heterogeneity, culminating in the establishment of the European no universal prescriptions exist for successful ETS Union Emissions Trading System (EU ETS) in 2005. ETSs governance. Even more than its technical design, the were subsequently deployed in North America and governance of an ETS depends on the specific context the Asia-Pacific region, and new systems are currently in which it is implemented, which may explain the emerging in Latin America and Asia. At the start of relative scarcity of relevant guidance material and re- 2021, 24 ETSs were in force in 36 jurisdictions, covering commended practices. Still, with a growing experience 16% of global GHG emissions (ICAP 2021). When China base, existing ETSs offer valuable insights into different launched a national ETS in 2021, emissions coverage aspects of this challenge. Drawing on insights from almost doubled (World Bank 2021b). established and emerging ETSs, this report introduces central concepts and principles related to governance ETSs come in a variety of shapes and forms. Most sys- (Chapter 2), describes the main governance require- tems are mandatory, requiring compliance by covered ments in an ETS (Chapter 3), and subsequently traces entities, but some allow for voluntary participation. A relevant experiences made across three stages in the majority of ETSs have absolute GHG emission ceilings, evolution of an ETS: its initial establishment (Chapter or ‘caps’, although some are subject to an emissions 4), its subsequent operation (Chapter 5), and its review intensity target, where the limit on emissions is set and modification (Chapter 6). 12 GOVERNANCE OF ETS ICAP & WORLD BANK 02. What Is Governance, and Why Does It Matter? Governance relates to the ways in which authority is channeled at multiple levels and through a variety of actors to manage social affairs. Although contemporary notions of governance extend beyond the state, this report focuses on the exercise of public authority through formal institutions. Research has shown the relevance of governance for successful policy design and implementation, including in the context of climate change. This chapter defines the concept of governance and discusses its importance, before proceeding to identify relevant actors, tools and processes, as well as a series of principles that can guide sound governance decisions. GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 13 2.1 Defining Governance Applied to the context of climate change, governance Governance can be understood as “the process displays a similar conceptual breadth. Climate gover- through which state and nonstate actors interact to nance has been described as “all purposeful mecha- design and implement policies within a given set of nisms and measures aimed at steering social systems formal and informal rules that shape and are shaped towards preventing, mitigating, or adapting to the risks by power” (World Bank 2017). Derived from the ancient posed by climate change, established and implemen- Greek verb kybernan (κυβερνάω), a nautical term ted by states or other authorities”(Jagers and Stripple to describe the steering of a ship, governance was 2003). Much of this will occur at the level of changing traditionally associated with the activity of ruling, ideas, norms, and expectations to bring about shifts in and thus with public authority exercised through interest perceptions and to foster stable and supporti- formal government institutions such as executive, ve coalitions for change (Meadowcroft 2009). judicial and legislative bodies. As the relationship of state and society evolved, however, this Again, however, this report takes a narrower understanding has expanded beyond government view of governance that is focused on the role of to include social practices at multiple levels – government institutions as architects and especially international, national, regional and local – as well as implementers of climate policy. Acknowledging the as private forms of governance. importance of governance for climate policy design and implementation, the Intergovernmental Panel on Climate Change (IPCC) has stated that “institutions Governance can be understood as and processes of governance shape and constrain “the process through which state and policy-making and policy implementation in multiple nonstate actors interact to design and ways relevant for a shift to a low carbon economy” by setting the incentive structure and political context of implement policies within a given set decision making, and by affecting patterns of thinking of formal and informal rules that shape and understanding of policy choices (IPCC, 2015). That and are shaped by power” interface between governance and climate policy – applied to a particular climate policy, emissions Contemporary governance encompasses the activi- trading – is the central focus of this report. Why it ties of governments as well as many other channels matters is explained next. through which authority can be exercised (Rosenau 1995). As a result, the concept is exceptionally broad 2.2 Why Governance Matters – representing “the sum of the many ways individuals It makes intuitive sense that governance matters. and institutions, public and private, manage their com- Nonetheless, the elusive boundaries of the mon affairs” (Commission on Global Governance 1995) concept make it difficult to capture its relevance in – and manifests itself at different and often overlap- straightforward terms. Systematic research on the ping levels, rendered operational through a complex role of governance has primarily occurred in the study network of actors and interests. In this report, the fo- of economic development, where measurement of cus will largely rest on the exercise of public authority a variety of governance indicators suggests a strong through formal government institutions, including the causal relationship with improved social and economic tools and processes through which these institutions development outcomes (Kraay, Zoido-Lobaton, manage public policies (see also below, Chapter 2.3). and Kaufmann 1999). Such is the link between 14 GOVERNANCE OF ETS ICAP & WORLD BANK governance and economic wellbeing that it was once The many ways in which governance acquires re- declared “perhaps the single most important factor in levance in the context of an ETS will be revisited in eradicating poverty and promoting development” by a greater detail in Chapter 3 below. What past research former Secretary-General of the United Nations (Annan has sufficiently established, however, is that gover- 1998). nance matters across all stages of the policy cycle,1 from the initial formulation through implementation to Specifically, robust governance has been associated the eventual evaluation of policy results. That is also with functioning and accountable institutions that the framing used in the main section of this report, in stakeholders regard as legitimate, through which which relevant governance functions are identified and they participate in decisions that affect their lives, discussed for each of the main phases in the evolution and by which they are empowered. In contrast, weak of an ETS, namely its establishment, its routine opera- governance has been linked to unpredictable or tion, and finally, its periodic review and the manage- arbitrary government behavior, excessive rules and ment of change. Before turning to the role of governan- regulations, misallocation of resources, and lack of ce in an ETS, the remainder of this chapter will describe transparency in decision making (World Bank 1992). key actors, tools and processes of governance, along How well institutions govern is not always a matter with a set of principles that have been suggested as of choice. However, a lack of human and financial conditions for successful governance. resources can significantly hamper the capacity for governance. Thus, in the exercise of public authority, 2.3 How Governance Occurs: governance is both a function and determinant of the Actors, Tools and Processes capacity of governments to prepare, implement, and As indicated earlier, governance is by nature a broad enforce policies, and to review and improve their concept. Its academic study is often highly abstract performance over time. and theoretical, assessing, for instance, the role of hierarchies, markets, and networks in the coordination Climate policy is no exception. Empirical research of social action. Without diminishing the importance has, for instance, revealed that perceptions of weak of such scholarship, this report intentionally assumes governance coincide with weaker climate policies a narrower and more applied focus, with a specific (Rafaty 2018). Investigating the political economy of interest in the exercise of public authority by formal go- carbon pricing – including, specifically, emissions vernment institutions and selected stakeholders. Start- trading – another empirical study of 167 national and ing with a more concrete understanding also allows 95 subnational jurisdictions identified well-governed for the identification of a typology of channels through institutions as one of two conditions for successful which governance manifests itself in practice, including implementation (Levi, Flachsland, and Jakob 2020). In in the design and implementation of policies. particular, it found that three governance indicators – perception of corruption, lack of technical capacity, In the theoretical literature, governance is sometimes and the absence of independent institutions – affect broken down into a structural and a process dimen- the likelihood that a carbon price is adopted, and also sion, distinguishing between its institutionalized have a bearing on the level of the carbon price in that manifestations and the modes through which it effects jurisdiction. Public trust in governments has likewise social coordination (Börzel, Risse, and Draude 2018). been shown to correlate positively with carbon For this report, the structural dimension is further dis- pricing levels (Klenert et al. 2018). sected into the more concrete channels of actors and (1) On the concept of the policy cycle, see Section 2.3 below. GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 15 tools of governance (see Figure 3). Like the concept of will vary depending on the context – with different sets governance itself, however, these channels have fluid of actors shaping local, national, and international boundaries and can overlap along the margins. Crea- governance processes – the primary actors are usually tion of a new administrative entity can, for instance, be formal government institutions, such as legislative, a tool for governments to exercise public authority, yet judicial or administrative bodies. Legitimized through a that entity can then become an actor in its own right. social contract with the constituency whose interests Likewise, some tools, such as information disclosure, they represent, governments and their bureaucracies can evolve into a continuous process. are endowed with the ability to reach binding decisions and enjoy a monopoly on enforcement Rather than provide conceptual precision, the chan- through sanctions. nels highlighted in this section are meant to help visu- alize the ways in which governance occurs. While the Still, the public sector is by no means the only relevant specific details vary, these channels manifest them- actor. Many private actors – both formal and informal selves at all levels of governance, including different – play important roles in governance, including geographic levels – local, national, or international – as business, NGOs, political parties, research institutes, well as public, private, and hybrid governance. Diffe- and the media. Finally, to the extent that it is not rent levels of governance can interact and influence organized through civil society organizations such as each other, adding new channels and a further layer of NGOs, the general public – as the entirety of private complexity. Below, the main channels of governance citizens – can become an important actor, for instance are described in greater detail, with examples used to when it is the addressee of public disclosures or a further illustrate their significance in practice. stakeholder in public consultations. As Chapter 3.2 will show, private actors are involved at various points in Actors. In the context of governance, actors denote the governance of an ETS. individuals or a group of individuals in formal and informal organizations who are engaged in purposive Tools. When engaging in governance, these actors action to exercise governance or influence it, or who can draw on a wide variety of tools to achieve desired are, in turn, affected by it. Although the relevant actors governance outcomes. Tools include different Figure 2: Dimensions and Channels of Governance GOVERNANCE DIMENSION STRUCTURAL PROCESS GOVERNANCE ACTORS TOOLS PROCESSES CHANNEL LEGISLATIVE GOVERNMENT INFORMATION, EXAMPLE(S) PROCEDURES, INSTITUTIONS, NGOS POLICIES POLICY CYCLE 16 GOVERNANCE OF ETS ICAP & WORLD BANK material and ideational resources used in the course services is also common in the operation of ETSs, of governing, such as staff, finance, or information. where private actors have taken on a number Information, for instance, can take the form of of important governance functions under a PPP innovative ideas, technical expertise, or statistical (see below, Chapter 4.2.1). data. Tools also encompass relevant services and infrastructure, such as databases to access such Processes. Processes are a series of actions taken in data. One tool acquires particular importance in the order to achieve a particular outcome, and may occur exercise of public authority, however, and merits once or recur periodically. They can assume the shape a more detailed description: the formulation and of formal procedures, such as the legislative process implementation of policies. with its precisely defined steps and roles of different actors, or be more informal, such as informational Broadly understood, policies are actions which set out outreach and knowledge exchange in the course of objectives and the means to achieve them (Howlett capacity building activities. Processes are thus central and Cashore 2014). Although actors other than govern- to governance, although one particular process is ments can adopt policies, this report focuses on public usually excluded from its scope: the political process. policies, which are statements by a government of Whereas politics focuses on the often antagonistic what it intends to do or not to do, or what it encoura- process of reconciling different interests to reach ges or requires public and private actors to do or not to collective decisions, governance is instead more do (Birkland 2020). Most often, these statements take interested in the administrative and procedural the form of laws, regulations, rulings, decisions, orders, elements of governing (Offe 2009). plans, guidelines or other expressions of government policy to shape and control social outcomes. They do Processes are also very relevant for the formation and so by influencing individual or collective behavior – for implementation of policies, one of the central tools instance that of organizations – through incentives of governance. Policies are not static, but part of an and prohibitions, rights and obligations, planning ongoing technical and political process in which policy measures, and other types of government intervention choices and their effects are continually assessed in social affairs, including in markets. and revisited. A useful concept to illustrate the role of process in public policy making is that of the policy As governance has become more decentralized, cycle, which describes an idealized sequence of how however, there has also been a shift in the types policies are formulated, implemented and assessed of policies governments rely on. Public authority (Lasswell 1971). While different iterations of the policy exercised by administrative institutions is increasingly cycle have been proposed, they commonly identify a being complemented by the activities of autonomous number of similar stages in the policy process (Cairney stakeholders who undertake some of the work of 2020). The policy cycle begins with the identification governing, implementing policies, providing public of a problem and deciding whether or not it should services, and even regulating themselves (Bevir 2012). be included in a policy agenda. If it is included in Public-private partnerships (PPP) exemplify such the policy agenda, the process continues with the forms of hybrid governance, consisting of one or more formulation of a policy proposal, which involves government actors cooperating with private actors defining the policy objectives, identifying alternative through loose alliances or formal agreements to jointly policy options, estimating their costs and effects, and deliver a public service. Contracting out relevant choosing the most appropriate solution. GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 17 Once a policy proposal has been formulated, it chapter, but the importance of the context in which requires legitimation to ensure political support, governance occurs precludes easy identification of which can occur through a legislative or executive universal metrics and prescriptions. In the fields of decision or a public referendum, and frequently development cooperation and public sector reform, involves seeking consent through consultations evaluation indicators are used to measure how states with interest groups. With that decision, the policy meet vital governance functions, but such indicators – is either rejected or approved, often with extensive and the assumptions they are premised on – have not modifications. If approved, the policy then proceeds been without criticism. Objections have been leveled to implementation, which often entails designating or against the perceived biases that such indicators creating a responsible institution and ensuring that conceal, as well as conceptual inconsistencies that it has the necessary authority and resources. Over follow from mingling descriptive and normative criteria time, the policy is evaluated by assessing its impacts in the evaluation frameworks (Gisselquist 2012). and outcomes in order to determine whether it is having the desired effects and should be maintained, Still, that does not rule out the usefulness of insights amended or terminated (see Figure 3). drawn from past experience in the exercise of public authority, and the guidance that such insights can 2.4 Successful Governance: Guiding Principles yield for governance. Over time, the observation of Understanding the channels through which different practices has allowed for the narrowing down governance is exercised offers an opportunity to of governance patterns that correlate with the achieve- evaluate its performance in practice. It is, however, ment of desired outcomes. Acknowledging the varying intrinsically difficult to define what constitutes role of context in each specific case, these patterns “successful” or “good” governance: not only is the have been purposefully articulated in the form of loose concept itself complex, as was shown earlier in this criteria, objectives or principles that avoid being overly detailed or prescriptive. One example is Sustainable Development Goal 16 (SDG 16), which calls for states to “build effective, accountable and inclusive institutions Figure 3: The Policy Cycle2 at all levels” (United Nations 2015).3 Another are the general categories used to group a set of Worldwide Governance Indicators (WGI) developed by the World Bank, which frame governance in terms of the inclusi- veness and independence of government, as well as POLICY PROBLEM EVALUATION IDENTIFICATION the quality of policies and their implementation (Kauf- mann, Kraay, and Mastruzzi 2010).4 A number of features tend to recur across these POLICY POLICY IMPLEMENTATION FORMULATION different frameworks to understand the quality of governance: procedural features, such as the degree of participation and transparency in the exercise POLICY of public authority; features related to governing DECISION capacity, including the availability and expertise of professional staff, or the availability of financial (2) Based on Lasswell (1971) (3) Ten “outcome targets” operationalize SDG 16, of which the following have a clear bearing on governance: “promote the rule of law and ensure equal access to justice”; “substantially reduce corruption and bribery”; “develop effective, accountable and transparent institutions”; “ensure responsive, inclusive and representative decision-making”; “strengthen the par- ticipation in global governance”; and “ensure public access to information and protect fundamental freedoms.” (4) This index, developed as part of a project administered by the World Bank and the World Bank Institute, identifies aggregate and individual indicators for more than 200 countries across six dimensions of governance: voice and accountability, political stability and lack of violence, government effectiveness, regulatory quality, rule of law, and control of corruption, see 18 GOVERNANCE OF ETS ICAP & WORLD BANK resources; and features related to the actual results of the sake of simplicity, they are labeled “principles”, governance, including its effectiveness and fairness. although that designation does not imply a formal Of these three sets of features, the latter is the most or universally accepted status.5 The list is neither contested, as they are likeliest to introduce subjective exhaustive, nor free of conceptual overlap. Also, value judgments and raise questions about causal it comes with an important caveat: no abstract attribution (Fukuyama 2013). Frequently included as a principle can account for all the unique circumstances separate category is adhesion to the rule of law, where encountered in a practical context, and some involve interpretations again vary, but core features – such as a greater degree of subjectivity in their application the impartiality and accountability of public authority, than others. As such, these principles are primarily protection of individual and collective rights, and an meant as a heuristic guide, and not as a prescription of absence of corruption – are commonly acknowledged. particular outcomes. Even without explicit reference, however, the principles manifest themselves at various Table 3 below lists a number of such recurring features stages in the governance of an ETS, and will therefore and briefly describes their main implications. For be revisited in later parts of this report. Table 3: Principles of Successful Governance Principle Description Participation Active and informed involvement of all affected or interested stakeholders in a decision-making process, whether directly or through representatives, and facilitated through formal and informal procedures such as consultations, hearings, surveys, and meetings Transparency Information on matters of public concern, including decision-making and implementation processes, is disclosed and made accessible to the public or to affected stakeholders in appropriate formats, in some cases subject to a right or guarantee of access to information Accountability Accountability implies answerability or responsibility for an action or outcome. Accountable parties, such as government institutions or officials, are answerable for the consequences of decisions they have taken, whether politically or within the organizational hierarchy they form part of Rule of Law Rule of law requires that the government act within the limits of its powers as prescribed by law, through impartial exercise of legislative, executive and judicial authority, respectful of individual and collective rights, within the boundaries of clear, determinate, and stable laws and a rule-based process Effectiveness Institutions, processes and actors involved in governance have the capacities to meet the and Efficiency needs of society while making the best use of the resources at their disposal, ensuring timely delivery of public services through a professionalized bureaucracy and avoiding unnecessary administrative cost Equity and Equity and fairness require that distributional impacts, especially on the most vulnerable, be Fairness taken into consideration during governance, ensuring that everyone has a stake in the outcome and no one feels alienated (5) Instead, the term “principle” is used loosely here, to denote a general proposition or value that serves as a guide for behavior or evaluation. GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 19 03. Governing Emissions Trading Systems: An Overview This chapter connects the conceptual framework outlined in the previous chapter to concrete governance requirements in an ETS. To that end, it describes the importance of governance for a functioning ETS, and introduces relevant actors, tools and processes. It subsequently highlights governance challenges at various phases in the evolution of an ETS, from its establishment through its operation to its review and amendment. Finally, it applies the principles of successful governance identified in the previous chapter to the context of emissions trading. 20 GOVERNANCE OF ETS ICAP & WORLD BANK 3.1 Emissions Trading and the with its rules and reviewing its operation. As will Governance Challenge be shown below, governance challenges manifest With any market, governance is critical to secure themselves differently across each stage of ETS the conditions needed for an efficient allocation of design and implementation, yet all of which place resources (Stiglitz 2012). However, as was already high demands on the actors involved in relevant observed early on in the development of carbon governance processes. Ensuring sufficient capacity trading, an ETS – which is premised on an artificially of these actors, including technical expertise and constrained supply of emission units created via policy professional staff, is therefore an important condition decision – poses a unique set of governance challenges of successful ETS governance, with such capacity (Newell, Jenner, and Baker 2009). In jurisdictions with often having to be newly created (Brewer and Mehling limited administrative capacities or lacking experience 2014). Adequate capacities are not only required with markets, such challenges may be particularly within government, moreover: shortfalls among pronounced (Bell 2003; 2006). Commentators other stakeholders – such as covered emitters – can have even suggested that, in the absence of robust erect barriers for the successful operation of an ETS. governance structures, abusive market behavior could Addressing the underlying cognitive,7 organizational, proliferate and severely erode the benefits of an ETS and political deficiencies can take time and require (Nordhaus 2005).6 As an ETS moves from theory to significant resources. practice, its conceptual simplicity thus gives way to a complex governance reality. Governing an ETS is more than a matter of ensuring adequate capacities, however. Some governance ETS governance is closely related to, yet also distinct challenges are owed to the unique incentive structure from, more technical aspects of ETS design and in an ETS, which differs fundamentally from that of implementation. Whereas the choice of alternative most traditional markets: as long as transacted units design options, for instance, will be guided by how remain eligible for compliance purposes, market well these options secure agreed policy objectives participants can afford to be indifferent about the and at what cost, the governance dimensions of integrity of such units. Units are intangible in nature this choice relate to the process through which – which allows the transfer of large quantities almost that decision is reached, the actors involved in the instantly – and their supply is largely inelastic, process, and the tools used to support the decision. because it is based on political decisions more than Similarly, technical aspects of implementation, such market signals. All these factors render an ETS more as the definition and periodic update of emission susceptible to price volatility and extremes, as well as factors to quantify emissions from covered activities, strategic or fraudulent market behavior (Hahn 1984; go hand in hand with governance concerns, such Hintermann 2011). as the transparency or confidentiality of emissions information, accountability for inaccurate reporting, Such vulnerabilities have occasionally manifested and institutional capacities to process and store themselves in practice, with detrimental effects for data. Boundaries can be fluid, and this report often the operation of the ETS and its support among introduces the technical dimensions of ETS design stakeholders and the broader public. Risks in the and implementation to provide context for their market for emission units became particularly visible governance implications. in a string of criminal activities encountered early on in the EU ETS, including value-added tax (VAT) fraud, Virtually all stages of ETS design and implementation phishing attempts on a national registry, and a series entail a governance dimension, from the initial of cyber-thefts (Europol 2009; Interpol 2013; Guegan, decision to establish an ETS to enforcing compliance Lassoudiere, and Frunza 2011; Keyzer et al. 2012, 13; (6) Referring to international emissions trading under the Kyoto Protocol and observed instances of fraudulent accounting, Nordhaus expressed concern that “cheating will probably be pandemic in an emissions trading system that involves large sums of money.” GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 21 Nield and Pereira 2016). Although the technical and Overall, a number of governance requirements have regulatory loopholes that enabled these incidents to be met for an ETS to function. These requirements were promptly rectified, they illustrate the stakes differ for each stage in its evolution, and involve at play in ETS governance. different channels of governance. A survey of these channels – again broken down in relevant actors, A desire to avoid such events may tempt policy tools, and processes – is presented in the next section, makers to seek the strictest regulatory framework followed by a taxonomy of governance functions in possible. Doing so would also increase the relation to key phases of emissions trading. Finally, the administrative burden, however, as well as the broad principles of successful governance identified transaction costs faced by market participants. Not in the previous chapter are discussed in the context of only might that diminish market liquidity and the an ETS, and correlated to the individual governance efficiency of price discovery (Stavins 1995), but it functions for better illustration. could altogether deter market participation (Nordhaus 2005). Ideally, therefore, the governance framework 3.2 Governing an ETS: of an ETS will identify a workable balance between Actors, Tools and Processes stringency and flexibility, in itself a daunting task. Given An earlier chapter of this report described the general the political nature of emissions trading as a policy channels through which governance can occur, with often significant distributional implications, any singling out relevant actors, tools, and processes (see such balance will be constantly tested by pressure Chapter 2.3). These channels can also be identified from different stakeholders, ranging from compliance in the context of an ETS, where governance relies on entities to public interest groups. the activities of various actors and recruits a number of tools and processes. Because an ETS entails the Like other climate policies, an ETS is exposed to creation of a market, these channels differ in important rent seeking behavior at different stages of its ways from those found in the governance of most evolution, but the complexity of this policy approach other climate policies. In fact, some of the channels arguably expands the number of entry points for that play a role in the governance of an ETS originated stakeholder influence (Grumbach 2015; Meckling in other markets, such as the financial market, from 2011). Stakeholders have, for instance, sought to which approaches to govern market behavior have influence the design of an ETS to increase flexibility, been drawn on when regulating emissions trading. maximize rents, and weaken compliance oversight This section provides a general overview of the actors, and penalty rules (Markussen and Svendsen 2005). tools, and processes relevant to the governance of Additionally, while emissions trading can reduce the an ETS, while later chapters provide greater detail on economic cost of achieving a defined mitigation specific channels in their respective context. target, it may not always distribute the resulting burden in ways that are considered fair or politically Actors. As in governance more generally, the public acceptable. Successful governance of an ETS sector plays a central role in governing an ETS. The therefore requires engaging affected constituencies public sector, in this case, includes all three branches while securing the impartiality and independence of of government: legislative, executive, and judicial. relevant decision making. Because of the importance By far the most visible is the executive branch, of sustained confidence in the functioning of an ETS where relevant functions may be distributed across (Smith and Mayer 2018), creating the right conditions several entities or concentrated in one entity that has for dialogue and mutual understanding may overall responsibility for the administration of the ultimately be the most important purpose served by ETS. In jurisdictions with distributed responsibilities, its governance framework. decisions about system design – including political 22 GOVERNANCE OF ETS ICAP & WORLD BANK coordination and rulemaking – are often reserved to involvement extends well beyond them: a wide the highest level of the executive branch, such as a variety of service providers also contribute to national ministry or department, whereas technical the different governance functions. Financial implementation and enforcement may be intermediaries, such as banks or brokers, provide delegated to subordinate bodies at the national, liquidity and risk management through lending and regional or local level. Often, the entity tasked with brokerage services as well as derivative products facilitating and supervising the routine operation (see Chapter 5.3). of the ETS – which may be an existing or a newly created administrative agency – will serve as the Similarly, exchanges and clearing platforms improve main contact point for compliance entities and market transparency and reduce counterparty risk. other stakeholders, and is therefore known as the Project developers originate and implement offset ‘ETS administrator’. projects. Other service providers, such as legal and accounting professionals as well as consultancies, Other parts of the executive branch can also become help market participants understand and involved in ETS governance, for instance those meet regulatory obligations, and also promote agencies responsible for overseeing financial and harmonization of practices and overall compliance. energy markets, managing statistical data, or defining Interest groups, such as trade associations and economic and industrial policy. Depending on the environmental advocacy groups, aggregate and scope of the ETS and its design, government entities articulate the preferences of their members in key responsible for administering the transport sector governance processes. Analysts and, more generally, and the agriculture and forestry sectors may become the media provide market intelligence and increase relevant, as may the treasury if there is auctioning transparency, helping inform market decisions and revenue. Although less visible, the legislative and foster overall trust in the ETS. judicial branches of government also enjoy important roles: the legislature when it comes to establishing a Some actors sit at the interface of public and private formal legal basis for the ETS, and the judiciary when sector, operating as Public-Private Partnerships (PPPs). it comes to resolving disputes arising in the context of These are themselves organized as private entities, but emissions trading. with a mandate to carry out public functions. Among these are accredited verifiers, who support the ETS On the other side of the dividing line between administrator and its oversight responsibilities by public and private sector are the compliance auditing the emission reports of compliance entities. entities (also referred to as ‘regulated entities’), Similarly, exchanges are charged with ensuring their that is, those actors – such as electricity generators members adhere to disclosure requirements and other or industrial facilities – whose GHG emissions safeguards set out in financial market regulations. are covered by the ETS, and who are therefore Some systems delegate more comprehensive subject to compliance obligations. In most governance functions to private actors, such as the systems, these tend to be individual installations tracking and allocation of emission units and overall owned by private companies, although some market monitoring (see Chapter 4.2.1). Finally, different ETSs cover companies rather than installations, standardization bodies help develop and administer and some also include partially or wholly common rules and guidance, for instance on the state-owned enterprises (SOEs). MRV of emissions or offset projects, that are then recognized or applied for compliance purposes. Table Compliance entities may be the main addressees 4 below provides an overview of actors involved in ETS of governance under an ETS, but private sector governance and gives examples for each category. (7) ‘Cognitive‘, in this context, refers to the informational deficiencies – such as information asymmetries – of administrative institutions, as well as the bounded rationality and cognitive biases of administrative personnel (see Viscusi and Gayer 2015). GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 23 Table 4: Actors in ETS Governance Actor Function Example(s) California Air Resources Board (CARB), ETS Administrator Overall management of the ETS German Emissions Trading Authority (DEHSt) Lead Executive Agency Political oversight and coordination, German Ministry for the Environment, Nature (where different from executive rulemaking Protection and Nuclear Safety (BMU) ETS Administrator) U.S. Commodity Futures Trading Commission Other Executive Offer guidance, support and scientific (CFTC), Japanese Statistics Bureau, Nether- Agencies input on select issues lands Environmental Assessment Agency (PBL) Public European Council and Parliament, Mexican Legislature Adopt formal ETS legislation Congress Resolve conflicts and decide judicial German Bundesverwaltungsgericht (BVerwG), Judiciary disputes UK High Court International Organi- Provide technical assistance, coopera- World Bank, International Carbon Action zations and Networks tion, and thought leadership Partnership (ICAP) Western Climate Initiative, Inc. (WCI, Inc.), Delegated Support Support on delegated tasks Regional Greenhouse Gas Initiative, Inc. Entity (RGGI, Inc.) Accredited accounting, auditing and Accredited Verifiers Audit and verify emissions reports certification firms Standardization Develop and administer standards and International Organization for Standardization Bodies guidance (e.g. for MRV, offset credits) (ISO), offset standard administrators Compliance Entities Subject to compliance obligations Utilities, industrial facilities Offer platform for trading of emission PPP European Energy Exchange (EEX), Exchanges units and derivatives, sometimes also Intercontinental Exchange (ICE) clearing and auctioning services Market making by facilitating transactions in emission units Commodity trading firms, specialized Brokers and derivatives, usually for non- dealers and brokers standardized transactions and smaller volumes; aggregating transactions Lending and financing, hedging Commercial banks, investment banks, Banks counterparty credit unions Originate and develop offset crediting Offset project owners, consultancies, Project Developers projects specialist service providers Professional Provide legal, accounting and other Consultancies, law firms, accounting firms Services advisory services Private Provide market intelligence, such as Financial analysts, strategic research Analysts price and transaction data providers, market data aggregators Report on policy and market Print media, broadcast news, trade Media developments publications Aggregate and articulate member Interest Groups Trade associations, environmental NGOs interests Research and Participate in foundational research Universities, think tanks Academia and education 24 GOVERNANCE OF ETS ICAP & WORLD BANK Tools. In general terms, an ETS draws on the same Processes. Processes likewise assume an important tools as other governance processes (see Chapter role in the governance of an ETS. Predictable, trans- 2.3). Itself the outcome of a policy decision, an ETS is parent, and inclusive processes can strengthen both particularly reliant on a variety of formal and informal the material quality of governance outcomes as well as policy statements for its governance framework, their acceptance by affected stakeholders. As mentio- including statutory legislation, administrative ned previously (see Chapter 2.3), distinguishing bet- ordinances, and technical guidelines. The level of ween tools and processes can be difficult at times. In formality and pedigree of these policy documents will an ETS, for instance, the compliance cycle (see Chapter depend on the aims they set out and their relative 5.2) represents a process of successive steps across a importance, as well as the degree to which they specified period of time, yet it is set out by way of poli- intervene in individual or collective behavior (see also cy statements defining each step in the process – such Chapter 4.1.2). Substantively, they can deploy a variety as the monitoring or reporting obligations – which of measures to influence behavior, such as planning, could, in turn, be classified as governance tools. suasion, prohibitions, obligations, authorizations, and Often, such processes are formally mandated by law, sanctions (see Table 5). such as the administrative process required in many jurisdictions when adopting or amending administrati- Institutional structures also play an important ve acts and ordinances, whereas others occur sponta- role, such as the registry established to track the neously in the exercise of administrative discretion or distribution and transfer of emission units, or a service due to stakeholder initiative. Some processes occur desk operated by an ETS administrator to assist only once or on occasion of major system changes, compliance entities. Finally, information can be an whereas others recur periodically throughout the important tool in the governance of an ETS, with the existence of the ETS, including the processes relating nature of information collected or generated – for to the distribution of emission units, the compliance instance data on emissions or market activities, or cycle, or ETS performance review. Judicial or media- independent assessments of market functioning – tion proceedings, finally, can be triggered in the event and the scope and timing of its disclosure all of legal disputes, for instance about the terms of a potentially influencing public perceptions and transaction or objections against a decision by the stakeholder behavior. ETS administrator. Table 5: Examples of Policy Tools Used in an ETS Type Examples Planning Setting the emissions cap or intensity target Suasion and Support Providing compliance assistance to covered emitters Prohibition Prohibition on theft, fraud, tax evasion or money laundering Obligation Obligation to monitor and report emissions Obligation to surrender emission units Obligation to disclose market activity data Authorization Requirement of operating permit for emitting installations Requirement of securities license to trade in financial products Requirement of accreditation to verify emission reports Sanction Administrative penalty and public disclosure of offender for failure to comply Criminal sanction for theft, fraud, tax evasion or money laundering GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 25 3.3 Governing an ETS: Each of these phases entails important governance The Phases of Emissions Trading functions, which are explored in greater detail and An ETS is not a static policy instrument: it is the with reference to practical experiences in subsequent product of an evolutionary process over time. chapters of this report. During the establishment of Borrowing from the conceptual depiction of the policy an ETS, specifically, governance acquires relevance cycle introduced in Chapter 2.3, this process can be for the processes that precede introduction of the broken down into three main phases: ETS as well as the architecture that sets out its • the initial establishment of the ETS; design. Table 8 below lists governance functions and • its routine operation; channels encountered during this inception phase, • and its review and amendment. and distinguishes three separate contexts that will also inform the structure of deeper analysis in Chapter 4: To visualize how they relate to and influence • the political and legal process; each other, these phases in the evolution of an • the institutional and regulatory framework ETS can be correlated with the stages in the policy of the ETS; cycle (see Figure 4). • and the technical and administrative capacities needed to establish the ETS. Applying this conceptual framework, the establish- ment of an ETS entails defining its objectives, identi- Different actors, tools, and processes play a role fying and evaluating alternative design options, and in each of these governance contexts. For ease reaching a decision on its adoption. Some steps in the of reference, Table 6 (pg.27) also correlates the initial establishment, such as the elaboration of the governance functions – on which this report focuses legal framework and the creation of administrative – to the design steps outlined in the PMR/ICAP structures, already contribute to policy implementa- Handbook “Emissions Trading in Practice: a Handbook tion, which otherwise mostly consists of the continu- on Design and Implementation” (PMR and ICAP 2021). ous process of routine operation. Finally, performance review correlates with the policy evaluation stage, Once the ETS has been established, a new phase in which in turn can result in modifications to the ETS, its governance begins. This is the phase of routine beginning the cycle over again. operation, which, unlike the previous phase, is less concerned with setting up new structures than it is with exercising day-to-day administrative functions and applying and enforcing rules. Here, the main Figure 4: Phases of Emissions Trading and governance functions relate to: the Policy Cycle • compliance oversight, including oversight of emissions reporting, collecting and managing emissions data, and performing accreditation and oversight of verifiers; • market oversight, which includes determining ESTABLISHING REVIEWING OR AMENDING market access and safeguards against market THE ETS THE ETS volatility and vulnerability to fraud; Policy Evaluation Policy Formulation • transparency, which includes disclosure of Policy Decision emissions data and information about market activities to stakeholders or the general public; • and dispute resolution in the event of judicial proceedings or other conflicts. OPERATING THE ETS Table 7 (pg.27) identifies these governance Policy Implementation functions and gives examples of relevant actors, tools, and processes. 26 GOVERNANCE OF ETS ICAP & WORLD BANK Table 6: Governance Functions during the Establishment of an ETS Governance Context Governance Actors Tools Processes Steps Function Political and Stakeholder Lead Executive Agency, e.g. Stakeholder e.g. Public and 1 Legal Process Engagement ETS Administrator, Mapping, Stakeholder and Consensus Compliance Entities, Engagement and Consultations, Building Interest Groups Communication Working Groups Strategy Creating a Legislature, Lead e.g. Legislation, e.g. Legislative 0, 1, Robust Legal Executive Agency Executive or Rulemaking 2, 3 Basis Rulemaking Procedures Regulatory Lead Executive Agency e.g. Data, Cost- e.g. Public and 0 Impact Benefit Analysis, Stakeholder Assessment Economic Consultations, Modelling Workshops Institutional Defining Legislature, Executive e.g. Legislation, e.g. Legislative 0, 1, and Regulatory Institutional Agencies, ETS Executive or Rulemaking 4, 6, Framework Functions and Administrator Rulemaking, Process, 9 Responsibilities Guidelines Interagency Establishment Coordination Deciding Legislature, Executive e.g. Legislation, e.g. Legislative 0, 6 the Level of Agencies Executive or Rulemaking Formality and Rulemaking Process, Federal Centralization Coordination Embedding in Legislature, Executive e.g. Legislation, e.g. Legislative 6 the Broader Agencies, Judiciary Executive or Rulemaking Legal Framework Rulemaking Process Technical and Capacity Needs Executive Agencies, e.g. Educational e.g. Training 1 Administrative of Public ETS Administrator, Material, Courses, Capacity Authorities International Simulations, Seminars, Organizations and Guidelines Workshops Networks, Analysts Capacity Needs ETS Administrator, e.g. Educational e.g. Training 1 of Regulated Compliance Entities, Material, Courses, Entities International Simulations, Seminars, and Other Organizations and Guidelines Workshops Stakeholders Networks, Interest Groups, Analysts, Media Table 6 also correlates the governance functions – on which this report focuses – to the design steps outlined in the PMR/ICAP Handbook “Emissions Trading in Practice: a Handbook on Design and Implementation” (PMR and ICAP 2021). Once the ETS has been established, a new phase in its governance begins. GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 27 Table 7: Governance Functions during the Operation of an ETS Governance Governance Actors Tools Processes Steps Context Function Compliance Oversight of the ETS Administrator, e.g. Reporting e.g. Compliance 6 Oversight Compliance Accredited Guidelines, Cycle, Accreditation Cycle (MRV and Verifiers, Complian- Accreditation Procedure Enforcement) ce Entities Criteria, Penalties Market Oversight of Market ETS Administrator, e.g. Registry, e.g. Authentication 6 Oversight Actors and Activities other Executive Registration and Process, Harmoni- Agencies, Disclosure Obli- zation of Financial Compliance gations, Position Market Rules as well Operation Entities, Market Limits as Accounting and Intermediaries Taxation Rules Transparency Disclosure of ETS Administrator, e.g. Emissions e.g. Reporting 1, 6 Emissions and other Executive Inventory, Emitter Cycles, Media Market Data, Agencies, Compli- Database, Central Engagement Information on ance Entities, Mar- Limit Order Book Revenue Use ket Intermediaries Conflict Resolution of ETS Administrator, e.g. Judicial e.g. Hearings, 6 Resolution Judicial Disputes or Judiciary, Rules of Appeal Process Mediation Professional Procedure, Services Mediation Table 7 identifies these governance functions and gives examples of relevant actors, tools, and processes. Table 8: Governance during the Review of an ETS Governance Governance Actors Tools Processes Steps Context Function Performance Assessing the Legislature, Lead e.g. Economic e.g. Evaluation 9 Review Performance of the Executive Agency, Modeling, Process, ETS and the Need for other Executive Qualitative Surveys Stakeholder Modifications Agencies, ETS Engagement Administrator, Review Analysts System Managing Legislature, Lead e.g. Legislation, e.g. Legislative 8, 9 Change Modifications to Executive Agency, Executive or Rulemaking the ETS, including ETS Administrator Rulemaking, Procedures, Linking and Notification Consultations Termination Table 8 lists governance functions and channels encountered during this inception phase, and distinguishes three separate contexts that will also inform the structure of deeper analysis in Chapter 4: the political and legal process; the institutional and regulatory framework of the ETS; and the technical and administrative capacities needed to establish the ETS. 28 GOVERNANCE OF ETS ICAP & WORLD BANK Finally, as mentioned at the outset of this section, sectors and activities, the establishment of a link to at certain points in its evolution, an ETS will face another ETS, or, finally, the termination of an ETS. the need for a review of its performance and 3.4 Principles of Successful ETS Governance potentially for adjustment or modification. Such a No set of abstract principles can ensure successful review will often be mandated at periodic intervals governance of a policy instrument as complex and in the legal framework of the ETS, for instance at the context sensitive as an ETS. Still, the principles outlined end of a compliance period. in the previous chapter (see Chapter 2.4) have shown It can also be discretionary, however, for instance in a reliable correlation with improved governance response to unforeseen developments such as an outcomes and are likewise apparent in key design economic shock or the adoption of a more ambitious choices and implementation practices found in mitigation target. During such a review, the perfor- existing ETSs. That is not to say that these ETSs were mance of an ETS will usually be evaluated against the necessarily designed and implemented to consciously objectives for which it was introduced in the first place, internalize such principles. Rather, it serves as a although these may also be revisited as part of the reminder that the principles are themselves born out review process to reflect evolving fundamental and of a legacy of relevant experiences and observations in political circumstances. the exercise of public authority, which, in turn, justifies their consideration in the establishment, operation and If the review culminates in a decision to modify the review of an ETS. ETS, many of the processes already encountered during the initial establishment of the ETS acquire For instance, given their technical complexity, ETSs relevance again. Managing system change is, in other have typically been preceded by extensive stakeholder words, also an important function of governance, and engagement and capacity building activities, both ranges from minor design recalibrations to more fun- to foster better understanding as well as to obtain damental adjustments, such as the expansion to new feedback that may help improve system design. Figure 5: Governance Phases, Contexts and Functions in an ETS PHASE ESTABLISHMENT OPERATION REVIEW ADMINISTRATIVE TECHNICAL AND TRANSPARENCY INSTITUTIONAL PERFORMANCE CONTEXT COMPLIANCE RESOLUTION FRAMEWORK OVERSIGHT OVERSIGHT AND LEGAL AND LEGAL POLITICAL CONFLICT CAPACITY PROCESS CHANGE MARKET SYSTEM REVIEW THE COMPLIANCE CENTRALIZATION OF INFORMATION RESPONIBILITIES MARKET ACTORS CAPACITY NEEDS FUNCTION MODIFICATIONS INSTITUTIONAL AND ACTIVITIES ASSESSING ETS PERFORMANCE MANAGING ETS ROBUST LEGAL OVERSIGHT OF OVERSIGHT OF STAKEHOLDER EMBEDDING IN ENGAGEMENT AUTHORITIES ASSESSMENT DISPUTES OR REGULATORY FRAMEWORK DISCLOSURE CREATING A OVERSIGHT MEDIATION THE LEGAL OF PUBLIC LEVEL OF JUDICIAL MARKET IMPACT CYCLE BASIS GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 29 A sufficient level of transparency – in the form of se administrative discretion, or operationalize relevant available data on emissions or market activities – is procedures. As experience with emissions trading vital for the efficient allocation of resources in the has shown, however, successful ETSs tend to reflect market through informed decisions. Accountability and the rule of law, in turn, are important for these principles in their governance practices, whether credibility of the system and confidence in the market. expressly or implicitly. How exactly they have done so Ensuring fairness by considering the distributional will be described over the next three chapters, drawing consequences of emission unit allocation or revenue on concrete examples for each governance context and expenditure can be critical to sustain political support. function featured in Table 9 on the next page. Table 9 relates the governance principles introduced in Chapter 2.4 to the three phases of ETS design and implementation, and lists the governance context and functions on which they have a bearing. Again, an A sufficient level of ETS will not succeed simply because its governance is faithful to these principles, nor will it necessarily fail transparency – in the form of just because these principles have not been conscious- ly internalized. Due to their general nature, principles available data on emissions rarely dictate a specific outcome and will, in fact, some- times contradict each other, for instance when transpa- or market activities – is vital rency interests collide with vested rights of privacy or confidentiality that form part of the rule of law. for the efficient allocation Overall, therefore, the value of principles primarily of resources in the market consists in offering guidance when the need arises, for instance, to balance alternative design options, exerci- through informed decisions. 30 GOVERNANCE OF ETS ICAP & WORLD BANK Table 9: Principles of Successful ETS Governance Governance Phase Governance Context Governance Function Principle Participation Establishment Political and Legal Process Stakeholder Engagement and Consensus Building Review Performance Review Assessing the Performance of the ETS and the Need for Modifications System Change Managing Modifications to the ETS, including Linking and Termination of the ETS Transparency Operation Transparency Disclosure of Emissions and Market Data, Informa- tion on Revenue Use Compliance Oversight Oversight of the Compliance Cycle (MRV and Enforcement) Market Oversight Oversight of Market Actors and Activities Accountability Operation Compliance Oversight Oversight of the Compliance Cycle (MRV and Enforcement) Market Oversight Oversight of Market Actors and Activities Conflict Resolution Resolving Judicial Disputes or Mediation Rule of Law Establishment Political and Legal Process Creating a Robust Legal Basis Institutional and Defining Institutional Functions and Responsibili- Regulatory Framework ties Deciding the Level of Formality and Centralization Embedding in the Broader Legal Framework Operation Conflict Resolution Resolving Judicial Disputes or Mediation Review System Change Managing Modifications to the ETS, including Linking and Termination of the ETS Effectiveness and Establishment Political and Legal Process Regulatory Impact Assessment (RIA) Efficiency Technical and Capacity Needs of Public Authorities Administrative Capacity Capacity Needs of Regulated Entities and Other Stakeholders Operation Market Oversight Oversight of Market Actors and Activities Review Performance Review Assessing the Performance of the ETS and the Need for Modifications System Change Managing Modifications to the ETS, including Linking and Termination of the ETS Equity and Fairness Establishment Political and Legal Process RIA GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 31 04. First Phase: Establishing the ETS Chapter 4 discusses governance requirements during the establishment of an ETS, encompassing both the processes that precede introduction of the ETS as well as the legal and administrative architecture that sets out its design. It breaks down the institutional, regulatory and procedural structures that need to be in place at the outset of an ETS and highlights the roles and responsibilities of relevant actors. To that end, Chapter 4 distinguishes three governance contexts encountered during this inception phase: the political and legal process preceding its establishment; the institutional and regulatory framework of the ETS; and the technical and administrative capacities needed to establish the ETS. 32 GOVERNANCE OF ETS ICAP & WORLD BANK 4.1 Political and Legal Process 4.1.1 Engaging Stakeholders and The introduction of an ETS will usually be preceded Building Consensus by a political and legal process, in which the Setting up an ETS involves making decisions about implementing jurisdiction considers options to countless options for its design and implementation, achieve defined policy objectives and progresses and understanding the respective implications of through a series of procedural steps. In the conceptual alternative choices. While governments often possess framework of the policy cycle described earlier extensive information – such as statistical data – (see Chapter 2.3), these are the stages of problem to help inform these choices, they may not have identification and policy formulation that eventually the same understanding of a particular context as culminate in a policy decision and its implementation. affected stakeholders. For instance, when it comes to Because political processes and the actors and estimating the abatement costs and opportunities in interests they involve are specific to a jurisdictional a specific sector, the emitters in that sector will often context, not all experiences and practices are easily have more recent and more accurate information transferable. Still, in general terms, some common than the government. To correct such information features can be identified across jurisdictions. asymmetries, governments can engage stakeholders and solicit views by way of different outreach activities. Before reaching a decision Stakeholder engagement is not only important to about the establishment obtain better technical and economic data, but it is also a means of building consensus, both among of an ETS, policy makers stakeholders and the general public, to secure broad acceptance of the ETS. This in turn improves its and stakeholders will seek durability, and fosters sustained confidence in the resulting market. While emissions trading can reduce to understand the options the economic cost of achieving a defined mitigation target, it may not always distribute the resultant available for ETS design and burden in ways that are considered fair or politically acceptable. Successful governance of an ETS implementation. therefore tends to entail an open dialogue with affected constituencies, affording them an opportunity to voice concerns and develop a sense Before reaching a decision about the establishment of ownership regarding the outcome. That said, of an ETS, policy makers and stakeholders will seek to policy makers have to balance consideration of understand the options available for ETS design and stakeholder views and the need to ensure the implementation. This process can be greatly enhanced impartiality and independence of their decisions. through early engagement with stakeholders in the Stakeholders will often seek to influence policy choices private sector and civil society, coupled with an active in their favor, but such particular interests may not outreach and communications strategy (see Chapter always align with the broader public interest in an 4.1.1). Once a jurisdiction decides to move forward effective ETS (Markussen and Svendsen 2005). and set up an ETS, it will typically require an existing or newly created legal basis empowering it to do so In practice, policy makers have a number of tools (see Chapter 4.1.2). Often, a detailed assessment of at their disposal to engage stakeholders and the the environmental, economic, and social impacts will general public. It can be helpful to develop a detailed accompany this process (see Chapter 4.1.3). Each of engagement and communications strategy well these governance steps is described in greater detail in advance that specifies the format, timeline, and below, along with case studies drawn from several objectives of engagement, and that ensures clarity existing ETSs. and consistency throughout the process (PMR and GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 33 ICAP 2021). Opinion surveys, focus groups, and other with stakeholders in their ETS. Such continuity forms of market research can help map stakeholder is important, as stakeholder engagement not positions, interests, and concerns related to emissions only matters during the planning and initial trading or specific design and implementation options design of an ETS, but should also persist (PMR and CPLC 2018). Often, rules of legislative and throughout its implementation and operation. administrative procedure will require formal hearings, Costs incurred through such activities can be borne consultations, and other means of stakeholder by the state budget, or they can be partially or entirely involvement as part of the rulemaking process. recovered from stakeholders through participation fees. Less formal activities, such as expert workshops, As the case studies in Box 1 below underscore, can help solicit feedback at specific points in the many jurisdictions have established institutionalized evolution of an ETS, such as a review of system processes – such as working groups or standing performance and amendments to system design committees – to facilitate continuous engagement (see Chapter 6). Box 1: Stakeholder Engagement in Existing ETSs Existing ETSs offer valuable insights into period, CARB conducted more than 40 space to discuss what the appropriate how stakeholders can be engaged during workshops to solicit input and promote measures could be, and convened a broad the introduction of emissions trading and agreement on ETS design issues. CARB also range of stakeholders, including business beyond. This box provides an overview constituted several advisory groups for associations, NGOs, and members of the of the approaches chosen in California, this process, which included stakeholders legislature. Over 160 AGE meetings have Québec, Germany, and Nova Scotia. from academia, government, NGOs, and taken place since it was launched, and business. These groups provided feedback all have been held under the ‘Chatham From 2008 to 2010, California and Québec, on several areas of ETS design, including House Rule’, meaning that participants are as partners of the Western Climate direct allocation of allowances versus free to use the information received, but Initiative (WCI), discussed and adopted the auctioning of allowances, use of auction neither the identity nor the affiliation of the framework and guidelines for the ETS they proceeds, assessing risks to market-based speaker, nor that of any other participant, wanted to implement with a view to linking systems, and environmental justice issues. may be revealed. Deliberations are recorded their respective systems in the future. In 2009, the focus of workshops shifted to – observing the Chatham House Rule – in All decisions were taken by consensus. decisions on issues for which there were the form of meeting proceedings. Members In California, informal engagement with several potential options, such as auction of the group must pay an annual fee to stakeholders was critical and proceeded design, trading rules, allocation, offsets, participate (although environmental NGOs in two parts. In 2007, California and other cost containment, how to address leakage, are exempt), but fees only fund the AGE western States founded the WCI in a bid and market oversight. In 2011, as the draft secretariat and cover the cost of meetings. to address climate change at a regional Cap-and-Trade Regulation came close The AGE is not meant to provide direct level. The WCI policy process culminated to being finalized, workshops reviewed advice to regulators, but its deliberations in design recommendations for a multi- specific proposals for regulatory text. inform, and therefore have an indirect state GHG registry to track and manage Québec followed a very similar process with impact on, ETS governance. emissions, and a market-based program a slightly different timeframe. While the to reach GHG emissions reduction outreach and engagement processes took Finally, the province of Nova Scotia is small targets. The WCI policy discussions and time, they afforded more interaction with enough that stakeholder engagement in recommendations provided a critical venue stakeholders, and allowed government staff the inception of its ETS could be conducted to develop the framework for the ETS, build to understand stakeholder issues better, directly with designated participants in support, and educate key stakeholders and to address specific concerns. the system, as well as other parties. The including industry, government, academia, consultation process for its ETS, which has and the public. Similarly, Germany established a been in force since January 2019, involved dedicated working group (Arbeitsgruppe a public consultation in March 2017, over 50 Concurrent with the WCI process, California Emissionshandel zur Bekämpfung des meetings with stakeholders (including two initiated informal engagement with Treibhauseffektes, or AGE) in 2000, well in large group sessions), and the evaluation of stakeholders interested in developing advance of the launch of the EU ETS in 2005. written responses and online stakeholder a California ETS. This engagement took The decision to set up the AGE originated submissions. A summary of feedback was place from early 2008 through completion in the German federal government, which released in a report in August 2017 (Nova of the California Cap on Greenhouse Gas at the time recognized the need for new Scotia 2017), which informed development Emissions and Market-Based Compliance emission reduction policies and measures of the program. Provincial regulators Mechanisms Regulation (California Cap- to meet obligations arising under the continue to have ongoing discussions with and-Trade Regulation) in 2011. During this Kyoto Protocol. The AGE provided a stakeholders even as the ETS is in force. 34 GOVERNANCE OF ETS ICAP & WORLD BANK 4.1.2 Adopting a Robust Legal Basis an ordained procedure governing the conditions to A common starting point of any ETS is the legal basis initiate relevant legislation or executive rulemaking, that mandates its creation and sets out its central the actors involved, and the applicable timeline. That parameters. An ETS imposes significant constraints does not mean, however, that all operational details on the economic freedom of regulated entities, which of an ETS need to – or indeed should – be set out in is why its introduction will generally presuppose a formal statutory law. On the contrary, legislators have formal mandate by a legislature or comparable body. to make a choice about the appropriate formality – or This requirement for a formal legal basis is a manifes- legal ‘pedigree’ – of different ETS design elements. tation of the rule of law, and vital for the subsequent One way to visualize the available options is the exercise of public authority by the executive branch.8 ‘normative pyramid’, in which different types of norms Central parameters of the ETS, such as the main rights are hierarchically ranked by their degree of formality and obligations of participants and core institutional and normative pedigree, with higher-ranking norms functions, are therefore also often set out in formal superseding lower-ranking rules (see Figure 6). Where legislation. a norm is situated in this hierarchy will also entail different procedural requirements, with ramifications Aside from formally establishing the ETS, the legal for the regulatory timeline and the extent of mandato- basis also frequently operationalizes various elements ry stakeholder involvement. That, in turn, affects the of the ETS governance framework, such as rules and flexibility of such norms to adjust to changing circums- procedures related to the compliance cycle (see tances, but also has implications for the perceived le- Chapter 5.2). From the moment a jurisdiction considers gitimacy and legal certainty they can afford to market the establishment of an ETS, it will usually adhere to participants and other stakeholders. Figure 6: The Normative Pyramid9 IN SOME JURISDICTIONS ALSO: CONSTITUTION INTERNATIONAL TREATIES STATUTORY e.g. LAWS, ACTS, STATUTES LEGISLATION EXECUTIVE e.g. REGULATIONS, RULEMAKING ORDINANCES, DECISIONS TECHNICAL NORMS e.g. ADMINISTRATIVE DECREES, AND GUIDELINES NOTICES (8) In some jurisdictions, the requirement is therefore called ‘statutory reservation’, meaning that any administrative action requires a formal legislative basis authorizing such action. (9) Note that terminologies vary across jurisdictions, in line with their unique legal traditions and convention. GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 35 Figure 7: Timeline of the Legal Basis for the EU ETS Legislative adoption Reform legislative Reform legislation Formal legislative Third trading period to link to Kyoto adoption for 2013 adoption for 2021 proposal submitted (2013-20) starts project mechanisms and beyond and beyond 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 EU ETS Early proposal Basic legal launches Second Market Fourth Aviation for an ETS framework with first trading period stability trading period included in discussed in adopted and trading (2008-12) reserve (2021-30) the EU ETS consultations in force period starts adoption starts (2005-07) Generally speaking, higher-ranking norms enjoy on the particular circumstances in a given context. greater resilience against judicial review as well as Figure 7 shows a timeline of the initial adoption and amendment, suspension or annulment following subsequent reforms of the legal basis of the EU ETS, political changes, but are also more cumbersome to illustrating the often-extended periods of preparation adopt or adjust. In the context of an ETS, opting for a and deliberation before formal legislation could enter legal basis that is situated higher up in the normative into effect. That high level of formality has helped pyramid, such as formal legislation, can strengthen the EU ETS withstand a number of legal challenges, the legitimacy and political durability of the ETS, but in large part because the legislative process that also tends to result in a slower and more cumbersome preceded its introduction and major reforms already adoption or amendment process. Conversely, norms necessitated building consensus across diverse that are placed lower, such as executive rulemaking interests and stakeholder constituencies to ensure and technical norms, are relatively more vulnerable passage. At the same time, the formality of the legal to political change and offer somewhat less stability basis can also make it harder to react swiftly to and predictability than formal legislation, but offer the system shocks, as exemplified by the long lead time of advantage of being easier to adopt and to amend. measures to address an allowance supply imbalance that began in the wake of the economic and financial Consequently, any decision about the formality crisis of 2009: nearly five years passed between that or pedigree of the legal basis of an ETS involves crisis and the adoption of legislation on the Market navigating trade-offs and identifying the right balance Stability Reserve (MSR) designed to address the between stability and legitimacy on the one hand, allowance supply overhang. and ease of adoption and flexibility on the other. There is no general prescription that is equally valid in all situations: the appropriate balance will depend 36 GOVERNANCE OF ETS ICAP & WORLD BANK Due to the political context of an ETS and its detailed examples of how different jurisdictions have market fundamentals being in a state of constant approached the choice of a legal basis for their ETS. flux, jurisdictions will routinely adopt certain elements In the end, however, these examples serve illustrative of an ETS through norms that have a lower level of purposes only: what approach will be most suited to formality and legal pedigree. As mentioned earlier, a specific jurisdiction will depend on local legal and the legal basis as well as central parameters of procedural constraints – as set out, for instance, in the ETS, such as its overarching objectives, general a constitution – as well as the prevailing regulatory principles, and the main rights and duties of covered entities, are often regulated at a higher level in the practices and legal culture. normative hierarchy, while operational details that require frequent updating or primarily consist of technical guidance, such as benchmarks and Table 10 provides an overview detailed MRV rules, are commonly adopted by way of more flexible sub-statutory ordinances and of the level of formality decrees. To illustrate how this can manifest itself in practice, Table 10 provides an overview of the level chosen for different parts of of formality chosen for different parts of the legal basis of the EU ETS. Box 2 (next page) sets out several the legal basis of the EU ETS. Table 10: Formality of Design Elements in the EU ETS Design Feature Norm Formality Legal Mandate Directive 2003/87/EC, as amended by Directive 2018/410/EU High Scope and Coverage Directive 2003/87/EC, as amended (Annexes) High Data Collection and Regulation (EU) 2018/1999 High Inventory Generation Nature and Stringency of Directive 2003/87/EC, as amended High Target Decision No 406/2009/EC; Regulation (EU) 2018/842 Medium Auctioning and Allocation Commission Regulation (EU) No 1031/2010 of Units and Definition of Commission Regulation (EU) 2019/331 Medium Benchmarks Commission Regulation (EU) 2019/1842 Guidance documents and tools Low Price Management and Decision (EU) 2015/1814 Medium Compliance Flexibility Decision No 1359/2013/EU Medium Registry Commission Regulation (EU) No 389/2013 Medium Monitoring, Reporting, Commission Regulation (EU) 2018/2066 Medium Verification (MRV) Commission Regulation (EU) No 2018/2067 Medium Guidance documents and compliance tools Low Compliance and Directive 2003/87/EC, as amended High Enforcement Directive 2014/57/EU Market Oversight and Directive 2014/65/EU High Regulation Regulation (EU) No 596/2014 High Commission guidance on the application of VAT to emission allowances Low GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 37 Box 2: Legal Bases of Emissions Trading in Existing ETSs Although there is no one single approach sions for the implementation of an ETS, as well as a staff report that explained the to the adoption of a legal basis for an ETS, regulations were developed to govern the need for the regulation and the rationale for many of the systems currently in opera- ETS process. Between 2011 and 2020, the each part. A final staff report also provided tion had their basis in amendments to government issued four National Allocation a written agency response to all comments existing climate or environment laws in the Plans for GHG allowances, marking the made during the formal process, and a vote respective jurisdictions. In New Zealand, trading periods of the ETS.12 Because inte- by CARB was then required to determine Kazakhstan, and Nova Scotia, for instance, rest groups representing the private sector whether to approve new regulations. CARB the legislation enabling their ETS took the expressed concerns about the ETS, the launched a formal rulemaking process in form of a legislative amendment – in the legislature chose to improve the regulatory 2010, which culminated in the addition of a case of New Zealand an amendment to the framework by adopting an amendment law new set of provisions to the California Code comprehensive Climate Change Response that suspended the articles of the Environ- of Regulations (California 2010). Act that had been enacted six years earlier; mental Code regulating GHG emissions until in the case of Kazakhstan, through a mo- 1 January 2018.13 Likewise, the National Like California, Québec is a subnational dification to the Environment Code; and in Allocation Plan for 2016-20 was suspended jurisdiction which has the required powers the case of Nova Scotia, through changes by Government Decree, although GHG – in this case under the Canadian consti- to the Environment Act originally passed emissions reporting requirements remained tution – to adopt and run an ETS. In 2009, in the province in the 1990s. In other cases, in effect. the Québec National Assembly adopted a such as the EU ETS and the California and bill amending the province’s Environmental Québec ETS, new legislation was adopted to Similarly, the legal basis for the New Zea- Quality Act, which paved the way for the im- enable the introduction of emissions trading land Emissions Trading Scheme (NZ ETS) plementation of its ETS. In 2011, the Québec as a policy option to achieve climate change is the Climate Change Response (Emis- government adopted amendments to its mitigation targets. What follows below are sions Trading) Amendment Act of 2008. Regulation Respecting Mandatory Reporting more detailed descriptions of the legal In early 2007, a group of representatives of Certain Emissions of Contaminants into bases of several ETSs at the supranational, from a range of New Zealand government the Atmosphere, mandating businesses national, and subnational level, including at departments designed an ETS, and public and municipalities emitting more than the level of a city. consultations later that year demonstrated 10,000 metric tons of CO2 annually to support for such a program. After further declare their GHG emissions. Also in 2011, In the case of the EU ETS, adoption of a legal consultations and policy development, Québec adopted a regulation setting out the basis was complicated by the multilevel a bill to establish an ETS was introduced operating parameters of the ETS, based on governance system of the EU, which is a su- to New Zealand’s unicameral parliament the WCI guidelines published in 2008 and pranational union of currently 27 sovereign in December 2007. It followed the usual 2010. All proposed regulatory amendments countries. Responsibilities in the EU are legislative process in New Zealand of in Québec must go through a 60-day public distributed between the EU and its Member being first considered and reported on by consultation period. In 2012, the Québec States, and the EU must have an explicit a parliamentary committee before going regulation was amended again, in part to mandate to act at the supranational level through final debates and passing a plenary enable the link with the California ETS, before it can adopt any policy measures. vote in September 2008. Regulations then which came into effect on 1 January 2014. Articles 191 to 193 of the Treaty on the came into force to set the finer details of Functioning of the European Union (TFEU) the ETS. Since its establishment, both the In Japan, regional governments likewise empower the EU to act on climate change, primary legislation and regulations have have the authority to enact local laws as and a harmonized approach is considered been updated. long as these do not conflict with national necessary because of the transboundary law. The national Act on Promotion of Glo- nature of the challenge and its solution. As a state within the federal system of the bal Warming Countermeasures (Law No. 107 Based on a legislative proposal first publis- United States, California retains legislative of 1998) explicitly provides that the national hed in 2001, the EU ETS was created by way and executive powers in many areas of and local governments are responsible for of formal legislation – a directive, defining governance, including climate change. the development and implementation of objectives and measures, but leaving some In 2006, California adopted the Global plans to reduce GHG emissions. Therefore, discretion to Member States – in 2003 (Euro- Warming Solutions Act (also known as the Tokyo Metropolitan Government was pean Union 2003). Any major changes to the ‘Assembly Bill 32’, or AB32), which sets out able to implement its ETS through a local EU ETS, such as extensions of its scope and emission targets and a framework enabling ordinance. First, however, the Tokyo Carbon coverage, have required an amendment to the creation of a market-based approach Reduction Reporting Program, a mandatory the original EU ETS Directive. An example is to reducing GHG emissions. A formal reporting system that lays the foundation the fourth trading period (2021-30), which rulemaking process yielded the regulatory for emissions trading, was implemented was defined by way of an amendment direc- changes that govern the ETS. It was, in turn, through amendments to the Tokyo Metrop- tive adopted in 2018.10 governed by the Administrative Procedure olitan Environmental Security Ordinance Act (APA) of the State of California, which (Tokyo 2000). As part of the Tokyo Climate In Kazakhstan, the legal basis for the crea- required public review of proposed regu- Change Strategy adopted in 2007, the tion of the ETS and its implementation is latory text, and provided opportunities for governor of Tokyo introduced a proposal to the Environmental Code of the Republic of written and oral comments on proposals. In the Tokyo Metropolitan Assembly in 2008 Kazakhstan (Kazakhstan 2007). The ETS was the case of emissions trading, the California that included mandatory targets for large launched in 2011 through an amendment Air Resources Board (CARB), the agency in emitters as part of an ETS. The assembly of the Environmental Code that added a charge of designing and implementing the adopted the proposal unanimously and new section.11 After publication of this new program, was required to produce econo- it entered into force in 2010, again as an section, which sets out the main provi- mic and environmental impact analyses amendment to the relevant ordinance. (10) Directive (EU) 2018/410 of the Parliament and of the Council of 14 March 2018 amending Directive 2003/87/EC to Enhance Cost-effective Emission Reductions and Low-carbon Investments, and Decision (EU) 2015/1814. (11) Law of the Republic of Kazakhstan No. 505-IV of 3 December 2011, which introduced Chapter 9-1 on State Regulation in the Field of Emissions and Removals of Greenhouse Gases. (12) These were adopted as government decrees; for instance, the first National Allocation Plan was adopted by Decree of the Government of the Republic of Kazakhstan No. 1588 in December 2012. (13) Law of the Republic of Kazakhstan No. 491-V ZRK of 8 April 2016, On Amendments and Additions to Certain Legislative Acts of the Republic of Kazakhstan on Environmental Issues. 38 GOVERNANCE OF ETS ICAP & WORLD BANK 4.1.3 Conducting a Regulatory Impact Research suggests that use of an RIA within an appro- Assessment (RIA) priate framework can underpin the capacity of govern- Implementing policies through legislation or ments to ensure that policies are efficient and effective executive rulemaking will commonly have a number in complex and evolving contexts, such as climate of consequences that are often difficult to anticipate policy. Accordingly, a growing number of jurisdictions without detailed study and consultation with affected have made an RIA mandatory prior to the adoption of parties. Regulatory impact assessment (RIA) – also new legislation or executive rulemaking, although the sometimes referred to as regulatory impact analysis scope, content, role and influence of the RIA on policy or review – denotes a systematic approach to the making vary. Conducting an RIA is considered adminis- assessment of positive and negative effects of tratively and technically challenging, especially when proposed or existing policies, including their ability to it entails using cost-benefit analysis (CBA) to identify achieve intended outcomes. As a type of administrative administrative burdens and basic compliance costs, procedure, this tool can draw on a diverse range of or more complex types of costs and benefits, such methods, and its sophistication and analytical breadth as environmental benefits, distributional effects and will vary depending on the issues at stake and the impacts on competitiveness. It bears noting, howe- resources available (Radaelli and Francesco 2010). RIA ver, that an RIA does not necessarily need to include is widely seen as an important part of an evidence- a quantitative CBA: some jurisdictions place greater based approach to improving the quality of public emphasis on qualitative indicators, including fairness policy decision making (Organisation for Economic considerations or structural transformation benefits Co-operation and Development (OECD) 2009). that cannot be easily expressed in monetary terms. Table 11: Steps in an RIA14 Steps Description Defining a First, an RIA presupposed identifying the regulatory or policy problem. This step roughly coincides regulatory with the ‘Problem Identification’ stage in the policy cycle introduced earlier in this report (see Figure 3). problem Problems usually fall within three categories: market failure, regulatory inefficiencies, and new policy targets or objectives. Identifying During this step, the need for regulatory intervention identified in Phase 1 is translated into concrete different regula- policy options. This step roughly coincides with the ‘Policy Formulation’ stage in the policy cycle intro- tory options duced earlier (see Figure 3). Collecting data This step is critical for an RIA, and can involve a variety of means that differ across jurisdictions and contexts. Relevant information for the RIA can be collected, for instance, through public consultations, interviews, questionnaires, online surveys, focus groups, and other channels. Assessing The central step of an RIA, which commonly involves a CBA, but can also be a cost-effectiveness ana- alternative lysis, a risk analysis, or some other approach to identifying the strengths and weaknesses of alternative options options. Options assessed typically include a ‘business-as-usual’ scenario – in which the policy in question is not adopted – as the baseline. Identifying pre- Once the available options have been identified and assessed (for instance by comparing their costs ferred regulato- and benefits, or qualitative metrics for the expected positive and negative effects), the comparison of ry options the different assessments will help identify a preferred option. This step roughly coincides with the ‘Policy Decision’ stage in the policy cycle introduced earlier (see Figure 3). Communica- Past experience suggests the value of publishing the RIA. Doing so allows further exchange with stake- ting results of holders and improves the general transparency of the process and its subsequent acceptance by the RIA regulated entities and the broader public. (14) Source: Lemoine (2018). GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 39 Table 11 (page 38) describes the main steps in an – including public authorities, compliance entities, RIA, and some of the approaches that each step and market participants – and sets out processes can entail. For further details on how to conduct to ensure that the ETS can function properly across an RIA in the context of carbon pricing, see all phases of its evolution. As part of this important World Bank (2021a). governance context, policy makers have to assign institutional functions and responsibilities (see A practical example of an RIA is provided in Box 3, Chapter 4.2.1), decide on the level of centralization which describes the regulatory analysis preceding in the administration of the ETS (see Chapter 4.2.2), adoption of the U.S. Greenhouse Gas Reporting and ensure that its regulatory architecture aligns with Program (GHGRP) that serves as the basis of GHG existing rules, principles, and doctrines in other areas emissions reporting and verification for RGGI. of law (see Chapter 4.2.3). 4.2 Institutional and Regulatory Framework 4.2.1 Assigning Institutional Functions Once an ETS progresses beyond the initial planning and Responsibilities stage, policy makers will be faced with the task of As described in Chapter 3.2, institutions play an elaborating its institutional and regulatory framework. important role in the establishment and subsequent This framework is critical for the governance of an operation of an ETS. In the broadest sense, institutions ETS, as it enshrines the design features of the ETS, can be understood as structures or mechanisms of so- defines the roles and responsibilities of key actors cial order and cooperation that help govern individual Box 3: Example of an RIA: The U.S. GHGRP Faced with a Congressional mandate to approach is preferable. Given the expected engineering analysis was then conducted elaborate a rule requiring “mandatory cost of compliance for reporting entities, for each source category to develop unique reporting of greenhouse gas emissions the GHGRP was classified as ‘economically unit costs. above appropriate thresholds”, the United significant’, thus requiring an RIA. States Environmental Protection Agency Assessing the GHGRP design options (EPA) instructed its Climate Change Division When the EPA issued its proposal for a rule, included in the final rule, the EPA estimated in 2008 to initiate a rulemaking process it accompanied that proposal with a draft that 10,152 entities would be covered by on a federal Greenhouse Gas Reporting RIA. Following the mandatory notice and the reporting obligation, facing USD 132 Program (GHGRP). Agency rulemaking in comment period, the EPA published the million overall in monitoring, recordkeeping, the United States is governed by the federal final rule along with a revised RIA reflecting and reporting costs for the first year, and Administrative Procedure Act (APA) and a stakeholder comments and feedback USD 82 million for subsequent years. The series of Executive Orders, which establish a from other government agencies. The RIA RIA also measured the economic impacts process and guidelines for the elaboration issued with the final rule establishing the for covered sectors by comparing per­entity of federal regulations. Under a tiered system GHGRP was a comprehensive document of costs with average per entity receipts, and to classify executive rulemaking based 213 pages, in which it evaluated the costs concluded that the cost ­to­sales ratios for on its expected impacts on the economy, associated with monitoring, recordkeeping, reporting entities was uniformly under ‘economically significant regulatory actions’ and reporting activities for each type of 0.8%. In addition to aggregate costs, the that are likely to have particularly significant affected facility, as well as the relative costs EPA also calculated the average private cost impacts require a centralized review, of alternative design options. To do so, the per unit of emissions reported, estimating including an assessment and, to the extent EPA relied on existing data available at the that to be USD 0.02 per metric ton of CO2e. possible, quantification of the benefits agency, as well as data obtained from trade Overall, therefore, the EPA determined that and costs anticipated from the regulatory associations, states, and publicly available costs under the GHGRP would be widely action. Such rulemaking also requires sources to characterize the processes, dispersed throughout the economy, and the agency to conduct an assessment sources, sectors, facilities, and entities that the rule would not have a significant of alternative, ‘potentially effective and affected by the proposed rule. It also economic impact on entities. This finding reasonably feasible’ regulatory approaches, considered cost data submitted in public contributed to the GHGRP coming into and to demonstrate why the chosen comments on the proposed rule. A detailed effect in late 2009. 40 GOVERNANCE OF ETS ICAP & WORLD BANK or collective behavior in pursuit of defined purposes. of a wide variety of institutions on the governance A common feature of institutions is their permanence; of an ETS, it is important that their functions and that is, their existence beyond the duration of a single responsibilities be defined in a clear and consistent decision or action. Institutions can be informal, such as manner, ensuring adequate coordination. cultural norms and habits, or formal, including govern- ment entities and other structures created intentional- Depending on the jurisdictional context, such ly with the purpose of governing. In this section, the functions can be distributed across several institutions focus will rest on formal government institutions and or concentrated in one institution that has overall their role in ETS governance. responsibility for the administration of the ETS, the so-called ‘ETS administrator’. Some jurisdictions All three branches of government can exercise differentiate more political tasks, such as overall governance functions in an ETS, although the executive coordination, stakeholder engagement, and branch will usually play the greatest role in ETS rulemaking, from the routine administration of an governance. Relevant institutions include government ETS, and assign the former to agencies at the highest agencies involved in the establishment, operation, and level of public authority, such as a national ministry. review of an ETS, such as ministries and technical or Technical and administrative tasks, meanwhile, may scientific agencies, as well as other formal mechanisms be delegated to subordinate bodies at the national, and structures that carry out specific tasks under regional or local level (see Box 4 below). Other an ETS, such as a registry established to track the agencies, such as those mandated with overseeing distribution and transfer of emission units, or a service financial and energy markets, may also exercise desk to assist compliance entities. Due to the influence relevant governance functions. Box 4: Role of the Lead Executive Agency and ETS Administrator In New Zealand, the primary responsibility and Treasury Board and the Department of also has a separate branch dedicated to for the ETS rests with the Minister Energy and Mines. Day-to-day operations annual GHG emissions data reporting and for Climate Change. Operational are administered by the Climate Change verification under the state’s Mandatory responsibilities for the ETS are defined Division within ECC, and include administer- GHG Reporting Regulation, and staff in in legislation and delegated to ing the GHG emissions reporting program, this branch work closely with ETS staff. several government departments: the managing participant registration and Information sharing between branches is Environmental Protection Authority fulfills account set-up, running and monitoring limited to protect market-sensitive data most general administrative and registry auctions and reserve sales, and managing and support the overall governance of the functions; the Ministry for Primary Industries and reporting on the revenue generated program. While CARB is responsible for manages ETS operations related to forestry from the program. ECC works with the the operation of the ETS, the California and agriculture; and the Ministry for the Department of Finance and Treasury Board state legislature directs spending of funds Environment administers the Climate regarding the financial management and associated with it, including the proceeds Change Response Act of 2002 and leads accounting of program revenue. from the sale of emission allowances development of the ETS and overarching through quarterly allowance auctions. climate change policy in collaboration In California, the ETS is administered by with other departments. Accordingly, one agency, the California Air Resources In Québec, the Ministry of the no single entity has responsibility for Board (CARB). There, the California ETS is Environment and the Fight against all aspects of ETS administration. This managed by a branch of approximately Climate Change administers the ETS. Its distribution of responsibilities across 35 people, who are divided into four Carbon Market Division consists of a government departments is confirmed sections, each of which is responsible for a team of approximately 30 people, and in a Memorandum of Understanding and different aspect of the ETS: administering is divided into four sections: operations, detailed in an NZ ETS Operations Manual. the auctions and running the compliance emitter outreach and follow-up, offset tracking system (registry), monitoring the credits, and market supervision, strategies Nova Scotia has assigned overall responsi- market, allocating free allowances, and and development. As their programs are bility for its ETS to the Environment Ministry running the offsets program. Managers linked, the Québec and California teams (‘Nova Scotia Environment’, or ECC), with of each section report to a branch chief, are in constant communication to make support from the Department of Finance who oversees the system as a whole. CARB their partnership work. GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 41 Not all governance functions in an ETS have to be competitive bidding process – and prove more exercised by the government itself. Depending on nimble than a traditional government agency. the jurisdictional context, an alternative approach Still, governments may hesitate to outsource can entail the delegation of relevant governance politically or legally sensitive tasks, and may functions to a private entity, such as an existing or choose to retain control of the private entity, for newly established corporation. Such public-private instance through a majority stake in its ownership. partnerships can help lower overall cost – especially Box 5 below describes experiences with the use of if the delegated services are tendered in a private entities in ETS governance. Not all governance functions in an ETS have to be exercised by the government itself. Box 5: Use of Private Entities in ETS Governance Western Climate initiative, Inc. (WCI, Inc.) is • WCI, Inc. also plays an administrative role Use of Public-Private Partnerships in the a non-profit corporation created in 2007, in managing the system and facilitating administration of ETSs can also be found which provides cost-effective technical coordination across teams, such as outside of North America. In Kazakhstan, and administrative solutions to support coordinating calls and dialogue with for instance, the Ministry of Ecology, the participant governments. WCI, Inc. jurisdiction staff. Geology and Natural Resources – and, is not a political body, but a technical within the ministry, the Department for one, providing administrative services Also in 2007, a number of U.S. states in Climate Policy and Green Technologies – for ETSs. By coordinating support across the Northeast and Mid-Atlantic created determines ETS policy, with a Committee jurisdictions, WCI, Inc. enables the market Regional Greenhouse Gas Initiative, Inc. for Environmental Regulation and Control to be administered at a lower cost than (RGGI, Inc.), a non-profit corporation that which exercises compliance oversight. would be possible with independent supports development and implementation Still, a joint stock company (Zhasyl Damu, administration by each jurisdiction. It of the Regional Greenhouse Gas Initiative or ‘Green Development’), which is fully provides a continuous framework that can (RGGI). RGGI is a cooperative effort between controlled by the ministry, is the main body be expanded as more jurisdictions join. currently 11 states – Connecticut, Delaware, responsible for the implementation and Each participating jurisdiction retains full Maine, Maryland, Massachusetts, New maintenance of the ETS. In the EU ETS, policy control and oversight authority over Hampshire, New Jersey, New York, meanwhile, Member States have entrusted its ETS, yet benefits from the following Rhode Island, Vermont, and Virginia – to the auctioning of emission units to a private advantages, among others: reduce GHG emissions.15 Among the exchange, the European Energy Exchange • WCI Inc. manages the joint compliance advantages of having RGGI, Inc. (EEX), which serves as a common auctioning tracking system; administers joint managing the system are: platform subject to a Joint Procurement allowance auctions; provides independent • Administrative efficiency of e.g. monitoring Agreement and, for Member States that market monitoring and oversight services, and housing the registry; have opted out of the common platform, and provides help desk services for • Centralized communication function subject to bilateral arrangements. Further, participants; of convening and hosting multi-party most systems, such as the Tokyo ETS, rely • With stability and institutional memory meetings and calls related to the on independent third-party entities to being an important factor in multi-year governance of the ETS; verify the accuracy or emissions reporting. policies such as an ETS, the fact that WCI, • Economies of scale for functions that Usually, these entities have to be accredited Inc. has low turnover and employees require a single approach to be followed by the ETS administrator or another public who can become specialized in specific by all participating jurisdictions, including authority, documenting that they meet functions has strengthened operations; auctions and allowance accounting. certain qualifications and observe certain • Cost sharing from centralizing and procedural and organizational standards. outsourcing operations offers a large Compliance and enforcement, however, are In Tokyo, for instance, approximately 20 net savings compared to individual not entrusted to RGGI, Inc. Like WCI, Inc., it verification agencies meet the verification jurisdictions setting up and managing does not have policymaking authority and requirements set out in an official guideline their own electronic tracking systems and does not perform executive functions or formulated by the Tokyo Metropolitan auctioning platforms; make decisions on behalf of states. Government. (15) See https://www.rggi.org/rggi-inc/contact 42 GOVERNANCE OF ETS ICAP & WORLD BANK 4.2.2 Determining the Level of Centralization path dependencies and better tailor ETS design Depending on the jurisdiction, the establishment and implementation to the specific context of GHG of an ETS will also require a determination of the emissions mitigation, it can also make sense to create appropriate level of governance. In jurisdictions a separate legal and institutional framework. Whether with a federal system of government or devolved the ETS thus builds on an existing field of regulation responsibilities, policy makers have to decide which or is established through entirely new structures, governance functions should be exercised at the regulators need to be aware of overlaps with other central level, and which should be delegated to a issue areas to ensure the best-possible alignment of subnational or local level. Similarly, where an ETS the ETS with the broader regulatory context (Acworth is being introduced through regional cooperation et al. 2019). Not doing so can result in legal uncertainty of several jurisdictions, governance functions will and outright conflicts, which may, in turn, trigger typically be distributed between a central level and judicial disputes (see Chapter 5.5). the level of individual jurisdictions. Finding the right balance between centralized and decentralized An example of such regulatory overlap is the governance can only occur for a specific context: a interaction between an ETS and energy markets. greater degree of centralization can help ensure more Where electricity prices are determined by a consistent application of the ETS, yet subnational government decision rather than competitive or local authorities tend to be closer to compliance markets, for instance, the price signal of an ETS entities and stakeholders, and therefore often possess cannot be passed through efficiently. In jurisdictions information and relationships that are unavailable with regulated electricity markets, such as China at the central level. Box 6 below describes how this (Baron et al. 2012), this has prompted an ETS design question has been addressed in different jurisdictions. that accounts for the government role in electricity price determination by shifting the incidence of ETS 4.2.3 Embedding the ETS in the Existing compliance obligations from electricity generators Legal Framework to commercial and industrial electricity consumers As an ETS is operationalized legally, it comes into (Munnings et al. 2016). As that example shows, an ETS existence within a densely populated context of can be designed to accommodate different energy existing rules and procedures across a variety of market realities, but may not always be able to reverse issue areas. Being an instrument of climate policy, the efficiency losses that can follow from planned or the ETS will often be rooted in the administrative regulated energy markets (Acworth et al. 2020). and regulatory system dedicated to environmental protection, and be able to build on that existing Another area of law with relevance for emissions tra- body of rules and institutions for its implementation, ding is financial market regulation, which has a bearing helping lower administrative cost and the need for on the oversight of the market for emission units and new policy learning. In Europe, for instance, the EU derivatives (see Chapter 5.3). Likewise, it is advisable to ETS assimilated elements of the existing regulatory consider from the outset how emission units and ETS framework for integrated prevention and control of transactions will be treated under a number of legal industrial emissions. In other jurisdictions, an ETS and compliance regimes, from taxation and financial may build on established rules and procedures for accounting rules to the law of property, contract, obli- the regulation of general economic activity, such as gations, tort, and insolvency. Across jurisdictions, the licensing or permitting requirements. definition of emission units has varied markedly, reflec- ting different legal traditions and regulatory contexts. Whenever an ETS inherits legacy governance Clarity on the legal nature and treatment of emission structures, however, these are likely to influence units and their purchase or sale can help avoid legal how it will operate, for instance by determining uncertainty, reduce transaction costs, and pre-empt applicable doctrines, principles, and the rights and loopholes that might undermine the integrity of the obligations of affected stakeholders. To avoid such ETS and the market it engenders (see Box 7, pg.44). GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 43 Box 6: Level of Centralization in ETS Governance Different considerations influence the designated the national ETS administrator. with its stakeholders. Nova Scotia made division of responsibilities between In the beginning, matters such as allowance the decision to use the existing national centralized and decentralized governance allocation decisions, emissions reporting, platform for GHG emissions reporting actors across jurisdictions. In the case of and sanctioning were decided at the operated by Environment and Climate the EU, a regional organization of economic central level by DEHSt. Other matters, such Change Canada, and an online registry and integration with its own legal order, this as defining the regulated entities through auction system run by WCI, Inc. (see above, division of responsibilities has evolved over issuing the required emission permits and Box 5). Many participants in Nova Scotia’s time, with a trend towards centralization. In approving monitoring plans were delegated ETS had already used these systems, and general, the EU has been given competence to the environmental authorities of the Län- thus possessed the necessary capacities. to act on matters in which there is added der. With the beginning of the third trading When developing the regulations, the value to regulating the respective issues at period, however, and as the system evolved, province was able to draw from existing the European rather than national level. it became increasingly clear that more cen- regulations in Québec and Ontario, which Initially, the EU ETS was implemented in a tralized decisions were needed for proper had already established successful ETSs. decentralized way, with central decisions – functioning of the system. Limited capaci- This prior experience not only helped Nova such as allocation of allowances – delega- ties at the level of the Länder, for instance Scotia to meet the tight timeline, but also ted to the Member States. At the time, in the with regard to monitoring plans, provided to apply lessons learned from the other absence of MRV data, Member States were additional reasons to centralize functions. jurisdictions. considered to have better information on Not all aspects of ETS governance were aspects such as the installations in their ter- centralized, however. The emission permit When separate jurisdictions link their ETSs ritory, emissions data, and national policies still forms a part of the permitting process to enable a more liquid market and to lower in place. Over the years, however, it became required for e.g. industrial installation and the overall cost of achieving mitigation ob- widely accepted that centralization of combustion plants under the European jectives, they face a number of governance certain design and implementation features Industrial Emissions Directive (IED), and has challenges related to the establishment and was preferable. Such features included set- therefore been retained at the local level. maintenance of that link (Santikarn et al. ting the cap and allocation of allowances to 2018). Coordination tasks that benefit from sectors, where comparable methodologies Similarly, Canada is organized as a federal a centralized approach are often addressed and levels of stringency were important to system, although there, decisions on how to through a joint agreement, such as the avoid competitive distortions in the single govern an ETS fall under the jurisdiction of international treaty operationalizing the market and unnecessary administrative those provinces that have introduced one. link between the EU ETS and the Swiss ETS, burdens. Registry functions have now been In 2016, the federal government announced that sets out mutual obligations, relevant centralized with the Union Registry hosted the Pan-Canadian Framework on Clean procedures, and also institutional structures by the European Commission, although Growth and Climate Change, which requires in the form of a Joint Committee.16 national administrators share some registry all provinces and territories to introduce functions. Likewise, auctioning of allowan- a carbon price. To translate this frame- Similarly, whenever emissions trading ces has become largely centralized under work into law, the Canadian Parliament has an international dimension, the Paris a common auctioning platform, the EEX. subsequently enacted the Greenhouse Gas Agreement – an international treaty with Such centralization reflects the fact that Pollution Pricing Act in 2018 (Canada 2018). nearly universal participation – can become the EU ETS is an EU-wide policy, and allows Some provinces challenged the authority of a relevant level of governance. Article 6 leveraging benefits related to economies-of- the federal government to adopt a centra- of the Paris Agreement allows its Parties scale effects. lized framework but, in 2021, the Supreme to transact ‘Internationally Transferred Court of Canada affirmed the constitutio- Mitigation Outcomes’ (ITMOs), which, for Still, despite the trend towards greater nality of the national backstop approach, instance, include transfers of emission centralization under the EU ETS, many which is only triggered if a province fails units between internationally linked ETSs. governance functions remain at the level to meet the minimum national standards While Parties retain substantial flexibility of the Member States. Even there, however, (Supreme Court of Canada 2021). in how they operationalize ITMO transfers, questions about the appropriate level One of the provinces, Nova Scotia, decisions adopted by the Parties set out of centralization can arise. For instance, announced that it would develop and centralized guidance on how to reflect such Germany is a federal republic and its implement an ETS to meet the national transfers in periodic national reporting constitution, in general, provides for legis- carbon pricing requirement. Once a under the ‘Enhanced Transparency lation to be enforced by the federal states proposal for the ETS has been elaborated, Framework’ (ETF) of the Paris Agreement (Länder). When the EU ETS began in 2005, the federal government determined that and account for them when calculating it was clear that a centralized approach it complied with the minimum national progress towards national NDCs.17 As was needed to ensure a level playing field standard. Nova Scotia chose to build its with the allocation of responsibilities and equal treatment of regulated entities ETS upon past regulatory measures, such between national, subnational, and across the country. The German Emissions as a hard declining cap on GHG emissions local jurisdictions, the centralization Trading Authority (Deutsche Emissions- from the electricity sector and an aggressive of governance requirements at the handelsstelle, or DEHSt), established as a renewable energy standard. Given its small international level is generally motivated by division of the German Environment Agency territory, it was also able to pursue a high a desire to ensure coordination and avoid a (Umweltbundesamt, or UBA), was ultimately level of engagement and communication divergence of approaches. (16) Agreement between the European Union and the Swiss Confederation of 23 November 2017 on the Linking of their Greenhouse Gas emissions Trading Systems. (17) See the Decisions of the Conference of the Parties to the United Nations Framework Convention on Climate Change (UNFCCC) serving as the Meeting of the Parties to the Paris Agreement (CMA) on Modalities, Procedures and Guidelines for the Transparency Framework for Action and Support Referred to in Article 13 of the Paris Agreement, adopted in Katowice in 2018, and Guidance on Cooperative Approaches Referred to in Article 6, Paragraph 2, of the Paris Agreement, adopted in Glasgow in 2021. 44 GOVERNANCE OF ETS ICAP & WORLD BANK Box 7: Legal Nature of Emission Units How emission units are defined and across systems, often evolving over time allowances as intangible property, while treated under the laws of the jurisdiction and on a case-by-case basis through judicial others consider them administrative or ‘sui implementing an ETS has a number of or administrative decisions, the practice of generis’ rights that afford their holders fewer important economic consequences for relevant actors (such as tax accountants), privileges than full property.19 Likewise, dif- market participants. Such consequences and the recommendations of professional ferent jurisdictions apply different rules on include: whether the holders of emission bodies such as the International Accounting how allowances are valued in the financial units can acquire genuine ownership of Standards Board (IASB). Although progress accounts of holders, with some requiring units, along with the rights that convey has been made in harmonizing the legal that they be valued at their purchase price with property, or only enjoy temporary definition and treatment of emission units, and others at fair market value, substantially possession; whether emission units are relevant work is still underway (ISDA 2021). affecting the taxable basis when allowances classified as financial instruments and thus are sold. Rules on capitalization and depre- fall within the remit of financial market In California, for instance, an emission ciation of allowances also vary considerably rules; whether and when emission units are allowance is defined as “a limited tradable between jurisdictions. Such differences taxed, and on what basis; whether emission authorization to emit up to one metric ton can result in legal uncertainty and higher units can serve as collateral or security for of CO2e” and “does not constitute property costs for market participants, and may a loan; and how emission units are treated or a property right” (California 2010).18 In also increase the risk of abusive practices in the case of insolvency of their holder. the statement of reasons for this provision, (European Court of Auditors 2015). For that Regulators have not always anticipated CARB declared that it “needs broad autho- reason, value-added taxation of these questions and possible outcomes, rity to limit or terminate the allowances to allowances traded in the EU ETS, for nor in every case chosen to adopt clear ensure that, in the event of any violations, instance, was eventually harmonized to and consistent legal guidance (Anttonen, fraud, or other malfeasance in the conduct prevent tax fraud, and since 2018 EU Mehling, and Upston-Hooper 2007). Hence, of the allowance market, it can be immedia- allowances are classified as financial the definition and treatment of allowances tely addressed” (California 2011). In the EU instruments under financial market rules has displayed significant heterogeneity ETS, by contrast, some Member States treat (see also Box 13). 4.3 Technical and Administrative Capacity private business, as well as research and civil society Governing an ETS – from its initial establishment organizations, but also depends on recognition of through its routine operation and eventual review – is climate change in organizational and management administratively complex, and requires a sufficiently structures as well as awareness across relevant high level of human, technical, and financial capacity. agencies, stakeholders, and the general public Capacity, like governance, is an opaque term with fluid (Willems and Baumert 2003). Again, like climate boundaries. In its broadest sense, it can be defined governance itself, the types and levels of capacity as “the ability to perform functions, solve problems required are specific to their context. and set and achieve objectives” (Fukuda-Parr, Lopes, and Malik 2002). It serves as a measure for the In the context of economic instruments for climate infrastructure, knowledge, and human and financial change mitigation, these capacity needs are resources that are required to prepare and implement sometimes referred to as conditions of ‘market decisions, although it has evolved to also include readiness’, meaning the “necessary technical, policy empowerment, social capital, and more generally the and institutional frameworks that a country and/or its existence of an enabling environment. entities” require to make market mechanisms such as an ETS operational (Aasrud, Baron, and Karousakis This latter dimension acquires particular relevance 2010). Compared to other market approaches, in the context of climate governance: by virtue of its such as offset crediting on a project basis, an ETS expansive scope and intersectional nature, climate requires a particularly high degree of government change calls for cooperation among a large number of involvement. Public authorities with responsibility for public and private institutions as well as individuals. the establishment and operation of the ETS need to It requires technical, financial, and human resources possess the requisite capacity to identify and evaluate dedicated to climate issues in public administration, ETS design options, draft the regulatory framework, (18) As the relevant provision goes on to state, an allowance and does not “limit the authority” of the state to “terminate or limit such authorisation to emit”, see California (2010), Section 95820(c). (19) See, for instance, European Commission et al. (2019). GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 45 administer core ETS functions, and understand and have to be able to understand and perform their manage the interactions of the ETS with other policies compliance obligations under the ETS, for which and administrative structures. they need to develop capacity to monitor and report their emissions. But a functioning market will also One assessment of capacity requirements for depend on adequate capacities of other actors in ETS emissions trading has suggested grouping these governance, for instance verifiers, who typically need in four different categories: institutional capacity, to demonstrate requisite expertise to be accredited, or policy level capacity, capacity for data collection and professional service providers and market analysts. management, and financial capacity (Clark, Gauthier, and Pinon 2010). Relevant capacities can also extend to less tangible, yet no less important, aspects such Understanding available as familiarity with markets and how they operate, regulatory culture, and traditions of transparency capacities and potential gaps is and accountability in the exercise of public authority, where different geographies display substantial therefore an important step in variation (Bell 2003; Goron and Cassisa 2016). Criteria the establishment of an ETS. for staff selection, for instance, should ideally be based on professional competence and technical merit, not on subjective considerations, such as personal Understanding available capacities and potential gaps relationships. Time, finally, is also a valuable resource, is therefore an important step in the establishment and avoiding an excessively rushed timeline for ETS of an ETS. Detailed capacity assessment studies design and implementation can affect the quality of its can provide greater clarity, and often distinguish governance (Betz and Sato 2006). between capacities at the individual, organizational, and broader institutional level (Willems and Baumert Often, capacities will be unevenly distributed across 2003). Where such an assessment identifies capacity the government, necessitating coordination between shortfalls, different means of capacity building – such different agencies as well as the private sector and as staff training, simulations, and guidance documents other stakeholders. This can favor the combination – can help foster the necessary technical skills, and of responsibilities for ETS governance in a single jurisdictions introducing an ETS can draw on existing government agency (see Box 4). Concentrating knowledge products and capacity building platforms internal government capacity within one specialized (Hausotter and Mehling 2013).20 entity, including through permanent civil service appointments, can be critical to the success and Jurisdictions assessing their capacity requirements durability of an ETS, as it helps ensure institutional will, at some point, also have to assess the financial memory and resilience against changes in the resources needed to establish and operate an ETS. political context and regulatory framework. It can Although attempts have been made to estimate the also signal a commitment to ETS implementation cost of achieving market readiness under different and maintenance, instilling confidence in market scenarios (Vieweg et al. 2009), such estimates are by participants. Because of the cyclical nature of ETS nature highly dependent on the particular context and operation, however, with important administrative relevant circumstances, such as the level of existing functions accumulating at specific periods of the capacities, the design and scope of the ETS, and the calendar year (see Chapter 5.2), reliance on external number of compliance entities it will cover. Instead entities for certain tasks can likewise be justified. of offering highly aggregated cost estimates, Box 8 therefore offers concrete examples of how capacity Ensuring adequate capacities for ETS governance requirements have been met in existing ETSs, and what extends beyond the public sector to other ETS institutional capacities – especially in terms of staff – stakeholders, notably to compliance entities. These have been established to operate these systems. (20) At the multilateral level, such platforms are offered by the Partnership for Market Readiness (PMR) and the Partnership for Market Implementation (PMI) operated by the World Bank, as well as the International Carbon Action Partnership (ICAP), an international forum for governments and public authorities that have implemented or are planning to implement an ETS. 46 GOVERNANCE OF ETS ICAP & WORLD BANK Box 8: Capacity Needs of Public Authorities in Existing ETSs The case of Nova Scotia offers interesting • Carbon Market Analyst (1 FTE): Unlike some other Member State insights into the capacities needed to monitors trades, administers auctions authorities, DEHSt opted not to rely develop and run an ETS. The early stages and reserve sales, ensures that the heavily on external resources, such as of Nova Scotia’s ETS development required market is effectively functioning, and consultants or a private entity, to administer full-time government staff including identifies and reports any concerns elements of the system. While this could an Executive Director, a Manager, and (such as manipulation or fraud). have lowered the required number of staff, a Program Administrator. As the ETS Also is responsible for publishing it would also have raised new challenges, transitioned to implementation, Nova auction reports; for instance around collection and Scotia Environment and Climate Change • Policy and Program staff (4 FTE): processing of confidential data. expanded its team to add specific roles and monitors and implements policy to skillsets. The size of other early-stage ETS ensure the program operates as Still, the large staff of DEHSt relative to, program teams will depend on the size of intended, registers participants, sets for instance, the ETS program staff in the ETS which the jurisdiction develops. The up accounts, provides training to Nova Scotia also has to be seen in Nova Scotia ETS currently includes: participants, and participates in the context: not only does Germany have the • Executive Director (1 FTE): provides administration of the WCI, Inc. technical largest number of covered entities under leadership and direction for the ETS and discussions for the online registry and the EU ETS, with over 1800 installations also serves as a Director on the WCI, Inc. auction systems. under its jurisdiction, but the agency has Board of Directors (see Box 5); also managed several functions beyond • Manager (1 FTE): oversees the While Nova Scotia is able to run its implementing the EU ETS: serving as the implementation of the ETS, including subnational ETS with a relatively limited Designated National Authority (DNA) for the managing staff and providing strategic number of staff, large systems – such as Clean Development Mechanism (CDM) and direction for policy decisions; the EU ETS – have placed greater demands the Designated Focal Point (DFP) for Joint • Engineer (1 FTE): manages the on the administrative capacities in Implementation (JI) activities under the implementation of the GHG reporting implementing Member States. In Germany, Kyoto Protocol, sponsoring and overseeing program and is responsible for the annual for instance, the German Emissions research and analysis, and administering Summary of Greenhouse Gas Emissions Trading Authority DEHSt (see Box 6) the recently introduced national ETS Report; started in 2004 with a staff size of around for fuels. Capacity building has been an • Green Fund Coordinator (1 FTE): 20, growing to 50 by the time trading important factor in ensuring that the works closely with other government began under the EU ETS in 2005. As the system is governed well, and from the departments and stakeholders to EU ETS expanded in scope during outset DEHSt has pursued capacity coordinate and report on spending of subsequent trading periods and DEHSt building and training activities for its revenue generated from the ETS. Also was mandated with additional own staff, as well as for staff of local is responsible for publishing the Public responsibilities, its staff increased further authorities tasked with implementation Proceeds Report; and now counts around 200 employees. functions. DEHSt opted not to rely heavily on external resources, such as consultants or a private entity, to administer elements of the system. GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 47 05. Second Phase: Operating the ETS Chapter 5 provides a more detailed description of the elements of routine ETS operation and the associated governance needs, including oversight of the compliance cycle, administration of offset crediting, market oversight, transparency with regard to emissions and market data, and dispute resolution. 48 GOVERNANCE OF ETS ICAP & WORLD BANK 5.1 Governing the Routine stakeholders, such as analysts, the media, and the Operation of an ETS broader public, needs to therefore be prudently Once the ETS has been set up, a new phase in the managed, and the rights and interests affected by the governance of the system begins. This is the phase of disclosure of such data need to be carefully balanced routine operation, which, unlike the previous phase, is with the interest in ETS transparency (see Chapter 5.4). less concerned with setting up new legal and insti- tutional structures than it is with exercising ongoing Finally, routine management of ETS operations governance functions and applying and enforcing also includes overseeing activities in the market for rules. Governing routine operations in an ETS includes emission units (see Chapter 5.3), which will typically ongoing management of key features of the ETS, such be a task performed by a different entity than the ETS as issuing operating licenses or permits; overseeing the administrator, often falling within the purview of the compliance cycle, including monitoring of emissions financial market administrator; such market oversight reporting, collecting and managing emissions data, also extends to supervision of market participants, and performing accreditation and oversight of verifiers such as brokers or exchanges; collecting and disclosing (see Chapter 5.2); as well as enforcing any incidents market data, again balancing potentially affected of non-compliance, including through judicial means interests of market participants with the broader where necessary (see Chapter 5.5). interest in market transparency; and facilitating market transactions. Although not all the foregoing Additional institutional functions include maintenan- aspects of ETS operation can be described in the ce of the registry and its account operations, such as following sections, those with particular relevance for account opening or closure; administering emission ETS governance are described with ample references units from initial issuance of allowances through free to practical examples drawn from existing systems allocation or auctioning – each of which requires per- around the world. formance of separate procedures, such as notification and carrying out of auctions, or defining and updating 5.2 Overseeing the Compliance Cycle benchmarks – to emission unit banking, borrowing, In order to secure achievement of the primary surrender or cancellation; assessment and approval objective of an ETS – reducing GHG emissions – it of offset projects, and issuance of offset credits (see must be governed by a rigorous system of emissions Chapter 5.2 and Box 10 below); and operating mecha- transparency as well as provisions to secure nisms for supply or price management. Relevant tasks compliance. Emissions transparency is ensured by also include the collection of revenue through fees for way of monitoring, reporting, and verification (MRV), administrative services, such as opening of registry which together provide an important means of accounts, and auctioning of allowances, as well as the tracking the progress of individual market participants expenditure of such revenue for eligible purposes. toward achievement of their defined mitigation objectives, establishing historical emission baselines An important function of the ETS administrator, for the allocation of allowances, and recognizing furthermore, consists in the evaluation and disclosure emission reductions through offset projects (see Box of data it has collected on emissions and compliance 10). Importantly, a credible MRV framework can also entities. This function can range from contributing strengthen confidence in the ETS, fostering stronger to national and international emissions reporting, to market participation (Haites and Bird 2002). publishing the names of compliance entities which are in violation of their compliance obligations. Data In the context of an ETS, monitoring refers to the thus disclosed can be highly sensitive, potentially observation and determination of GHG emissions and affecting demand and prices in the market as well compliance with emission mitigation obligations, as the privacy or confidentiality rights of different be it through on-site and remote monitoring, or market participants. How and when such data are through use of inferences and indirect indicators. made available to market participants and other GHG emission inventories, for instance, are generally GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 49 calculated on the basis of direct and indirect activity providing the factual basis for subsequent legal data, such as the amount of fuel and electricity used determinations. Unlike reporting, verification cannot as well as industrial output, in combination with be performed by the regulated entity itself. In many individually determined or default calculation factors, ETSs, this task is performed by independent verifiers, such as emissions, combustion, and oxidation factors. which are private entities – typically accounting and Some systems differentiate the required methods auditing companies – that meet specified criteria in by emissions volume or production output, with order to become accredited. different tiers of accuracy and data quality required for emissions monitoring (PMR and ICAP 2021). How these independent verifiers are selected and remunerated for their services – whether, for Reporting, by contrast, requires communication of instance, this is left to the compliance entities or is information obtained through monitoring, with a view carried out by the ETS administrator, with randomized to facilitating the assessment of the ETS and the indi- assignment and subsequent cost recovery from vidual performance of covered compliance entities. compliance entities – can affect their impartiality Information to be reported may include emissions (Shen et al. 2020). In most ETSs, public authorities carry data, activity levels, and technology investments. Use- out plausibility or random checks, but otherwise rely fulness of reporting generally depends on the precision on the work of verifiers. Not all jurisdictions delegate and reliability of reported information, and the degree verification to private entities, however, with some to which information is presented in a transparent opting to retain full supervision of MRV reports, for and standardized way so as to allow for comparisons instance by the ETS administrator. between reports and verification by others. Although governance frameworks for MRV differ Finally, verification refers to a process through which across jurisdictions, they tend to rely on a set of the accuracy and reliability of reported information common principles and procedures. One reason or the procedures used to generate information for these similarities are their common origins in are assessed (PMR 2019). Verification can play guidelines and standards defined by international a preliminary role in compliance procedures by bodies such as the IPCC and ISO, which have Box 9: The Compliance Cycle in the EU ETS Under the EU ETS, covered installations combinations thereof. Still, based on the heat values and emission, conversion, and measure and report emissions in annual emissions of each installation, oxidation factors; and laboratory analyses accordance with an implementing act of the different accuracy requirements – or ‘tiers’ and sampling results. Prior to submission, Commission, the Monitoring and Reporting – apply; installations that exceed specified annual emission reports have to be Regulation (MRR, European Commission emission thresholds are required to achieve audited – often including a site visit – by an 2018a), and a series of supporting guidance a higher level of accuracy. If producers independent verifier accredited pursuant documents. For each installation covered by can demonstrate that observance of a to the Accreditation and Verification the EU ETS, operators are initially required tier incurs unreasonable costs, however, Regulation (AVR, European Commission to submit a monitoring plan that sets the competent authority can allow a less 2018b). Accreditation requires periodic out the methodologies used to calculate accurate monitoring approach. attestation by a national accreditation body emissions. Approval of the plan is not a that a verifier meets the requirements set discretionary decision, but has to be given if Once the monitoring plan is approved by by the AVR and harmonized verification the monitoring plan meets the requirements the competent national authority, operators standards, such as ISO 14065, and is subject of the MRR, including its principles of are required to compile emissions in an to ongoing surveillance. After submission completeness, consistency, comparability, annual emission report, applying the of the verified report, the competent accuracy, and integrity of monitoring and methodology contained in the monitoring national authority can perform spot reporting. Operators have some discretion plan. Relevant information in the report checks and inspections, and – if it detects to choose between alternative monitoring includes annual activity data, such as fuel misstatements or non-conformities – take methodologies, such as calculation- and input and raw material throughput data; different facilitative and enforcement measurement-based methodologies, or calculation values, such as net calorific measures. 50 GOVERNANCE OF ETS ICAP & WORLD BANK become templates or points of reference for national enforcement actions, however, for instance when and subnational MRV systems. International and their addressee files an administrative or judicial regional cooperation on MRV frameworks continues appeal. Such delays are not uncommon, and are a through bodies such as the EU ETS Compliance Forum, manifestation of the rule of law (see also Chapter 5.5). which offers a platform for information Taken together, the foregoing procedural steps and sharing and learning. Directly or indirectly, obligations are often described as the ‘compliance such initiatives contribute to coordination and cycle’ of an ETS. Box 9 and Figure 8 below describe harmonization of MRV standards. the compliance cycle as it is applied in the EU ETS. Experience has shown that even the most robust In most ETSs, an enforcement system with appropriate MRV and enforcement framework cannot ensure penalties provides assurance that emissions reporting requirements as well as other compliance full compliance, however. Increasing the rate of obligations are observed. Penalties can consist of adherence with the processes and rules of an ETS a reputational deterrent – ‘naming and shaming’ – also depends on the design of the governance under which the names of noncompliant entities are framework itself, favoring a smart approach that published, financial penalties such as a monetary creates few opportunities to evade, obfuscate, or fine, requirements to ‘make good’ any compliance ignore mandatory requirements (Giles 2013; Hindin shortfalls, and further sanctions, including criminal and Silberman 2016). Research on regulatory designs charges for serious breaches of relevant obligations. that strengthen compliance has yielded useful insights Procedural and material requirements can delay that can also be applied to climate policy and the Figure 8: The Compliance Cycle in the EU ETS 1 JANUARY Start of Monitoring Period 31 DECEMBER 28 FEBRUARY End of Monitoring Issuance Period of Allowances ETS Administrator Accredited Verifier Compliance Entity 31 MARCH ENFORCEMENT Submission of Verified (Sanctions) Emissions Report 30 APRIL CHECKING Surrender REPORT of Allowances GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 51 governance of an ETS (Giles 2021). of secondary importance. Yet efficient and secure A similar compliance cycle also applies to offset market operation is important to ensure that emission crediting, the process of issuing emission units – reductions are met at the lowest available cost. or “offsets” – to entities implementing approved Abatement cost, in turn, has a direct influence on the mitigation activities (PMR and ICAP 2021). Many ETSs definition of economically viable levels of mitigation. afford compliance entities flexibility to cover emissions Accordingly, maintaining market functionality is a with offset credits instead of allowances, extending a priority in its own right, yet it is once again subject price signal and carbon finance to sectors or activities to a number of challenges. Different practices beyond those covered by the ETS, unlocking additional can disrupt the market and impair its efficiency abatement opportunities, and helping reduce overall as an allocative mechanism. Some of these may compliance cost. Such use is commonly subject to a be permissible, but pose risks, such as excessive number of conditions, however, observance of which speculation, whereas others represent forbidden is a critical condition for sustained confidence in – and practices, such as market manipulation, theft, fraud, demand for – offset credits.21 Box 10 below identifies tax evasion, and money laundering. Market oversight some common features in the governance of offset refers to the governance framework aimed at crediting systems. preventing or managing such practices. 5.3 Overseeing the Market for As outlined earlier, some particularities of an ETS can Emission Units render it more susceptible to interference and criminal Provided the environmental integrity of an ETS activities than conventional markets, compromising is ensured through robust compliance oversight, its ability to incentivize investment and reveal low- subsequent operation of the carbon market may seem cost abatement opportunities. Unlike traditional Box 10: Governance of Offset Crediting Systems Because offset credits enable compliance developers of mitigation activities. Ongoing sustainable development” which allows entities to compensate for emissions and implementation and oversight functions, in crediting of mitigation activities subject embody an economic value, it is essential turn, include the approval and registration to the rules, modalities and procedures that they represent real, permanent, of eligible mitigation activities, certification adopted by parties to the Paris Agreement and additional emissions reductions. and issuance of offset credits, maintenance and overseen by a Supervisory Body.22 Ensuring the integrity of offset crediting of a registry for offset credits, accreditation Also at the international level, and therefore hinges on robust rules and of auditors, review of implementation specifically for the sector of international procedures to govern the registration of decisions, as well as administration of aviation, the International Civil Aviation mitigation activities, the issuance of credits, grievances and appeals. Periodically, Organization (ICAO) has introduced accounting for their transfer and use, as well methodologies and technical guidelines as CORSIA, which enables international civil as instituting liability for the quantity and well as overall system operation need to aviation to achieve carbon neutral growth quality of transacted credits, for instance if be reviewed – for instance to evaluate the from 2020 through use of offset credits – a reversal of credited emission reductions sectoral and geographical distribution of labelled “Eligible Emissions Units” – occurs (PMR and ICAP 2021). Similar to an mitigation activities, or the transaction costs from several approved offset crediting ETS, an offset crediting system requires a faced by developers – in order to identify systems.23 At the domestic level, governance framework that guides the three and rectify any shortfalls (PMR 2021). meanwhile, California has established phases of initial establishment, subsequent a “Compliance Offset Program”, which operation and review of the system. Governance frameworks for offset crediting allows entities covered by the state’s ETS currently exist at the domestic and to satisfy a share of their obligations with Establishing an offset crediting system international level, can be vested in public offset credits issued by CARB for mitigation entails defining eligible sectors, as well as private standards, and can serve activities listed with one of several technologies, and types of activities that mandatory or voluntary carbon markets. At approved Offset Project Registries (OPR), may be credited, as well as developing the international level, for instance, Article which are private entities that administer or approving suitable methodologies, 6 of the Paris Agreement establishes a offset crediting standards and provide accreditation rules for independent “mechanism to contribute to the mitigation offset project registration, verification, and auditors, and technical guidelines for of greenhouse gas emissions and support other related services. (21) Demand for offset credits, for instance, has been shown to depend on the legitimacy of the governing institution that issues the credits, see Bernstein (2011). (22) See Decision of the Conference of the Parties to the United Nations Framework Convention on Climate Change (UNFCCC) serving as the Meeting of the Parties to the Paris Agreement (CMA) on Rules, Modalities and Procedures for the Mechanism established by Article 6, paragraph 4, of the Paris Agreement, adopted in Glasgow in 2021. (23) ICAO, Resolution A39-3: Consolidated Statement of Continuing ICAO Policies and Practices related to Environmental Protection – Global Market-based Measure (MBM) Scheme, 27 September to 7 October 2016. 52 GOVERNANCE OF ETS ICAP & WORLD BANK commodities that require physical delivery, service or even imprisonment. Criminal offenses emission units are intangible, instantly tradable, include various types of fraud and theft, such as and subject to an artificially constrained supply of intentionally false or misleading claims related to allowances and credits, which can make it easier the ETS compliance cycle and market transactions; for one or more market participants to influence cybercrimes, including hacking and phishing; and trading activity. When trading systems allow banking, financial crimes, such as money laundering, moreover, the absence of any storage cost for securities fraud,24 and tax fraud25 (Interpol 2013). allowances or credits makes it viable to accumulate Because such offenses trigger criminal proceedings, large positions for sale at a later date (Monast, their prosecution involves a different set of actors Anda, and Profeta 2009). Market participants looking than more routine aspects of ETS governance and to act in bad faith can exploit information follows a separate dynamic. Box 13 provides asymmetries, loopholes in the regulatory framework specific examples of how ETS governance can and gaps in market oversight – for instance where help limit fraud and other criminal activities, but administrative responsibilities are distributed first this section will describe the primary channels across multiple agencies or jurisdictions – to of ETS market oversight. their advantage. When establishing a governance framework for ETS These vulnerabilities of emissions trading have market oversight, policy makers have a number of called attention to the need for robust market governance levers at their disposal, from regulating oversight. Some market practices are merely what is traded in the carbon market and how it is considered risky or otherwise undesirable, and traded, to who can participate in the market. For therefore discouraged with the threat of administrative instance, over-the-counter (OTC) transactions between fines or regulatory consequences, such as the loss market participants are considered more susceptible of an operating license. An example of undesirable to harmful market practices because they occur on practices is strategic market behavior by dominant the basis of bilateral bargaining and usually without players, for instance when large volumes of carbon public disclosure of the price. Hence, some programs units become concentrated in the hands of a small have mandated that trading take place on regulated group of market participants, vesting them with exchanges, where transactions tend to be standardized considerable market power (Hahn 1984; Hintermann and market activity is generally more transparent. 2017). Variations of market power Market participation can also be subjected to a include price manipulation through aggressive number of additional conditions, such as: purchasing on a market with low liquidity, or • clearing and margin requirements to lower achievement of defined threshold, or ‘trigger’, prices counterparty risk; to activate certain regulatory consequences, such • holding and position limits implemented at the as relaxed constraints on borrowing and offset use, level of the registry, a central clearinghouse or an or execution of strategic reserve auctions (Whitesell exchange to counteract abuse of market power; and Davis 2008). Even manipulation across different • reporting and disclosure requirements – for markets is conceivable, given that, for instance, instance by creating a Central Limit Order Book developments in the carbon market can affect (CLOB) showing outstanding limit orders – to prices in energy markets (Chan 2009). improve transparency in the market (see also Box 13 and Chapter 5.4 below for examples and details). While these activities are considered detrimental to efficient market operation and may undermine In addition to specifying the modalities of trading, confidence in the market, other activities are market oversight can entail restrictions on the types considered so egregious or harmful that they are of units transacted in the market. While all ETSs punished as criminal offenses, with sanctions are premised on the ability to transfer emission ranging from severe financial penalties to community allowances, not all markets allow transactions in (24) Securities fraud can take the shape of e.g. collusion, insider trading, and ‘wash trades’, in which a market participant, acting through agents, is itself both the beneficial buyer and seller of the instrument, pushing prices higher to eventually conduct a large genuine sale. (25) See Box 13 below for examples of tax fraud in the operation of emissions trading. GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 53 offset credits and another type of tradable asset: on meeting specified criteria to obtain an carbon derivatives. Carbon derivatives are financial operating license, including capital requirements products embodying promises to deliver emission and notification or disclosure duties. Finding the allowances or credits in a certain quantity, at a certain right balance between openness of the market to price, by a specified date, and they make up a majority ensure liquidity and adequate safeguards to ensure of transactions in some existing systems. Box 11 below market integrity can be difficult, and it must reflect provides a more detailed discussion of different market the specific circumstances in each ETS (see Box 12). segments and the types of units and financial products traded in the carbon market. Finding the right balance While theoretically increasing liquidity and helping allocate risk, derivatives transactions are often not between openness of the carried out by regulated entities seeking to minimize compliance costs and risk exposure, but by financial intermediaries seeking to profit from developments market to ensure liquidity in emission prices (Button 2008). Not all speculation – whether with emission allowances and credits, or and adequate safeguards to with carbon derivatives – is undesirable in itself, but excessive levels can artificially inflate prices and create ensure market integrity can detrimental cycles in the market while incentivising risky activities or fraud. In the EU ETS, for instance, some market observers ascribed a dramatic increase be difficult, and has in the price of EU allowances (EUAs) after 2018 to speculative activity by financial intermediaries, to reflect the specific although an analysis conducted by the European Securities and Markets Authority (ESMA) suggested circumstances in each ETS that speculation played a negligible role in driving EUA prices higher (ESMA 2021). Closely related to market access is robust Still, the foregoing example shows why market data management, which plays an important oversight extends beyond regulating the ‘what’ role in securing market transparency and confidence and ‘how’ of trading to also specifying the ‘who’. in its operation. Market access is often made Specifically, governance of market access in an conditional on reporting requirements for ETS entails determining who may participate in the different market participants, as well as a duty to market, and under what conditions (Nield and Pereira retain records and allow access for inspection 2016). Some ETSs have limited market access to through the oversight authority. In this context, compliance entities, for instance, excluding financial governance also entails determining what intermediaries and other participants out of concern transaction data and other information can be that speculation might contribute to volatility and collected and disseminated to ensure market large price swings. Others allow for broader market transparency (see also Chapter 5.4). Such data access, but limit activities considered particularly can, in turn, help detect unusual or suspicious prone to abuse or risk, such as derivatives transactions, trading patterns with advanced software tools. to registered exchanges, where market access is Where responsibility for overseeing trading activity limited to those participants who are ‘members in and collecting or storing relevant data is good standing’ with the exchange. Market access distributed across different actors, proper can also be made conditional on registration with an governance may also entail data sharing or authority – such as the financial market regulator – or cooperation arrangements. 54 GOVERNANCE OF ETS ICAP & WORLD BANK Where responsibility for overseeing trading activity and collecting or storing relevant data is distributed across different actors, proper governance may also entail data sharing or cooperation arrangements. Box 11: Market Segments, Units and Derivatives in an ETS An ETS creates a market for tradable • Forward sales involve transactions traded OTC rather than on an exchange, emission units, which allow their holder of allowances or credits at a quantity and the terms of the contract are to emit a specified quantity of GHGs in a specified contractually by the parties, customized (Monast, Anda, and Profeta specified period of time, typically one metric but with delivery scheduled for a future 2009). ton of CO2 equivalent. Emission units – date. Pricing can be agreed upon in sometimes also referred to as ‘permits’, advance, or at a later date, such as the While adding a level of complexity ‘certificates’ or ‘compliance instruments’– time of delivery. Forward contracts and entailing unique governance include the allowances distributed by the tend to be customized in order to requirements, all the foregoing derivatives ETS administrator through sales, auction, accommodate individually negotiated can serve as instruments of risk or free allocation, as well as offset credits dates of delivery, cash settlement, volume, management to hedge price fluctuations issued for eligible emission reduction ‘tenor’ (single period blocks or multiple in the underlying carbon units, a purpose activities. These units can be traded year strips), and other commercial terms, that is particularly useful at the early – directly between market participants in which is why these contracts are not and usually most volatile – stages of an OTC transactions, or indirectly through traded on an exchange. ETS. Derivatives also play a role in offset exchanges, electronic platforms, and • Futures, by contrast, are standardized markets, where credits are not available brokers. When allowances or credits are contracts involving an established until emission reductions are verified transacted for immediate delivery, such quantity of underlying allowances or and registered, forcing many project a trade is usually referred to as a ‘spot credits which will be delivered or cash developers to rely on forward contracts trade’, entailing financial settlement upon settled at a known future date. Pricing is for the necessary capital to develop the confirmation that the allowances have been determined at initiation of the contract, projects. transferred from the registry account of the and each party to the contract is held seller to that of the buyer. A contract – often to fulfill at the specified price. Because Still, derivative trading is considered standardized – will then typically define a of their standard contractual terms, riskier than spot trading in emission settlement process. futures can usually only be traded on an units because of a perceived lack of exchange, which define the terms and transparency and a higher incidence of Trading activity does not only involve conditions of their use. speculative behaviour. Securitization of transfers of the foregoing emission units, • Options afford the buyer the right, but derivatives – a process by which often- however. Most ETSs also allow trading in not the obligation, to purchase or sell a sophisticated contractual arrangements so-called carbon derivatives. Derivatives given quantity of allowances or credits at are sold in tranches on capital markets are financial contracts whose value is a determined price within a specified time after origination – can further reduce derived from the value of an underlying frame, regardless of the actual market transparency and accountability. emission unit. Derivatives may constitute price. A premium is paid for the right to Adequate oversight of derivative trading a significant share of transactions in the transact at a set ‘strike’ price in the future. is therefore critical to ensure that market market, given that these instruments are Options contracts can be traded on both participants have options to manage not directly dependent on the volume of exchanges and OTC markets. the risks associated with price volatility allowances available in the marketplace. In • Swaps are derivatives where two or abatement while avoiding financial some markets such as the EU ETS, in fact, counterparties exchange streams of instruments whose underlying value and a majority of transactions take the form of allowances, offsets, derivatives or cash associated risks are difficult to ascertain. derivative contracts. If transaction prices are flows with each other, for instance Such oversight can be exercised with the visible to the wider ETS market, derivative through buying allowances on the spot same levers that govern market access and trading can inform market participants on a market and simultaneously selling them the modalities of trading regular emission reasonable range of allowance values. forward. As such, they can lengthen units, as described earlier in this section. Common derivatives in the carbon trading or shorten maturity periods, or help Additionally, the issuance of derivative market include forward sales, futures, maximize revenue and minimize products is typically conditional on prior swaps, and options: financing costs. Swaps are commonly regulatory approval or certification.26 (26) In 2021, for instance, a new derivative contract, the Global Emissions Offset (GEO) futures contract, was filed for self-certification before the Commodity Futures Trading Commission (CFTC) under the Commodity Futures Modernization Act of 2000, see CME (2021). GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 55 Box 12: Market Access Rules in Existing ETSs Jurisdictions have differed in their saw demand for the services they offered, as well as new financial products. CSRC approaches to market access for their ETS, such as brokering of transactions. Another approval of the creation of a futures each finding its own balance between important service provided by financial exchange in Guangzhou has opened a door openness of the market and stringency of intermediaries in the EU ETS is the issuance for carbon derivative trading (Reklev 2021), restrictions. Experiences in Asia, Europe, of derivative products that enable risk although no actual contracts had been and North America illustrate the range of management and hedging (see Box issued and transacted as of late 2021 (Liu choices available to policy makers, and also 11 above). Still, while market access is and Reklev 2021). provide insights into the reasons behind relatively broad in the EU ETS, a number alternative choices. Under the EU ETS, for of conditions apply for intermediaries to Until 2016, legal entities in Kazakhstan instance, the market for emission units participate in the market (see Box 13 below). participating in the implementation of grew substantially after its launch in 2005. offset projects as well as participants in In order to foster confidence and ensure Compared to the EU ETS, access to the exchange-based trading had access to the a safe and efficient trading environment, Chinese national ETS is more heavily market for emission units. This period saw market access has been subject to an regulated, reflecting a higher level of several instances of entities other than oversight regime designed along the lines concern about risks in the financial market. compliance entities purchasing emission of that governing European financial This preoccupation with controlling units and selling them at a much higher markets. The primary participants in the market risks has manifested itself, among value. Because of such incidents, market European carbon market are energy and other things, in two aspects of market access was restricted from 2016. Currently, industrial companies that have compliance access: first, in the ability of entities other the Environmental Code of the Republic of obligations. Still, with any natural or legal than compliance entities to participate Kazakhstan specifies that the purchase and person able to open a registry account if in trading; and second, in the types of sale of emission units can only be carried they meet certain conditions, participation products admitted for trade in the market. out by installation operators, offset project in the market is open to actors other than Contrary to earlier expectations that developers, and subordinate government compliance entities. A number of financial trading in the market for emission units entities (Kazakhstan 2007). Similarly, Nova intermediaries, for instance, engage in would be limited to compliance entities, Scotia has decided to limit market access market transactions, often on behalf of the regulation on administration of the for intermediaries. Given the short timeline smaller companies (ESMA 2021). Allowing national ETS market adopted at the end to establish the ETS in line with the federal intermediaries access to the market was of 2020 specifies that financial institutions carbon pricing framework, Nova Scotia justified with the need to ensure market and individuals can also participate in the decided to focus on registering and training liquidity and offer alternative ways to market (MEE 2020). China has taken a more compliance entities first and ensuring participate in the market. Given the large restrictive approach to financial derivative that the ETS runs smoothly in its initial number and heterogeneity of compliance products based on emission units, however, compliance period. Allowing additional entities – with some smaller entities lacking and notably futures contracts. The China market participants would have entailed the required capacity and experience to Securities Regulatory Commission (CSRC) further regulatory needs that the province apply sophisticated buying and selling is the authority responsible for approving did not have time to adequately analyze strategies in the market – intermediaries services related to derivatives trading and address. Finally, a registry or some other form of electronic possible due to vulnerabilities of the database will typically assign a unique serial number registry infrastructure (Interpol 2013), and to emission units and track those serial numbers from improvements that have since been carried their issuance onward, capturing information on who out include enhanced control for account has been issued units, who holds them, and when and opening with harmonized Know-Your-Customer from whom units are surrendered or canceled. Prior to (KYC) checks, enhanced transaction security engaging in unit transfers, market participants have to with a waiting period prior to transfers, a trusted sign up to the registry and create an account to obtain account list, and improved authentication and hold allowances, usually subject to the operating methods for transactions, strengthened registry terms and conditions of the registry, and often oversight with expanded administrator powers incurring an administrative fee (PMR and FCPF 2016). to suspend registry access and block transfers, and enhanced protection of good faith Many of the criminal activities observed in the acquirers through irrevocability of transfers EU ETS during its second trading period were only (see Box 13). 56 GOVERNANCE OF ETS ICAP & WORLD BANK Box 13: Preventing Fraudulent Activities in Existing ETSs In California and Québec, one of the for instance, they were targeted by several reporting requirements, and additional responsibilities of the ETS lead agencies, cyber-attacks, such as the theft of emission disciplines for the previously unregulated CARB and the Québec Ministry of the units from Member State accounts (Interpol spot market. These include protection Environment and the Fight against 2013; Nield and Pereira 2016). Technical against market abuse and other types of Climate Change (see Box 4), is to ensure and regulatory changes to address those market misconduct regulated under the that the market for allowances is free security shortfalls include the consolidation Market Abuse Regulation (European of fraud and other disruptive activity so of registries in a centralized Union Union 2014a). Since these changes to that it adequately reflects the supply and Registry, which is now a closed system: financial market and taxation rules as demand for emission units. To this end, once an allowance is used for compliance, well as adjustments to the registry were CARB and the Ministry carry out continuous it is automatically canceled. Additionally, instituted, no new incidents of emission market surveillance and analysis in both security arrangements in the Registry unit theft or VAT fraud have been jurisdictions. In addition, staff at CARB Regulation were improved, including detected, although the considerable work closely with an independent market adoption of KYC rules; new growth in the value of EUAs since 2018 monitor, Monitoring Analytics, to monitor types of accounts (holding accounts, warrants continued vigilance. A recent allowance auctions as well as holding and trading accounts, and ‘preferred accounts’ empirical analysis of the EU ETS, for trading of allowances and offset credits. for larger transaction volumes); delays instance, has suggested continued risk CARB also cooperates with several state between transfers to make sure they can of money laundering – where the carbon and federal agencies – including the be checked; and several other measures market is misused to process illicit California Independent System Operator to improve security in the system profits from criminal activities – which (CAISO), the Commodity Futures Trading (European Commission 2013). Still, may require further countermeasures Commission (CFTC), and the Federal cybersecurity requires constant vigilance (Bussmann 2020). Energy Regulatory Commission (FERC). as new threats emerge. It worked closely with the Office of the As the experience in the EU ETS has Attorney General in California to develop Another challenge encountered in the shown, not all vulnerabilities of the market the regulatory framework, which protects EU ETS in earlier years was the repeated for emission units will necessarily be against collusion, market power, and incidents of value added taxation (VAT) addressed from the outset. New Zealand is price manipulation by imposing holding fraud, also known as ‘carousel’ or ‘missing another example of an evolving governance limits and auction purchase limits. It trader’ fraud, that deprived Member framework for market oversight. There expressly prohibits any trading that States of significant tax revenue (Europol has been no evidence of fraudulent or involves manipulative practices or 2009; Guegan, Lassoudiere, and Frunza criminal practices in the context of the NZ attempts to corner the market, as well 2011). These incidents were enabled by ETS to date, and the Commerce Act 1986, as fraud, attempted fraud, or false or differences in tax rules between Member Fair Trading Act 1986, Crimes Act 1961 inaccurate reports. On the Québec side, States and highlighted the complex and existing contracts for counterparty the ministry collaborates with many interactions between the ETS and other risk have helped address potential market other ministries and public agencies such policy areas, such as taxation. Following risks. As the value of New Zealand emission as Québec’s energy regulator (Régie de changes to tax legislation that extended units increases with time, however, the l’énergie du Québec), its revenue agency the application of the so-called ‘VAT risk of fraudulent activity in the NZ ETS (Revenu Québec) or its financial market reverse charge mechanism’ to emissions may also increase. To ensure that the NZ regulatory agency (Autorité des marchés trading (Kogels 2010), the previous ETS maintains its high level of integrity, financiers). The Québec regulatory regulatory loophole was closed. a program of work is currently underway framework is aligned with California’s to to strengthen governance of the market protect market integrity. Similarly, EU financial market rules on and introduce a comprehensive legislative market abuse, market manipulation, framework. The overall objectives of this In the EU ETS, oversight of the market and transparency have been amended market governance work program are: for emission units is shared by various to treat emission units like any other • to facilitate an effective and efficient actors, including ESMA and, under its financial instrument. Since January 2018, market governance framework, which coordination, the national competent a change to the Markets in Financial supports the broader policy objectives authorities in each Member State Instruments Directive (MiFID 2) mandates of the NZ ETS; responsible for financial market trading of derivatives on regulated venues, • to ensure that participants can trade surveillance. Other actors, such as auction introduces position limits and reporting fairly and with integrity, recognising platforms, exchanges, and financial requirements for certain derivatives, the interests of smaller participants; intermediaries, have an active duty to and classifies allowances as financial • and to design a governance framework perform checks to prevent, detect, and instruments (European Union 2014b). that aligns with best practice of report cases of suspicious transactions to Previously, only derivative contracts had established ETS and retains the the national competent authority. In early fallen within the scope of MiFID. As a option for New Zealand to access trading periods, the EU ETS faced a number result of these regulatory changes, market high-integrity international units of security challenges. Back when registries participants are subject to new registration in the future if the government were still operated at the national level, and licensing duties, disclosure and chooses to. GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 57 5.4 Ensuring Transparency be disclosed; and 3) consideration of who is entitled As part of their transparency framework, existing to those documents (Schauer 2011). Importantly, ETSs set out a number of disclosure requirements for to be meaningful, transparency should not only be information related to the trading system, variously internal to a policy regime, meaning that only those requiring communication and publication of such managing and participating in that regime are privy information to the public or specific stakeholders, to relevant information, but also should include wider such as other market participants or compliance dissemination of information, including its availability entities. These disclosure requirements are distinct to the public. In some jurisdictions, for instance, from the monitoring and reporting obligations that publication of emissions data is mandatory under rules compliance entities are subject to with regard to GHG on access to information in environmental matters. emissions, and instead serve to improve the smooth functioning of the market as well as to promote public trust, goodwill, and credibility in the system (Deane, Importantly, to be meaningful, Hamman, and Pei 2017). transparency should not only They contribute to transparency in a broader be internal to a policy regime... sense, which can be defined as “the extent to which but also should include wider information is made publicly available within a given social system”(Moon, Welch, and Wong 2005), dissemination of information, covering both the flow of information itself as well as including its availability to the its quality and the method of dissemination (Hollyer, Rosendorff, and Vreeland 2017). Such transparency public. requirements are an expression of the broader trend towards increased public access to information, public participation, and access to justice in environmental Accordingly, in the context of emissions trading, infor- matters, all of which are accepted as central pillars of mation disclosure requirements can relate robust environmental governance and even emerging to various aspects of system design and operation. norms in environmental law (Hunter 2014). Aside from the duties to collect, report, and verify installation- or company-level emissions data descri- Transparency acquires substantial importance in bed earlier (see Chapter 5.2), transparency obligations the context of emissions trading, where a can extend to information on aggregate emissions and sophisticated policy instrument addressing a highly emission trends under the trading system, information complex threat can quickly challenge the capacity of about allowance distribution, including auction results stakeholders and the broader public to comprehend and use of proceeds, information on offset credit issu- technical nuances and the implications and impacts ance, market and transaction data, as well as informa- of alternative policy choices. Additionally, the market tion related to compliance and enforcement. for emission units is itself highly dependent on information to function efficiently, including data Likewise, the subjects of these requirements – that is, on emissions and other fundamental factors that the entities under an obligation to disclose informa- influence demand for emission units, and data on tion – can range from public authorities, such as the transactions and prices in the market that influence government body administering the ETS, to market market behavior and strategic decision making.27 facilitators and intermediaries, such as exchanges, to the compliance entities themselves. Such obligations Robust transparency requirements encompass also include provisions for the when and how sensitive three different dimensions of transparency: data is made available, so as to ensure, for instance, 1) consideration of who possesses information; that information relevant to price developments in 2) consideration of which data or documents need to the market is disclosed in a predictable process and (27) Without effective price-revealing mechanisms in place, there is a high likelihood that information asymmetries between governments and participating entities will prevent adequate price dis- covery and thus equalization of prices at the margin of abatement costs; that, in turn, will reduce the overall efficiency of the carbon market as a mitigation policy, see Flachsland, Marschinski, and Edenhofer (2009) 58 GOVERNANCE OF ETS ICAP & WORLD BANK not leaked prematurely or shared asymmetrically, and transaction data consequently is more difficult to which might benefit some market participants and not obtain and aggregate; to improve access to OTC trans- others. Similarly, some data may be subject to privacy action data, all market participants – not just exchan- or confidentiality rules, limiting its disclosure. Box 14 ges and professional intermediaries – can be asked below describes how California has ensured transpa- to register with an oversight institution and provide rency across a variety of aspects of its ETS. pricing information for transactions exceeding certain volume thresholds, for instance where such trans- With a view to increasing transparency about market actions are determined to have a significant effect on and transaction data, exchanges and other facilitating carbon price discovery due to their size and relevance. entities may be required to publicize daily information Additionally, they can be required to maintain trading on settlement prices, volume, open interest, and ope- protocols and detailed records of all transactions for ning and closing ranges for all allowances, credits and the purposes of identifying and providing evidence of carbon derivatives traded on the trading facility.28 manipulation. To date, however, such requirements OTC trading, by contrast, is typically not standardized, are not common in emissions trading. Box 14: California and Québec’s Approaches to ETS Transparency In California and Québec, CARB and the about each auction in a coordinated information. CARB and the Québec Ministry Québec Ministry of the Environment and fashion to ensure market participants of the Environment therefore apply strict the Fight against Climate Change are and the public are provided with internal policies and procedures to ensure committed to providing a wide range of simultaneous access to information via the security of all personal information information to the public on virtually all public web postings about available supply, provided by ETS market participants. aspects of their respective ETS. They do requirements for participating, summary Additionally, there are penalties for violating this because it supports the operation of results statistics, and proceeds. CARB and state and federal privacy rules in California the ETS, notably to ensure efficient market the Québec Ministry also take considerable and provincial privacy rules in Québec. operation. The information provided steps to ensure there are no data leaks to the public ranges from reported and or information asymmetries where one Strict rules are also in place to ensure third-party verified GHG emissions data, part of the market obtains data before the that ETS participants protect market- offset credit issuance, compliance results, rest of the market. For market-sensitive sensitive information, and CARB and the auction announcements, auction results, information, such as auction results, Québec Ministry of the Environment can aggregated allocation information, notifications of the posting time of such take enforcement action if there is any market data, and enforcement actions. In information are announced in advance. inappropriate use or disclosure of market- addition, CARB and the Québec Ministry Enforcement actions and settlements sensitive information. Market monitoring of the Environment provide extensive are publicly posted as they arise. Other and robust enforcement are key to ensuring information on the overall GHG emissions ETS-related data, such as compliance these rules are followed and the integrity inventory, which utilizes verified GHG data information, allowance allocation, and GHG of the market is protected. Program to indicate progress towards achieving emissions, are posted annually. rules prohibit auction participants from overall emissions reductions, and a full releasing information regarding auction accounting of the expenditure of proceeds CARB and the Québec Ministry of the or reserve sale participation. This includes from quarterly auctions. Because the ETS Environment balance extensive data a prohibition on releasing information deals with multiple private and public transparency with the protection of market- regarding an intent to participate or not companies, certain types of information sensitive information and confidential to participate in an auction; auction – such as those related to confidential business information through regular approval status; bidding strategy at past or business information – may be protected public release of information on specific future auctions; bid price and bid quantity from disclosure pursuant to the California schedules, clear rules, penalties, and robust information at past or future auctions; and Public Records Act, Québec’s Act respecting enforcement of rules related to protected the amount of any bid guarantee provided Access to Documents Held by Public Bodies information. Robust procedures, internal to the financial services administrator. and the Protection of Personal Information, oversight, and trained staff dedicated CARB evaluates the disclosure of such and other applicable privacy laws. to market oversight are required to information and takes enforcement actions ensure proper disclosure of information when necessary. Table 12 provides further CARB and the Québec Ministry of the and the protection of market-sensitive details on the transparency measures and Environment publicly post information information and confidential business timelines in California. (28) An effective means of increasing market transparency, moreover, can be to require the use of an automated quotation system or a central limit order book (CLOB). Operated either by a public agency or a private exchange, such a CLOB provides a central location to consolidate unexecuted market orders, either automatically (‘hard’ CLOB) or by providing market participants with information to facilitate trading (‘soft’ CLOB). At a minimum, it shows orders to buy and sell as well as the name of the intermediary (market maker) posting each order. GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 59 Table 12: Transparency Measures in the California ETS Information Information Disclosure Requirement Disclosing Entity Timing Category Type Emissions Mandatory Greenhouse Gas Regulator (CARB) based on Annually Data and Reports verified emission reports of Reporting reporting facilities Emissions CARB Pollution Mapping Tool Regulator (CARB) Ongoing List of Accredited Verifiers Regulator (CARB) Ongoing Emissions GHG Inventory Website Regulator (CARB) Ongoing Inventory GHG Inventory Trends Regulator (CARB) Annually Unit Allocation Percentages for Regulator (CARB) Annually Allocation Electrical Distribution Industrial Benchmarks, Assis- Regulator (CARB) Annually tance Factors, Cap Adjustment Factors Report on Use of Allocated Regulator (CARB), based on annual Annually Allowance Value reports of allocation recipients Allowances and Offsets Auction An- Auction Notice Regulator (CARB) Quarterly nouncement Annual Auction Reserve Price Regulator (CARB) Annually Notice Auction Joint Auction Summary Results Regulator (CARB) Quarterly Results Report Post-Auction Public Proceeds Regulator (CARB) Quarterly Report Reserve Sales Regulator (CARB) When conditi- ons for reserve sale met Offsets List of Offsets Issued Regulator (CARB) Biweekly Offset Credit Issuance Table Regulator (CARB) Biweekly List of Accredited Offset Regulator (CARB) Ongoing Verifiers Market Data Report on Market Transfers Regulator (CARB) Annually Activity Market CITSS Registrant Report Regulator (CARB) Quarterly Compliance Instrument Report Regulator (CARB) Quarterly Compliance Compliance Report Regulator (CARB) Annually Compliance Enforcement List of Settlement Agreements Regulator (CARB) Ongoing Auction California Climate Investments Regulator (CARB) Ongoing Proceeds Website Revenue Use Expenditu- California Climate Investments Regulator (CARB) Ongoing re/Climate Map Investments Climate Investments Report to Regulator (CARB) Annually the Legislature 60 GOVERNANCE OF ETS ICAP & WORLD BANK 5.5 Resolving Conflicts – where parties still have control over the process, In the course of operating an ETS, conflicts between including the arbitrators appointed to decide on the different actors will invariably arise and call for outcome – or judicial proceedings before a public resolution. Because the economic stakes can be court, the most confrontational option with the least significant, the ability to resolve emerging disputes amount of control by parties. in a peaceful and orderly manner is critical to secure confidence in the market and ensure acceptance Each of these approaches to dispute resolution of the outcomes. Conflicts can originate in a variety is subject to negotiated or mandatory rules of of causes and occur between all actors involved in procedure, and typically involves a process that or affected by an ETS, including compliance entities, begins with the filing of a complaint or some other other market participants and stakeholders, and type of application, a discovery stage geared toward government entities. Box 15 lists types of conflicts finding of relevant facts, and a hearing or trial. It between different actors or groups of actors in an concludes with a decision or judgment, which can ETS and provides relevant examples. take different forms – depending on the underlying conflict – such as a legal remedy including Settling such conflicts can involve a variety of formal compensatory damages, or sanctions for a civil or and informal means, often beginning with informal criminal offense. Often, the process ends before a mediation between parties to seek a negotiated decision or judgment is handed down because parties outcome and avoid unnecessary costs and delays. agree to a negotiated settlement. Depending on the Mediation may not always offer the desired recourse jurisdiction and context, parties may also have a right to one or more parties to a dispute, however, so they to appeal the outcome, with differences in terms of may instead opt for more formal means of conflict availability of an appeal, the scope of review, and the resolution. Such means include binding arbitration remedies it affords. In the course of operating an ETS, conflicts between different actors will invariably arise and call for resolution. GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 61 Box 15: Examples of Conflicts in an ETS Conflicts between market participants: against decisions of a government Conflicts between other stakeholders: Parties to a transaction involving the agency, such as the ETS administrator. Because an ETS can affect many segments transfer of units or related financial Such conflicts can arise, for instance, of civil society, disputes can also arise products may find themselves in a dispute where a compliance entity challenges a beyond direct market participants. over the terms of the transaction, such decision on the free allocation of units, Concerns about environmental justice, as the price and quantity of units or the or appeals a decision that it has failed for instance, have prompted advocacy timing of delivery, or seek redress for flawed to comply with its obligations under the groups to file challenges against ETS or incomplete performance. In cases of ETS. Designated compliance entities or policies where these have been claimed to fraudulent market behavior, a market other stakeholders have even challenged offer insufficient protections for minorities participant may seek recovery of stolen plans to introduce an ETS based on and other disadvantaged constituencies. units from another market participant who a perceived violation of constitutional Even jurisdictions can find themselves in purchased them in good faith. Conflicts may rights. ETS-related legal disputes, for instance also involve market intermediaries, such as if a national government challenges the trading platforms, brokers, and lenders, for Examples of conflicts between authority of a subnational government to instance if a market participant violates the compliance entities and the government operate its own ETS. contractual terms of an exchange or fails to include the case of ArcelorMittal Rodange repay a loan. et Schifflange SA v. État du Grand-duché For instance, in the case of California de Luxembourg before the European Chamber of Commerce et al. v. California An example of a dispute between market Court of Justice (ECJ), in which the Air Resources Board et al. decided by the participants is the case of Armstrong DLW claimant, a compliance entity under the California Court of Appeal, the plaintiffs GmbH v. Winnington Networks Ltd. before EU ETS, challenged the ability of unsuccessfully challenged the Californian the High Court of Justice of the United Luxembourg to request the surrender ETS because, as they saw it, the Kingdom, in which Armstrong DLW GmbH, of unused allowances after the claimant requirement to purchase emissions the plaintiff, sought relief for allowances ceased to engage in emitting activities;30 allowances through auction constituted a stolen by a third party and purchased by or an earlier case decided by the tax that had not been properly authorized Winnington Networks Ltd., the defendant, German Federal Administrative Court by the State legislature and was therefore who argued it had done so in good (Bundesverwaltungsgericht, or BVerwG), illegal under the California Constitution.32 faith.29 Ultimately, the court decided that in which the court rejected the appeal Similarly, in the case of United States v. Armstrong DLW GmbH was entitled to of a cement manufacturer who had California before the U.S. District monetary restitution. claimed that its inclusion in the scope Court for the Eastern District of California, of the EU ETS had the effect of an the U.S. federal government unsuccessfully Conflicts between compliance entities and expropriation and violated its fundamental challenged the California ETS and its the government: Conflicts can also involve rights under European law and the linking agreement with the Canadian compliance entities seeking legal recourse German constitution.31 province of Québec.33 (29) High Court of Justice of the United Kingdom, Armstrong DLW GmbH v. Winnington Networks Ltd. [2012] EWHC 10, [2013] Ch 156 (Ch). (30) European Court of Justice, Case C-321/15, ArcelorMittal Rodange et Schifflange SA v. État du Grand-duché de Luxembourg, Judgment of the Court (Fifth Chamber) of 8 March 2017, ECLI:EU:C:2017:179. (31) Federal Administrative Court (Bundesverwaltungs- gericht), Case BVerwG 7 C 26.04, Judgment of 30 June 2005, ECLI:DE:BVerwG:2005:300605U7C26.04.0. (32) California Court of Appeal, California Chamber of Commerce et al. v. California Air Resources Board et al., 10 Cal. App. 5th 604, 216 Cal. Rptr. 3d 694 (2017). (33) United States District Court for the Eastern District of California United States of America, Plaintiff, v. the State of California; Gavin C. Newsom, in his official capacity as Governor of the State of California et al., 444 F. Supp. 3d 1181 (E.D. Cal. 2020). 62 GOVERNANCE OF ETS ICAP & WORLD BANK 06. Third Phase: Reviewing and Amending the ETS Chapter 6 provides an overview of ETS review and system changes, and describes why the governance of these processes matters. Specifically, it describes approaches to performance review and evaluation, and the role of independent advisory bodies in this process. It also discusses scheduled or unscheduled changes to the ETS design, as well as ways to ensure robust governance through transparent and consistent procedures, timelines and institutional responsibilities. GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 63 6.1 Reviewing Performance timing of a review. Box 16 describes the procedures for Performance review is an important part of the performance review in these systems. policy cycle (Chapter 2.3), enabling the evaluation and adjustment of an ETS in a continuously evolving In the context of performance review, the government context. Such a review can be targeted, focusing on agencies charged with designing and implementing a specific aspect of ETS design or implementation, the ETS may be exposed to claims of bias or partiality. or it can be comprehensive, and serve to assess An increasing number of jurisdictions have therefore whether the ETS has met its objectives and how opted to rely on independent advisory bodies – such it can be fundamentally improved (PMR and ICAP as a scientific council or climate change committee 2021). Performance reviews can also be scheduled – to conduct the review of their ETS, or to inform and in advance, for instance at the end of an ETS trading complement a review led by the government with an period, or they can be performed spontaneously in external opinion. Because of their independence, such response to unforeseen developments, such as a bodies tend to enjoy a high degree of credibility with system shock. Existing programs have approached stakeholders and the general public. Independent ad- performance review very differently. Some, such as the visory bodies can take different shapes, from formally New Zealand ETS, require periodic reviews at specified instituted and permanent councils or committees milestones in the evolution of the ETS, whereas others, to temporary scientific expert groups. Box 17 (pg.64) such as the EU ETS, the Québec ETS and RGGI, provide describes the contribution of an advisory body to the considerable discretion regarding the need for and review of the NZ ETS. Box 16: Performance Review in Existing ETSs In New Zealand, the Climate Change periodic reviews would occur. Such reviews to which the Québec system is linked, Response Act 2002 enables the Minister for would be milestones to evaluate the engage in informal conversations on a Climate Change to initiate a review of the functioning of the system and determine weekly basis at the management and operation and effectiveness of the NZ ETS whether improvements would be needed professional team level to assess the at any time. Three reviews have taken place, for the subsequent phase. Still, the EU functioning of the ETS and discuss any the first in 2008, the second in 2011, and the ETS Directive does not set out an explicit issues observed or reported by stakeholders most recent spanning 2015-16. The three obligation to conduct a review before each or participants that might require reviews of the NZ ETS have been underta- new trading phase, and instead requires attention. This ongoing exchange of ken in different ways, but each has called for the European Commission to publish an views is supported by analysis and written submissions from the public which annual report on the functioning of the consultation with third parties, such as were taken into consideration. For the 2008 carbon market for transparency purposes. an external market monitor or WCI, Inc. review, a special committee was established It also includes review clauses on specific If it identifies a need for changes to the by the Parliament. The committee called for issues, along with a general clause for a ETS, the process results in a consultation written submissions and selected a number review scheduled after 2023. What is not to ensure broad awareness of any of submitters to speak to the committee specified in detail is the scope of these pending amendments. Similarly, in RGGI, in person. In 2010, the Minister for Climate reviews, and whether they can be broad member jurisdictions decide by consensus Change appointed an independent Review programmatic reviews or need to instead to initiate a program review. RGGI was Panel and established Terms of Reference include an in-depth analysis as well as launched in 2009, with a first program for its work. The review took place in 2011, concrete reform proposals. Occasionally, review in 2012, a second in 2016, and a and the Panel called for submissions and ad-hoc developments have prompted third in 2021. Each review has involved met with a number of stakeholders. For an unscheduled evaluation and reform solicitation of stakeholder views through each stage of the 2015-16 review, a discus- of the EU ETS, for instance regarding the formal meetings and consultations with sion document prepared by the Ministry for establishment of the MSR as a reaction external constituencies, as well as internal the Environment was released along with to the accumulation of an emission unit processes involving environmental a call for written submissions. A series of surplus. Also, any major legislative reform and utility regulators from each member public meetings accompanied each stage of of the EU ETS has been preceded by an RIA jurisdiction. Program reviews have the review, and each review has taken into (see Chapter 4.1.3) assessing its expected taken between one and two years, and account obligations of the Crown to Māori economic and environmental impacts. have resulted in identification of a under the Treaty of Waitangi. number of recommended changes to Neither the Québec ETS nor RGGI specify the system. At the end of each review, In the EU ETS, the inclusion of trading a mandatory program review.34 Instead, the date of the next review has been phases implied from the outset that management staff in Québec and California, announced. (34) That is not to say that Québec does not carry out targeted reviews ahead of certain ETS amendments, such as setting the emissions cap every ten years, which is closely linked to the multi-stake- holder process of defining Québec’s overall GHG reduction targets; likewise, the periodic revision of rules on free allocation of emission units is accompanied by formal consultations. 64 GOVERNANCE OF ETS ICAP & WORLD BANK Performance reviews can also be scheduled in advance, for instance at the end of an ETS trading period, or they can be performed spontaneously in response to unforeseen developments, such as a system shock. Box 17: Independent Advisory Bodies in New Zealand In New Zealand, a number of independent May 2021, the Climate Change Commission Commission commented on the NZ ETS bodies have a role in providing advice on issued its first formal advisory report to in a 2018 report which advised on how the functioning of the ETS. The Climate the government, which was preceded New Zealand could best make the Change Commission is a recently- by public consultations on a draft report transition to a low-emission economy while established Crown Entity that provides released in February 2021. Among other continuing to grow incomes and wellbeing. independent, evidence-based advice to things, the Climate Change Commission’s The report recommended reforming the the government on mitigating climate advice included recommendations on the NZ ETS, with a focus on making it effective change and adapting to the effects of level of the first three emissions budgets in achieving the country’s NDC and its climate change. It also monitors and covering from 2022 to 2035, which aim commitment to substantially reduce net reviews progress towards emissions and to put New Zealand on track to meeting domestic GHG emissions. The Productivity climate adaptation goals. Its independence its 2030 and 2050 emissions targets. The Commission’s suggestions were taken means it can provide impartial advice, Minister for Climate Change is not bound into account during the Climate Change challenge the government, and hold it to to follow the advice of the Commission, Response (Emissions Trading Reform) account. The Climate Change Commission but must respond to it within a specified Amendment Bill process. made submissions on the Climate Change timeline and explain the reasons for any Response (Emissions Trading Reform) decisions that differ from its advice. Such Finally, the Parliamentary Commissioner for Amendment Bill 2020 as well as NZ ETS reasoning must be published in a publicly the Environment is an independent Officer unit supply and price control regulations. available report. of the New Zealand Parliament who reviews These submissions showed support for and provides independent advice about strengthening the NZ ETS and offered The New Zealand Productivity Commission, environmental concerns. The Commissioner recommendations for further improvement, another independent Crown entity, provides has provided submissions on reviews of the for example suggesting that auction price advice to the government on improving NZ ETS and on legislation to make changes controls should increase year-on-year to productivity in a way that supports to the system, along with comments on the signal increasing mitigation ambition. In the wellbeing of New Zealanders. The NZ ETS issued in its reports. GOVERNANCE OF ETS MARCH 2022 ICAP & WORLD BANK 65 6.2 Managing System Change initial establishment of the ETS – such as stakeholder Representing a complex policy instrument operating in engagement and robust communications – acquire a constantly evolving geophysical and socioeconomic renewed importance. Box 18 below describes context, an ETS will invariably have to adjust to experiences made in various jurisdictions when changing circumstances over time. As described in the changing an existing ETS. previous section, the impetus for such adjustments of an ETS may stem from a review of its performance, if that review has revealed design flaws and Many of the steps already opportunities for improvement. It may also originate in an external development, such as a change in encountered during the political leadership or an unforeseen economic shock. Either way, changes to an ETS can have consequential initial establishment of the implications for its functioning, influencing unit prices, asset values, and perceptions of market ETS – such as stakeholder participants and the broader public. Ensuring that engagement and robust any modifications to the ETS are implemented in a balanced and transparent way is therefore critical to communications – acquire sustain confidence in the system (PMR and ICAP 2021). Many of the steps already encountered during the renewed importance. Box 18: Managing System Change in Existing ETSs In Québec, the ETS has been relatively transparency and coordination across all at the level of the EU; at the same time, stable since it was launched, enabling it to relevant levels of government. Also, a clear the cap has become significantly more provide a more predictable price signal for legal authorization to effect changes – and stringent, decreasing in a linear way to changes to investment and corporate beha- notably technical details – through execu- increase predictability, and an MSR has vior. Likewise, system stability has lowered tive regulation proved helpful, as it obviated been created to adjust the supply of uncertainty about the revenue generated the need to enter the cumbersome process emission allowances. through auctioning and the investments of formal legislation. such revenue enables. Still, expanding the In New Zealand, finally, major reforms have coverage of the ETS was intended from By contrast, the EU ETS has evolved also required legislative changes, with the the outset: when the system design was significantly since its inception, yet each most recent of these implemented through first being elaborated, the jurisdictions major reform had to be preceded by formal adoption of the Climate Change (Emissions participating in the WCI still needed to work legislation – often requiring several years to Trading Reform) Amendment Act 2020. Over through potential issues in the reporting develop and adopt – to amend the under- time, changes have been made to improve system for the fuel distribution sector, in lying EU ETS Directive and other provisions. the effectiveness of the ETS, moderate its contrast to the accurate emissions reporting Major changes to the EU ETS have included impacts in the wake of the global financial and monitoring methods that already the expansion to new sectors, such as aviati- crisis, reflect changing economy-wide existed for the industrial and electricity on and aluminum, as well as adjustments to emission reduction targets and internatio- sectors. To leave more time to collect data how emission units are allocated. Similarly, nal commitments, and improve technical and consider implications, the ETS started the manner in which the overall emissions and operational elements. 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