Tuesday, 23 December 2008

Emissions Trading - Going Global

The original version of this article appeared in the June 2008 (No. 60) issue of The Environmentalist.

Greenhouse gas emissions impose a serious cost. For over a century, the main cost of releasing carbon dioxide (CO2) from factories and vehicles has been borne by the environment, in the form of gradually rising global temperatures and the cumulative impacts of climate change. The 2006 Stern Report suggests that climate change, left unchecked, could cost as much as 5% of GDP.

However, the main emitters – operators of vehicles, factories, and power plants –have rarely had to bear the full environmental cost of their actions. Without clear price signals, polluters have had little incentive to reduce their CO2 emissions.

This situation is changing. Since 2005 governments around the world have been phasing in pricing systems that give polluters a financial incentive to reduce their CO2 emissions. The most popular approach, called cap-and-trade, sets a gradually diminishing quota on allowable greenhouse gas emissions, based on historic performance. Firms that emit more CO2 than their allowance must pay a hefty fine or purchase pollution rights from another firm at a mutually agreed price. Firms that emit less than their allowance can sell their excess allocation. In other words, regulators use market mechanisms to find and implement the fastest and most cost-effective emissions reductions, wherever they occur.

The most established CO2 emissions trading system is the European Union Emissions Trading Scheme (EU ETS) launched in 2005 to help European nations meet their commitments under the Kyoto Protocol. EU-ETS focused initially on those large industrial emitters collectively producing almost half of the EU’s CO2 emissions from about 11,500 sources: iron and steel, certain mineral industries (including the cement industry), energy production (including electric power facilities and refining), and pulp and paper.

The trial phase of the ETS ran from January 2005 until December 2007. The second phase of the scheme, launched in January 2008, reflects the EU’s 8% binding reduction target by 2012, and imposes a lower emissions cap than did the first phase.

There are two main ways the EU scheme can expand: by including additional sectors, and by including additional countries and linking to other cap and trade schemes. The EU system is open to cooperation with compatible systems in other countries. This year, EU ETS will undergo its first enlargement when Norway, Iceland and Liechtenstein join.

The European Union is including aviation emissions into the system from 2011 and considering expanding the system to further industrial sectors and other greenhouse gases from 2013. For companies across Europe, the price of carbon is getting higher.

The UK’s Carbon Reduction Commitment
While the EU-ETS is a cap-and-trade system designed to help European countries meet their Kyoto obligations, the UK Government wants to use cap-and-trade to achieve even greater reductions. The proposed Carbon Reduction Commitment (CRC) is a cap-and-trade system aimed at large, non-energy intensive companies whose emissions may not be covered under the ETS. These companies’ UK energy consumption exceeds 6,000 MWh per year – equivalent to an energy bill of around £500,000.

Participating companies would include supermarket chains, hotels, office buildings, and government departments. These businesses account for nearly 10% of the UK’s annual emissions.

Under the CRC, companies will self-report their direct and indirect energy emissions (see our December 2007 Environmentalist article “Whose footprint is it anyway?” for an overview of emissions categories). Companies covered by the CRC will have to purchase their initial allowances and will eventually be assigned an emissions reduction target. Firms can then trade any allowances surplus to their requirements or purchase extra if there is a shortfall. CRC participants will also be able to buy (but not sell) allowances from the EU-ETS instead of from their counterparts within the CRC.

The Government intends to publish a league table comparing CRC participants’ progress in reducing emissions, and will refund all or part of the allowance fees in proportion to each company’s league rankings. It is expected that the need to purchase credits, the promise of a cash rebate linked to performance, and the threat of being branded a climate change laggard in the league tables will provide incentives for rapid emissions reductions.

The carbon price is influencing behaviour. In recent conversations with large companies, Carbon Clear's advisory team has found that anticipation of the CRC is encouraging more firms in Britain to measure their carbon footprint and identify rapid emissions reduction opportunities.

Cap-and-trade in the USA
In December 2007, the Climate Security Act (S. 2191) was approved by the US Senate Environment Committee- the first global warming bill to make it out of any committee in the US Congress. Sources responsible for eighty-six percent of US emissions would be covered by the Bill, with targets to reduce emissions by 18%-25% by 2020, and by 62% by 2050. The Bill contained provisions for selling, transferring, retiring, and borrowing emissions allowances.

The Senate Bill establishes a Carbon Market Efficiency Board to determine the number of emissions allowances under this cap-and-trade scheme and set up allowance auctions. Unlike the UK's CRC, which rebates the proceeds from the sale of allowances, the Carbon Market Efficiency Board would use auction proceeds to support energy efficiency and other low carbon technology investments.

In addition, while the US cap-and-trade scheme is not part of the Kyoto Protocol, it allows up to 15% of a company’s emissions reduction obligations to be met through the purchase of international credits from other recognized trading systems.

While the Climate Security Act ultimately failed in the face of an election-year economic downturn and spiraling fuel prices in the first half of 2008, it generated considerable political support and provides a template for future legislation.

Preventing “carbon leakage”
Across the industrialised world, cap-and-trade schemes and voluntary carbon-neutrality pledges are helping companies incorporate the price of carbon into their business decsions. But the same does not hold true everywhere. Countries with less stringent requirements may see a net gain in heavy industry, where the cost of carbon can have a major impact on profitability. Where this happens, emisions reductions in industrialised countries may be negated by increases in other parts of the world.

Without a global climate change agreement, “carbon leakage” to rapidly growing developing countries such as India and China is inevitable. German Chancellor Angela Merkel has urged EU leaders to back measures to prevent industries such as cement and steel from leaving the EU as tighter limits on CO2 emissions are imposed in the Community after 2012. Two options are under consideration for post-2012 Europe:

  1. Granting free emission allowances to industries which are particularly exposed to international competition, or
  2. imposing a "carbon tax" on imports from countries with no CO2 emission constraints of their own.

It remains to be seen whether these proposals survive local lobbying and the give-and-take of international negotiations.

Cross-system linkages?
Cap-and-trade systems are operational or under development in Europe, North America, Australia, and other parts of the world. Linking these various cap-and-trade systems could contribute to a global carbon market.

A larger carbon market with an increased number of participants helps to increase liquidity in the market. There are more actors able to achieve lower-cost emissions reductions and more willing to pay a premium for spare carbon credits. Greater liquidity can lead to an improved allocation of resources and more cost effective and rapid emissions reductions overall.

With a larger carbon market, there is less burden-shifting, that is, a lower likelihood of CO2 emissions leaking to countries that lack a strong regulatory framework.

There are, however, challenges to linking the European and US cap-and-trade systems. In particular, how would Europe react to more flexible standards that could cause the price of carbon in the EU to plummet? How readily would the US give up the flexibility required to achieve cost-effective emissions reductions across a large and diverse economy spanning multiple climactic and time zones? And how will both systems accomodate the need to purchase external carbon credits from developing countries that require financial help achieving reductions?

While challenges abound, a broader carbon market can help to accelerate the transition to a low-carbon economy. Without a clear price for carbon, we risk a major misallocation of our resources and threaten to pass on the costs of climate change to future generations.

Suzy Hodgson, AIEMA, is a principal consultant and Jamal Gore, AIEMA is the managing director at specialist carbon management company, Carbon Clear Limited.