Emissions trading is a market-based approach used to control pollution by providing economic incentives for achieving reductions in the emissions of pollutants.

A central authority (usually a governmental body) sets a limit or cap on the amount of a pollutant that can be emitted. The limit or cap is allocated or sold to firms in the form of emissions permits which represent the right to emit or discharge a specific volume of the specified pollutant. Firms are required to hold a number of permits (or carbon credits) equivalent to their emissions. The total number of permits cannot exceed the cap, limiting total emissions to that level. Firms that need to increase their emission permits must buy permits from those who require fewer permits.

The transfer of permits is referred to as a trade. In effect, the buyer is paying a charge for polluting, while the seller is being rewarded for having reduced emissions. Thus, in theory, those who can reduce emissions most cheaply will do so, achieving the pollution reduction at the lowest cost to society.

There are active trading programs in several air pollutants. For greenhouse gases the largest is the European Union Emission Trading Scheme. In the United States there is a national market to reduce acid rain and several regional markets in nitrogen oxides. Markets for other pollutants tend to be smaller and more localized.

Pollution as an Externality

By definition, an externality is an activity of one entity that affects the welfare of another entity in a way that is outside the market mechanism. Pollution is the prime example most economists think of when discussing externalities. There are many different ways to address these from a public economics perspective including emissions fees, cap-and-trade, and command-and-control regulation. Here we will discuss cap-and-trade as the chosen public response to externalities.

Overview

The overall goal of an emissions trading plan is to minimize the cost of meeting a set emissions target. The cap is an enforceable limit on emissions that is usually lowered over time — aiming towards a national emissions reduction target. In other systems a portion of all traded credits must be retired, causing a net reduction in emissions each time a trade occurs. In many cap-and-trade systems, organizations which do not pollute may also participate, thus environmental groups can purchase and retire allowances or credits and hence drive up the price of the remainder according to the law of demand. Corporations can also prematurely retire allowances by donating them to a nonprofit entity and then be eligible for a tax deduction.

Definitions

The economics literature provides the following definitions of cap and trade emissions trading schemes.

A cap-and-trade system constrains the aggregate emissions of regulated sources by creating a limited number of tradable emission allowances, which emission sources must secure and surrender in number equal to their emissions.

In an emissions trading or cap-and-trade scheme, a limit on access to a resource (the cap) is defined and then allocated among users in the form of permits. Compliance is established by comparing actual emissions with permits surrendered including any permits traded within the cap.

Under a tradable permit system, an allowable overall level of pollution is established and allocated among firms in the form of permits. Firms that keep their emission levels below their allotted level may sell their surplus permits to other firms or use them to offset excess emissions in other parts of their facilities.

Market-based and least-cost

Economists have urged the use of "market-based" instruments such as emissions trading to address environmental problems instead of prescriptive "command and control" regulation. Command and control regulation is criticized for being excessively rigid, insensitive to geographical and technological differences, and for being inefficient. However, emissions trading requires a cap to effectively reduce emissions, and the cap is a government regulatory mechanism. After a cap has been set by a government political process, individual companies are free to choose how or if they will reduce their emissions. Failure to reduce emissions is often punishable by a further government regulatory mechanism, a fine that increases costs of production. Firms will choose the least-costly way to comply with the pollution regulation, which will lead to reductions where the least expensive solutions exist, while allowing emissions that are more expensive to reduce.

Emission markets

For trading purposes, one allowance or Certified Emission Reduction (CER) is considered equivalent to one metric ton of CO₂ emissions. These allowances can be sold privately or in the international market at the prevailing market price. These trade and settle internationally and hence allow allowances to be transferred between countries. Each international transfer is validated by the UNFCCC. Each transfer of ownership within the European Union is additionally validated by the European Commission.

Climate exchanges have been established to provide a spot market in allowances, as well as futures and options market to help discover a market price and maintain liquidity. Carbon prices are normally quoted in Euros per tonne of carbon dioxide or its equivalent (CO₂e). Other greenhouse gasses can also be traded, but are quoted as standard multiples of carbon dioxide with respect to their global warming potential. These features reduce the quota's financial impact on business, while ensuring that the quotas are met at a national and international level.

Currently there are six exchanges trading in carbon allowances: the Chicago Climate Exchange, European Climate Exchange, NASDAQ OMX Commodities Europe, PowerNext, Commodity Exchange Bratislava and the European Energy Exchange. NASDAQ OMX Commodities Europe listed a contract to trade offsets generated by a CDM carbon project called Certified Emission Reductions. Many companies now engage in emissions abatement, offsetting, and sequestration programs to generate credits that can be sold on one of the exchanges. At least one private electronic market has been established in 2008: CantorCO2e. Carbon credits at Commodity Exchange Bratislava are traded at special platform - Carbon place.

Managing emissions is one of the fastest-growing segments in financial services in the City of London with a market estimated to be worth about €30 billion in 2007. Louis Redshaw, head of environmental markets at Barclays Capital predicts that "Carbon will be the world's biggest commodity market, and it could become the world's biggest market overall."

History

The efficiency of what later was to be called the "cap-and-trade" approach to air pollution abatement was first demonstrated in a series of micro-economic computer simulation studies between 1967 and 1970 for the National Air Pollution Control Administration (predecessor to the United States Environmental Protection Agency's Office of Air and Radiation) by Ellison Burton and William Sanjour. These studies used mathematical models of several cities and their emission sources in order to compare the cost and effectiveness of various control strategies. Each abatement strategy was compared with the "least cost solution" produced by a computer optimization program to identify the least costly combination of source reductions in order to achieve a given abatement goal. In each case it was found that the least cost solution was dramatically less costly than the same amount of pollution reduction produced by any conventional abatement strategy. Burton and later Sanjour along with Edward H. Pechan continued improving and advancing these computer models at the newly-created U.S. Environmental Protection agency. The agency introduced the concept of computer modeling with least cost abatement strategies (i.e. emissions trading) in its 1972 annual report to Congress on the cost of clean air. This led to the concept of "cap and trade" as a means of achieving the "least cost solution" for a given level of abatement.

The development of emissions trading over the course of its history can be divided into four phases:

# Gestation: Theoretical articulation of the instrument (by Coase, Crocker, Dales, Montgomery etc.) and, independent of the former, tinkering with "flexible regulation" at the US Environmental Protection Agency. # Proof of Principle: First developments towards trading of emission certificates based on the "offset-mechanism" taken up in Clean Air Act in 1977. # Prototype: Launching of a first "cap-and-trade" system as part of the US Acid Rain Program in Title IV of the 1990 Clean Air Act, officially announced as a paradigm shift in environmental policy, as prepared by "Project 88", a network-building effort to bring together environmental and industrial interests in the US. # Regime formation: branching out from the US clean air policy to global climate policy, and from there to the European Union, along with the expectation of an emerging global carbon market and the formation of the "carbon industry".

In the United States, the "acid rain"-related emission trading system was principally conceived by C. Boyden Gray, a G.H.W. Bush administration attorney. Gray worked with the Environmental Defense Fund (EDF), who worked with the EPA to write the bill that became law as part of the Clean Air Act of 1990. The new emissions cap on NOx and SO2 gases took effect in 1995, and according to Smithsonian Magazine, those acid rain emissions dropped 3 million tons that year.

Public opinion

In the United States, most polling shows large support for emissions trading (oftentimes referred to as cap-and-trade). This majority support can be seen in polls conducted by Washington Post/ABC News, Zogby International and Yale University.

According to PolitiFact, it's a misconception that emissions trading is unpopular in the United States because of earlier polls from Zogby International and Rasmussen which misleadingly include "new taxes" (taxes aren't part of emissions trading) or high energy cost estimates.

Comparison of cap-and-trade with other methods of emission reduction

Cap-and-trade, offsets created through a baseline and credit approach, and a carbon tax are all market-based approaches that put a price on carbon and other greenhouse gases and provide an economic incentive to reduce emissions, beginning with the lowest-cost opportunities.

The textbook emissions trading program can be called a "cap-and-trade" approach in which an aggregate cap on all sources is established and these sources are then allowed to trade amongst themselves to determine which sources actually emit the total pollution load. An alternative approach with important differences is a baseline and credit program.

In a baseline and credit program polluters that are not under an aggregate cap can create credits, usually called offsets, by reducing their emissions below a baseline level of emissions. Such credits can be purchased by polluters that do have a regulatory limit.

Cap-and-trade versus Carbon tax and other methods

Cap-and-Trade versus Carbon tax

Regulation by Cap-and-trade emissions trading can be compared to emissions fees or environmental tax approaches under a number of possible criteria.

Responsiveness to inflation: In the case of inflation, cap-and-trade is at an advantage over emissions fees because it adjusts to the new prices automatically and no legislative or regulatory action is needed.

Responsiveness to cost changes: It is difficult to tell which is better between cap-and-trade and emissions fees therefore it might be a better option to combine the two resulting in the creation of a safety valve price (a price set by the government at which polluters can purchase additional permits beyond the cap).

Responsiveness to uncertainty: As with cost changes, in a world of uncertainty, it is not clear whether emissions fees or cap-and-trade systems are more efficient—it basically depends on how fast the marginal social benefits of reducing pollution fall with the amount of cleanup (e.g. whether inelastic or elastic marginal social benefit schedule).

Cap-and-Trade versus Command-and-Control Regulation: Unlike emissions fees and cap-and-trade which are incentive based regulations, command-and-control regulations take a variety of forms and are much less flexible. An example of this is a performance standard which sets an emissions goal for each polluter that is fixed and therefore the burden of reducing pollution cannot be shifted to the firms that can achieve it more cheaply. So, as a result, performance standards are unlikely to be as cost effective as cap-and-trade emissions trading.

The policy framework should be different for regional pollutants (e.g. SO₂ and NO_X, and also mercury) because the impact exerted by these pollutants may not be the same in all locations. The same amount of a regional pollutant can exert a very high impact in some locations and a low impact in other locations, so it does actually matter where the pollutant is released. This is known as the Hot Spot problem.

A Lagrange framework is commonly used to determine the least cost of achieving an objective, in this case the total reduction in emissions required in a year. In some cases it is possible to use the Lagrange optimization framework to determine the required reductions for each country (based on their MAC) so that the total cost of reduction is minimized. In such a scenario, the Lagrange multiplier represents the market allowance price (P) of a pollutant, such as the current market allowance price of emissions in Europe and the USA.

Countries face the market allowance price that exists in the market that day, so they are able to make individual decisions that would minimize their costs while at the same time achieving regulatory compliance. This is also another version of the Equi-Marginal Principle, commonly used in economics to choose the most economically efficient decision.

Prices versus quantities, and the safety valve

There has been longstanding debate on the relative merits of price versus quantity instruments to achieve emission reductions.

An emission cap and permit trading system is a quantity instrument because it fixes the overall emission level (quantity) and allows the price to vary. Uncertainty in future supply and demand conditions (market volatility) coupled with a fixed number of pollution credits creates an uncertainty in the future price of pollution credits, and the industry must accordingly bear the cost of adapting to these volatile market conditions. The burden of a volatile market thus lies with the industry rather than the controlling agency, which is generally more efficient. However, under volatile market conditions, the ability of the controlling agency to alter the caps will translate into an ability to pick "winners and losers" and thus presents an opportunity for corruption.

In contrast, an emission tax is a price instrument because it fixes the price while the emission level is allowed to vary according to economic activity. A major drawback of an emission tax is that the environmental outcome (e.g. a limit on the amount of emissions) is not guaranteed. On one hand, a tax will remove capital from the industry, suppressing possibly useful economic activity, but conversely, the polluter will not need to hedge as much against future uncertainty since the amount of tax will track with profits. The burden of a volatile market will be borne by the controlling (taxing) agency rather than the industry itself, which is generally less efficient. An advantage is that, given a uniform tax rate and a volatile market, the taxing entity will not be in a position to pick "winners and losers" and the opportunity for corruption will be less.

Assuming no corruption and assuming that the controlling agency and the industry are equally efficient at adapting to volatile market conditions, the best choice depends on the sensitivity of the costs of emission reduction, compared to the sensitivity of the benefits (i.e., climate damages avoided by a reduction) when the level of emission control is varied.

Because there is high uncertainty in the compliance costs of firms, some argue that the optimum choice is the price mechanism. However, the burden of uncertainty cannot be eliminated, and in this case it is shifted to the taxing agency itself.

Some scientists have warned of a threshold in atmospheric concentrations of carbon dioxide beyond which a run-away warming effect could take place, with a large possibility of causing irreversible damages. If this is a conceivable risk then a quantity instrument could be a better choice because the quantity of emissions may be capped with a higher degree of certainty. However, this may not be true if this risk exists but cannot be attached to a known level of GHG concentration or a known emission pathway.

A third option, known as a safety valve, is a hybrid of the price and quantity instruments. The system is essentially an emission cap and permit trading system but the maximum (or minimum) permit price is capped. Emitters have the choice of either obtaining permits in the marketplace or purchasing them from the government at a specified trigger price (which could be adjusted over time). The system is sometimes recommended as a way of overcoming the fundamental disadvantages of both systems by giving governments the flexibility to adjust the system as new information comes to light. It can be shown that by setting the trigger price high enough, or the number of permits low enough, the safety valve can be used to mimic either a pure quantity or pure price mechanism.

All three methods are being used as policy instruments to control greenhouse gas emissions: the EU-ETS is a quantity system using the cap and trading system to meet targets set by National Allocation Plans; Denmark has a price system using a carbon tax (World Bank, 2010, p. 218), while China uses the CO₂ market price for funding of its Clean Development Mechanism projects, but imposes a safety valve of a minimum price per tonne of CO₂.

Carbon leakage

Carbon leakage is the effect that regulation of emissions in one country/sector has on the emissions in other countries/sectors that are not subject to the same regulation (Barker et al.., 2007). There is no consensus over the magnitude of long-term carbon leakage (Goldemberg et al., 1996, p. 31).

In the Kyoto Protocol, Annex I countries are subject to caps on emissions, but non-Annex I countries are not. Barker et al.. (2007) assessed the literature on leakage. The leakage rate is defined as the increase in CO₂ emissions outside of the countries taking domestic mitigation action, divided by the reduction in emissions of countries taking domestic mitigation action. Accordingly, a leakage rate greater than 100% would mean that domestic actions to reduce emissions had had the effect of increasing emissions in other countries to a greater extent, i.e., domestic mitigation action had actually led to an increase in global emissions.

Estimates of leakage rates for action under the Kyoto Protocol ranged from 5 to 20% as a result of a loss in price competitiveness, but these leakage rates were viewed as being very uncertain. For energy-intensive industries, the beneficial effects of Annex I actions through technological development were viewed as possibly being substantial. This beneficial effect, however, had not been reliably quantified. On the empirical evidence they assessed, Barker et al.. (2007) concluded that the competitive losses of then-current mitigation actions, e.g., the EU ETS, were not significant.

Trade

One of the controversies about carbon mitigation policy thus arises about how to "level the playing field" with border adjustments. One component of the American Clean Energy and Security Act, for example, along with several other energy bills put before Congress, calls for carbon surcharges on goods imported from countries without cap-and-trade programs. Even aside from issues of compliance with the General Agreement on Tariffs and Trade, such border adjustments presume that the producing countries bear responsibility for the carbon emissions.

A general perception among developing countries is that discussion of climate change in trade negotiations could lead to "green protectionism" by high-income countries (World Bank, 2010, p. 251). Tariffs on imports ("virtual carbon") consistent with a carbon price of $50 per ton of CO₂ could be significant for developing countries. World Bank (2010) commented that introducing border tariffs could lead to a proliferation of trade measures where the competitive playing field is viewed as being uneven. Tariffs could also be a burden on low-income countries that have contributed very little to the problem of climate change.

Trading systems

Kyoto Protocol

As the IPCC reports came in over the years they shed abundant light on the true state of global warming and they gave support to the environmental effort to address this unprecedented problem. However, the same discussions that started decades back had never ceased and the crusade for a tangible solution to global climate change had gone on all the while. In 1997 the Kyoto Protocol was adopted. The Kyoto Protocol is a 1997 international treaty which came into force in 2005. In the treaty, most developed nations agreed to legally binding targets for their emissions of the six major greenhouse gases. Emission quotas (known as "Assigned amounts") were agreed by each participating 'Annex 1' country, with the intention of reducing the overall emissions by 5.2% from their 1990 levels by the end of 2012. The United States is the only industrialized nation under Annex I that has not ratified the treaty, and is therefore not bound by it. The Intergovernmental Panel on Climate Change has projected that the financial effect of compliance through trading within the Kyoto commitment period will be limited at between 0.1-1.1% of GDP among trading countries.

The Protocol defines several mechanisms ("flexible mechanisms") that are designed to allow Annex I countries to meet their emission reduction commitments (caps) with reduced economic impact (IPCC, 2007).

Under Article 3.3 of the Kyoto Protocol, Annex 1 Parties may use GHG removals, from afforestation and reforestation (forest sinks) and deforestation (sources) since 1990, to meet their emission reduction commitments.

Annex 1 Parties may also use International Emissions Trading (IET). Under the treaty, for the 5-year compliance period from 2008 until 2012, nations that emit less than their quota will be able to sell Assigned amount units to nations that exceed their quota. It is also possible for Annex I countries to sponsor carbon projects that reduce greenhouse gas emissions in other countries. These projects generate tradable carbon credits that can be used by Annex I countries in meeting their caps. The project-based Kyoto Mechanisms are the Clean Development Mechanism (CDM) and Joint Implementation (JI).

The CDM covers projects taking place in non-Annex I countries, while JI covers projects taking place in Annex I countries. CDM projects are supposed to contribute to sustainable development in developing countries, and also generate "real" and "additional" emission savings, i.e., savings that only occur thanks to the CDM project in question (Carbon Trust, 2009, p. 14). Whether or not these emission savings are genuine is, however, difficult to prove (World Bank, 2010, pp. 265–267).

Australia

Garnaut Draft Report

In 2003 the New South Wales (NSW) state government unilaterally established the NSW Greenhouse Gas Abatement Scheme to reduce emissions by requiring electricity generators and large consumers to purchase NSW Greenhouse Abatement Certificates (NGACs). This has prompted the rollout of free energy-efficient compact fluorescent lightbulbs and other energy-efficiency measures, funded by the credits. This scheme has been criticised by the Centre for Energy and Environmental Markets (CEEM) of the UNSW because of its lack of effectiveness in reducing emissions, its lack of transparency and its lack of verification of the additionality of emission reductions.

On 4 June 2007, former Prime Minister John Howard announced an Australian Carbon Trading Scheme to be introduced by 2012, but opposition parties called the plan "too little, too late". On 24 November 2007 Howard's coalition government lost a general election and was succeeded by the Labor Party, with Kevin Rudd taking over as prime minister. Prime Minister Rudd announced that a cap-and-trade emissions trading scheme would be introduced in 2010, however this scheme was initially delayed by a year to mid-2011, and in May 2010, it was subsequently delayed further until 2013.

Australia's Commonwealth, State and Territory Governments commissioned the Garnaut Climate Change Review, a study by Professor Ross Garnaut on the mechanism of a potential emissions trading scheme. Its interim report was released on 21 February 2008. It recommended an emissions trading scheme that includes transportation but not agriculture, and that emissions permits should be sold competitively and not allocated free to carbon polluters. It recognised that energy prices will increase and that low income families will need to be compensated. It recommended more support for research into low emissions technologies and a new body to oversee such research. It also recognised the need for transition assistance for coal mining areas.

In response to Garnaut's draft report, the Rudd Labor government issued a Green Paper on 16 July that described the intended design of the actual trading scheme.

Subsequent to this, the emission trading scheme proposed by the Government was defeated in the Senate, with the Opposition, the Greens and two independent senators opposing the proposed legislation.

New Zealand

The New Zealand Emissions Trading Scheme (NZ ETS) is a national all-sectors all-greenhouse gases uncapped emissions trading scheme first legislated in September 2008 by the Fifth Labour Government of New Zealand and amended in November 2009 by the Fifth National Government of New Zealand.

Although the NZ ETS covers all-sectors and all-gases, individual sectors of the economy have different entry dates when their obligations to report emissions and surrender emission units have effect. Forestry, a net sink which contributed removals of 14 Mts of CO₂e in 2008 or 19% of NZ's 2008 emissions, entered on 1 January 2008. Emissions from stationary energy, industrial and liquid fossil fuel sectors (34 Mts in 2008, 45% of 2008 emissions, entered the NZ ETS on 1 July 2010. Agricultural emissions (mainly 35 Mts of methane and nitrous oxide emissions from pastoral ruminants or 47% of 2008 emissions) do not enter the scheme until 1 January 2015.

Tradable emission units will be issued by free allocation to emitters, with no auctions in the short term. The fishing sector will receive free units on a historic basis, 90 per cent of their 2005 emissions (bullet points 9 & 10 MfE September 2009). Pre-1990 forests will receive a fixed free allocation of 60 emissions units per hectare. Allocation to emissions-intensive industry, and agriculture will be provided on an output-intensity basis, which will be based on the industry average emissions per unit of output and will be uncapped. Bertram and Terry (2010, p 16 ) state that as there is no 'cap' on emissions, the NZ ETS is not a cap and trade scheme as understood in the economics literature.

A transition period will operate from 1 July 2010 until 31 December 2012. During this period the price of New Zealand Emissions Units (NZUs) will be capped at NZ$25. Also, one unit will only need to be surrendered for every two tonnes of carbon dioxide equivalent emissions, effectively reducing the carbon price to NZ$12.50 per tonne (MfE 2009, second bullet point).

Section 3 of the Climate Change Response Act 2002 (the Act) defines the purpose of the Act as to reduce emissions from business-as-usual-levels and to fulfill New Zealand's international obligations under the United Nations Frame Work Convention on Climate Change (UNFCCC) and the Kyoto Protocol. Some stakeholders have criticized the New Zealand Emissions Trading Scheme for its generous free allocations of emission units and the lack of a carbon price signal (the Parliamentary Commissioner for the Environment), and being ineffective in reducing emissions (Greenpeace NZ).

European Union

The European Union Emission Trading Scheme (or EU ETS) is the largest multi-national, greenhouse gas emissions trading scheme in the world. It is one of the EU's central policy instruments to meet their cap set in the Kyoto Protocol (Jones et al.., 2007, p. 64).

After voluntary trials in the UK and Denmark, Phase I commenced operation in January 2005 with all 15 (now 25 of the 27) member states of the European Union participating. The program caps the amount of carbon dioxide that can be emitted from large installations with a net heat supply in excess of 20 MW, such as power plants and carbon intensive factories and covers almost half (46%) of the EU's Carbon Dioxide emissions. Phase I permits participants to trade amongst themselves and in validated credits from the developing world through Kyoto's Clean Development Mechanism.

During Phases I and II, allowances for emissions have typically been given free to firms, which has resulted in them getting windfall profits (CCC, 2008, p. 149). Ellerman and Buchner (2008) (referenced by Grubb et al.., 2009, p. 11) suggested that during its first two years in operation, the EU ETS turned an expected increase in emissions of 1-2 percent per year into a small absolute decline. Grubb et al.. (2009, p. 11) suggested that a reasonable estimate for the emissions cut achieved during its first two years of operation was 50-100 MtCO₂ per year, or 2.5-5 percent.

A number of design flaws have limited the effectiveness of scheme (Jones et al.., 2007, p. 64). In the initial 2005-07 period, emission caps were not tight enough to drive a significant reduction in emissions (CCC, 2008, p. 149). The total allocation of allowances turned out to exceed actual emissions. This drove the carbon price down to zero in 2007. This oversupply reflects the difficulty in predicting future emissions which is necessary in setting a cap.

Phase II saw some tightening, but the use of JI and CDM offsets was allowed, with the result that no reductions in the EU will be required to meet the Phase II cap (CCC, 2008, pp. 145, 149). For Phase II, the cap is expected to result in an emissions reduction in 2010 of about 2.4% compared to expected emissions without the cap (business-as-usual emissions) (Jones et al.., 2007, p. 64). For Phase III (2013–20), the European Commission has proposed a number of changes, including:

the setting an overall EU cap, with allowances then allocated to EU members;

tighter limits on the use of offsets;

unlimiting banking of allowances between Phases II and III;

and a move from allowances to auctioning.

In January 2008 Norway, Iceland, and Lichtenstein, joined the European Union Emissions Trading System (EU ETS) according to a publication from the European Commission. The Norwegian Ministry of the Environment has also released its draft National Allocation Plan which provides a carbon cap-and-trade of 15 million metric tonnes of CO₂, 8 million of which are set to be auctioned. According to the OECD Economic Survey of Norway 2010, the nation "has announced a target for 2008-12 10% below its commitment under the Kyoto Protocol and a 30% cut compared with 1990 by 2020."

Tokyo, Japan

The Japanese city of Tokyo is like a country in its own right in terms of its energy consumption and GDP. Tokyo consumes as much energy as "entire countries in Northern Europe, and its production matches the GNP of the world’s 16th largest country". Originally, Japan had its own cap and trade system that had been in place for some years, but was not effective. Japan has its own emission reduction policy but not a nationwide cap and trade program. This climate strategy is enforced and overseen by the Tokyo Metropolitan Government (TMG). The first phase, which is alike to Japan's scheme, runs up to 2014, these organizations will have to cut their carbon emissions by 6%; those who fail to operate within their emission caps will from 2011 on be required to purchase emission allowances to cover any excess emissions, or alternatively, invest in renewable energy certificates or offset credits issued by smaller businesses or branch offices. Firms whom fail to comply will face fines. According to local reports, organizations that do not operate within their caps will also be ordered to cut emissions by 1.3 times the amount they failed to reduce during the first phase of the scheme. The long term aim is to cut the metropolis' carbon emissions by 25% from 2000 levels by 2020. Some experts argue that the cap-and-trade system of SO₂ emissions reduction has reduced the cost of controlling acid rain by as much as 80% versus source-by-source reduction. The SO₂ program was challenged in 2004, which set in motion a series of events that led to the 2011 Cross-State Air Pollution Rule (CSAPR). Under the CSAPR, the national SO₂ trading program with four separate trading groups for SO₂ and NOx.

In 1997, the State of Illinois adopted a trading program for volatile organic compounds in most of the Chicago area, called the Emissions Reduction Market System. Beginning in 2000, over 100 major sources of pollution in eight Illinois counties began trading pollution credits.

In 2003, New York State proposed and attained commitments from nine Northeast states to form a cap-and-trade carbon dioxide emissions program for power generators, called the Regional Greenhouse Gas Initiative (RGGI). This program launched on January 1, 2009 with the aim to reduce the carbon "budget" of each state's electricity generation sector to 10% below their 2009 allowances by 2018.

Also in 2003, U.S. corporations were able to trade CO₂ emission allowances on the Chicago Climate Exchange under a voluntary scheme. In August 2007, the Exchange announced a mechanism to create emission offsets for projects within the United States that cleanly destroy ozone-depleting substances.

Also in 2003, the Environmental Protection Agency (EPA) began to administer the NOx Budget Trading Program (NBP)under the NOx State Implementation Plan (also known as the “NOx SIP Call”) The NOx Budget Trading Program was a market-based cap and trade program created to reduce emissions of nitrogen oxides (NOx) from power plants and other large combustion sources in the eastern United States. NOx is a prime ingredient in the formation of ground-level ozone (smog), a pervasive air pollution problem in many areas of the eastern United States. The NBP was designed to reduce NOx emissions during the warm summer months, referred to as the ozone season, when ground-level ozone concentrations are highest. In March 2008, EPA again strengthened the 8-hour ozone standard to 0.075 parts per million (ppm) from its previous 0.008 ppm.

In 2006, the California Legislature passed the California Global Warming Solutions Act, AB-32, which was signed into law by Governor Arnold Schwarzenegger. Thus far, flexible mechanisms in the form of project based offsets have been suggested for three main project types. The project types include: manure management, forestry, and destruction of ozone-depleted substances. However, a recent ruling from Judge Ernest H. Goldsmith of San Francisco's Superior Court states that the rules governing California's cap-and-trade system were adopted without a proper analysis of alternative methods to reduce greenhouse gas emissions. The tentative ruling, issued on January 24, 2011, argues that the California Air Resources Board violated state environmental law by failing to consider such alternatives. If the decision is made final, the state would not be allowed to implement its proposed cap-and-trade system until the California Air Resources Board fully complies with the California Environmental Quality Act.

Since February 2007, seven U.S. states and four Canadian provinces have joined together to create the Western Climate Initiative (WCI),a regional greenhouse gas emissions trading system. July 2010, a meeting took place to further outline the cap-and-trade system which if accepted would curb greenhouse gas emissions by January 2012.

On November 17, 2008 President-elect Barack Obama clarified, in a talk recorded for YouTube, his intentions for the US to enter a cap-and-trade system to limit global warming.

The 2010 United States federal budget proposes to support clean energy development with a 10-year investment of US $15 billion per year, generated from the sale of greenhouse gas (GHG) emissions credits. Under the proposed cap-and-trade program, all GHG emissions credits would be auctioned off, generating an estimated $78.7 billion in additional revenue in FY 2012, steadily increasing to $83 billion by FY 2019.

The American Clean Energy and Security Act (H.R. 2454), a greenhouse gas cap-and-trade bill, was passed on June 26, 2009, in the House of Representatives by a vote of 219-212. The bill originated in the House Energy and Commerce Committee and was introduced by Rep. Henry A. Waxman and Rep. Edward J. Markey. It was never passed in the Senate. The big Republican wins in the November 2010 U.S. Congressional election have further reduced the chances of a climate bill being adopted during President Barack Obama's first term.

Renewable energy certificates

Renewable Energy Certificates, or "green tags", are transferable rights for renewable energy within some American states. A renewable energy provider gets issued one green tag for each 1,000 kWh of energy it produces. The energy is sold into the electrical grid, and the certificates can be sold on the open market for profit. They are purchased by firms or individuals in order to identify a portion of their energy with renewable sources and are voluntary.

They are typically used like an offsetting scheme or to show corporate responsibility, although their issuance is unregulated, with no national registry to ensure there is no double-counting. However, it is one way that an organization could purchase its energy from a local provider who uses fossil fuels, but back it with a certificate that supports a specific wind or hydro power project.

Carbon market

Carbon emissions trading is emissions trading specifically for carbon dioxide (calculated in tonnes of carbon dioxide equivalent or tCO₂e) and currently makes up the bulk of emissions trading. It is one of the ways countries can meet their obligations under the Kyoto Protocol to reduce carbon emissions and thereby mitigate global warming.

Market trend

Carbon emissions trading has been steadily increasing in recent years. According to the World Bank's Carbon Finance Unit, 374 million metric tonnes of carbon dioxide equivalent (tCO₂e) were exchanged through projects in 2005, a 240% increase relative to 2004 (110 mtCO₂e) which was itself a 41% increase relative to 2003 (78 mtCO₂e).

In terms of dollars, the World Bank has estimated that the size of the carbon market was 11 billion USD in 2005, 30 billion USD in 2006, and 64 billion in 2007.

The Marrakesh Accords of the Kyoto protocol defined the international trading mechanisms and registries needed to support trading between countries, with allowance trading now occurring between European countries and Asian countries. However, while the USA as a nation did not ratify the Protocol, many of its states are now developing cap-and-trade systems and are looking at ways to link their emissions trading systems together, nationally and internationally, to seek out the lowest costs and improve liquidity of the market. However, these states also wish to preserve their individual integrity and unique features. For example, in contrast to the other Kyoto-compliant systems, some states propose other types of greenhouse gas sources, different measurement methods, setting a maximum on the price of allowances, or restricting access to CDM projects. Creating instruments that are not truly fungible would introduce instability and make pricing difficult. Various proposals are being investigated to see how these systems might be linked across markets, with the International Carbon Action Partnership (ICAP) as an international body to help co-ordinate this.

Business reaction

With the creation of a market for mandatory trading of carbon dioxide emissions within the Kyoto Protocol, the London financial marketplace has established itself as the center of the carbon finance market, and is expected to have grown into a market valued at $60 billion in 2007. The voluntary offset market, by comparison, is projected to grow to about $4bn by 2010.

23 multinational corporations came together in the G8 Climate Change Roundtable, a business group formed at the January 2005 World Economic Forum. The group included Ford, Toyota, British Airways, BP and Unilever. On June 9, 2005 the Group published a statement stating that there was a need to act on climate change and stressing the importance of market-based solutions. It called on governments to establish "clear, transparent, and consistent price signals" through "creation of a long-term policy framework" that would include all major producers of greenhouse gases. By December 2007 this had grown to encompass 150 global businesses.

Business in the UK have come out strongly in support of emissions trading as a key tool to mitigate climate change, supported by NGOs. However, not all businesses favor a trading approach. On December 11, 2008, Rex Tillerson, the CEO of Exxonmobil, said a carbon tax is "a more direct, more transparent and more effective approach" than a cap-and-trade program, which he said, "inevitably introduces unnecessary cost and complexity". He also said that he hoped that the revenues from a carbon tax would be used to lower other taxes so as to be revenue neutral.

The International Air Transport Association, whose 230 member airlines comprise 93% of all international traffic, position is that trading should be based on “benchmarking,” setting emissions levels based on industry averages, rather than “grandfathering,” which would use individual companies’ previous emissions levels to set their future permit allowances. They argue grandfathering “would penalise airlines that took early action to modernise their fleets, while a benchmarking approach, if designed properly, would reward more efficient operations".

Measuring, reporting, verification (MRV)

An emissions trading system requires measurements at the level of operator or installation. These measurements are then reported to a regulator. For greenhouse gases all trading countries maintain an inventory of emissions at national and installation level; in addition, the trading groups within North America maintain inventories at the state level through The Climate Registry. For trading between regions these inventories must be consistent, with equivalent units and measurement techniques.

In some industrial processes emissions can be physically measured by inserting sensors and flowmeters in chimneys and stacks, but many types of activity rely on theoretical calculations for measurement. Depending on local legislation, these measurements may require additional checks and verification by government or third party auditors, prior or post submission to the local regulator.

Enforcement

Another significant, yet troublesome aspect is enforcement. Without effective MRV and enforcement the value of allowances is diminished. Enforcement can be done using several means, including fines or sanctioning those that have exceeded their allowances. Concerns include the cost of MRV and enforcement and the risk that facilities may be tempted to mislead rather than make real reductions or make up their shortfall by purchasing allowances or offsets from another entity. The net effect of a corrupt reporting system or poorly managed or financed regulator may be a discount on emission costs, and a (hidden) increase in actual emissions.

According to Nordhaus (2007, p. 27), strict enforcement of the Kyoto Protocol is likely to be observed in those countries and industries covered by the EU ETS. Ellerman and Buchner (2007, p. 71) commented on the European Commission's (EC's) role in enforcing scarcity of permits within the EU ETS. This was done by the EC's reviewing the total number of permits that member states proposed that their industries be allocated. Based on institutional and enforcement considerations, Kruger et al. (2007, pp. 130–131) suggested that emissions trading within developing countries might not be a realistic goal in the near-term. Burniaux et al.. (2008, p. 56) argued that due to the difficulty in enforcing international rules against sovereign states, development of the carbon market would require negotiation and consensus-building.

Criticism

Emissions trading has been criticised for a variety of reasons.

In the popular science magazine New Scientist, Lohmann (2006) argued that trading pollution allowances should be avoided as a climate change policy. Lohman gave these reasons for this view. First, global warming will require more radical change than the modest changes driven by previous pollution trading schemes such as the US SO₂ market. Global warming requires "nothing less than a reorganisation of society and technology that will leave most remaining fossil fuels safely underground." Carbon trading schemes have tended to reward the heaviest polluters with 'windfall profits' when they are granted enough carbon credits to match historic production. Carbon trading encourages business-as-usual as expensive long-term structural changes will not be made if there is a cheaper source of carbon credits. Cheap "offset" carbon credits are frequently available from the less developed countries, where they may be generated by local polluters at the expense of local communities.

Lohmann (2006b) supported conventional regulation, green taxes, and energy policies that are "justice-based" and "community-driven." According to Carbon Trade Watch (2009), carbon trading has had a "disastrous track record." The effectiveness of the EU ETS was criticized, and it was argued that the CDM had routinely favoured "environmentally ineffective and socially unjust projects."

Annie Leonard provided a critical view on carbon emissions trading in her 2009 documentary The Story of Cap and Trade. This documentary emphasized three factors: unjust financial advantages to major pollutors resulting from free permits, an ineffectiveness of the system caused by cheating in connection with carbon offsets and a distraction from the search for other solutions.

Offsets

Forest campaigner Jutta Kill (2006) of European environmental group FERN argued that offsets for emission reductions were no substitute for actual cuts in emissions. Kill stated that "[carbon] in trees is temporary: Trees can easily release carbon into the atmosphere through fire, disease, climatic changes, natural decay and timber harvesting."

Supply of permits

Regulatory agencies run the risk of issuing too many emission credits, which can result in a very low price on emission permits (CCC, 2008, p. 140). This reduces the incentive that permit-liable firms have to cut back their emissions. On the other hand, issuing too few permits can result in an excessively high permit price (Hepburn, 2006, p. 239). This is one of the arguments in favour of a hybrid instrument, that has a price-floor, i.e., a minimum permit price, and a price-ceiling, i.e., a limit on the permit price. A price-ceiling (safety value) does, however, remove the certainty of a particular quantity limit of emissions (Bashmakov et al.., 2001).

Incentives

Emissions trading can result in perverse incentives. If, for example, polluting firms are given emission permits for free ("grandfathering"), this may create a reason for them not to cut their emissions. This is because a firm making large cuts in emissions would then potentially be granted fewer emission permits in the future (IMF, 2008, pp. 25–26). This perverse incentive can be alleviated if permits are auctioned, i.e., sold to polluters, rather than giving them the permits for free (Hepburn, 2006, pp. 236–237).

On the other hand, allocating permits can be used as a measure to protect domestic firms who are internationally exposed to competition (p. 237). This happens when domestic firms compete against other firms that are not subject to the same regulation. This argument in favour of allocation of permits has been used in the EU ETS, where industries that have been judged to be internationally exposed, e.g., cement and steel production, have been given permits for free (4CMR, 2008).

Auctioning

The revenues from auctioning go to the government. These revenues could, for example, be used for research and development of sustainable technology. Alternatively, revenues could be used to cut distortionary taxes, thus improving the efficiency of the overall cap policy (Fisher et al.., 1996, p. 417).

Distributional effects

The Congressional Budget Office (CBO, 2009) examined the potential effects of the American Clean Energy and Security Act on US households. This Act relies heavily on the free allocation of permits. The Bill was found to protect low-income consumers, but it was recommended that the Bill be changed to be more efficient. It was suggested that the Bill be changed to reduce welfare provisions for corporations, and more resources be made available for consumer relief.

See also

Acid Rain Retirement Fund

Asia-Pacific Emissions Trading Forum

AP 42 Compilation of Air Pollutant Emission Factors

Cap and Share

Cap and Dividend

Carbon credit

Carbon emissions reporting

Carbon finance

Emission standard

Energy law

Flexible Mechanisms

Green certificate

Green investment scheme

Individual and political action on climate change

Low-carbon economy

Low carbon power generation / Renewable energy

Mitigation of global warming

Mobile Emission Reduction Credit (MERC)

Pigovian tax

Public Smog

Tradable smoking pollution permits

References

Further reading

External links

Q&A; with Dr. Daniel Fine on Cap and Trade legislation and policy

Dr. Daniel Fine of the New Mexico Center for Energy Policy on Cap and Trade

Emissions Trading and CDM – International Energy Agency website

Greenhouse Gas Emissions Trading – Organisation for Economic Co-operation and Development website

US EPA's Acid Rain Program

Illinois'' Emissions Reduction Market System

Texas'' Emissions Banking and Trading program

"The Making of a Market-Minded Environmentalist", article by Fred Krupp in Strategy+Business (registration req''d) that articulates some of the reasoning and history behind emissions trading in California

International Emissions Trading Association

EU-ETS for airlines

Category:Articles with inconsistent citation formats Category:Climate change policy Category:Economics and climate change Category:Article Feedback Pilot

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