Linking Emissions Trading Schemes

linking emissions trading schemes

GUEST EDITOR:

Andreas Tuerk

VOLUME 9 ISSUE 4 2 0 0 9

linking emissions trading schemes 339–340

MICHAEL GRUBB

Climate Policy 9(4), July 2009. Published by Earthscan: Dunstan House, 14a St Cross Street, London EC1N 8XA, UK. © 2009 Earthscan

341–357

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SYNTHESIS Linking carbon markets: concepts, case studies and pathways ANDREAS TUERK, MICHAEL MEHLING, CHRISTIAN FLACHSLAND, WOLFGANG STERK

358–372

Responsibility for statements made in the articles printed herein rests solely with the contributors. The views expressed by individual authors are not necessarily those of the editors, the funders or the publisher. Climate Policy is editorially independent. The editorial administration of the journal is supported by Climate Strategies (a not-for-profit research network), the French region Ile de France and Le Centre National de la Recherche Scientifique (CNRS) in France.

PREFACE Linking emissions trading schemes

RESEARCH To link or not to link: benefits and disadvantages of linking cap-and-trade systems CHRISTIAN FLACHSLAND, ROBERT MARSCHINSKI, OTTMAR EDENHOFER

373–388

Linking existing and proposed GHG emissions trading schemes in North America ERIK HAITES, MICHAEL MEHLING

389–401

Establishing a transatlantic carbon market WOLFGANG STERK, JOSEPH KRUGER

402–414

Australia’s emissions trading scheme: opportunities and obstacles for linking FRANK JOTZO, REGINA BETZ

415–430

Linking emissions trading schemes for international aviation and shipping emissions ERIK HAITES

Climate Policy is indexed in Thomson ISI Social Sciences Citation Index. Abstracting services which cover this title include: Elsevier Scopus, Geobase, International Political Science Abstracts and Econlit. Printed in the UK by MPG Books Ltd on FSC-certified paper. The Publishers acknowledge the generous support of Climate Strategies for the publication of this journal. Climate Policy is published 6 times a year (bi-monthly). Periodicals Postage Paid at Rahway, NJ. US agent: Mercury International, 365 Blair Road, Avenel, NJ 07001. POSTMASTER: Address changes to CLIMATE POLICY, 365 Blair Road, Avenel, NJ 07001.

  

    



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Preface 339

■ editorial

Linking emissions trading schemes MICHAEL GRUBB

With the rush of the Obama Administration to develop a domestic cap-and-trade programme, hard on the heels of concrete Australian and Canadian plans for domestic schemes and pilot programmes in Japan, Korea and other countries, the idea of linking emissions trading schemes is now a hot topic. Linking means that one system’s allowances or other trading units can be used, directly or indirectly, by a participant in another system for compliance. Linking thus creates opportunities for inter-system trading; it enlarges the carbon market by connecting otherwise isolated domestic emissions trading systems. The inclusion of more participants entails a greater diversity of sources and more abatement options. This expansion of the market, in turn, would improve market liquidity and hence result in a more efficient allocation of resources, directing them to least-cost abatement measures and thus lowering the overall costs of achieving a given collective level of emission reductions. In theory, trading can take place until carbon prices are equalized in the linked systems. Given these benefits, linking is gaining currency as a major policy goal, with an interlinked OECD market leading on to a global carbon market now formally declared as an objective of EU policy. Indeed linking appears to be such a simple and unambiguously sensible idea that one is tempted to ask, ‘What’s the problem?’ This special issue of Climate Policy is devoted to understanding the challenges and moving the debate forward on to more specific, grounded terrain. In contrast to the ‘top-down’ viewpoint that leads to a generalized view on why linking is a good idea, it adopts a ‘bottom-up’ approach, seeking to explain and understand the characteristics of the different schemes emerging around the world, their driving forces, and what that implies for attempts to link them. The view that emerges from considering how the world is, in reality, is noticeably more cautious than the top-down perspective on how it maybe should be. Schemes differ hugely in key design characteristics that will pose various problems for linking. Countries have gone through extensive debates to reach their own conclusions about preferred scope, basis, levels of ambition in terms of cutbacks, costs and cost control, and their proposed use of various internal and external offset credits. There is no common view on what constitutes a ‘good’ design; and some characteristics are demonstrably incompatible. And while a major focus of the analysis is upon the technical barriers to linking arising from the current and proposed designs, these in turn reflect the deeper realities of sovereignty, and related realities that can create a large wedge between national perspectives and global objectives. Linking may be optimal from a global perspective, but it requires each country to adapt its domestic designs and ambitions for the sake of international coordination, and to set rules by which it (or its industry) either pays another one in return for doing less ambitious abatement, or vice versa. The evidence already available from the Kyoto process – and other fields – is that countries (and

■ *Corresponding author. E-mail: [email protected] CLIMATE POLICY 9 (2009) 339–340 doi:10.3763/cpol.2009.0665 © 2008 Earthscan ISSN: 1469-3062 (print), 1752-7457 (online) www.climatepolicy.com

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their electorates) simply do not regard paying money abroad for abatement as an acceptable substitute for doing it at home: nor, conversely, may they see it acceptable to have domestic carbon prices driven up due to linking with a more ambitious region, and in effect to have domestic carbon and energy prices so strongly influenced by decisions outside their jurisdiction. The debate on linking will now also be set against the backdrop of the credit crunch and subsequent recession, which may also feed scepticism about the desirability, integrity and stability of complex interlinked systems dependent in part upon governance in numerous different jurisdictions. The most obvious breakthrough could come if the EU ETS can link effectively with a US Federal scheme, as discussed in one of the contributed articles. That would clearly create a strong focal point for other schemes and wider linking efforts. This would require two large and powerful jurisdictions to develop a more common view on key elements of both design and comparable levels of ambition. It remains too early to judge whether this will be possible, and it will depend both upon internal US political developments and possible flexibility in the EU to renegotiate key aspects of its scheme after the Copenhagen conference. The prize, however, could be very large. This special issue forms the fifth in the Climate Policy series on the design of emissions trading systems, in as many years. The first looked at the basic concepts and design principles, and the series evolved with focused assessments of issues particularly around the EU ETS. It is a great pleasure to see the debate expanding so rapidly now to encompass such a wide range of schemes around the world. There remains much to be learned on all fronts, and much to be decided. Like some of the earlier special issues, this one carries the products of research convened by the international research organization Climate Strategies. The project was led by Andreas Tuerk at Joanneum Research in Austria, who skilfully brought together researchers from the EU, Canada, the USA, Australia, New Zealand and Japan to ensure that the analysis was well grounded in the realities of each country, and who edited the special issue under the guidance of Climate Policy’s Executive Editor, Richard Lorch. It is a pleasure to see this major project finally reach such a timely fruition. Not everyone will like the conclusions, and the complexities and challenges the work reveals, but we trust it will be a major contribution to the international debate. Michael Grubb Editor-in-Chief April 2009

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■ Synthesis article

Linking carbon markets: concepts, case studies and pathways ANDREAS TUERK1,2,*, MICHAEL MEHLING3, CHRISTIAN FLACHSLAND4, WOLFGANG STERK5 1

Joanneum Research, Institute of Energy Research, Elisabethstrasse 5, 8010 Graz, Austria Wegener Center for Climate and Global Change, University of Graz, Leechgasse 25, A-8010 Graz, Austria 3 Ecologic Institute, 1630 Connecticut Avenue, NW, Suite 300, Washington, DC 20009, USA 4 Potsdam Institute for Climate Impact Research, PO Box 601203, 14412 Potsdam, Germany 5 Wuppertal Institute for Climate, Environment and Energy, Research Group on Energy, Transport and Climate Policy, Döppersberg 19, 42103 Wuppertal, Germany 2

The barriers to linking greenhouse gas cap-and-trade schemes are assessed, based on an analysis of existing and emerging trading schemes, including those in the USA, Japan, Australia, New Zealand and the EU. The feasibility of different forms of linking and the time frames for their implementation are examined. In particular, the barriers to direct bilateral linking are considered. It was found that only a few direct bilateral links will be viable in the short term, due to the divergent policy priorities of different nations and regions, reflected in critical design features, such as costcontainment measures. However, in the short term, cap-and-trade markets will very likely be indirectly linked via unilateral links to the CDM or new crediting mechanisms, which may be adopted within a successor treaty to the Kyoto Protocol. In order to ensure a harmonization of critical design elements in the mid to long term, early institutional cooperation may become necessary. Necessary policy steps and the appropriate institutional framework for such harmonization and, overtime, further integration of trading schemes are briefly delineated. Keywords: barriers; carbon markets; climate regime; emission trading schemes; institutional framework; linking Les obstacles à l’association de systèmes d’échange de droits d’émissions sont évalués, sur la base d’une analyse de systèmes d’échanges existants et émergeants, y compris aux Etats-Unis, au Japon, en Australie, en Nouvelle Zélande, et dans l’Union européenne. La faisabilité de différentes formes de liens et les délais de mise en place sont examinés. En particulier, les obstacles à l’établissement de liens bilatéraux directs sont pris en compte. Nous trouvons que seuls quelques liens bilatéraux directs seraient viables à court terme, étant données les divergences de priorités de politiques entre nations et régions distinctes, ce qui se reflète dans les caractéristiques de conception clés, telles que les mesures du maintien des prix. Cependant, à court terme, les marchés cap-and-trade seront indirectement liés par des liens unilatéraux avec le MDP ou autres mécanismes nouveaux ou similaires, lesquels pourraient être adoptés par un accord successeur au protocole de Kyoto. Dans le but d’assurer une harmonisation des éléments constitutifs clés dans le moyen à long terme, une coopération institutionnelle précoce serait requise. Les étapes politiques nécessaires et le cadre institutionnel seyant à cette harmonisation pouvant entraîner une intégration accrue des systèmes d’échange au fil du temps est brièvement décrite. Mots clés: cadre institutionnel; établissement de liens; marchés du carbone; obstacles; régime climatique; systèmes d’échange de droits d’émissions

■ *Corresponding author. E-mail: [email protected] CLIMATE POLICY 9 (2009) 341–357 doi:10.3763/cpol.2009.0621 © 2009 Earthscan ISSN: 1469-3062 (print), 1752-7457 (online) www.climatepolicy.com

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1. Introduction A growing number of OECD countries are implementing cap-and-trade schemes as key elements of their national climate policies.1 In 2005, the European Union launched its Emissions Trading Scheme (EU ETS), which regulates about 10,000 facilities that currently emit around 2 Gt of CO2 per year (Skjærseth and Wettestad, 2008). With a market value of US$50 billion, the EU ETS dominates the international carbon market, which totalled US$64 billion in 2007 (Capoor and Ambrosi, 2008). In the USA, in particular, initiatives have been launched at the regional and state level, e.g. the Regional Greenhouse Gas Initiative (RGGI) on the East Coast, the Western Climate Initiative (WCI) on the West Coast, as well as the Midwestern Greenhouse Gas Accord (MGGA). In addition, several legislative proposals for a federal cap-and-trade system have been discussed in the US Congress. In Japan, proposals for a mandatory cap-and-trade system are increasingly being discussed (Kimura and Tuerk, 2008).2 New Zealand and Switzerland implemented cap-and-trade schemes in 2008 (Mehling and Haites, 2009) and Canada plans to implement such a scheme as of 2010 (Canada, 2008).3 In Australia, detailed provisions for a scheme planned to start in 2011 have been tabled, though it is unclear whether, when and in what form the legislation will get through parliament (Department of Climate Change, 2008; Jotzo and Betz, 2009). Current and planned emissions trading schemes vary significantly in their size, design characteristics and geographical scope. While most of the existing or planned schemes have absolute caps, Canada, and possibly a national Japanese scheme if implemented before 2013, provide for intensity-based caps. Also, the mechanisms for cost containment are significantly different between schemes. Furthermore, there are differences in the types and volumes of credits that are allowed. While the EU ETS can be understood as a system of linked national trading systems (Ellerman, 2008) and includes links established in 2007 to the European Economic Area (EEA) countries Norway, Iceland and Liechtenstein (EU Council, 2007), there are currently no other direct bilateral links between different company-level cap-and-trade systems. However, all existing and emerging systems foresee links to the Clean Development Mechanism (CDM). The European Commission regards the EU ETS as the nucleus for the emerging global carbon market and has the vision of a broad, liquid global carbon market based on deep cuts in GHG emissions, in line with a 2°C objective (Marr, 2008).4 This EU vision includes setting up an OECDwide carbon market by 2015, and the establishment and integration of trading systems in major emerging economies by 2020 (EU Commission, 2009). A transatlantic link between the EU ETS and a potential US ETS currently has high priority for the EU (EU Commission, 2009). Clearly, a US–EU carbon market would constitute the major share of an OECD-wide system and would send a strong political signal regarding the further development of international climate policy based on a global carbon market. The emergence, to date, of national and regional carbon markets has been characterized by a virtual absence of institutional structures for the governance of trading markets across borders. Where it has occurred, cooperation between states has been informal in nature, and has been largely limited to the exchange of information and experience. In some cases, cooperation has achieved a certain degree of institutionalization, as in case of the International Carbon Action Partnership (ICAP).5 Against the background of the EU vision for a global carbon market, this article draws on country case studies of existing and emerging schemes to assess which types of links appear possible in the coming decade, what are the most critical barriers to bilateral links, and how the institutional framework might evolve to overcome these barriers on the pathway to a global carbon market.

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2. Conceptual foundations of linking 2.1. Types of links Conceptually, a link can be either direct or indirect, with direct linking conditional on an explicit decision by at least one of the linked jurisdictions. Direct links allow trade between different schemes and can be distinguished by whether they allow trading in one or more directions. Under a unilateral link, entities in system A can purchase and use allowances from system B for compliance, but not vice versa (Sterk et al., 2006). The administrator of a scheme can establish a unilateral link with another scheme by agreeing to accept allowances or credits issued by the other scheme for compliance purposes. Norway, for example, accepted Phase I EU allowances for compliance purposes, but the EU ETS did not accept Norwegian allowances. Another example is the EU Linking Directive (European Council, 2004), linking the EU ETS to the CDM. If system A establishes a one-way link by recognizing system B’s allowances, and system A’s allowance price is the higher of the two, inter-system trading will occur until the prices of the two systems converge at an intermediate level. If system A’s price is the lower of the two, there will be no incentive for inter-system trading (Stavins and Jaffe, 2007). Another important issue for unilateral links is their effect on the scheme being linked to. A large cap-and-trade system that establishes a unilateral link with a much smaller one could cause a price increase in the smaller scheme if the unilateral link results in the withdrawal of a large number of allowances for use in the larger scheme (Mehling and Haites, 2009). A scheme faced with an undesired withdrawal of allowances can amend its rules governing access to the registry, for instance by specifying that only domestic participants may open an account and hold allowances. If necessary, additional safeguards – for instance penalties – may be implemented to ensure that such a restriction is not circumvented. Hence, the risk of a scheme involuntarily losing control over its market due to a unilateral link is very limited (Mehling and Haites, 2009). Unilateral links of small schemes to large ones will not significantly affect the price of the large schemes. Such links de facto introduce price caps for the smaller scheme at the price level of the larger scheme. In a full bilateral link, allowances can be freely traded between two systems and each system’s allowances are equally valid for compliance in both systems (Haites and Mullins, 2001). If more than two schemes participate, this becomes a multilateral link. To implement bilateral or multilateral links, coordination is needed to synchronize the relevant aspects of the legislation or rules governing each scheme. Such coordination may either be formal and binding, or informal and non-binding. Hence, a bilateral link can either be adopted through a formal international treaty, which binds its partners to domestic implementation of the link, or through reciprocal domestic legislation accompanied by an informal Memorandum of Understanding or other negotiated expression of intent (Mehling, 2007; Mace et al., 2008). Binding agreements afford market participants significantly greater certainty, by specifying the exact conditions of withdrawals and termination (Mehling and Haites, 2009). Even if two systems are not directly linked, they can be indirectly linked through separate unilateral links with a common third system, such as the CDM. By means of trading between each system and the common third system, the supply and demand for allowances in one system will be able to affect those in the other system, even though the two systems are not directly linked (Flachsland et al., 2009a).

2.2. Implications of linking Without adjustment mechanisms (e.g. exchange rates, import quotas), direct bilateral linking of cap-and-trade schemes leads to full price harmonization across the linked schemes. In a standard

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partial equilibrium analysis, linking reduces the aggregate economic costs of abatement in proportion to the difference in pre-link allowance prices (see Blyth and Bosi, 2004; Anger, 2008). Linking also creates a larger, more liquid, carbon market, thus reducing volatility. At the same time, a linked system may import volatility from partner systems (McKibbin et al., 2008). As an additional benefit, linked trading schemes with harmonized prices eliminate any competitive distortions that might arise from different pre-link carbon prices between linking partners. Regarding leakage effects with respect to third regions, any changes resulting from a market link will depend on the sensitivity of each economy to changes in the carbon price. Regions with rising carbon prices due to linking may encounter an increase in leakage, while regions with falling carbon prices will observe a reduced incidence of leakage (Stavins and Jaffe, 2007). In addition, linking can serve as a government commitment device to enhance the dynamic efficiency of climate policy, as adjusting caps relative to announced trajectories will tend to be more difficult in a linked scheme than in autonomous schemes (Flachsland et al., 2009b). Linking promises political benefits insofar as it entails a signalling of multilateral commitment, which may be valuable for enabling further international cooperation in climate change policy. On the other hand, linking trading schemes also entails considerable challenges and tradeoffs, most notably with regard to distributional issues, the attainment of prioritized policy objectives, and reduced control over the domestic market. With regard to distribution, game-theoretic analyses using a standard emissions game framework demonstrate that enabling allowance trade can create incentives for net selling countries to relax caps in order to gain from additional sales (Helm, 2003). However, Carbone et al. (2008) point out that there can also be an incentive to reduce a net seller’s carbon endowment when the increasing allowance price is anticipated, raising the revenue from allowance sales. In addition, shifts in regional abatement activity will alter the distribution of co-benefits from abatement, such as improved air quality, reduced fossil fuel dependence, or the encouragement of domestic low-carbon-technology markets (Westskog, 2002). The integration of two trading systems modifies each system’s design; e.g. price caps from one system propagate into the other. If such changes critically touch upon a system’s policy priorities, such as certainty over emission abatement, this would constitute a clear disadvantage for that system (Flachsland et al., 2009b).6

3. Scenarios for the architecture of the global carbon market When discussing future linkages and barriers to linking emissions trading systems, it is important to be clear about assumptions regarding the policy scenario in which linkages occur. Most importantly, a distinction is needed as to whether a Kyoto-type agreement will be implemented or not. We characterize a Kyoto Protocol type of agreement as entailing binding absolute national-level caps (emission budgets), at least for developed countries, with the possibility to trade the corresponding emission entitlements, which are called assigned amount units (AAU) in the Kyoto Protocol (Flachsland et al., 2009a). A crediting mechanism, such as the CDM or new trading mechanisms, can enable developing countries without binding caps to participate in an international carbon market. If a climate change regime were to follow the current system’s trading rules, trading would be enabled on a nation-to-nation basis. A major advantage of the Kyoto-type approach is that it facilitates negotiations of regional levels of ambitions in terms of emission caps, and enables flexibility in meeting these. If major emitters adopt caps, or at least clear incentives for reducing emissions from their baseline, this can reduce concerns over carbon leakage, enabling a higher level of ambition of the aggregate reduction effort. However, given a lack of consensus over burden-sharing rules, negotiations of a Kyoto-type agreement will end up in political stalemate. In addition, a Kyoto-type government-level carbon market is prone to economic inefficiency,

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mainly due to concerns over market power (Böhringer and Löschel, 2003) and the question of whether governments are generally able to act as cost minimizers on carbon markets (Hahn and Stavins, 1999). Links between domestic trading schemes operating at the company level may occur: ■ within a Kyoto-type framework ■ between Parties and non-Parties to the Kyoto-type agreement ■ in the absence of such a framework. In the first case, governments can devolve trading activity to the level of companies in order to enhance carbon market efficiency, and trade only on behalf of sectors not covered by domestic emissions trading schemes ([Q1]Hahn and Stavins, 1999). In fact, this is the approach currently adopted by the European Union, where EU ETS allowances (EUAs) traded across national country borders correspond to Kyoto units (AAUs). Another design option relates to whether companies may or may not be allowed to trade with governments. According to economic theory this would be the most efficient option.7 The second scenario implies significant difficulties, as allowances from non-Party systems would not be eligible for use in meeting obligations under the Kyoto-type regime. For example, if the EU ETS were to link to some US trading scheme in the period 2008–2012, allowances from the USA could not be used by EU Member States to comply with their Kyoto targets. This problem is resolved if the rules allow Parties to use non-Party allowances for compliance, thus effectively including the linked scheme into the Kyoto-type agreement. In the third case, bilateral links would be established between regional company-level cap-andtrade systems such as the EU ETS and a future federal US trading scheme in the absence of a Kyoto-type agreement (Tangen and Hasselknippe, 2005). Thus, assuming that the creation of a global carbon market is an objective of policy-makers (ICAP, 2007; EU Commission, 2009), the latter approach represents an alternative pathway in case no Kyoto-type agreement materializes at Copenhagen or beyond. This process on its own would not enable negotiation of a global burden-sharing regime and may not result in the broad instantaneous coverage of global emissions, except for the case where a significant number of major emitters such as the USA, the EU, China, Russia and others agree to form a joint carbon market outside the UNFCCC arena. Indirect links between trading systems are also likely to play a prominent role under any of the scenarios. As argued by Stavins and Jaffe (2007), indirect links between domestic cap-and-trade systems might emerge as the de facto architecture of international emissions trading after 2012, at least for an intermediate period. Indirect links could emerge through the acceptance of CDM or other credits in all trading systems, and would lead to a complete or incomplete convergence of allowance prices, depending on market conditions. In general, the probability of price convergence increases with the available pool of credits and the relaxation of import restrictions for these in cap-and-trade systems. Thus, large-scale crediting schemes (e.g. EU Commission, 2009) and the absence of credit import restrictions in cap-and-trade schemes will work towards enhanced price convergence in indirectly linked systems.

4. Assessing carbon market compatibility Based on the current literature and the analyses of emerging emissions trading schemes, this section examines the barriers to different forms of linking. The emissions trading schemes taken into consideration include Australia’s blueprint for a national ETS, the New Zealand scheme, Japanese

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proposals for a mandatory scheme, the US Boxer–Lieberman–Warner bill, the US Waxman–Markey proposal and the US Western Climate Initiative (WCI). Section 4.1 provides an overview of barriers to direct bilateral linking of cap-and-trade schemes, Section 4.2 looks more closely at national positions on linking. Prospects for different forms of links between trading schemes are discussed in Section 4.3.

4.1. Assessment of barriers to bilateral linking of cap-and trade schemes The analyses of different schemes show that some system differences described in the literature are unlikely to create barriers to bilateral linking in practice, or are comparably easy to harmonize. Major barriers to bilateral linking at this time include the relative stringency of targets, and design features of cap-and-trade schemes that propagate into the linked scheme, such as cost-containment measures or offset provisions. The following discussion first reviews system differences where harmonization is comparably easy to achieve or differences that do not imply major problems when linking, and then examines system differences which are likely to result in significant barriers to linkage.

4.1.1. System differences unlikely to create barriers or which are relatively easy to harmonize In these cases, although there are differences between systems, harmonization is not needed and/ or is relatively easy to achieve. The issues in this category include: ■ ■ ■ ■ ■ ■

monitoring, reporting and verification (MRV) rules for allowances banking provisions registries rules governing new entrants and closures compliance periods allocation methods.

To support linking, each linked scheme must have credible MRV standards. However, different MRV systems should not present barriers to linking as long as the schemes are robust and can ensure integrity. Since the Kyoto Protocol is underpinned by robust MRV requirements, concerns regarding MRV are unlikely to inhibit the trade of emissions permits between schemes whose trading units are backed by the Protocol or some comparable follow-up agreement. With regard to offset credits, comparable stringency of MRV and additionality in their creation is likely to be a precondition for linking. The degree to which different MRV and additionality rules will form a barrier to linking depends whether linking occurs under a widely accepted framework governing emissions limitations or not. If linking occurs between countries in which the emissions trading schemes function within an overall limit on emissions – e.g. a limited number of AAUs in the entire system – the stringency of MRV and additionality provisions governing offset credits are less problematic. However, if the schemes are not operating within such a common framework, the comparability of the MRV provisions must be assessed and harmonized. There is one exception to the observation that, within the Kyoto Protocol, MRV and additionality rules governing offset credits should not pose linking problems. The EU excludes all LULUCF (land use, land-use change and forestry) credits from its scheme, partly due to a lack of confidence regarding the MRV provisions of these credits (Tuerk et al., 2008). This issue is further reviewed in the following section, which examines the most challenging system differences. In theory, different banking provisions could pose problems for linking, since linking effectively extends the most generous banking rules to all other schemes. Therefore it could be undesirable to link

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schemes with banking provisions to schemes which do not allow banking. However, all of the assessed schemes allow banking, providing a good example of an issue that is unlikely to arise in practice. Different cap-and-trade systems are likely to have different registries, regulations with regard to new entrants and closures, and allocation methods. None of these differences are, however, likely to pose significant barriers to linkage. In the case of different registries, these can be rendered compatible through technical means. Distortions due to differing approaches in the treatment of new entrants and installation closures have the potential to affect the overall cap of a linked system. At the margins, a company will have an incentive to shut down production in countries that continue to allocate emissions permits to closed plants. Conversely, companies have an incentive to start up or expand new production capacity in countries that will allocate allowances free of charge (Blyth and Bosi, 2004). Consistency in these areas should be sought, even though linkage between systems can continue in the absence of consistent treatment (Mace et al., 2008). This has been seen within the EU ETS, where closures and new entrants have been treated differently in different Member States. The important point here is that the problem exists even in the absence of linking, and differences in these rules only impact linking insofar as they affect allowance prices. Different compliance periods also do not pose problems for linking. Sterk et al. (2006) argue that different compliance periods are actually beneficial, as they improve market liquidity. Temporary market shortages in one scheme at the end of the compliance period can be alleviated by purchases from another scheme that is at the beginning or in the middle of its compliance period. Having different allocation methods (typically, auctioning, free allocation, or a mixture of measures) is not, in itself, an obstacle for linking. However, the selected methods for auctioning will be an important to ensure consideration in deciding whether a linkage with an auction-based system is acceptable, as the allocation method can significantly affect the legitimacy of the system as a whole (Mace et al., 2008). If auctioning is used, it is important to ensure that auctions are well-designed to avoid garning and other detrimental outcomes. Poor auction design may facilitate non-competitive or collusive behaviour by bidders, potentially impacting not only the carbon price at auction but also in the wider market (Mace et al., 2008). In general, insofar as linking changes the carbon price in linked systems, this will alter the distributional outcome of any method of allocation applied.

4.1.2. System differences likely to pose significant barriers Barriers that can pose significant challenges to linking include: ■ ■ ■ ■ ■

relative stringency of targets stringency of enforcement eligibility of offset credits intensity targets cost-containment measures.

The relative stringency of targets is one of the most politically critical issues when two or more systems consider linkage, and it may be a political precondition for linking that all systems involved have comparable caps (i.e. require comparable effort). This is because cap levels in combination with the abatement cost structure of regions determines the international distribution of mitigation costs, and linking raises the issue whether countries consider their levels of effort mutually acceptable (Sterk et al., 2006; Flachsland et al., 2009b). The advantage of a Kyoto-type agreement is that the international agreement itself establishes an accepted burden-sharing rule for participating nations. However, an internationally agreed economy-wide cap may not be sufficient for linking. Nations

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may also require that the stringency of the national emissions trading schemes be comparable. The fact that two or more nations have agreed to respective national emissions targets does not mean that the stringencies of the schemes reflect the relative stringencies of the national targets. Since national emissions trading schemes do not impose emission obligations on all sectors, the cap within the ETS may be more or less stringent than the national commitment (Alexeeva-Talebi and Anger, 2007; Anger, 2008). However, even in the absence of a Kyoto-type successor agreement, countries could agree on comparably stringent caps for their emissions trading schemes. Stringency of enforcement is critical in order to ensure adequate market performance over time and to uphold confidence at the level of market participants. Stringency of enforcement will also impact carbon prices. Comparable governmental and enforcement structures are therefore essential to a link (Victor, 2007). When linking between OECD systems, comparable governance and enforcement provisions can be assumed. Significant difficulties could arise if some types of offset credits are considered as eligible in one ETS but not in the ETS of a potential linking partner. In particular, a US scheme is likely to allow domestic credits from the domestic agricultural and forest sectors as well as REDD (reducing emissions from deforestation and degradation) credits from developing countries, whereas the EU does not currently allow the use of any credits from the land sector in the EU ETS. Even if some credits are eligible only in one scheme, they will affect the overall supply of units, and therefore prices, in the combined scheme. Operators in the scheme where the credits are eligible can use the credits for their domestic compliance and sell their domestic allowances to the scheme where the offsets are not allowed. In addition, linking a scheme with a discount factor on international offsets, as provided for in the Waxman–Markey proposal, and a scheme that does not discount these can lead to arbitrage trading between schemes, and therefore pose a barrier. Although intensity targets do not impose a defined cap on overall emissions, it is possible to link trading schemes with absolute targets to those with intensity targets (Ellis and Tirpak, 2006). However, the large degree of uncertainty and technical challenge when linking schemes with absolute and intensity-based targets is likely to make such links politically very difficult. Concerns include competitiveness, cap integrity, and liquidity shocks. Under an intensity-based system, companies have some incentive to increase output, and therefore emissions, because the intensitybased allocation does not discourage increased production. Compared with a system that imposes absolute targets, this could be viewed as a subsidy and thus raises competitiveness concerns (Fischer, 2003). If an intensity-based system becomes a net buyer of permits from a trading system operating under an absolute cap, the intensity target system can compromise the environmental effectiveness of the intensity-based system by allowing more production than would otherwise have been possible. This then compromises the cap of the combined regime as well. Another potential problem is that in intensity-based approaches allocations are adjusted ex-post. This could lead to liquidity shocks for the linked scheme at the moment of adjustment (Sterk et al., 2006). The only regions planning intensity-based trading systems are Canada and a Japanese ETS which may be implemented before 2013. Japan, however, may see a mandatory ETS based on absolute caps after 2013 (Kimura and Tuerk, 2008) and Canada is also moving to absolute caps in the long term (Canada, 2008). In order to avoid high CO2 prices or price spikes, cap-and-trade schemes may implement costcontainment measures, including offset provisions, borrowing provisions or price caps. If these provisions are present in one of the linked systems, they will be made available to participants in the other system regardless of whether the other system has the same provisions (Stavins and Jaffe, 2007). The unlimited import of low-cost credits from other sectors and regions will reduce the CO2 price and total abatement costs in a cap-and-trade system. However, if policy-makers

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want to ensure that a certain level of domestic abatement is achieved, they may want to impose restrictions on credit imports. Different views on appropriate limits may inhibit linkages. Allowing high rates of borrowing from future commitment periods can lead to delays in GHG abatement. This may lead to a situation where future abatement costs become very high, introducing an incentive for governments to relax emission caps, thereby reducing the environmental effectiveness of the scheme (Boemare and Quirion, 2002). Thus, linking a scheme that allows borrowing to a scheme that does not allow borrowing requires restrictive provisions in order to maintain the environmental effectiveness of the combined scheme. However, of the schemes analysed here, only the Lieberman–Warner bill provides for a large degree of borrowing. If a system without a price cap is linked to a scheme with a price cap (e.g. Jacoby and Ellerman, 2004), this effectively introduces the price cap in the entire linked market. If the market price for companies from the scheme without a price cap is above the price cap, companies in the price cap system will have an incentive to sell allowances to companies in the linked system, undermining the environmental integrity of the combined scheme (Blyth and Bosi, 2004; Sterk et al., 2006). Moreover, if the penalty for non-compliance releases the operator of an installation from the obligation to cover its full emissions with eligible units, this acts as a price cap and therefore poses a problem for linking (see Sterk et al., 2006).

4.2. Linking and domestic policy priorities The analysis of existing and emerging trading schemes illustrates that the design of ETS varies greatly, reflecting different national and regional policy priorities and country circumstances. The design of each ETS is tailored to achieve certain domestic or regional policy objectives and also reflects domestic circumstances. Policy priorities and national circumstances are reflected in the scope and coverage of an ETS including eligible offset credit types, as well as its acceptable domestic impacts, such as the distributional effects of the ETS and competitiveness effects. Policy priorities also manifest themselves in different views on the acceptable level of the carbon price.8 The consequences of a CO2 price change due to linking can affect the achievement of some of these objectives (see Stavins and Jaffe, 2007) and may lead to unacceptable impacts for a region. The EU ETS has a clear priority to meet a defined reduction target, and thus tolerates a higher CO2 price for achieving this aim. In many other countries, there is greater sensitivity to the level of future carbon prices and the risk of high prices. As a case in point, the proposed Australian scheme includes a price cap which, if triggered, would make additional permits available to domestic emitters (Jotzo and Betz, 2009). System coverage can also impact the acceptable CO2 price range. In schemes which cover almost all economic sectors, the CO2 price is reflected in the costs faced by consumers, and the country may want to keep CO2 prices low, at least initially, in order to achieve political acceptance for the scheme. Some emissions trading schemes, such as the WCI, are not only designed to meet an emissions target at least cost, but are also intended to stimulate innovation in low-carbon technologies (Western Climate Initiative, 2008); accordingly, they rely on a higher range of CO2 prices as a condition for their goal attainment. Each ETS, in its design, reflects the evolution of climate policy and other specific circumstances in the country concerned. Some of the resulting differences in ETS design will make short-term harmonization difficult to achieve. Japan, for example, has been relying on voluntary intensitybased targets for more than a decade. Consequently, a shift to mandatory, absolute targets may be a longer-term process. Economic and natural resource circumstances and the consequent emissions structure are also important determinants for the design of a scheme. In the USA, for example, the forestry and agriculture sectors have a large mitigation potential; it would be politically very difficult not to include these sectors as offset credits into an ETS. The EU ETS, however,

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currently rejects the integration of forestry into emissions trading due to concerns over monitoring and other technical challenges, and land-use credits in US schemes therefore may represent a barrier to linking to the EU ETS. The analysis of existing and emerging trading schemes suggests that tolerance to a significant CO2 price increase due to direct linkages – either bilateral or unilateral – is low in most of the assessed schemes. Emerging schemes, such as a federal US scheme modelled after the Boxer–Lieberman– Warner bill or an Australian scheme, both with a large coverage, may not accept linkages that lead to significantly increased CO2 prices, at least in the initial years of the schemes (Jotzo and Betz, 2009; Sterk and Kruger, 2009). As some of the country analyses, such as that of Australia, show, governments see their short-term priority in minimizing the implementation risks while schemes are being established (Jotzo and Betz, 2009). Ensuring a large degree of regulatory certainty and promoting price stability and predictability in the early years of the scheme, including costcontainment measures such as price caps or offset credit provisions, have a higher priority in some of the analysed schemes than the early consideration of direct bilateral linkages to other trading schemes. This is particularly relevant for markets that can be expected to become price takers in fully linked markets. When establishing a bilateral link, small schemes are much more affected by the price volatility and price-relevant decisions of large schemes than vice versa. Some countries (e.g. Australia) may even discourage unilateral links to their schemes in order to avoid price increases and the price cap being adjusted too often (Department of Climate Change, 2008). The EU Commission, although it has indicated that it will first observe foreign markets operating for sometime before agreeing to create a link to the EU ETS (Delbeke in ECCP, 2007), has expressed its desire for bilateral links with other OECD country schemes by 2015 (EU Commission, 2009), without declaring the avoidance of unwanted effects on its CO2 price (price increase, volatility) to be an essential condition. The EU ETS has been characterized by high CO2 price volatility since its inception in 2005. The absence of a clear position regarding the desired CO2 price range in the EU may, however, limit the desire of other schemes to fully link up with the EU ETS in the short term, given its large market size and the desire of emerging schemes for long-term regulatory price certainty.

4.3. Prospects for different types of links Based on the review of barriers above, this section considers the prospects for different types of links. Given the need to harmonize critical design features, full bilateral links between OECD company-level cap-and-trade schemes prior to 2015 appear rather unlikely. Prospects for a transatlantic link between the EU ETS and a federal US scheme, however, are difficult to predict, given the uncertainty surrounding the possible repositioning of US climate policy under the new political administration. Full bilateral links are probably rather a mid- to long-term issue, as they require a harmonization of critical design features, such as cost-containment measures. Schemes in countries that are already close trading partners and have undergone some degree of legal and political integration may see earlier bilateral links, as policy coordination may prove easier. Likewise, the outlook for unilateral links between national cap-and-trade schemes is modest. Currently, there is only one unilateral link between cap-and-trade schemes: under certain conditions, the RGGI provides for recognition of European Union allowances (EUAs).9 So far, no unilateral links have been established between two cap-and-trade systems where the system establishing the link has a dominant effect on allowance prices in the system with which the link is established. Some emerging schemes, such as that of Australia, will discourage the establishment of unilateral links to their schemes in order to prevent a CO2 price increase. The EU, which has the vision of a harmonization of ETS and full bilateral linking, is also likely to resist unilateral links to its scheme.

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However all existing and emerging cap-and- trade schemes provide for unilateral links to international crediting mechanisms. As mentioned above, full bilateral links are likely to be established earlier between schemes that are close trading partners and where a history of policy coordination already exists. Most ETS are created as part of a larger body of environmental and energy policies, and are thus subject to the overarching objectives and principles governing those policies; ETS interact with other environmental policies, and hence, any decision affecting the functioning and effectiveness of an ETS will also be considered in the light of other policies and measures. Generally, countries operating in regional organizations of economic integration will already have harmonized their regulatory frameworks to some extent as part of their efforts to reduce competitive distortions and other obstacles to free and open trade. Given the greater similarity of underlying conditions for economic activity and converging policy priorities, linking of ETS between such countries is likely to prove easier than between countries that have not engaged in similar legal and political approximation. One example is the link between the EU ETS and Norway, Iceland and Lichtenstein. The link was established through incorporation of the EU ETS Directive into the European Economic Area agreement. In this case, the countries that linked to the EU ETS implemented the same scheme design, have similar climate policy objectives, economic and legal structures, and the same ETS coordinator: the European Commission. In a similar way, other European countries may also link to the EU ETS in the future, such as Croatia prior to its EU accession, or Switzerland. Linking within the same economic area gives a high degree of regulatory certainty. Early full bilateral links may also be established between North American nations that have close economic and political ties, and are part of the NAFTA agreement, e.g. Mexico. Likewise, full bilateral links between Australia and New Zealand are realistic in the near future given the similarities in their scheme design, as well as the desire of New Zealand – being a small market – to increase liquidity and to reduce transaction costs by sharing governance arrangements and technical resources with Australia (Jotzo and Betz, 2009).

5. Institutional framework for an integrated global carbon market 5.1. From coordination to integration As the previous sections show, a number of barriers, notably domestic political priorities and widely divergent regulatory traditions, are likely to prevent direct bilateral or multilateral links between emissions trading schemes in the near future. Still, as climate policy objectives become more ambitious over time, and domestic trading schemes are expected to achieve greater GHG reductions, the economic implications in terms of rising compliance costs and impacts on industrial competitiveness will increase the attraction of market integration across regional and national borders.10 Once a decision is reached to seek greater market integration, past experience – both in the area of climate policy and in other areas, such as international trade – suggests that it will result in an evolutionary process, starting from an informal discussion between coalitions of states on shared objectives and principles of emissions trading, and eventually progressing to a truly international market with a global reference price for carbon. While different pathways are conceivable for this integration process, many of which are conditional on the outcome of international negotiations under the UNFCCC, potential stages of development can be identified and are mentioned below. As markets become integrated, their governance will arguably necessitate mechanisms beyond the scope of the link itself, which is, in the end, a mere provision recognizing the validity of foreign units. Instead, linked markets are likely to require overarching structures governing the relationships between emissions trading systems (Flachsland et al., 2009a), including institutional

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arrangements that extend further than the governance structures of each domestic ETS (Stewart and Sands, 2001). In this context, the notion of an ‘institutional arrangement’ is applied in broad terms; as shown below, it can range from loose fora of ad-hoc cooperation to formal institutions endowed with broad mandates and rulemaking powers. Both for the broader policy framework and the technical design of trading schemes, the international regime succeeding the Kyoto Protocol will be of crucial importance. Aside from defining common policy objectives and a widely endorsed distribution of reduction burdens, a follow-up agreement can also set out uniform standards for tradable units and other design aspects of emissions trading. Overall, the existence of a consensus-based international framework for domestic emissions trading could greatly facilitate and accelerate linking at the bilateral or multilateral level. Nevertheless, the decision-making bodies established under many treaties, such as the Kyoto Protocol with its periodic meeting of the Parties, only have a limited ability to react to evolving conditions, being constrained by the intermittent nature of their activities and burdensome decision procedures. However, given the need to ensure adequate governance of a growing and increasingly complex carbon market, the creation of new institutional arrangements has a high likelihood of entering the political agenda. Such institutional arrangements could be charged with a range of market oversight functions, ensuring market access and market transparency, as well as providing accountability procedures and setting out certain safeguards, such as mandatory use of exchanges for certain transactions. This mandate could extend to the physical spot market, but also, and especially, to trading in derivatives, offset creation and verification, and monitoring, reporting and verification obligations. Going further, an institutional arrangement could also intervene in certain market features, including price formation and allowance supply,11 although opinions are highly divided on the expedience of such intervention. Relevant powers would need to be expressly conferred by the participating jurisdictions, and would clearly require a careful assessment of their appropriate scope and nature. Such an institutional arrangement should also be responsive to the evolving framework of international climate policy, and clarify its relationship with the bodies already created to govern the international climate regime. In the event that no adequate regime is adopted for the period beyond 2012, for instance by failing to define quantitative emissions limitation or reduction obligations, an institutional arrangement for the integration of carbon markets may also provide the basis for discussions on appropriate targets and levels of ambition for participating jurisdictions. Most of the issues arising when negotiating a global trading system would remain important, but could then be negotiated more flexibly between coalitions of linking partners rather than at the multilateral level and contingent on universal participation (Flachsland et al., 2008).

5.2. Designing an institutional architecture In terms of formal implementation, different options are available to achieve a higher level of market integration. Such options range from a loose cooperation between states and regions to a formal international organization endowed with legislative and enforcement powers. In terms of the degree of formality and the scope of inherent competences, the options outlined here might even be realized in chronological order. Indeed, the development of an institutional framework may find parallels in the successive integration and consolidation of bilateral trade agreements into the General Agreement on Tariffs and Trade (GATT) in 1947 and, eventually, the comprehensive, far-reaching institutional architecture of the World Trade Organization (WTO).

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5.2.1. Cooperation in a loose network of states and regions At a very general level, states and regions operating or implementing emissions trading schemes may decide to engage in a loose cooperation through an informal network geared towards an exchange of information, promotion of uniform approaches and standards, stakeholder involvement, and outreach activities. Rather than effecting actual governance, such a network would be largely limited to issuing recommendations and providing advice on the implementation and harmonization of trading schemes. Its implementation could occur by way of a Memorandum of Understanding (MoU) between the affected jurisdictions, without resulting in formal bilateral or multilateral trading links. An example of such cooperation already exists in the form of the International Carbon Action Partnership (ICAP) launched in October 2007 by more than 15 national and regional governments, expressly aimed at creating a ‘forum to discuss relevant questions on the design, compatibility and potential linkage of regional carbon markets’ (ICAP, 2007).

5.2.2. Umbrella agreement As the integration of emissions trading schemes becomes more aligned with domestic political priorities, states may be willing to consider formal and legally binding arrangements to promote further market harmonization, such as an umbrella agreement defining common features of the domestic ETS and specifying procedures of cooperation (Stavins and Jaffe, 2007; Mace et al., 2008). Such an umbrella agreement need not interfere with the operation and design of national or regional markets, but might limit itself to outlining minimum standards, e.g. for monitoring, reporting and verification, or technical details, such as the registry technology used by participating jurisdictions. Procedures could include mutual notification and information duties, external review or reciprocal monitoring of the trading schemes, and periodic meetings of representatives from each trading scheme to discuss items for harmonization, such as cost containment. An umbrella agreement might also be used to create an institution, such as a treaty secretariat or clearinghouse facilitating trade across linked markets, collecting transaction data, ensuring market access, defining eligibility requirements – e.g. position limits, margin requirements, or mandatory licensing for derivative traders – and providing general logistical functions such as registry maintenance.

5.2.3. International or supranational organization The most far-reaching option for the integration of carbon markets would call for establishment of an international or supranational organization, with a constitutive mandate, governance structures and defined responsibilities. As an option for the longer term, such an institution would be distinct from mere coordinating and facilitating arrangements, such as a treaty secretariat, a clearing-house or gateway, due to the conferral of an independent legal personality and – in the most far-reaching scenario – the genuine power to adopt and enforce rules for market participants and linked jurisdictions. Such an institution could have comprehensive governance functions to achieve carefully defined objectives, including, but not limited to: ■ maintaining the environmental integrity of the market as regards the stringency of domestic caps, and the reliability of monitoring and enforcement arrangements ■ affecting carbon price formation to avoid short-term volatility and undesired price signals, for instance by defining price corridors, controlling unit reserves and adjusting limitations on banking, borrowing or offsetting

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■ participating in the process of allocating or auctioning units and coordinating revenue expenditure ■ preventing market speculation and manipulation (fraud, unfair competition) as well as the exploitation of regulatory loopholes. In order to achieve these objectives, such an organization would need to have considerable powers. Its establishment would, again, be a matter of adopting a binding international treaty between participating jurisdictions. Aside from defining objectives and responsibilities, such a treaty – often termed an organizational ‘charter’ or ‘establishing treaty’ – would also have to specify its own governance structures and procedures. Typically, this would necessitate the creation of a body of appointed officials with specified terms and conditions of appointment, and with rules on geographical and professional diversity. Experience with other international bodies operating in the area of environmental policy and governance also suggests the need for clear and transparent accountability and dispute settlement procedures and rules.

6. Conclusions and outlook While the EU envisions an OECD carbon market by 2015, this article has drawn on country case studies to conclude that an OECD-wide company-level carbon market by 2015 is an ambitious goal. In most of the assessed schemes, full bilateral linking is not a short-term priority, and its benefits will be weighed against giving up on other objectives, such as control over the domestic CO2 price level via price caps and other cost-containment measures. A larger number of full bilateral links between emissions trading systems in different OECD countries is therefore unlikely in the next decade, although prospects for an earlier transatlantic link between the EU ETS and a federal US scheme may improve under the new administration (Sterk and Kruger, 2009). If the EU and the USA find common ground on key design elements, this would probably exert significant influence on the other, smaller OECD trading systems to align their designs accordingly and to join the linked market. Early bilateral links may emerge in regions that have close economic ties, a history of policy coordination or even the same regulatory institutions. The future of the global carbon market will crucially depend on the outcome of current negotiations on a Kyoto successor treaty. In case it is adopted, bottom-up linking of company level trading schemes may supplement government-level emissions trading in the mid- to long term; otherwise, it may represent an alternative pathway in the event that no Kyoto-type agreement materializes at Copenhagen or beyond. Some of the potential barriers to linking cap-and-trade schemes, such as significantly divergent MRV provisions, will be easier to overcome with the adoption of a Kyoto successor treaty. More importantly, the comparability of targets will have been resolved through an international consensus-based burden-sharing determination. In the case of a Kyoto successor treaty, most emissions trading systems will have unilateral links to international crediting mechanisms, such as the CDM or potential new trading mechanisms for non-OECD countries. Therefore, OECD country emissions trading schemes will be indirectly linked through the CDM or new trading mechanisms, and hence will be in competition with each other for credits. Depending on the extent of the price differential and credit supply, this competition may lead to a significant convergence of prices, even if full bilateral links cannot be implemented in the short term. While a full set of bilateral links is unlikely to emerge in the short term, if a global carbon market remains a priority over the longer term, it is crucial to start early with the establishment of

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frameworks and procedures to promote harmonization of critical design issues, such as costcontainment measures. This development is likely to occur through an evolutionary process of progressive market integration. While no single trajectory can currently be identified, a case can be made for successive stages of institutional development, starting with informal cooperation and information exchange, to more formal arrangements specifying uniform standards and best practices on the technical implementation of trading schemes. Such integration might eventually culminate in the creation of a separate international or supranational entity endowed with powers to oversee and regulate the integrated carbon market, much as central banks govern currency markets. International institutions and frameworks are critical to ensure that integrated markets are well governed, and will therefore play an increasingly important role in future climate policy.

Notes 1.

This article uses the terminology ‘emissions trading schemes’ and ‘carbon market’, both for cap-and-trade and for emission reduction credit systems. Cap-and-trade systems set a binding, absolute cap on total emissions, but allow for certificates (corresponding to the right to emit a specific volume of emissions) to be traded between the covered entities, which are either nations or companies. The Kyoto Protocol trading system for Annex B countries is an example of cap-and-trade at the governmental level, while the EU ETS operates at the company level. In contrast, credit systems define a certain baseline such as an absolute business-as-usual projection or a relative target, and only allow emission reductions that go beyond this baseline to be used as sellable credits (often referred to as ‘offsets’). The CDM and JI mechanisms established under the Kyoto Protocol are examples of such credit systems that are non-binding. 2. For detailed descriptions of emerging ETS in the USA, Australia and New Zealand, see other contributions in this Special Issue of Climate Policy. 3. Although New Zealand ETS legislation came into force in September 2008, the cap-and-trade scheme will not apply to most covered sectors until 2010 and, as a result of a change of government, a parliamentary committee is reviewing the scheme (including alternatives to an ETS). 4. The European Council (2007) underlined the importance of achieving the strategic objective of limiting the global average temperature increase to not more than 2°C above pre-industrial levels. 5. ICAP is composed of countries and regions that have implemented or are actively pursuing the implementation of mandatory cap-and-trade systems (ICAP, 2007). The partnership provides a forum to share experience and knowledge. Sharing and evaluating best practice will help ICAP members in determining the extent to which their respective programmes can be supported by, and/or benefit from, the ICAP process. 6. See Flachsland et al. (2009b) for an extensive treatment of the generic implications and trade-offs when linking cap-and-trade systems. 7. While the EU ETS does not recognize AAUs, the proposed New Zealand scheme does (Jotzo and Betz, 2009). 8. For a conceptual illustration how policy objectives, scheme design, and impacts when linking are interrelated, see Flachsland et al. (2009b). 9. If prices for RGGI allowances exceed a specified threshold, participants may use ‘allowances or credits issued pursuant to any governmental mandatory carbon constraining programme outside the USA that places a specific tonnage limit on greenhouse gas emissions, or certified greenhouse gas emissions reduction credits issued pursuant to the United Nations Framework Convention on Climate Change (UNFCCC) or protocols adopted through the UNFCCC process’ (RGGI, 2006). 10. Such a tendency towards integration is not a given; as Victor (2007) persuasively argues, different priorities and policy preferences may lead to a fragmented market with countless barriers, rather than a linked and integrated market; but while he accurately highlights the challenges faced in the early phase of the EU ETS as examples for the barriers to market integration, the revised EU ETS Directive for the third and subsequent trading phases shows how initial challenges can be successfully overcome on the path towards greater integration, with a stronger mandate and increased central powers of a supranational authority, the European Commission. 11. In the event of a sudden and unexpected rise in prices, for instance, such an intervention could relax the rules on borrowing and quantitative limitations on offset usage.

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References Alexeeva-Talebi, V., Anger, N., 2007, Developing Supra-European Emissions Trading Schemes: An Efficiency and International Trade Analysis, ZEW Discussion Paper No. 07-038, Zentrum für Europäische Wirtschaftsforschung (Centre for European Economic Research), Mannheim, Germany. Anger, N., 2008, ‘Emissions trading beyond Europe: linking schemes in a post-Kyoto world’, Energy Economics 30, 2028–2049. Blyth, W., Bosi, M., 2004, Linking Non-EU Domestic Emissions Trading Schemes with the EU Emissions Trading Scheme, OECD and IEA, Paris. Boemare, C., Quirion, P., 2002, ‘Implementing greenhouse gas trading in Europe: lessons from economic literature and international experiences’, Ecological Economics 43(2–3), 213–230. Böhringer, C., Löschel, A., 2003, ‘Market power and hot air in international emissions trading: the impacts of US withdrawal from the Kyoto Protocol’, Applied Economics 35(6), 651–663. Canada, 2008, Turning the Corner: Regulatory Framework for Industrial Greenhouse Gas Emissions, Government of Canada, Ottawa [available at www.ec.gc.ca/doc/virage-corner/2008-03/pdf/541_eng.pdf]. Capoor, K., Ambrosi, P., 2008, State and Trends of the Carbon Market 2008, World Bank, Washington, DC. Carbone, J.C., Helm, C., Rutherford, T.F., 2008, The Case for International Emission Trade in the Absence of Cooperative Climate Policy, Darmstadt Discussion Papers in Economics 194, Institut für Volkswirtschaftslehre (Institute of Economics), Technische Universität Darmstadt (Darmstadt University of Technology), Darmstadt, Germany. Department of Climate Change, 2008, Carbon Pollution Reduction Scheme: Australia’s Low Pollution Future, White Paper, Commonwealth of Australia, Canberra. ECCP (European Climate Change Programme), 2007, Final Report of the Fourth Meeting of the ECCP Working Group on Emissions Trading on the Review of the EU ETS on Linking with Emissions Trading Schemes of Third Countries, 14–15 June, Brussels [available at http://ec.europa.eu/environment/climat/emission/pdf/070614_15finalreport.pdf]. Ellerman, A.D., 2008, The EU Emission Trading Scheme: A Prototype Global System? Discussion Paper 08-02, Harvard Project on International Climate Agreements, Cambridge, MA. Ellis, J., Tirpak, D., 2006, Linking GHG Emission Trading Systems and Markets, OECD/IEA, Paris. EU Commission, 2009, Towards a Comprehensive Climate Change Agreement in Copenhagen, Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the Committee of the Regions, COM(2009) 39/9, Brussels. European Council, 2004, Directive 2004/101/EC of the European Parliament and of the Council of 27 October 2004 Amending Directive 2003/87/EC Establishing a Scheme for Greenhouse Gas Emission Allowance Trading within the Community, in Respect of the Kyoto Protocol’s Project Mechanisms. European Council, 2007, Brussels European Council 8/9 March, Presidency Conclusions, 2 May, 7224/1/07 REV, Brussels. Fischer, C., 2003, ‘Combining rate-based and cap-and-trade emissions policies’, Climate Policy 3 (Supplement 2), S89–S103. Flachsland, C., Edenhofer, O., Jakob, M., Steckel, J., 2008, Developing the International Carbon Market: Linking Options for the EU ETS, Report to the Policy Planning Staff in the Federal Foreign Office, PIK, Potsdam, Germany. Flachsland, C., Marschinski, R., Edenhofer, O., 2009a, ‘Global trading versus linking: architectures for international emissions trading’, Energy Policy 37(5), 1637–1647. Flachsland, C., Marschinski, R., Edenhofer, O., 2009b, ‘To link or not to link: benefits and disadvantages of linking capand-trade systems’, Climate Policy 9(4) Special Issue Linking GHG Trading Systems, 358–372. Hahn, R.W., Stavins, R.N., 1999, What Has the Kyoto Protocol Wrought? The Real Architecture of International Tradable Permit Markets, AEI Press, Washington, DC. Haites, E., Mullins, F., 2001, Linking Domestic and Industry Greenhouse Gas Emission Trading Systems, EPRI, International Energy Agency (IEA) and International Emissions Trading Association (IETA), Paris. Helm, C., 2003, ‘International emissions trading with endogenous allowance choices’, Journal of Public Economics 87, 2737–2747. ICAP (International Carbon Action Partnership), 2007, Political Declaration, Lisbon [available at www. icapcarbonaction.com]. Jacoby, H.D., Ellerman, D.A., 2004, ‘The safety valve and climate policy’, Energy Policy 32(4), 481–491. Jotzo, F., Betz, R., 2009, ‘Australia’s emissions trading scheme: opportunities and obstacles for linking’, Climate Policy 9(4) Special Issue Linking GHG Trading Systems, 402–414. Kimura, H., Tuerk, A., 2008, Emerging Japanese Emissions Trading Schemes and Prospects for Linking, Climate Strategies Working Paper, Cambridge, UK.

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McKibbin, W.J., Morris, A., Wilcoxen, P.J., 2008, Expecting the Unexpected: Macroeconomic Volatility and Climate Policy, Discussion Paper 08-16, Harvard Project on International Climate Agreements, Belfer Center for Science and International Affairs, Harvard Kennedy School, Cambridge, MA. Mace, M.J., Millar, I., Schwarte, C., Anderson, J., Broekhoff, D., Bradley, R., Bowyer, C., Heilmayr, R., 2008, Analysis of the Legal and Organisational Issues Arising in Linking the EU Emissions Trading Scheme to Other Existing and Emerging Emissions Trading Schemes, Final Report, FIELD/IEEP/WRI, London. Marr, S., 2008, Towards a Global Carbon Market, Accra Climate Change Talks 2008, 3rd Session of the AWG-LCA 3, 6th Session of the AWG-KP 6. Mehling, M., 2007, ‘Bridging the transatlantic divide: legal aspects of a link between regional carbon markets in Europe and the United States’, Sustainable Development Law and Policy 2, 46–52. Mehling, M., Haites, E., 2009, ‘Mechanisms for linking emissions trading schemes’, Climate Policy 9(2), 169–184. RGGI Model Rule, 2006, issued 15 August [available at www.rggi.org]. Skjærseth, J.B., Wettestad, J., 2008, EU Emissions Trading: Initiation, Decision-making and Implementation, Ashgate, Aldershot, UK. Stavins, R.N., Jaffe, J., 2007, Linking Tradable Permit Systems for Greenhouse Gas Emissions: Opportunities, Implications, and Challenges, International Emissions Trading Association (IETA) and Electric Power Research Institute (EPRI), Geneva. Sterk, W., Kruger, J., 2009, ‘Establishing a transatlantic carbon market’, Climate Policy 9(4) Special Issue Linking GHG Trading Systems, 389–401. Sterk, W., Braun, M., Haug, C., Korytarova, K., Scholten, A., 2006, Ready to Link Up? Implications of Design Differences for Linking Emissions Trading Schemes, Jet-Set Working Paper I/06, Wuppertal Institute, Wuppertal, Germany. Stewart, R.B., Sands, P., 2001, ‘The legal and institutional framework for a plurilateral greenhouse gas emissions trading system’, in: UNCTAD (ed), Greenhouse Gas Market Perspectives: Trade and Investment Implications of the Climate Change Regime, UNCTAD, Geneva, 5–34. Tangen, K., Hasselknippe, H., 2005, ‘Converging markets’, International Environmental Agreements: Politics, Law and Economics 5(1), 47–64. Tuerk, A., Streck, C., Johns, J., Pena, N., 2008, The Role of Land-based Offsets in Emissions Trading Systems: Key Design Aspects and Considerations for Linking, Climate Strategies Working Paper, Cambridge, UK.. Victor, D.G., 2007, ‘Fragmented carbon markets and reluctant nations: implications for the design of effective architectures’, in: J.E. Aldy, R.N. Stavins (eds), Architectures for Agreement: Addressing Global Climate Change in the Post-Kyoto World, Cambridge University Press, Cambridge, UK, 133–160. Westskog, H., 2002, ‘Why should emissions trading be restricted?’ Climate Policy 2, 97–103. Western Climate Initiative (WCI), 2008, Background Report on the Design Recommendations for the WCI Regional Cap-and-Trade Program 14.

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■ research article

To link or not to link: benefits and disadvantages of linking cap-and-trade systems CHRISTIAN FLACHSLAND*, ROBERT MARSCHINSKI, OTTMAR EDENHOFER Potsdam Institute for Climate Impact Research, PO Box 601203, 14412 Potsdam, Germany

A framework was devised for policy-makers to assess direct bilateral cap-and-trade linkages. A systematic analysis of the economic, political and regulatory implications indicates potential benefits along with a number of potentially negative sideeffects. Theoretically, economic benefits are expected from quasi-static short-term and dynamic efficiency gains. However, a careful review of these arguments indicates that, due to the presence of market distortions or terms-of-trade effects, international emissions trading may not be welfare-enhancing for all countries. Political benefits are derived from the reinforced commitment to international climate policy and the elimination of competitiveness concerns among linking partners, but this must be weighed against the possible incentive to adjust national caps in anticipation of linking. Regulatory disadvantages may arise from the linked system’s inconsistency with original domestic policy objectives, and from the partial de facto cession of discretionary control over the domestic emissions trading system. Finally, as an illustration, a link between the EU ETS and a prospective US trading system is assessed, and the major trade-offs identified. Keywords: carbon markets; climate policy; domestic emissions trading systems; emissions trading; EU ETS; linking; US ETS Un cadre pour évaluer l’établissement de liens directs bilatéraux entre systèmes cap-and-trade est conçu pour les décideurs. Une analyse systématique des implications économiques, politiques et réglementaires met en valeur les avantages potentiels ainsi qu’un certain nombre de répercussions négatives. En théorie, les avantages économiques sont prévus en gains de court terme quasi statique ainsi qu’en efficacité dynamique. Cependant, une revue attentive de ces arguments indique que la présence de distorsions de marché ou l’effet des termes d’échange sur le négoce international de droits d’émissions n’entraînerait pas une amélioration sociale pour tous les pays. Les avantages politiques sont liés à un engagement renforcé en politique climatique internationale et l’élimination des préoccupations liées à la compétitivité entre partenaires de systemes liés, mais ceci doit être mis en balance avec les incitations possibles à l’ajustement des plafonds nationaux dans l’anticipation d’établissement de liens. Les inconvénients réglementaires pourraient émaner de l’incompatibilité du système avec les objectifs de politique intérieure originels, et de la cession partielle de facto de contrôle discrétionnaire sur le système d’échange de droits d’émissions. Enfin, en tant qu’illustration, un lien entre l’EUETS et un système d’échange aux Etats-Unis potentiel est évalué et les compromis majeurs identifiés. Mots clés: EU-ETS; lier; marchés du carbone; politique climatique; systèmes d’échange de droits d’émissions; systèmes intérieurs d’échange d’émissions; US-ETS

1. Introduction After the initiation of the EU Emission Trading Scheme (EU ETS) in 2005, several cap-and-trade systems are now emerging world-wide, e.g. in the USA, Australia, New Zealand, Canada, Japan and Switzerland.1 Direct bilateral links between regional cap-and-trade systems have been proposed as one option to strengthen economic efficiency and politically reinforce the international emissions trading regime (e.g. Stern, 2007, 2008; Edenhofer et al., 2008; Garnaut, 2008).2 Others, ■ *Corresponding author. E-mail: [email protected] CLIMATE POLICY 9 (2009) 358–372 doi:10.3763/cpol.2009.0626 CLIMATE POLICY © 2009 Earthscan ISSN: 1469-3062 (print), 1752-7457 (online) www.climatepolicy.com

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however, have emphasized the considerable political and regulatory challenges that this would entail (e.g. Egenhofer, 2007; Victor, 2007; McKibbin et al., 2008). The objective of this article is to develop a framework for comprehensively assessing – from a policy-maker’s point of view – the expected benefits and drawbacks of a link between two cap-and-trade systems. We find that the major expected benefits from linking are economic and political in nature. Static efficiency gains derive from enabling trade across systems with different pre-link allowance prices, from increased market liquidity, and the reduced volatility. Inasmuch as linking creates an institutional lock-in on a jointly agreed reduction schedule, it also enhances the dynamic efficiency of climate policy. In political terms, linking can serve as a signal of commitment to close international cooperation. Links across OECD cap-and-trade systems – e.g. a transatlantic EU–US link (EU Commission, 2009) – can become important test cases for further carbon-market-based cooperative climate policy between developed and developing countries. On the other hand, linking also involves a number of potential economic, political and regulatory caveats. For some countries, negative distortionary or terms-of-trade effects may outweigh the efficiency gains from enabling international emissions trade. There are also some economic distributional questions about how efficiency gains are shared between linking partners, potential losses of cobenefits associated with emissions abatement, and whether linking could introduce a perverse incentive for allowance sellers to relax their cap. The greater openness of a linked trading system also implies a higher exposure to market shocks. From a political perspective, the important normative question arises of whether linking partners mutually accept their effort level, i.e. their reduction schedules. In terms of regulatory consequences, unfettered linking entails a ‘mixing’ of system designs, which can turn into a disadvantage if it leads to a ‘washing out’ of any of the two systems’ original policy priorities. Finally, linking also limits the scope for regulatory interventions of the single systems. In a policy application based on these arguments, we identify the major trade-offs that policymakers face when considering a specific link between the EU ETS and a US cap-and-trade system along the lines of the Waxman–Markey proposal (Waxman and Markey, 2009). In the face of limited knowledge about the prospective efficiency gains and negligible benefits from the increased market size, the political signal for international and domestic climate policy, and the effect as a commitment mechanism appear as the most tangible benefits of a transatlantic link. These benefits need to be weighed against the potential conflict over the relative priority of cost containment versus environmental effectiveness, and the loss of unilateral control over the domestic carbon market. The following sections analyse the economic (Section 2), political (Section 3) and regulatory (Section 4) implications of linking. In Section 5 we apply these theoretical findings to the case of a link between the EU ETS and a US ETS along the lines of the Waxman–Markey proposal. Section 6 contains the conclusions.

2. Economic implications Three types of economic implications are considered: (i) quasi-static, short-term efficiency gains, (ii) dynamic efficiency gains, and (iii) distributional effects. A series of counter-arguments against the conventional gains-from-trade rationale are discussed. In this context, the economic benefits of linking are not as clear-cut as they may seem.

2.1. Short-term efficiency gains The basic rationale for linking cap-and-trade systems is that significant efficiency gains can be realized when permit prices (implicitly: marginal abatement costs) across schemes are equalized

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through trade (e.g. UNCTAD, 1992; Chichilnisky and Heal, 1995; Edenhofer et al., 2007), with a greater pre-link difference in the allowance price leading – ceteris paribus – to a greater benefit from linking. In standard partial equilibrium analysis (e.g. Anger, 2008), linking will always be a Pareto improvement, i.e. no system will be worse off after linking than it was before. Quantitative estimates for the expected efficiency gains from international emissions trading were first created in the context of the Kyoto Protocol (e.g. Weyant and Hill, 1999). Typical results from these modelling studies suggest cost savings of about 50% for Annex-I only trade, and up to 75% for the case of global permit trade. However, few such computations have so far been carried out for post-Kyoto climate policy. As one exception, Russ et al. (2009) assume a policy scenario in line with current EU objectives,3 and – after applying two different types of models – conclude that a global carbon market with trade across all countries and sectors would halve the abatement costs compared with the no-trade case. While confirming the basic rationale for linking carbon markets, these analyses of large trading coalitions are not tailored to situations where policy-makers have to decide on a link between two given trading systems. As an exception, Carbone et al. (2009) choose a game-theoretic approach and systematically assess the bilateral linking option with a general equilibrium model calibrated on the base year 2015. They generally find large benefits only for linkages between asymmetric countries, with the highest global and EU welfare gains occurring for the case of an EU–China link. This would enable the EU to take advantage of China’s low-cost abatement options, and would allow China to benefit from selling permits. However, as a principal objection to the conventional gains-from-trade analyses, it should be questioned whether the latter’s implicit assumption of a ‘first-best’ world, i.e. one without market imperfections such as distorting taxes or externalities, does not lead to an overly optimistic and misleadingly clear-cut view on linking. Generally speaking, the theory of the second-best (Lipsey and Lancaster, 1956) states that optimality conditions that hold in a first-best world may no longer be valid in a second-best world, i.e. one characterized by distortions. In the context of climate policy, pre-existing energy taxes and/or fuel subsidies, as well as uncompetitive energy markets, suggest a second-best scenario. Hence the standard prescription of an ‘equalization of permit prices’ may cease to be optimal in some cases or – worse – could even become harmful. As a simple example, assume that – for instance, due to market power in the permit market – the one-to-one correspondence between marginal abatement costs and permit prices is lost. Evidently, emissions trading cannot yield an efficient outcome under such conditions. More formally, Babiker et al. (2004) and Paltsev et al. (2007) have shown that an increase in carbon prices due to emissions trading can reinforce pre-existing distortions associated with inefficiently high fuel taxes – up to the point where the corresponding welfare losses outweigh the primary gains from emissions trade. In a similar vein, McKibbin et al. (1999) demonstrate how a country may become subject to falling terms-of-trade after engaging in international emissions trading. Another reason why partial equilibrium analysis may overestimate the efficiency gains from linking is its neglect of adjustments in relative prices via international trade in goods. In fact, as one of the pillars of trade economics, the factor price equalization theorem (Samuelson, 1949) states the conditions under which efficiency is guaranteed even if production factors (e.g. emissions allowances) are not internationally traded. The relevance of this insight for climate policy and the resulting redundancy of emissions trading has been emphasized by Copeland and Taylor (2005). Admittedly, for the theorem to hold strictly, a set of rather restrictive assumptions is required, but the underlying mechanism will also work – albeit in a weakened form – in a less idealized context. Obviously, there are several other non-traded inputs, such as labour and energy, which have different prices across regions, without a perceived urgent need to have ‘one price’ for these.

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Finally, a side-benefit of linking consists of the creation of a larger carbon market, with more players and allowances and thus higher liquidity, which can particularly benefit smaller systems.4 Moreover, price shocks within one system will be absorbed and cushioned within a larger overall market. However, from a single system’s point of view this implies that, as a downside, volatility from other systems might be imported (McKibbin et al., 2008). As a consequence, the overall economic effect remains ambiguous: the benefits of spreading domestic price volatility over a larger market needs to be weighed against the costs of imported additional volatility.

2.2. Dynamic efficiency Basic economic theory holds that the implementation of an ambitious climate policy creates a time-inconsistency problem for a government with limited commitment power (Kydland and Prescott, 1977). Intertemporal economic efficiency breaks down when firms suspect that the government will loosen climate policy once sufficient private investments into low-carbon technology have materialized. Hence, firms do not invest the optimal amount in the first place (Helm et al., 2005; Montgomery and Smith, 2007). Drawing on Putnam (1988), we argue that internationally linked cap-and-trade systems are less prone to the lure of discretionary policy than systems in autarky, due to mutual pressure among linking partners not to relax emission caps, e.g. relative to some long-term schedule. 5 As a consequence, linked systems can establish a more credible price signal, and improve the dynamic efficiency of their climate policy. Admittedly, such pressure will also exist in the absence of linkages; however, only a linked carbon market provides some kind of sanctioning mechanism, such as trade restrictions (Rehdanz and Tol, 2005), or complete de-linking. When justifying national caps vis-à-vis domestic stakeholders, national policy-makers can point to this international pressure, claiming that it ‘ties their hands’ to some extent. Evidence of this mechanism could be observed in negotiations over the Phase I National Allocation Plans (NAP) in the EU ETS: on the basis of a pre-announced formula, the EU Commission successfully rejected several national allocation plans in which countries had endowed themselves with generous allocations (Zapfel, 2007). As pointed out by Ellerman et al. (2007, p.350), the possibility of ‘blaming’ the EU Commission as an institution representing some greater good sometimes helped to justify the adoption of unpopular decisions vis-à-vis the domestic constituency. In this sense, the multilateral architecture of the EU ETS helped to uphold the environmental ambition of the system.

2.3. Distributional considerations Three types of distributional questions arise in the context of linking. The first, and most obvious, concerns the distribution of the short-term efficiency gains expected from linking. As illustrated in Figure 1, in a partial equilibrium setting the region with the steeper marginal abatement cost (MAC, here assumed to be linear) curve will always obtain the largest share of the total benefits from trading. This is simply because the shift in abatement activity (depicted on the x-axis) is identical for both regions, leaving the relative size of the areas X and Y – which represent the gains from trade – to depend only on the steepness of the MAC curves. Given that the EU abatement cost curve is widely perceived as relatively steep (see, e.g., Weyant and Hill, 1999; Viguier et al., 2003), this may help explain the European Union’s keenness on linking (EU Commission, 2009). The second distributional aspect relates to the ancillary benefits associated with emission abatement, which include reduced local air pollution, increased energy security due to reduced dependency from fossil fuel imports, encouragement of R&D, and the general economic stimulus

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€/t

€/t MAC B B Paut

Y

A Plink

B Plink

X

A Paut MAC A q aut Reduction Target A

qlink Reduction Target B

FIGURE 1 Distribution of efficiency gains when linking two cap-and-trade systems Note: If marginal abatement cost (MAC) curves are linear, the system with the steeper MAC curve – here system B – always obtains more benefits from linking, i.e. we have Y > X.

that goes along with low-carbon investments (e.g. Westskog, 2002). If linking leads to a substantial outsourcing of abatement to other regions, these co-benefits – which are not internalized in the allowance price – will be lost. Considerations of this type may carry some weight in the perception of policy-makers and the public (see, e.g., California, 2007), in particular if linking is expected to significantly shift domestic abatement abroad. Unfortunately, a balanced appraisal of this argument is impeded by the fact that these ancillary benefits are ‘external’ to emission abatement, and hence not easily quantifiable in economic terms. However, such co-benefits will usually be addressed by additional targeted policy instruments, e.g. air pollution standards. Third, and finally, game-theoretic approaches have analysed whether and how the prospect of a linked carbon market creates an incentive for regions to adjust their allowance endowment, i.e. emissions cap, so as to increase their expected benefits from linking. For instance, using a standard emissions game framework, Helm (2003) found that linking creates an incentive for permit sellers (low-damage countries) to relax their cap in order to sell even more permits. Since, in compensation, permit buyers (high-damage countries) tend to choose fewer allowances, linking creates a distributional shift in favour of the seller countries. However, with appropriate instruments, in particular import quotas, buyers can contain the sellers’ expansionary tendencies (Rehdanz and Tol, 2005). The picture changes when players are assumed to anticipate the impact of their quota allocation on international markets for goods and allowances (Carbone et al., 2009): in line with oligopolistic behaviour, the incentive of net permit sellers to raise permit prices by increasing the stringency of their cap can outweigh the incentive to relax the cap. Arguing less formally, it can be expected that the incentive to relax caps when linking will be weakened for several reasons: the potential reputational damage, the threat of import quotas or other penalties, and the fact that linking partners could defect from cooperation in other policy areas as well. In any case, to make the choice of allowances assessable and transparent, mid- to long-term cap schedules should be defined prior to linking.

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3. Political implications We find that linking has three distinct political implications: an ambivalent effect on the international climate policy agenda, facilitating the acceptance of climate policy at the domestic level, and, third, it can work as a signalling mechanism in the context of global burden-sharing. First of all, linking represents an instrument of international cooperation and, as such, signals a commitment to long-term climate policy and multilateralism. However, it has an ambivalent impact on the UNFCCC process, as linking could be seen both as a complement or substitute thereof (Flachsland et al., 2009): as far as linking confirms the framing of climate change as a global issue and demonstrates how climate policy can be implemented in an efficient way, it can help to reinforce the UNFCCC process and accelerate the adoption of mid- to long-term climate policy targets. But linking may also be seen as weakening the UNFCCC, by breaking its political monopoly and providing a viable back-up option in case the negotiations fail or drag on too long. Second, inasmuch as linking is seen as an effective means to address the politically sensitive issue of competitive distortions between countries with different prices of carbon (e.g. Houser et al., 2007; Reinaud, 2009), it can facilitate the acceptance of climate policy among domestic business actors and the general public. The relevance of this point is manifest in business and labour associations’ calls to ‘level the carbon playing field’ (e.g. BDI, 2008; Blue Green Alliance, 2009), emphasizing the importance of harmonizing carbon prices among major international competitors. Evidently, linking offers no remedy against the competitive super-advantage of third countries without any price on emissions at all, such as China, which might constitute the more serious problem.6 Third, linking constitutes a way of signalling approval towards other systems’ underlying level of effort. Conversely, a linking offer could be declined – despite the tempting efficiency gains – if the prospective linking partner’s efforts are perceived to be unacceptably low. As an example, consider the option of linking the EU ETS and the RGGI system: even though cost savings would be expected, it is hard to imagine the EU agreeing to link to a system, which would – thanks to its overallocation7 – sell ‘hot air’ allowances into the EU ETS. The implicit endorsement of the low level of ambition of RGGI would be in contradiction with the European Union’s official climate policy goals. While the development of a common metric for comparing different ‘levels of effort’ in climate policy remains a complicated and unresolved issue (see den Elzen et al., 2008), it is obvious that the linking of emissions trading systems forms part of a general meta-game on the burden-sharing of global emission control. Thus, the assessment of a linking option might be determined more by questions of fairness in the level of effort than by who will become net seller or buyer. From this point of view, a UNFCCC-administered agreement on international burden-sharing that takes into account the principle of comparable but differentiated efforts (UNFCCC, 2008) would eliminate a potential barrier to linking trading systems.

4. Regulatory implications Several authors have emphasized the regulatory challenges involved in the linking of regional cap-and-trade systems (Egenhofer, 2007; Victor, 2007). Below, we argue that design differences between to-be-linked trading systems are problematic only insofar as they imply a conflict over policy priorities. In addition, we discuss the implications of the loss of regulatory flexibility which each system incurs due to linking.

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4.1. Conflicting policy objectives To ensure the proper functioning of a linked system, some basic design features require harmonization; namely the provisions for monitoring, reporting and verification (MRV) of emissions, enforcement and penalty mechanisms, and the registry system (e.g. Sterk et al., 2006; Jaffe and Stavins, 2007; Mace et al., 2008). Beyond these fundamentals, linking will generally lead to a ‘mixing’ of system designs (Tuerk et al., 2009a), which may create a conflict if the resulting ‘mix’ happens to be too much out of line with the system’s original policy priorities. To illustrate this point, consider first the following four policy objectives which can be associated with an ETS: 1. Reducing GHG emissions: The very reason why cap-and-trade systems are introduced is to achieve a specific emission reduction. 2. Supplementarity: Four reasons are commonly cited for why a certain share of abatement should be realized at home (see, e.g., Westskog, 2002): (i) the need to demonstrate leadership, particularly vis-à-vis developing countries; (ii) the co-benefit of reduced air pollution; (iii) the co-benefit of reduced dependency on fossil fuel imports; and (iv) the co-benefit of creating an internationally competitive domestic industry in the field of low-carbon technology. 3. Inducing technological change: Only a stable and sufficiently high price of carbon is expected to induce (via R&D) the technological change that is essential for making climate stabilization economically feasible (Edenhofer et al., 2006). 4. Cost minimization: Overall costs associated with climate policy, particularly reduction targets, should be kept at a minimum. These – and possibly more – policy objectives can be promoted by choosing the design parameters of an ETS appropriately. For instance, consider the following five design features,8 and how their setting relates to the above policy objectives: 1. Emission reduction target: A more stringent reduction target increases the amount of required overall abatement and thus increases the permit price. 2. Price cap: This places an upper limit on the permit price and, thereby, also on total abatement costs. On reaching the price cap level, additional allowances are issued, leading to more emissions than originally envisaged (Jacoby and Ellerman, 2004). Clearly, the lower the price cap, the more likely its activation becomes. 3. Price floor: A price floor, by contrast, guarantees a minimum price for emission allowances. If this mechanism is triggered, which is more likely if the price floor is set to a high level, the government contracts the volume of marketable allowances, thus leading to less emissions than originally envisaged (Grubb, 2009). 4. Restrictions on credits: A limit on importable credits – in particular from the CDM – implies that relatively more abatement has to be achieved at home, which can raise the allowance price.9 5. Borrowing: We assume that the possibility of borrowing permits from future commitment periods induces a downward pressure on current prices. There are concerns, however, about a possible relaxation of future reduction targets, if – due to heavy borrowing in early periods – permit prices eventually rise to unacceptably high levels (Boemare and Quirion, 2002; Australian Government, 2008, pp.8–15). Table 1 summarizes the functional relationships between policy objectives and ETS design features, and highlights how the setting of some parameters necessarily involves a trade-off between the

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TABLE 1 Functional relationship between ETS design parameters and policy objectives

POLICY OBJECTIVES

ETS PARAMETERS Reduction

Level of

Level of

Credit (e.g. CDM)

target

price cap

price floor

import restriction

Borrowing

Promote emission

Ambitious

High level

High level

Indifferent (restrict

reduction

target

Restrict

if concerns about additionality)

Promote domestic

Indifferent

Indifferent

Indifferent

Restrict imports

Indifferent

Ambitious target

High level

High level

Restrict imports

Restrict

Modest target

Low level

Low level

Allow unrestricted use

Allow

abatement Induce technological change Minimize costs

Note: ETS design parameters (vertical columns) and policy objectives (horizontal rows). The presence of bold and italic type within the same column signals an inherent goal conflict in the setting of the respective parameter: for example, credit imports should be restricted to promote domestic abatement, but should remain unrestricted in order to lower abatement costs.

different policy objectives. For instance, a price cap helps to confine abatement costs, but may compromise the stimulation of technological change. If, and at what level, the price cap will eventually be set becomes a question of which of the two involved policy goals prevails. Therefore, implementing an ETS and setting its design parameters forces policy-makers to prioritize (at least implicitly) some policy objectives over others. This issue comes into play whenever two systems with different policy priorities engage in linking: when establishing the link, the overall system’s properties will become a ‘mix’ of the single system’s features. This ‘mix’, however, might undermine the original priority ranking of one or both of the regions. For example, consider a system with a high priority on cost minimization and thus without restrictions on CDM-like credit imports, and with a price cap at some intermediate level. Another system, the prospective linking partner, puts a higher priority on substantial emission cuts and therefore has no price cap, and some quantity restriction on CDM credits. If the two systems engage in joined trading without further provisions, the newly established linked system – de facto – features a global price cap and an unrestricted inflow of CDM credits. Thus, one linking partner would experience a dilution of its original policy objectives, which might induce it to opt out of the linking project.

4.2. Reduced control and regulatory flexibility From the point of view of the single country or region, linking implies that part of the formerly exclusive control and authority over the carbon market is ceded (Jaffe and Stavins, 2008). Smaller schemes, for instance, will experience a one-sided convergence towards the larger partner’s permit price. But even smaller systems may strongly affect the overall market behaviour by exporting some of their ETS design features (‘contagiousness’): for example, price caps in one system automatically propagate throughout the entire linked market. Moreover, under joined trading, price shocks originating in one region will affect the entire market, thus increasing the domestic economy’s exposure to external factors (McKibbin et al., 2008).10

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Especially in view of the latter, the question arises whether a joint regulation of the carbon market can at all times optimally serve the individual needs of each linking partner. In fact, inasmuch as their economies remain idiosyncratic, it might be preferable for each country to be able to respond to temporary shocks (e.g. business cycle related) independently, for example through an adaptive setting of price corridors, or a temporary modification of banking and borrowing rules.11 Somewhat analogous to the theory of optimum currency areas (Krugman and Obstfeld, 2000), linking involves a trade-off between increased overall efficiency and reduced leeway for regulatory interventions. On economic grounds, the net effect can be expected to be positive whenever the expected efficiency gains are large and price shocks arrive to some extent simultaneously, which would be the case if the economies of the two prospective linking partners, in particular their emission-intensive energy sectors, are already strongly integrated. As a general point, the imminent concerns about the loss of full domestic control over the carbon market imply that adequate joint governance arrangements and mutual trust constitute an important prerequisite for any linking project (on institutional arrangements when linking, see Mehling and Haites, 2009; Tuerk et al., 2009a).

5. Policy application: benefits and disbenefits of a transatlantic link Along the lines of our analytical framework, we now discuss the prospects of a link between the EU ETS and a future US cap-and-trade system as defined by the Waxman–Markey (WM) proposal.12 For brevity, we do not exhaustively address all of the issues mentioned above, but instead highlight the key points. First of all, perhaps the most high-profile question regarding the expected efficiency gain from linking remains largely undeterminable, given the lack of quantitative studies on the subject. However, the widespread assumption (e.g. Weyant and Hill, 1999; Viguier et al., 2003) that the marginal abatement cost curve of the EU is steeper than that of the USA, would imply that such gains can indeed be expected.13 On the other hand, assuming a higher allowance price in the EU ETS, the resulting shift of abatement from the EU to the USA would also lead to a redistribution of the co-benefits from abatement in the same direction. One could then point to the EU’s currently high tolerance towards large CDM credit imports as an indicator that this would nevertheless be acceptable. Also, additional policy objectives such as reduction of air pollution are often addressed by complementary policy instruments, e.g. the IPPC Directive in the European Union (European Union, 2008). As a positive economic effect, linking can be expected to help climate policy to consolidate its status as ‘irreversible’ in both regions, spur additional R&D, and thus improve the dynamic efficiency of climate policy. However, specific numbers are – again – elusive. As the final aspect on the economic side, the benefits from increased market liquidity do not loom large in view of each system’s large individual size. The second aspect, the political implications of linking, might very well be the category where the largest benefits from a transatlantic link would materialize. A joint commitment by the two largest integrated economic areas in the world would send a strong political signal, and could become a first step towards a closer cooperation with major developing countries. In fact, an EU–US carbon market could serve as the test case for the engagement of China, India and other developing countries, which remains the sine qua non for resolving the problem of global climate change. In addition, appeasing concerns about unfair competitive conditions by harmonizing carbon prices across the fairly close trading partners EU and the USA will certainly boost the general acceptance of carbon pricing in both regions, even if the actual economic relevance may be less certain.

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Third, in terms of regulatory issues14 the EU ETS design reflects a strong preference for achieving the environmental target, and abstains from price control mechanisms that may alter the cap. The WM proposal, by contrast, places a higher weight on avoiding excessive costs, allowing – under certain conditions – the auctioning of additional allowances from a reserve pool. Another key difference concerns the treatment of credits from offset programmes: the WM proposal foresees the use of international credits from measures reducing emissions from deforestation and forest degradation (REDD), which is ruled out in the EU ETS. Also, MW uses a discount factor of 20% in the accounting of all credits. From the EU’s point of view, accepting a price control and REDD credits would constitute the most controversial issue, while the USA might be reluctant to accept the EU’s 100% recognition of credits. Finally, given the clearly stated desire of EU policy-makers to link the EU ETS to other schemes (e.g. Steinmeier and Gabriel, 2008; EU Commission, 2009), the loss of regulatory control is apparently not seen as a drawback in the EU. This contrasts with the fact that the limited integration of the two economies – especially of their energy sectors – would instead suggest the retention of full domestic regulatory control over the carbon market. To sum up, the major trade-off in a link between the EU and a Waxman–Markey US ETS resides in the benefits of the political signal, uncertain but possibly positive efficiency gains, enhanced domestic acceptance of carbon pricing, and reinforced credibility of climate policy on the one hand. On the other hand, drawbacks include the loss of regulatory control, as well as the potential conflict over differences in system design and policy priorities. In fact, the major benefits might already materialize once the credible prospect of a transatlantic link, perhaps by 2015–2020, has been created.15

6. Conclusions By systematically going through all the major issues involved in the linking of regional cap-andtrade systems,16 we have identified a framework for assessing linkages from the policy-makers’ point of view. Table 2 provides an overview of the potential benefits and disbenefits. When considering a specific linking proposal, policy-makers will have to quantify and weigh up the impact of each issue to determine the net effect, and whether to link or not to link their cap-andtrade system. As an illustration, we considered the case of a link between the EU ETS and a US cap-and-trade system along the lines of the Waxman–Markey proposal. In the face of limited knowledge about the prospective efficiency gains and negligible benefits from the increased market size, we identified the political signal for international and domestic climate policy and the effect as commitment mechanism as the most tangible benefits of a transatlantic link. On the other side, differences in system design signal a potential incompatibility in the priority ranking of cost containment versus environmental effectiveness. Also, the absence of a close integration of the two economies suggests that keeping the right of unrestricted regulatory intervention on the home market might entail some value. These trade-offs resemble those involved in the deliberation about common currency areas, where increased economic efficiency (reduced transaction costs and exchange rate uncertainty, higher price stability) and the wider political benefits are weighed against the costs of ceding discretionary regulatory control over the domestic economy. In the case of the single European currency, economists arrived at a negative verdict, denying that the European economy qualifies as a so-called optimum currency area (Krugman and Obstfeld, 2000). However, the expected political benefits turned out to be of overriding importance, and the Euro was eventually adopted.

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TABLE 2 Potential benefits and disadvantages of linking regional cap-and-trade systems, as seen from the point of view of domestic policy-makers Potential benefits

Potential disbenefits

Economic

Economic

•

• Loss (or negligible gain) from linking due to

Short-term efficiency gains: Gains from trade (magnitude uncertain) Improved liquidity (smaller schemes)

•

pre-existing distortions

• Adverse distributional impacts:

Reduced volatility

Loss of co-benefits

Dynamic efficiency gains:

Regions may expand emission caps to increase

Enhanced credibility of commitment

permit sales Exposure to other regions’ market shocks

Political

Political

• Signalling of multilateral commitment

• Risk to endorse reduction targets that are inconsistent

•

Enhanced domestic policy acceptance

with a fair global burden-sharing Regulatory

• Possible violation of prioritized policy objectives due to incompatible designs

•

Reduced regulatory leeway

To inform the assessment of prospective bilateral linkages, economic modelling exercises on the expected changes in regional welfare will be highly desirable. The political dimension will generally be much more difficult to judge in an objective manner, and depends on the overall state of climate policy – e.g. whether or not a global carbon trading system is seen as an important long-term target of climate policy, as emphasized by ICAP (2007) and the EU Commission (2009). Fixing mid- to long-term cap schedules prior to linking will help to stabilize expectations and place subsequent negotiations over cap adjustments on a transparent basis. Finally, with regard to the technical issue of regulatory compatibility, a rich body of literature is now emerging, which can readily inform assessments of linking (e.g. Tuerk et al., 2009a, and other articles in this Special Issue). In summary, while linking may appear to be a straightforward issue at first sight – enabling international trade in allowances should be of benefit to all – it turns out that a number of sometimes complex caveats have to be taken into account. Careful and case-specific analysis will be required to determine whether the balance of evidence combined with wider normative assumptions warrants a decision to link or instead not (yet) link two trading systems.

Acknowledgements We would like to thank Steffen Brunner, Michael Jakob, Andreas Tuerk and the anonymous Climate Policy referees for helpful comments and discussions.

Notes 1.

For detailed descriptions of the emerging regional systems, see the case studies in this Special Issue of Climate Policy and Tuerk et al. (2009b).

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2.

3.

4.

5. 6.

7. 8.

9. 10. 11. 12.

13. 14. 15.

16.

In this article, we only consider direct bi- and multilateral links between cap-and-trade systems with binding absolute targets. A bilateral link means that two emissions trading systems mutually accept their allowances for compliance (Haites and Mullins, 2001). We do not deal with voluntary schemes or systems based on intensity targets. Also, we assume that such links occur in absence of a government-level trading scheme such as the trading scheme set up under the Kyoto Protocol. For an overview and analysis of different carbon market architectures, see Flachsland et al. (2009). OECD countries and other major emitters adopt the emission reduction targets proposed by the EU, i.e. 30% reductions below 1990 for developed countries (on aggregate) by 2020, and 20% reduction below 2020 baseline emissions for major developing countries. For example, the Swiss system covers only 3 Mt of annual emissions, and the New Zealand scheme is expected to cover 62 Mt annually, as compared to the roughly 2,000 Mt annual emissions of the EU ETS (Carbon Market Data, 2009; Jotzo and Betz, 2009; Point Carbon, 2009a). This bears some analogy with the ‘importing price stability’ argument in the theory of optimum currency areas (see, e.g., Krugman and Obstfeld, 2000, p.613). From an economic point of view, the competitive distortions caused by asymmetric carbon prices appear to affect only few sectors, which account for a relatively small share of GDP (e.g. Reinaud, 2005; McKinsey and Ecofys, 2006; Hourcade et al., 2007; Morgenstern et al., 2007); the reason being that carbon is only one among several factors of production for which prices differ. Thus, a significant impact on investment decisions across two capped economies appears unlikely – in particular if the permit prices of the cap-and-trade systems are not too different. RGGI has an estimated overallocation of 17%, i.e. actual emissions in 2008 were well below the cap (Point Carbon, 2009b). The list of design parameters is not meant to be exhaustive. Banking, for example, constitutes another important design feature, but banking does not raise the issue of trade-offs in scheme design, because it supports all of the policy objectives discussed here. Credit imports may also be restricted for concerns over additionality (Schneider, 2007; Wara, 2007), which is not discussed further here. In fact, McKibbin et al. (2008) warn that economic losses due to imported carbon market volatility might erode its political support, possibly discrediting the entire approach. The current state of research does not allow for a definite conclusion on whether or not such features are needed for an optimal functioning of greenhouse gas cap-and-trade systems – a priori, however, it does not seem implausible. The WM system proposed on 31 March 2009 would commence in 2012 and cover ~68% of US GHG emissions in the initial year 2012 (rising to a share of 85% in US GHG emissions in 2016), with a cap of 4,770 MtCO2e. The cap would decline to 20% below 2005 emission levels by 2020, and, eventually, 83% below 2005 emissions by 2050. Covered entities can make up to 15% of their needed allowances by means of domestic offsets (including LULUCF activities), and another 15% by international offsets, but both are subjected to a 20% discount factor. See Sterk et al. (2009) and Point Carbon (2009c) for more details. Of course, pre-link carbon price asymmetries and corresponding efficiency gains from linking are not only determined by the shape of marginal abatement cost curves, but also by the emission reduction targets. See Sterk and Kruger (2009) for a detailed analysis of regulatory issues when linking the EU ETS to the system proposed by Waxman–Markey. Given the possibility of banking, markets will price in expectation of future linkages. This reaffirms the need for actively managing market expectations on future political developments, in order to avoid the volatility induced by policy uncertainty over linkages. Our analysis omitted two other economic implications of linking, both relating to the economic consequences of adjustments in allowance prices when linking. First, a changing regional allowance price might affect the rate of carbon leakage, depending on the affected industries’ elasticity of leakage with respect to the carbon price (Jaffe and Stavins, 2007). Second, allowance price changes will translate into adjustments of commodity (e.g. fuel) prices, the value of freely allocated allowances, as well as auctioning revenues, with corresponding distributional implications.

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Linking existing and proposed GHG ETS in North America 373

■ research article

Linking existing and proposed GHG emissions trading schemes in North America ERIK HAITES1*, MICHAEL MEHLING2 1 2

Margaree Consultants Inc, 120 Adelaide Street West, Suite 2500, Toronto, ON M5H 1T1, Canada Ecologic Institute, 1630 Connecticut Avenue, NW, Suite 300, Washington, DC 20009, USA

A number of greenhouse gas emissions trading schemes have been implemented or proposed for Canada, the USA and Mexico. Links between those schemes make sense, given the close economic ties between the countries. All of the existing and proposed schemes, except Alberta’s, include provisions for unilateral use of credits and/or allowances from other schemes with quantity and qualitative restrictions. A federal scheme in the USA is likely to pre-empt state schemes, with the possible exception of a few states with more stringent schemes, especially if states are given a role in the federal scheme. In Canada, provinces that want – and are able – to establish that their schemes are equivalent to the federal scheme could continue to operate. Canada will have to modify its proposed scheme to achieve its expressed desire of linking with regulatory-based emissions trading schemes in the USA and Mexico. Keywords: Canada; carbon markets; emissions trading schemes; linking; Mexico; NAFTA; USA Nombre de systèmes d’échange de quotas de gaz à effet de serre ont été mis en place ou sont proposés pour le Canada, les Etats-Unis et le Mexique. L’association de ces systèmes semble logique, étant donnés les liens économiques étroits entre ces pays. Tous les systèmes, existants ou proposés, à part ceux de l’Alberta, incluent des provisions pour l’utilisation unilatérale de crédits et/ou quotas provenant d’autres systèmes, sous réserve de conditions quantitatives et qualitatives. Il est probable qu’un système fédéral aux Etats-Unis soit à l’origine d’autres systèmes, à l’exception éventuelle de certains états ayant des systèmes plus rigoureux, surtout si les états sont pourvus d’un rôle dans le système fédéral. Au Canada, les provinces désireuses – et capables – de démontrer l’équivalence de leurs systèmes au système fédéral pourraient continuer à fonctionner. Le Canada devra modifier sa proposition de système pour réaliser son désir manifeste d’établir un lien avec des systèmes d’échange d’émissions réglementaires aux EtatsUnis et au Mexique. Mots clés: ALÉNA; Canada; établissement de liens; Etats-Unis; marchés du carbone; Mexique; systèmes d’échange de droits d’émissions

1. Introduction The USA was, until recently, the largest emitter of greenhouse gases, accounting for over 15% of the global total, while Canada ranks about tenth with almost 2% of global emissions, and Mexico follows with roughly 1.5% of global emissions.1,2 Canada and the USA have higher per capita emissions than Mexico, while Mexico is experiencing a higher growth of its economy, its population, and therefore its emissions. Vulnerability to climate change impacts is highest in Mexico, and lowest in Canada (Craik and DiMento, 2009). Canada and Mexico are Parties to the Kyoto Protocol, but the USA is not. Canada has a national emissions limitation commitment under the Protocol, although this commitment is unlikely to be met. Mexico has not entered into any emissions limitation commitments. ■ *Corresponding author. E-mail: [email protected] CLIMATE POLICY 9 (2009) 373–388 doi:10.3763/cpol.2009.0622 © 2009 Earthscan ISSN: 1469-3062 (print), 1752-7457 (online) www.climatepolicy.com

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All three national governments have announced various climate change initiatives, including market-based approaches such as emissions trading. Several proposals for emissions trading schemes have been introduced in the US Congress, but none has been passed into law. The Canadian government has announced an emissions trading scheme for large emitters to begin in January 2010. Mexico has announced plans to implement a binding cap on emissions from cement and oil refining and to launch emissions trading for these sectors by 2012.3 A number of US states and Canadian provinces have responded to the slow pace of national action by implementing or planning greenhouse gas emissions trading schemes on their own, or in groups. Regional cooperation across national borders is common due to common geographical features, close economic ties, and shared political institutions; it has also extended into the area of climate policy (Betsill, 2007), where many of the impacts associated with climate change are regional in scope, and where divergent approaches to greenhouse gas mitigation might favour industrial relocation (‘leakage’) due to open market access rules under the North American Free Trade Agreement (NAFTA). In many cases, north–south economic links between neighbouring states and provinces are even stronger than east–west links within the same country. Thus, regional climate policy initiatives by US states have attracted Canadian provinces and Mexican states as observers and participants. If all of the proposed schemes are implemented, overlaps between the national and the state/ provincial schemes will need to be addressed. Mexico’s emissions trading initiatives are limited to the plan to establish binding emissions caps with trading for cement and oil refining by 2012 and informal statements expressing a desire to eventually become part of a North American emissions trading scheme. Sufficient detail on these possible future schemes to assess their potential to link with other North American schemes is not available. Hence, Mexico is not included in the following analysis except to the extent that US and/ or Canadian schemes might accept allowances from capped sectors or other trading schemes in Mexico. This article examines possible links between US and Canadian emissions trading schemes and between those schemes and schemes in other countries.4 Linking allows the achievement of an aggregate emissions cap at lower cost by increasing the range of available mitigation options; moreover, a link creates a larger, more liquid, market for the allowances of the linked schemes (Edenhofer et al., 2007; Anger et al., 2009; Mehling and Haites, 2009). Yet linking also poses certain risks if the underlying schemes are ‘incompatible’, that is, if they differ significantly in key design features (Jaffe and Stavins, 2007). Such features include price caps, non-compliance penalties, borrowing, banking, allowance life, nature (absolute or intensity) of the emissions caps, and length of the compliance period (Baron and Bygrave, 2002; Bodansky, 2002; Haites 2003; Ellis and Tirpak, 2006; Springer et al., 2006; Sterk et al., 2006; Mace et al., 2008). To assess the prospects for links between North American emissions trading schemes, the next section sets the context by reviewing greenhouse gas emissions and climate change initiatives at the national and state/provincial level in the USA and Canada. The existing and proposed emissions trading schemes are described in Section 3. Overlaps between the national and the state/provincial schemes are discussed in Section 4. Section 5 discusses potential links by US and Canadian schemes with each other and with other schemes. Conclusions are drawn in Section 6.

2. Background US greenhouse gas emissions have increased at an average annual rate of 0.95% between 1990 and 2005. The states with the largest emissions in 2003 were Texas (782 MtCO2e), California (453), Pennsylvania (301), Ohio (299), Florida (271), Indiana (269), Illinois (268), New York (244),

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Michigan (212) and Louisiana (210).5 The list includes the most populous states – California, Texas, New York, Florida, Illinois, Pennsylvania, Ohio and Michigan – as well as states that rely heavily on coal-fired generation – Indiana (95%), Ohio (87%), Michigan (61%) and Pennsylvania (57%) – and states with large oil and gas and chemical industries – Texas and Louisiana. Twenty states have greenhouse gas emissions targets. The most common targets for 2020 are 1990 emissions or 10% below 1990 emissions. Of the ten largest emitters, only California, Florida, Illinois and New York have emissions targets. Canada’s greenhouse gas emissions reached 721 MtCO2e in 2006, representing an average rate of growth of over 1.4% per year since 1990.6 Canada’s commitment under the Kyoto Protocol – a 6% reduction from 1990 emissions – requires a reduction of almost 30% from projected emissions. A 30% reduction of domestic emissions for 2008–2012 is not feasible, and the government has indicated that it will not purchase Kyoto units.7 Therefore it is unlikely that Canada will comply with its Kyoto commitment. Alberta (234 MtCO2e in 2006) is the province with the largest emissions, followed by Ontario (190), Quebec (82), Saskatchewan (72) and British Columbia (62).8 Alberta produces most of the country’s fossil fuels, with the remainder coming mainly from Saskatchewan and British Columbia. Ontario’s and Quebec’s emissions are high due to their size – over 40% and over 20% of total population and GDP, respectively. Eight of the ten provinces have an emissions target, but the level of ambition varies widely (David Suzuki Foundation, 2006).

3. Existing and proposed emissions trading schemes Both Canada and the USA have seen the emergence of state and provincial initiatives to establish regional emissions trading schemes (ETS), as well as federal initiatives to establish emissions trading schemes at a national level. This section summarizes those initiatives.

3.1. Membership of regional emissions trading schemes Three regional emissions trading schemes have been launched by the states and provinces: the Regional Greenhouse Gas Initiative (RGGI), the Western Climate Initiative (WCI), and the Midwestern Regional GHG Reduction Accord (MGGA), as shown in Table 1. There is a small amount of overlap in their membership, with Manitoba being a member of both the MGGA and the WCI, Kansas being a member of the MGGA and an observer of the WCI, and Ontario being a member of the WCI and an observer of the MGGA. In 2001, the premiers of the five eastern provinces (Quebec, New Brunswick, Nova Scotia, Prince Edward Island, Newfoundland and Labrador) and governors of six New England states (Maine, New Hampshire, Vermont, Massachusetts, Rhode Island and Connecticut) adopted a climate change action plan with the goal of reducing regional greenhouse gas emissions to the 1990 level by 2010 and by at least 10% below the 1990 level by 2020. Although climate change action has been discussed at their annual meetings since 2001, no emissions trading scheme involving these 11 jurisdictions has yet been proposed.

3.2. Emissions trading schemes 3.2.1. Alberta Alberta implemented an emissions trading scheme that took effect on 1 July 2007.9 Industrial facilities that emit more than 100,000 tonnes of greenhouse gases per year must reduce their emissions intensity by 12%. They can comply by reducing the emissions intensity of their operations,

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TABLE 1 Members and observers of the regional emissions trading schemes Regional GHG

Western Climate Initiative

Midwestern Regional GHG

Initiative (RGGI)

(WCI)

Reduction Accord (MGGA)

Members

Members

Members

Connecticut

Arizona

Illinois

Delaware

British Columbia

Iowa

Maine

California

Kansas

Maryland

Manitoba

Manitoba

Massachusetts

Montana

Michigan

New Hampshire

New Mexico

Minnesota

New Jersey

Ontario

Wisconsin

New York

Oregon

Observers

Rhode Island

Quebec

Indiana

Vermont

Utah

Ohio

Observers

Washington

Ontario

Pennsylvania

Observers a

South Dakota

New Brunswick

Alaska

Ontario

Colorado

Quebec

Idaho Kansas Nevada Saskatchewan Wyoming

Note: a The Mexican states of Baja California, Chihuahua, Coahulia, Nuevo Leon, Sonora and Tamaulias are also observers. Sources: Initiative websites, at www.rggi.org/states; www.westernclimateinitiative.org/View_all_Observers.cfm; www.midwesterngovernors.org/govenergynov.htm; and Pew Center on Global Climate Change, www.pewclimate.org/what_s_being_done/in_the_states/regional_initiatives.cfm.

buying credits for emission reductions or sink enhancements in Alberta, or contributing C$15/ tCO2e to the Climate Change and Emissions Management Fund.10 The Alberta scheme has no provisions for a link of any kind to any other emissions trading scheme. The intensity target, price cap and offset credits, which do not have an additionality requirement, are likely to deter other schemes from linking to the Alberta scheme.

3.2.2. Regional Greenhouse Gas Initiative The Regional Greenhouse Gas Initiative (RGGI), which came into effect on 1 January 2009, covers CO2 emissions by electricity generators with a capacity of 25 MW or more.11 The cap is constant from 2009 through to 2014, and then declines by 2.5% per year to achieve a reduction of 10% by 2018. Most states plan to auction all of the allowances.

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Emission reductions relative to the reference case will be approximately 5 MtCO2 in 2012 and 15 MtCO2 in 2018.12 Prices have been projected to rise gradually from US$2 in 2009 to US$3.75 in 2018. The clearing price for the first three quarterly auctions increased from US$3.07 per allowance in September 2008 to US$3.51 in March 2009.13 Participants are allowed to use credits from specified offset projects in eligible states for up to 3.3% of their compliance obligation.14 If the allowance price averages more than US$7, the limit on credit use rises to 5%. If the allowance price averages more than US$10, the limit on credit use rises to 10% and credits can be units issued by the UNFCCC or an approved emissions trading scheme outside the USA.15 The RGGI does not include a provision for a bilateral link with another emissions trading scheme. The RGGI, then, has a unilateral link with the mechanisms under the UNFCCC and with any other approved emissions trading scheme if its allowance price is above US$10. That link, of course, would not be used unless the price of RGGI allowances approached the price of the eligible units, such as CERs, ERUs and EUAs.16 Adjusted for inflation, those units currently have prices of US$11–15/ton.17 The multi-year compliance period would be likely to deter schemes with annual compliance from establishing a unilateral link with the RGGI.18

3.2.3. Western Climate Initiative States and provinces that are partners in the Western Climate Initiative (WCI) have agreed to reduce their greenhouse gas emissions to 15% below their 2005 level by 2020.19 A recommended design for an emissions trading scheme was released in September 2008 (Western Climate Initiative, 2008). The scheme, to be launched at the start of 2012, will have annual emissions caps and a 3-year compliance period. Initially, sources with annual emissions over 25,000 tCO2e will be covered. Beginning in 2015, coverage will be extended to the emissions associated with fossil fuels sold for transportation, heating and other purposes. At least 10% of the allowances will be auctioned, rising to 25% by 2020. Allocation rules for free allowances may be coordinated to address competitiveness concerns. Participants will be allowed to use credits from WCI offsets and allowances from other greenhouse gas emissions trading schemes to a maximum of 49% of the emission reductions from 2012 to 2020.20 CERs can be used, although additional criteria may be imposed to ensure that they are comparable to WCI offsets. Credits for emission reductions by developed country sources covered by the WCI will not be eligible.21 In summary, the WCI proposes unilateral links with the CDM, possibly subject to additional criteria, to JI for credits from sources not covered by the WCI, and to other, unspecified, emissions trading schemes. The WCI is interested in bilateral links with government-approved cap-andtrade schemes, but has not agreed on criteria for such links. The 3-year compliance period might deter links to schemes with annual compliance obligations, but not to other schemes, such as the RGGI and MGGA, with similar compliance periods. Point Carbon reports that a WCI link to the RGGI could drive up the price of RGGI allowances (Point Carbon, 2008).

3.2.3.1. BRITISH COLUMBIA British Columbia passed legislation in 2008 to enable implementation of a greenhouse gas emissions trading scheme in the province (British Columbia, 2008).22 The detailed design of the scheme, expected to follow the WCI design, would be implemented through regulations adopted under the law. The regulations can stipulate units from other schemes that are acceptable as recognized compliance units (RCUs).23

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British Columbia has implemented a carbon tax of C$10/tCO2, rising to C$30/tCO2 in 2012. Large sources in British Columbia covered by the WCI will pay the carbon tax on the fossil fuels they purchase. To avoid double regulation of these emissions, the tax on the fossil fuels consumed by those entities could be refunded.24

3.2.3.2. CALIFORNIA California’s Global Warming Solutions Act of 2006 set an enforceable target of reducing the state’s greenhouse gas emissions to 1990 levels by 2020.25 It makes the California Air Resources Board (CARB) responsible for adopting the measures needed to achieve the target, and allows for the use of market mechanisms. The draft plan for meeting the targets includes an emissions trading scheme linked with the WCI scheme (California Air Resources Board, 2008). The plan was approved in December 2008.26

3.2.3.3. ONTARIO AND QUEBEC Ontario and Quebec signed a Memorandum of Understanding in June 2008 to work on the development of a cap-and-trade system for greenhouse gas emissions that could be in place as early as 2010 (Ontario, 2008). Since both are partners in the WCI, the design of the scheme is likely to be similar to that of the WCI.

3.2.4. Midwestern Regional Greenhouse Gas Reduction Accord In November 2007, the participating states and provinces agreed to establish greenhouse gas reduction targets and develop a market-based and multi-sector cap-and-trade scheme to help achieve the targets.27 Draft recommendations for the design of the cap-and-trade scheme propose that it should cover emissions associated with the generation of the electricity used in the region, industrial processes and fuel consumption and, possibly, transportation fuels and fuels used in buildings in the participating jurisdictions (Midwestern Greenhouse Gas Reduction Accord, 2008). Allowance distribution would be a mix of free, low fixed-price, and auctioned allowances. There would be a 3-year compliance period. Limited borrowing is recommended; up to 2 years after the compliance deadline, with some ‘interest’ payable on borrowed allowances. A regional offset programme is recommended, limited initially to reductions achieved in participating jurisdictions, but evolving to include the CDM and JI. The Advisory Group recommends that the MGGA cap-and-trade scheme should seek to link to the RGGI, the WCI, the EU Emissions Trading Scheme (EU ETS), and other mandatory greenhouse gas trading schemes as appropriate. Harmonization with, and potential incorporation into, a future federal scheme, while ensuring the ability to operate independently if necessary, is a design criterion for the MGGA scheme. The 3-year compliance period might preclude links to schemes with annual compliance obligations, such as the EU ETS, but not to other schemes – e.g. RGGI and WCI – with similar compliance periods. The borrowing provision might also deter schemes from linking with the MGGA. If use of the CDM and JI is allowed, this would create an indirect link with many other schemes that also accept these units.

3.2.5. Florida The Florida Climate Protection Act authorizes the Department of Environmental Protection to develop an electric-utility greenhouse gas cap-and-trade scheme for legislative approval. The Governor’s Action

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Team on Energy and Climate Change recommended that Florida advocate a strong federal cap-andtrade programme and join one or more of the regional (RGGI or WCI) programmes (Florida, 2008).

3.2.6. Canada Canada is implementing an emissions trading scheme on 1 January 2010 for facilities with emissions over 100 ktCO2 per year (Canada, 2008a). Each facility will have an intensity allocation (tCO2/ unit of output). For an existing facility, the intensity allocation for 2010 will be an 18% reduction from 2006. The intensity allocation then drops by 2% per year through to 2015. For a new facility, the intensity allocation starts in the fourth year of operation, based on data from its third year of operation, and declines by 2% each year. To comply, a facility will be able to: reduce its own emissions; contribute to a technology fund; purchase surplus allowances from other participants; purchase emission reduction credits from non-regulated activities; purchase CDM credits; and use credits for early action. 28 Allowable contributions to the technology fund decline from 70% in 2010 to zero after 2017, and rise from C$15/tCO2e in 2010 to over C$20/tCO2e after 2013. Credits will be issued for emission reductions by non-regulated activities, such as capture of landfill gas to generate electricity. CERs, with the exception of those from forest sink projects, can be used for up to 10% of a facility’s target. In addition to the limited unilateral link to the CDM, Canada will consider linking with state, regional or national regulatory-based emissions trading schemes in the USA. Cooperation on emissions trading with Mexico will also be explored.29 Initially, export of allowances and credits from Canada will not be allowed, so the scope for bilateral links will be limited. The intensity target and price cap (for the first few years) are likely to deter other schemes from establishing a link with the Canadian scheme.

3.2.7. United States of America Bills to regulate greenhouse gas emissions have been introduced in Congress regularly since 1998. Most of the bills include an emissions trading scheme (Paltsev et al., 2008). The bill that has advanced furthest was America’s Climate Security Act (ACSA) (2008) – the Boxer substitute amendment to the Lieberman–Warner bill, which was defeated in the Senate in 2008. While federal initiatives to regulate greenhouse gases are already emerging for 2009, the outcome of those initiatives is largely unknown. A number of variables, including the respective roles of the new president, new chairs for key Congressional committees, Supreme Court decisions, and an endangerment finding by the EPA will determine the nature and scope of a federal emissions trading scheme. (Conference Board of Canada, 2008; Hight and Silva-Chavez, 2008) Due to its influential sponsors, a bill introduced on 15 May 2009 by Henry Waxman and Edward Markey, entitled the American Clean Energy Security Act (ACES) (2009) has a high likelihood of influencing future US climate legislation at the federal level. Several of the recent bills would permit participants to use offset credits and foreign allowances towards their compliance requirements.31 Both the ACSA and the ACES include a limited unilateral link to emission reduction credits and emission allowances from other countries.32 Likewise, both would exclude allowances from the Canadian scheme due to its intensity allocation, and would possibly exclude credits from facilities in Canada and Mexico that compete directly with US facilities. There is no provision in either proposal for a bilateral link with another emissions trading scheme. Many US bills, including the ACSA, include cost-containment provisions such as a price cap.33 Cost-containment provisions would probably preclude a link with another emissions trading scheme. If these provisions keep the price below that in the EU ETS, for instance, it could lead to

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large purchases of US allowances by European entities if the schemes were linked. The result could be a large wealth transfer to the USA due to less stringent emissions reduction targets, which is unlikely to be palatable to the EU (Sterk, 2008). The Canadian price cap could be lower than the US price for several years, so a link with the Canadian scheme is unlikely for that reason, as well as its intensity target.

4. Overlap of national and state/provincial emissions trading schemes If the proposed emissions trading schemes are implemented, the national schemes would overlap with the state/provincial schemes. The potential overlap is likely to be resolved differently in the USA and Canada.

4.1. United States of America The US Constitution provides that federal law will govern in the case of a conflict with state law. Jurisdiction for other complex problems has been shared by the federal and state governments (Litz, 2008). Historically, state and federal governments have shared authority over most areas where climate change action is needed, including air pollution control, energy supply, energy efficiency, transportation, forestry and agricultural policy. A comprehensive national climate change programme, then, is likely to involve a mix of federal and state responsibilities. This is also reflected in the current political discussion, where states with greater climate policy ambitions want to ensure their ability to maintain stringent emission reduction objectives, while other stakeholders are concerned about a legislative patchwork and state interference in federal carbon prices. With respect to emissions trading, Litz and Zyla (2008) recommend a federal scheme that incorporates a role for states. Specifically, they recommend that: Congress should allow states … full or partial control of their federal emissions allowance budgets, the ability to receive allowances for reductions achieved through complementary programs, the ability to petition the federal government to strengthen the program, or the right to opt out of the federal program and into a single more aggressive alternative (Litz and Zyla, 2008, p.7).

At least in part, this recommendation has also found its reflection in the ACES bill, which imposes an initial moratorium on state-based emissions trading schemes, but would allow more stringent obligations at the state and regional level after 2017. If a federal emissions trading scheme is implemented, states likely could implement trading schemes with more stringent requirements for the same sources. Still, this can have undesired consequences. New York, for example, has an emissions trading scheme for SO 2 emissions by electric utilities that applies to the same sources but is more stringent than the national acid rain SO2 trading scheme. This is ineffective, however, since compliance with the state cap leaves sources with surplus federal allowances that they can sell to out-of-state sources (Litz, 2008).34 Thus, a federal scheme could include a role for states, for instance some control over the state allowance budget, as is already the case for the NOx emissions trading scheme. That would be a more effective way of addressing their interests than implementing state schemes in addition to the federal scheme (Litz, 2008). States also have the option of retiring federal allowances, although this can entail a financial disincentive for states that would have otherwise been able to sell the allowances; a conceptual proposal therefore calls for creation of a federal allowance pool from which allowances could be retired if states can prove these represent additional emissions reductions

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(Bianco et al., 2009). The USA, then, is likely to have a federal scheme, a federal scheme with some more stringent state schemes, or several regional/state schemes.

4.2. Canada The national emissions trading scheme is being implemented under the Canada Environmental Protection Act (CEPA). CEPA allows equivalency agreements with provincial governments. When an equivalency agreement is approved, the federal regulations are suspended, so that only the provincial regime applies. The federal government has indicated that it will seek to establish equivalency agreements with provincial governments (Canada, 2008a, p.iii). The result would be provincial schemes in provinces that want, and are able, to establish that their schemes are equivalent to the national scheme, and a ‘national’ scheme in the other provinces. It is not clear whether equivalence can be established on the basis of similar design, comparable results, or either. Alberta adopted an intensity design similar to the proposed national scheme, in part, to facilitate establishing equivalence. British Columbia, Ontario and Quebec are committed to absolute caps, and would need to demonstrate comparable results, if that test of equivalence is allowed. The federal government plans to move from emission-intensity targets to fixed emission caps, taking into account developments in other countries, especially the USA (Canada, 2008a, p.21). When, and if, the national scheme moves to an absolute cap, some of the provincial schemes might need to change or lose their equivalency agreements. As a result, the mix of schemes could change over time.

5. Prospects for linking US and Canadian emissions trading schemes Given the uncertainty surrounding the implementation of possible national and regional emissions trading schemes, the prospects for linking are best discussed for different scenarios. For the USA, linking with foreign schemes is considered for the following scenarios: (1) a federal scheme only, (2) a federal scheme together with one or more state schemes, and (3) multiple regional schemes. For Canada, linking with foreign schemes is considered for the following scenarios: (1) a federal scheme only, (2) a federal scheme and one or more provincial schemes, and (3) a revised federal scheme with a link to a federal scheme in the USA. For both countries, scenarios (2) and (3) also require the observance of constitutional constraints placed on sub-state governments to engage in foreign relations and build sub-national institutions (Kysar and Meyer, 2008).

5.1. Linking scenarios for the USA 5.1.1. A federal scheme only A federal emissions trading scheme would probably establish a declining absolute cap, possibly with some state control over their allowance budgets, with annual compliance, would permit the use of foreign allowances and credits subject to quantitative and qualitative restrictions, and would include cost-containment provisions such as a price cap. America’s Climate Security Act (ACSA), for example, restricted foreign credits and allowances to between 15% and 30% of the cap, depending upon the availability of domestic offsets. Foreign credits had to meet the same requirements as domestic offsets. And foreign allowances had to be issued by a foreign government for a scheme with a mandatory absolute cap of comparable stringency to that of the US scheme. The price would have been capped between US$22 and US$30 per allowance in 2012, with an annual adjustment for inflation thereafter. Likewise, the American Clean Energy and Security Act (ACES) would allow international offsets up to approximately 30% of the cap, as well as allowances issued by a national or supra-national foreign government under a scheme that imposes a mandatory absolute cap on

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emissions, and is at least as stringent as the US programme in terms of comparable monitoring, compliance, enforcement, quality of offsets, and restrictions on the use of offsets. Those provisions might allow unilateral links with the Canadian provincial schemes and schemes (sectoral, state or national) in Mexico that have absolute caps and annual compliance periods, the EU ETS, and some CDM, JI or REDD credits.35 A link with Canada’s national scheme, as currently proposed, would be precluded due to its intensity-based cap and likely differences in the price caps. Other schemes probably would not link directly to a US scheme with a price cap, such as the ACSA. Even then, however, acceptance of CDM and JI credits by the US scheme would create an indirect link with most other emissions trading schemes which also accept those credits.

5.1.2. A federal scheme together with one or more state schemes Most bills, such as the ACSA, have not specified the relationship of the federal and state-based schemes. By contrast, the recently proposed ACES scheme imposes a moratorium on state capand-trade schemes between 2012 and 2017; holders of Californian or RGGI allowances can be compensated through auction revenues. After 2017, states will be allowed to implement requirements for covered sources that are more stringent than those under the federal scheme, for instance through application of a multiplier; an approach that is in line with experience in other issue areas (Litz, 2008). The prospects for linking with the federal scheme would be the same as described in the previous section. Since the state schemes would be more stringent than the federal scheme, their linking provisions would presumably be more restrictive – smaller quantities and more stringent qualitative criteria. This might create niche state markets with higher prices for the eligible foreign allowances and credits, but would not change the federal market for imported units.36

5.1.3. Multiple regional schemes If there is no federal scheme, at least three regional schemes are likely to be implemented – the RGGI, the WCI and the MGGA. If there are only a few regional emissions trading schemes, they would probably explore options for direct links. The MGGA Advisory Group, for example, recommends that it should seek to link to the RGGI, the WCI and other mandatory greenhouse gas reduction programmes, as appropriate. All three are likely to have declining absolute caps with 3-year compliance periods. However, they might need to harmonize their borrowing and offset provisions. RGGI participants could purchase credits generated by offset projects in any state with a cooperating regulatory agency, which could include WCI and MGGA partner states. The WCI may approve and certify offset projects located throughout the USA, Canada and Mexico. The RGGI and the WCI share some of the same types of eligible offset projects. Both schemes also propose to allow the use of CDM credits, subject to some restrictions. The RGGI has a more restrictive quantity limit on the use of offsets than the WCI. The offset provisions of the MGGA have not yet been finalized, but the use of CDM and JI credits could be allowed. Thus, the schemes might establish bilateral links with each other. Without direct links, they could be effectively linked to each other and to foreign schemes through their domestic offset and CDM provisions if they agree on the protocols for their respective offset projects.37

5.2. Linking scenarios for Canada 5.2.1. A federal scheme only Canada’s proposed federal emissions trading scheme offers limited scope for linking. A firm will be allowed to use CDM credits, with the exception of those originating from forest sink projects,

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for up to 10% of its target. In addition, Canada will consider linking with state, regional or national regulatory-based emissions trading schemes in the USA and possible schemes in Mexico. Due to its intensity target, the allowances and credits issued by the Canadian scheme are unlikely to be acceptable to any scheme with an absolute cap, including a federal scheme in the USA, RGGI, WCI, MGGA, sectoral schemes in Mexico, and the EU ETS.38 The proposed price cap for the first several years would probably also preclude a link with any other scheme. However, the ability to use CDM credits would create a limited indirect link with many other schemes that also accept some CDM credits.

5.2.2. A federal scheme and one or more provincial schemes Canada’s federal scheme could enter into equivalency agreements with one or more provincial schemes. The most likely provincial schemes are the existing scheme in Alberta and possible schemes in British Columbia, Manitoba, Ontario and/or Quebec; all of which are WCI partners. Thus, the provincial scheme(s) in those provinces would probably be similar to the WCI design. The proposed federal scheme allows trading of allowances and domestic offset credits across Canada. Apart from a limited use of CDM credits, it has no provisions for linking with other emissions trading schemes. The equivalency agreements could presumably include provisions for mutual recognition of allowances and offset credits – bilateral links. For example, a British Columbia scheme could agree to accept federal allowances and credits, and the federal scheme could agree to accept British Columbia allowances and credits, thus linking the two schemes. It could be argued that such a bilateral link, with no quantitative or qualitative restrictions, must be a requirement of an equivalency agreement, otherwise the agreement reduces the market from what it would be under a federal scheme alone. The Alberta scheme has no provisions for a link of any kind to any other trading scheme, and may resist a requirement to link with a federal scheme. The provinces that are WCI partners might prefer not to link with the federal scheme due to its intensity target and price cap. Thus, although it could be argued that a bilateral link should be part of an equivalency agreement, political considerations on both sides could limit such links. Links with schemes outside Canada could be limited as well. The federal scheme, as discussed in the previous section, is unlikely to have a link with any other scheme except for the limited use of CDM credits. Alberta has expressed no interest in linking with any other scheme. The other provincial schemes might wish to have links with other schemes. However, if the equivalency agreement includes bilateral federal–provincial links, it might restrict the links to those in the federal scheme because a foreign link for any provincial scheme would then apply indirectly to all federal and provincial schemes. If the equivalency agreements do not require bilateral links, the result could be a few, largely or completely isolated, emissions trading schemes operating in different provinces. If bilateral links are part of the equivalency agreements, the foreign links are likely to be limited, as in the case of a federal scheme only.

5.2.3. A revised federal scheme linked with a federal scheme in the USA Canada plans to move from emission-intensity targets to fixed emission caps between 2020 and 2025, but might do so earlier to facilitate development of a North American emissions trading scheme. Since one, perhaps the main, reason for changing the design would be to link with a US (and possibly Mexican) scheme, it is safe to assume that the modified Canadian scheme would include additional linking provisions.

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A switch to an absolute cap by the federal scheme could affect provincial schemes with equivalency agreements. Those schemes would need to change in order to be equivalent to the revised federal scheme. That would entail bigger changes for the Alberta scheme, with its intensity targets, than for provincial schemes with absolute caps. Switching to an absolute cap would eliminate one of the barriers to linking with national or regional schemes in the USA. The Canadian price cap mechanism would probably need to be dropped as well. Changes to the US scheme(s) would also be needed. The cost-containment provisions proposed for some national schemes and the 3-year compliance periods proposed for the regional schemes could preclude links to a modified Canadian scheme.

6. Conclusions A number of greenhouse gas emissions trading schemes have been implemented or proposed for Canada and the USA. Links between those schemes, and possible schemes in Mexico, make sense, given the close economic ties between the countries. North–south ties across the national borders are often closer than east–west ties within the same country, and this is reflected in the membership of some of the regional schemes. All of the existing and proposed schemes, except that of Alberta, include provisions for the unilateral use of credits and/or allowances from other schemes. But those provisions all include quantity restrictions and qualitative restrictions; for example that the allowances come from a scheme of comparable stringency. A federal scheme in the USA is likely to replace state schemes, with the possible exception of a few states with more stringent schemes, especially if states are given a role in implementation of the federal scheme. In Canada, provinces that want, and are able, to establish that their schemes are equivalent to the federal scheme could continue to operate. A federal emissions trading scheme in the USA would probably establish a declining absolute cap and permit the use of foreign allowances and credits subject to quantitative and qualitative restrictions. It may also include cost-containment provisions. State schemes might create niche markets with higher prices for the eligible foreign allowances and credits, but would not change the federal market. In the absence of a federal scheme, the regional schemes would be likely to explore linking options beyond their domestic offset and CDM provisions. Any of these structures might allow unilateral links with the Canadian provincial schemes and schemes (sectoral, state or national) in Mexico that have absolute caps and annual compliance periods, the EU ETS, and some CDM, JI or REDD credits, but not the proposed national scheme in Canada. Canada’s proposed federal emissions trading scheme offers limited scope for linking. If the equivalency agreements with the provincial schemes do not require bilateral links, the result could be a few, largely or completely isolated, emissions trading schemes operating in different provinces. If bilateral links are part of the equivalency agreements, the foreign links are likely to be limited, as in the case of a federal scheme only. Canada will have to modify its proposed scheme in order to achieve its expressed desire of linking with regulatory-based emissions trading schemes in the USA and Mexico. It would probably need to adopt an absolute cap and drop the price cap mechanism. But changes to the Canadian scheme would not be sufficient. Some features of a US scheme, such as the cost-containment provisions occasionally proposed for a national scheme or the 3-year compliance periods of the regional schemes, would need to be changed so as to allow bilateral links with a modified Canadian scheme.

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Acknowledgements We would like to express our appreciation to Vicki Arroyo, Johanna Koolemans-Beynen, Vincent Royer, Andreas Tuerk and three anonymous referees for constructive comments on previous drafts. Work on this article was partially supported by funding from Climate Strategies.

Notes 1.

2. 3. 4.

5. 6. 7. 8. 9. 10.

11. 12. 13. 14.

15.

16.

17.

Data from Climate Analysis Indicators Tool (CAIT), World Resources Institute, Washington, DC [available at http:// cait.wri.org] for 2004 CO2 emissions, excluding emissions due to land use, land-use change and forestry (LULUCF) indicate that the USA is the largest emitter, with 21.27% of the global total, Canada ranks 7th with 2.03%, and Mexico ranks 13th with 1.43% of the global total. Emissions of all greenhouse gases including LULUCF for 2000 indicate that the USA is the largest emitter, with 15.47% of the global total, Canada ranks 10th with 1.84%, and Mexico ranks 11th with 1.61% of the global total. The Global Carbon Project (2008) estimates that China’s total fossil CO2 emissions surpassed those of the USA in 2006. Reported by Reuters, Poznan, Poland, 11 December 2008. A scheme that accepts the allowances and credits of another for compliance, but not vice versa, has a unilateral link with that scheme. If each scheme accepts the allowances and credits of the other, they have a bilateral link. Bilateral links between more than two schemes constitute a multilateral link. If two schemes are each linked to another scheme, but not to each other, they are nevertheless indirectly linked. MtCO2e = million tonnes CO2 equivalent. Data from http://cait.wri.org/cait-us.php?page=yearly. Includes all greenhouse gases, but not LULUCF emissions. Excludes LULUCF (see Canada, 2008b). ‘The Government of Canada will not purchase credits or otherwise participate in the carbon market’ (Canada, 2007, p.14). See Canada (2008b, Annex 10) for the source of these figures. See http://environment.alberta.ca/631.html. For the last 6 months of 2007, participants complied by contributing almost C$40 million to the Fund (about 2.6 million tCO2e) and reducing emissions at their own facilities or through emission reduction or sink enhancement projects by about 2.6 million tCO2e. See www.rggi.org/home. There will be approximately 225 participants, and the initial cap will be approximately 188 million tons of CO2. Note these are short tons (2,000 pounds) rather than metric tonnes (2,205 pounds). Updated results, 11 October 2006; see www.rggi.org/about/history/modeling. See www.rggi.org/co2-auctions/results. Eligible project types include: landfill methane capture and destruction; reduction in emissions of SF6; sequestration of carbon due to afforestation; reduction or avoidance of CO2 emissions from natural gas, oil, or propane combustion due to end-use energy efficiency in the building sector; and avoided methane emissions from agricultural manure management. Other project types may be added. The project can be located in any RGGI state or any other US state which has entered into a Memorandum of Understanding with the RGGI states. Price thresholds are based on 2005 and adjusted for inflation. A 12-month rolling average allowance price equal to or greater than US$10 is a ‘stage two trigger event’. In that case, participants may use ‘allowances or credits issued pursuant to any governmental mandatory carbon constraining program outside the United States that places a specific tonnage limit on greenhouse gas emissions, or certified greenhouse gas emissions reduction credits issued pursuant to the United Nations Framework Convention on Climate Change (UNFCCC) or protocols adopted through the UNFCCC process’ (RGGI, 2006). The compliance period is also extended from 3 to 4 years. Certified emission reductions (CERs), emission reduction units (ERUs) and European Union allowances (EUAs) are, respectively, the units of the Clean Development Mechanism (CDM), Joint Implementation (JI), and the EU Emissions Trading Scheme (EU ETS). March 2009 prices for CERs and EUAs are approximately €10–12. When converted and adjusted for inflation from 2005, this is equivalent to about US$11.80–14.15 per short ton.

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18. The administrator of another emissions trading scheme could establish a general account in the RGGI registry to receive RGGI allowances for compliance purposes. 19. See www.westernclimateinitiative.org. 20. Given the broad coverage, offsets are expected to come from soil sequestration, forestry and waste management. The cap on use of offsets translates into a relatively small percentage of overall emissions. 21. For example, JI credits for emission reductions by electricity generators in developed countries will not be eligible. 22. See www.env.gov.bc.ca/epd/climate/. 23. This could include allowances and credits from other WCI jurisdictions, allowances from other emissions trading schemes, and CDM and other credits accepted by the WCI. 24. The WCI design explicitly recognizes that British Columbia may use its carbon tax to address emissions from transportation fuels and fuel use by residential and commercial sources instead of including those emissions in the trading scheme in 2015. 25. See www.arb.ca.gov/cc/cc.htm. 26. Press Release 08-102, 11 December, at www.arb.ca.gov/newsrel/nr121108.htm. 27. See www.midwesternaccord.org. 28. Firms covered by the emissions trading scheme that reduced their greenhouse gas emissions between 1992 and 2006 can apply for credits for the reductions achieved. A maximum of 15 MtCO2 will be allocated, with no more than 5 MtCO2 to be used in any one year. 29. In November 2008, the Canadian government stated that it wished to explore development of a cap-and-trade system with the USA and Mexico once the new administration had taken office. 30. The President could submit draft legislation to Congress. Members of Congress could propose bills. The Supreme Court could order the Environmental Protection Agency to regulate greenhouse gas emissions under the Clean Air Act in response to its April 2007 decision on the issue, and the EPA released a corresponding ‘endangerment finding’ in April 2009, paving the way for regulation. 31. The ACSA, for example, would have allowed (1) credits for domestic offsets from LULUCF activities and emissions not covered by the trading scheme up to 15% of the cap for the year; (2) approved allowances and credits from other countries up to 5% of the cap. Allowances must be issued by a foreign government for a scheme with mandatory absolute tonnage limits on emissions that is of comparable stringency. Credits would have to meet the requirements established by the act for US offsets and could not come from facilities directly competing with US facilities; and (3) international forest carbon credits for up to 10% of the cap for the year. If the limit on a particular category is not exhausted, units from other categories may be used. Unused units in each category can be carried over with no restrictions. 32. Under the ACSA, the use of such credits and allowances would be limited to 5% of the US cap unless there were insufficient domestic or international forest credits to meet their respective caps; under the ACES, the total quantity of offsets allowed in any year cannot exceed 2 billion tons, or about 30% of the allocation in 2020, to be split evenly between domestic and international offset credits, with international offsets subject to a discount factor of 0.8 starting 2017. Recognition of foreign allowances under the ACES is possible, but is subject to further determination. 33. The ACSA included a Carbon Market Efficiency Board with the power, at its discretion, to (1) increase the quantity of emission allowances that an entity can borrow; (2) expand the period of repayment for borrowed allowances; (3) increase allowances obtained from foreign GHG markets; (4) expand the eligible offset project types. In addition, the EPA would conduct a ‘cost-containment auction’ for each year from 2012 to 2027 that offers additional allowances at a fixed price: the price to be determined between US$22 and US$30 in 2012 and adjusted for inflation annually thereafter. Participation would be limited to entities required to submit allowances for the preceding year and the allowances would have to be used for compliance within a year. The EPA would also conduct a regular auction of allowances annually with a reserve price starting at US$10 per allowance in 2012 and adjusted for inflation annually thereafter. The reserve price would set a floor price for allowances. 34. Emissions by sources in New York are lower, but national emissions do not change, because the surplus federal allowances can be used by sources in other states. 35. The inclusion of credits for reductions in deforestation and forest degradation (REDD) in developing countries is being considered for a post-2012 agreement under the UNFCCC. 36. States in the WCI could import CDM credits, possibly subject to additional criteria, JI for credits from sources not covered by the WCI, and allowances from other, unspecified, emissions trading schemes that meet the established criteria.

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37. The RGGI would need to accept that the WCI includes Canadian and Mexican jurisdictions and that allowances and offset credits from those jurisdictions would affect the quantity of offset credits from US projects that could be sold to RGGI participants. Given the levels of domestic offset credit use allowed – 3.3% and 5% – this may not be a serious concern. 38. The price cap will be phased out in 2018.

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Jaffe, J., Stavins, R., 2007, Linking Tradable Permit Systems for Greenhouse Gas Emissions: Opportunities, Implications, and Challenges, International Emissions Trading Association (IETA) and Electric Power Research Institute (EPRI), Geneva. Kysar, D.A., Meyer, B.A., 2008, ‘Like a nation state’, UCLA Law Review 55(6), 1621–1674. Litz, F., 2008, Toward a Constructive Dialogue on Federal and State Roles in U.S. Climate Change Policy, Pew Center on Global Climate Change, Arlington, VA [available at www.pewclimate.org/statefedroles]. Litz, F., Zyla, K., 2008, Federalism in the Greenhouse: Defining a Role for States in a Federal Cap-and-Trade Program, Climate and Energy Policy Series, World Resources Institute, Washington, DC [available at http://pdf.wri.org/ federalism_in_the_greenhouse.pdf]. Mace, M.J., Millar, I., Schwarte, C., Anderson, J., Broekhoff, D., Bradley, R., Bowyer, C., Heilmayr, R., 2008, Analysis of the Legal and Organisational Issues Arising in Linking the EU Emissions Trading Scheme to other Existing and Emerging Emissions Trading Schemes, FIELD/IEEP/WRI, London. Mehling, M., Haites, E., 2009, ‘Mechanisms for linking emissions trading schemes’, Climate Policy 9(2), 169–184. Midwestern Greenhouse Gas Reduction Accord (MGGA), 2008, Preliminary Recommendations of the Advisory Group, 11/1/08 Draft [available at www.midwesternaccord.org/News%20Page/Accord%20Draft%20Recs%2011%201%2008.doc]. Ontario, 2008, A Greenhouse Gas Cap-and-Trade System for Ontario, Discussion Paper, Ministry of the Environment, Toronto. Paltsev, S., Reilly, J., Jacoby, H., Gurgel, A., Metcalfe, G., Sokolov, A., Holak, J., 2008, ‘Assessment of US GHG cap-andtrade proposals’, Climate Policy 8(4), 395–420. Point Carbon, 2008, Carbon Market North America 3(20), 17 October. Regional Greenhouse Gas Initiative (RGGI), 2006, Regional Greenhouse Gas Initiative Model Rule, 15 August 2006 [available at www.rggi.org/docs/model_rule_8_15_06.pdf]. Springer, U., Oleschak, R., Suter, S., Forrister, D., Youngman, R., 2006, Linking Domestic Emissions Trading Schemes to the EU ETS, TETRIS Deliverable. Ecoplan, Berne, Switzerland. Sterk, W., Braun, M., Haug, C., Korytarova, K., Scholten, A., 2006, Ready to Link Up? Implications of Design Differences for Linking Emissions Trading Schemes, Jet-Set Working Paper I/06, Wuppertal Institute, Wuppertal, Germany. Sterk, W., 2008, Prospects of Linking the EU Emission Trading Scheme with a Federal US Emissions Trading Scheme along the Lines of the Lieberman–Warner Proposal, Working Paper Linking-3, Climate Strategies [available at www.climatestrategies.org/reportfiles/working_paper_linking_3.pdf]. Western Climate Initiative (WCI), 2008, Design Recommendations for the WCI Regional Cap-and-Trade Program [available at www.westernclimateinitiative.org/ewebeditpro/items/O104F19865.PDF].

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■ research article

Establishing a transatlantic carbon market WOLFGANG STERK1*, JOSEPH KRUGER2 1

Wuppertal Institute for Climate, Environment and Energy, Research Group on Energy, Transport and Climate Policy, Döppersberg 19, 42103 Wuppertal, Germany 2 Bipartisan Policy Center, National Commission on Energy Policy, 1225 Eye Street NW, Washington, DC 20005, USA

The current emissions trading debates in the EU and the USA were examined and the prospects for creating a transatlantic carbon market were analysed. A future US Emissions Trading Scheme (US ETS) may be designed very differently from the EU ETS, raising questions of compatibility. Crucial differences relate to the stringency of targets, the recognition of offsets, and price control mechanisms. These differences flow directly from the different policy and economic perspectives on emissions trading and climate policy in the USA and the EU. The two sides should therefore seek a way forward that reconciles potentially different climate policies. For example, the USA and the EU should consider an effort to harmonize carbon prices, and US legislation could phase out cost-containment mechanisms after some time period. Finally, both US and EU policies should have mechanisms that allow periodic recalibration, which would allow each to adjust to new technology, react to developing-country climate policies, and learn from each other. In the longer term, this would allow both sides to strive for greater policy convergence, either through linked trading systems, harmonized prices, or a transition from harmonized prices to linkage. Keywords: carbon markets; domestic emissions trading systems; emissions trading; EU ETS; linking; US ETS Les débats courants dans l’Union européenne et aux Etats-Unis sur les échanges de droits d’émissions sont examinés et les perspectives de création d’un marché du carbone transatlantique sont analysées. Un US-ETS futur pourrait être conçu de manière très différente de l’EU-ETS, générant des questions de compatibilité. Les différences clés sont liées à la rigueur des objectifs, la prise en compte des compensations et les mécanismes de contrôle des prix. Ces disparités s’écoulent directement des différentes perspectives politiques et économiques sur les échanges d’émissions et la politique climatique aux Etats-Unis et dans l’Union européenne. Les deux camps devraient par conséquent trouver une façon d’avancer, réconciliant des politiques climatiques potentiellement différentes. Par exemple, les Etats-Unis et l’Union européenne devraient envisager un effort d’harmonisation des prix du carbone et la législation des Etats-Unis pourrait supprimer progressivement les mécanismes de maintien du prix après un certain temps. Enfin, les politiques à la fois des Etats-Unis et de l’Union européenne devraient intégrer des mécanismes favorisant un recalibrage périodique, pouvant permettre à chaque camps de s’adapter aux nouvelles technologies, réagir aux politiques climatiques des pays en développement, et tirer des leçons réciproques. A long terme, ceci devrait permettre aux deux camps de solliciter une plus grande convergence de leurs politiques, que ce soit à travers des systèmes d’échange liés, l’harmonisation des prix, ou par une transition allant d’une harmonisation des prix à l’établissement de liens. Mots clés: EU-ETS; établissement de liens; marchés du carbone; systèmes d’échange de droits d’émissions; systèmes intérieurs d’échange d’émissions; US-ETS

1. Introduction The EU Emissions Trading Scheme (EU ETS), which has been up and running since 2005, has been a leading element of the global response to climate change. The emissions trading debate in the ■ *Corresponding author. E-mail: [email protected] CLIMATE POLICY 9 (2009) 389–401 doi:10.3763/cpol.2009.0623 © 2009 Earthscan ISSN: 1469-3062 (print), 1752-7457 (online) www.climatepolicy.com

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USA has been on a slower track, although there have been several bills proposed in the Senate and in the House of Representatives. Given the stated commitment of President Barack Obama to a strengthened climate policy in general, and to a cap-and-trade system in particular, the US debate might evolve very quickly in 2009. The prospect of emissions trading systems on both sides of the Atlantic raises the question of whether the EU and US systems should be linked with each other. Economic theory suggests that linking increases efficiency, as a larger system has a greater diversity of sources and more abatement options. This should, in turn, lead to improved market liquidity, more efficient allocation of resources towards least-cost abatement measures, and lower overall compliance costs (Haites and Mullins, 2001; Anger et al., 2006; Edenhofer, Flachsland and Marschinski, 2007). Given the size of the EU and US economies, the economic benefits would be expected to be significant. Linking the emerging domestic systems could also be politically significant because it would underpin the top-down approach of the international climate regime with a bottom-up process, which might further strengthen the international regime via bi- and plurilateral agreements. Creating a global carbon market is therefore a key goal of EU climate policy: The EU wants to work with other Parties to build a liquid global carbon market with a broad coverage and deep emission cuts to create a robust carbon price signal as a key means to deliver cost-effective GHG emission reductions (European Community, 2008).

In its recent post-2012 communication, the European Commission proposed the establishment of an OECD-wide market by 2015, in addition to substantial reforms to the project-based Kyoto mechanisms (European Commission, 2009). Engagement with the USA is seen as the key in this strategy. The EU and USA combined account for about 60% of total current Annex I emissions. Among the non-EU Annex I countries, only Australia, Canada, Iceland, Japan, New Zealand, Norway, Switzerland and the USA have introduced, or are seriously considering, emissions trading programmes. Among these, the EU and the USA combined account for almost 80% of current emissions (UNFCCC, 2009). The EU and the USA are also set to account for the lion’s share of demand for offset credits from developing countries in the post-2012 regime. Russia and Ukraine, the other two large Annex I countries, will probably not become buyers due to their massive bankable surplus of assigned amount units and substantial low-cost domestic reduction potential. Hence, if a combined EU–US market was established, the ‘global carbon market’ would essentially be synonymous with this transatlantic market and would provide the backbone for the overall international climate regime. If the EU and the USA did find common ground on key design elements, this would probably exert significant influence on the other, much smaller-sized, OECD trading systems to align their designs accordingly. With this in mind, the European Commission has suggested the creation of an EU–US working group on the design of carbon markets (European Commission, 2009). The scenario discussed above assumes that similar cap-and-trade approaches are taken in the EU and the USA. However, it is far from certain that the USA will adopt a classic cap-and-trade model with an absolute cap on emissions. Cap-and-trade is an intensely political issue in the USA, which is rife with regional conflicts based on different patterns of fuel use and industrial manufacturing capacity. The recent economic downturn and continuing concerns in the USA about international competitiveness could lead to provisions to contain the costs of a cap-and-trade programme. Moreover, as Congress and the new US administration work through these issues, they will be likely to revisit the debate about whether a price-based policy (i.e. a carbon tax or cap-and-trade with a price cap)

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is superior to a quantity-based policy (i.e. cap-and-trade with an absolute cap). This price vs quantity debate has been well explored and continues to be part of the ongoing discussion in the USA (Weitzman, 1974; Pizer, 2002). More recently, a ‘cost-containment auction’ has been proposed that would inject additional allowances into the market at a predetermined allowance price. These allowances would be borrowed on a system-wide basis from future years (Murray et al., 2008). A price-based US approach would be incompatible with the current European approach, which emphasizes emissions certainty. A further impediment to linking may come from different policies in the USA and the EU on the quantities and types of offsets (e.g. from sinks) that may be used in each system. Finally, even if the USA does not adopt these cost-containment or offset policies, it is possible that targets and allowance prices could be significantly different in the two systems. Thus, it may not be advisable to link emissions trading systems when the key features that determine short-term policy goals (e.g. target stringency and cost-containment features) are not harmonized (see, e.g., Sterk et al., 2006; Mace et al., 2008). This article, therefore, aims to assess the potential for linking, given the differing policy debates and political considerations in Europe and the USA. Although it is certainly possible that the USA will adopt an approach that is fully compatible with the EU ETS, for this article we have chosen to explore the implications of the opposite outcome. Thus, the main questions posed in this article are: ■ Do potentially differing approaches make linking in Europe and the USA unlikely and undesirable? ■ If so, what are the implications and options for future transatlantic cooperation on climate policy? The article focuses on the design features that will be critical if the systems are linked in the future. We believe these features are: ■ The stringency of emissions targets ■ Recognition of external trading units (offsets) ■ Cost-containment and intervention mechanisms. These design elements are examined to determine whether possible US and actual European features would allow for linking without negating the policy or political choices made in each system. The article concludes with some recommendations on possible approaches for the USA and the EU in the event that linking of emissions trading systems is not possible in the short term. Before proceeding, it should be noted that three additional elements important to the linking discussion are not addressed here: monitoring, reporting and verification (MRV) of emissions, distribution of emission allowances, and greenhouse gases and industry sector coverage. An assessment of different MRV practices in Europe and the USA is beyond the scope of this article. Elsewhere, Kruger and Egenhofer (2006) highlight the differences and similarities between the US and EU approaches. Regarding allowance distribution, different allocation approaches in Europe and the USA should not significantly affect competitiveness unless allocations are updated in ways that distort product prices (Blyth and Bosi, 2004; Jaffe and Stavins, 2008). Moreover, the EU and the USA seem to be heading in similar directions on allowance distribution. Phase 3 of the EU system and most leading US proposals would start with significant auctions and would phase out all or most free allocation over time.

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Finally, the EU ETS and a future US ETS may differ significantly in their coverage of sources and sectors. While the EU ETS is so far restricted to the energy-intensive sectors, a US ETS may cover most of the US economy. Differences in coverage may affect the overall efficiency of policies within the EU or the USA (Böhringer and Löschel, 2005; Pizer et al., 2006). However, the authors do not think that this issue would be a significant barrier to linkage.

2. The state of the US emissions trading debate vis-à-vis the EU ETS Cap-and-trade continues to be the most likely mechanism to address greenhouse gas emissions in the USA, although there is uncertainty about the final design of a US climate change policy. Nevertheless, it is likely that a US cap-and-trade programme will build upon past legislative proposals such as the Boxer Substitute Amendment to the Lieberman–Warner Climate Security Act (Boxer–Lieberman–Warner), the Bingaman–Specter Low Carbon Economy Act of 2007 (Bingaman–Specter) and the Waxman–Markey American Clean Energy and Security Act of 2009 (Waxman–Markey). For the purposes of this article, discussion will focus on these three bills. Of course, an additional factor influencing climate legislation will be the new ideas and approaches introduced by President Obama and his key advisors. In the EU, the Emissions Trading Directive (ET Directive) was passed in 2003 and the EU system started its operation at the beginning of 2005. The ET Directive was recently thoroughly revised for the period after 2012 (EU, 2008). Given that the establishment of a national US system is several years away, the following will focus on the post-2012 design of the EU ETS.

2.1. Targets In the USA, both short- and long-term targets vary in the leading proposals. Waxman–Markey and Boxer–Lieberman–Warner have 2020 targets for affected sources of 17% and 19%, respectively, below 2005 levels, and 2030 targets of 42% and 30%, respectively, below 2005 levels for affected sources. Waxman–Markey has a long-term target of 83% below 2005 levels, and Boxer–Lieberman– Warner has a 2050 target of 71% below 2005 levels. President Obama has announced support for a cap-and-trade programme that would reduce 2020 emissions to 14% below 2005 levels, and would reduce emissions by 83% below 2005 levels by 2050. How stringent are these targets? One metric of stringency is the projected allowance price. An earlier (although generally similar) version of the Boxer–Lieberman–Warner proposal has been modelled by the US Environmental Protection Agency (US EPA) and the US Department of Energy’s Energy Information Administration (EIA). The EPA analysis forecast a price range of $37–51 in 2020 and $63–83 per ton of CO2e in 2030. The EIA forecast a price of $30 per ton in its core case for 2020 and $61 per ton in 2030 (US EIA, 2008; US EPA, 2008). Modelling by the US EPA of an earlier version of Waxman–Markey forecast a price of $17–22 in 2020 (US EPA, 2009). In the EU, starting in 2013, there will be one Community-wide cap on the emissions trading sectors. The cap will mandate an emission reduction of 21% compared with 2005 levels by 2020, which would mean an average annual cap of 1.8 Gt for the period 2013–2020. This value is based on the unilateral target of reducing EU emissions by 20% below 1990 levels. If the international negotiations lead to a stricter target, the cap is to be adjusted in a further revision of the ET Directive.

2.2. Recognition of external trading units In the USA, all of the major proposals allow for the use of project-based offsets credits; i.e. emission reductions outside of the cap that are made either domestically or internationally. However, the proposals vary in their specificity about the types of offsets allowed and the quantitative restrictions

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imposed on offset use. For example, Boxer–Lieberman–Warner allows 15% of the compliance obligation to be met from domestic offsets and 15% from international offsets. The Waxman– Markey discussion draft would allow for 2 billion tons of offsets each year, split evenly between domestic and international offsets. Offsets can be used for about 30% of compliance obligations in the early years of the bill, increasing to roughly 65% by 2050. After the first 5 years of the programme, the bill discounts international offsets so that an offset is worth only 80% of an allowance. Bingaman–Specter has no quantitative limit on domestic offsets, but would require additional administrative action by the President to set up an international offsets programme and would limit the use of these offsets to no more than 10% of the compliance obligation. Boxer–Lieberman–Warner has explicit language allowing the use of offsets from domestic agricultural and forestry projects. Waxman–Markey does not specify project types that are presumptively eligible, but it does signal the possibility of agricultural and forestry projects by requiring the US EPA to establish policies to account for reversals of sequestered emissions. Agricultural projects such as using no-till practices to sequester soil carbon have significant support from agricultural groups. Given the large number of legislators from farming states, it is likely that at least some offsets from soil carbon sequestration will be allowed under US climate legislation. The treatment of international offsets in the legislative proposals is more complex. Boxer– Lieberman–Warner allows for use of Clean Development Mechanism (CDM) credits. Waxman– Markey would allow recognition of offset credits in developing countries if an appropriate bilateral or multilateral agreement with the project host country exists. The bill also leaves the door open for accepting CDM credits and allows for awarding offset credits for emission reductions across an entire sector. Bingaman–Specter would not allow for international offsets initially, but would allow the President to establish a programme later if certain criteria were met. The different approaches reflect a lack of consensus about the benefits of international offset programmes in general and the CDM in particular. On one hand, there is strong support from many large companies for the widespread use of international offsets as a cost-reduction proposal (US CAP, 2009). On the other hand, widely reported problems with the CDM have raised questions about the integrity of the international offset market, particularly regarding the additionality of projects (Wara and Victor, 2008). Although offsets would reduce the allowance price and the cost of compliance in the USA, some legislators have viewed offsets as an unwelcome flow of capital to economic competitors. For example, during the debate over Lieberman–Warner, four Senators introduced an amendment that would have eliminated international offsets from the bill (Samuelsohn, 2008). The EU ETS allows operators to purchase and use credits from the Kyoto Protocol’s projectbased mechanisms, the CDM and Joint Implementation (JI), subject to certain conditions. First, there are a number of qualitative restrictions on the type of projects that will be eligible in the EU ETS. Credits from sink projects are not eligible, due to concerns about the permanence of sequestered carbon. Credits from hydropower projects are allowed only if they ‘respect’ the social and environmental criteria established by the World Commission on Dams (WCD). Second, there are quantitative restrictions to ensure that the use of project-based credits remains ‘supplemental’ to domestic action in accordance with the Kyoto Protocol. Historically, the EU was very sceptical about the inclusion of the flexible mechanisms in the Kyoto Protocol and maintained that their use should be restricted to, at most, 50% of the required reduction (European Community, 1999). Hence, while the exact CDM/JI entitlements are yet to be determined, the revised ET Directive is consistent with this 50% requirement. In addition to the quantitative limits, the EU may also develop implementation measures that restrict the use of credits from certain project types. This provision reflects concerns about the integrity

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of the CDM similar to those expressed in the USA. The EU is pushing for significant reforms of the mechanism at the UN level. In particular, the EU emphasizes that only projects producing additional reductions and that go beyond low-cost options should be credited. For more advanced developing countries and economically competitive sectors, the Commission has proposed to phase out the project-based CDM altogether and move to sectoral crediting mechanisms (European Commission, 2009; Santarius et al., 2009). If these efforts to improve the CDM do not yield the desired result, the EU may opt to further restrict use of the mechanism to protect the integrity of its ETS. In addition to the CDM and JI, the revised ETS Directive states that ‘Community-level projects’ (often referred to as Community Offset Projects) may be allowed in sectors not covered by the EU ETS. These would be analogous to the ‘domestic offsets’ allowed in US proposals.

2.3. Cost containment Cost containment is one of the most contentious issues in the US debate. In the Senate, the issue will be critical to a large bloc of Democratic senators, many of them from mid-Western or Southeastern states that rely on coal and have lost manufacturing jobs over the last few decades. The support of these Democratic Senators will be critical for successful legislation in the Senate (Broder, 2009). Cost containment can be defined broadly to include the temporal flexibility provided by banking and borrowing of allowances. All of the US legislative proposals allow banking of allowances and some allow limited borrowing at the source level as a means to control costs of compliance and allowance price volatility. More controversial than banking and source-level borrowing is whether there should be provisions that provide additional price certainty by allowing emissions above the cap. At one end of the spectrum, the Bingaman–Specter bill proposes an explicit price cap or safety valve that would start at $12/ton and would increase every year by 5% above the rate of inflation. Under this type of mechanism, there would be a certain and transparent upper price limit for carbon. However, if the price of allowances exceeded the price cap level, it would lead to emissions above the cap. Two other legislative proposals allow for a cost-containment auction, a reserve of allowances brought forward from future years that would be auctioned starting at a specified minimum price. This type of mechanism is essentially a hybrid of a price and quantity mechanism because it maintains the cumulative multi-year emissions cap while providing some extra degree of price certainty in the short term. Murray et al. (2008) describe some of the economic and political advantages of this approach. The cost-containment auction differs from a price cap because only a limited number of allowances are available at the trigger price so there is no absolute guarantee of price certainty. In Boxer–Lieberman–Warner, the cost-containment auction price would be between $22 and $30 and would be determined by the US EPA. Under Waxman–Markey, the price would start at $28/ton but would ultimately be set 60% above a 36-month rolling average of the allowance spot price. Both bills have price floors that start at $10/ton. Why is there so much emphasis on cost containment in the USA? In the past, the inability to agree on the potential costs of carbon policies has contributed to political stalemate. To some extent, cost-containment policies are designed to ease concerns about the uncertainty inherent in factors that will affect costs, including the availability of new low- and no-carbon technologies such as carbon capture and sequestration (CCS). There is also concern about extreme shorterterm allowance volatility arising from unexpected trends in weather, economic growth and fuel markets. Finally, the debate about whether price vs quantity instruments are best for addressing climate change is still ongoing in the USA.

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The EU ETS allows for full banking. In the discussions on environmental certainty vs price management and protecting business from potentially high costs, the EU has so far clearly come down on the side of environmental certainty. Non-compliant installation operators need to pay fines of €100 per excess tonne of CO2 emissions. Starting in 2013, this amount will be annually adjusted for inflation. In addition, non-compliant operators are required to surrender a compensating amount of compliance units in the subsequent year. Due to this make-good requirement, the fine does not function as a price cap. However, the recent severe drop in prices resulting from the economic crisis – from more than €30 per tonne in July 2008 to less than €10 in early 2009 – has led to renewed debate on price management in the EU. Some analysts and politicians have spoken out in favour of price floors and price caps. For example the German Ministry of Economics and Technology (2009) called for the establishment of a price corridor. The French Société Générale called for the establishment of a carbon central bank to regulate the supply of allowances. Other market actors and the European Commission have strictly opposed any market intervention, saying that this would destabilize the market. One official noted that price controls would turn the market into a ‘betting game on the next intervention by public authorities’ (Point Carbon, 2009a). Another factor to consider is that the EU has so far been virtually alone in its resistance to price management. All the countries outside Europe that are discussing the introduction of emissions trading are considering some form of price control (Schüle et al., 2008). Given these developments inside and outside Europe, it is not inconceivable that the EU may eventually move towards some form of price management as well. The revised ET Directive does in fact foresee some limited intervention mechanisms in case of excessive price fluctuation. If, for more than six consecutive months, the allowance price is more than three times higher than the average price during the preceding two years, measures may be adopted to allow Member States to either bring forward the auctioning of some future year allowances, or to auction up to 25% of remaining allowances in the New Entrant Reserve (NER).

3. Compatibility between EU and emerging US systems: prospects for linking 3.1. Targets A perfect balance of efforts between the EU and the USA is very unlikely to be achieved. However, it is probably a political precondition for linking that all sides demonstrate comparable efforts. The unilateral EU target of –20% compared with 1990 will be implemented by a 21% reduction in the EU ETS compared with 2005, plus a further reduction of 10% below 2005 levels in the non-ETS sectors. Modelling by the European Commission projects that this will lead to a carbon price of €39 per tonne CO2e, which is approximately $50 at current exchange rates (European Commission, 2008a). Targets being discussed in the USA vary. Boxer–Lieberman–Warner and Waxman–Markey have respective 2020 targets of 19% and 17% below 2005 levels, and the Obama Administration has proposed a 2020 target of 14% below 2005 levels. Modelling of an earlier version of the Boxer– Lieberman–Warner proposal projected a price range of $37–51 in 2020. The EIA forecast a price of $30 per ton in its core case for 2020. Modelling of the US EPA of an earlier version of Waxman– Markey forecast a price of $17–22 in 2020. On the surface, the EU 20% case and the US targets being discussed therefore appear to be similarly strict. In all cases the same baseline year is used and the reduction percentages are similar, as are projected carbon prices. However, the 20% case is only the EU’s fallback position. The EU is pushing for a comprehensive international agreement that would include a stricter EU commitment. In addition, one also needs to take into account potential US cost-containment measures. For example,

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the trigger prices in the Boxer–Lieberman–Warner cost-containment auction would start between $22 and $30 per ton. Thus, if the US system triggered the auction of additional allowances, it could be viewed as less stringent than the EU ETS system with allowance prices above these levels.

3.2. Recognition of external trading units If two trading systems are linked, a particular type of credit used in one system would have an impact on the second system, even if that system tried to restrict its use. This is because credits and allowances are fungible. If a particular type of unit, such as credits from carbon sinks, is not recognized in the first scheme, companies in the second scheme could use them for domestic compliance purposes. This would free up ‘regular’ domestic allowances to sell to companies in the first scheme. The combined linked system would therefore be using credits from sinks. The political decision in the first scheme about which trading units are recognized would thus be bypassed. This issue is salient with regard to the use of credits from carbon sinks and domestic offset projects, which the EU ETS currently excludes but a US system seems set to include. By contrast, the EU ETS accepts credits from the Kyoto Protocol’s project-based mechanisms, which are being regarded with a high degree of scepticism in some US quarters. While a scheme with a more narrow recognition of units may take adjustment measures such as the introduction of exchange rates, these would increase transaction costs while producing only limited effects: the scheme’s administrators would never be able to tell whether an incoming allowance has possibly been freed up by use of an external trading unit which they themselves would not accept for compliance. In the case of the USA and the EU, some convergence does seem possible. The EU ETS may come to include ‘Community offsets’, which are essentially domestic offsets but regulated at the EU level. The EU has also been moving towards accepting sinks. During the discussions on revising the ETS Directive, numerous Member States, as well as the European Parliament’s Environment Committee, were in favour of creating at least a limited access to sink credits (ENVI, 2008). The EU is also far from satisfied with the current performance of the CDM and may establish further restrictions on access to CDM credits in addition to the quantitative limits that have already been adopted. In its post-2012 communication, the European Commission explicitly calls for seeking common ground with the USA on offset credits (European Commission, 2009). International offsets remain controversial with some political constituencies in the USA. Nevertheless, the Waxman–Markey bill signals an openness to both significant use of international offsets (i.e. 1 billion tons/year) as well as reform of the international offset process. In particular, the development of criteria to provide credits on a sectoral basis could be an area of future collaboration between the USA and the EU. However, there are also significant differences regarding offset provisions. The Lieberman–Warner and the Waxman–Markey proposals allow for use of international forest credits from avoided deforestation and degradation, while the EU ETS does not. The European Commission recently recommended that such credits are not included before 2020 due to concerns about the balance of supply and demand, the permanence of forest carbon stocks, and unresolved monitoring, reporting, verification and liability issues (European Commission, 2008b). Moreover, linking between a scheme that applies a discount factor to offsets, as proposed by Waxman–Markey, and a scheme that does not is also problematic. This is because linking can undermine the decision to treat offsets as a less desirable compliance option in the scheme imposing the discount. Participants in the EU ETS importing CDM credits may free up EUAs within the quantitative limit imposed on CER use in the EU; such EUAs could then be sold to participants in

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the Waxman–Markey scheme, avoiding the discount factor. Having said that, there is also some consideration of discounting offsets inside the EU (see, e.g., Schneider, 2008). Finally, access to offsets would be much more generous under both the Lieberman–Warner and Waxman–Markey proposals than under the EU ETS. Whereas the former two cap the use of offsets at 30% or higher of the compliance obligation, the EU ETS limits the use of offsets to 50% of the required reduction. In the case of Waxman–Markey, it has been calculated that, in principle, all of the required reduction could be covered by offsets well into the 2020s (Point Carbon, 2009b). On the other hand, the Waxman–Markey scheme would discount offsets, and so, depending on relative price levels of offsets and allowances, the advantage might not be so large. All the foregoing aspects may constitute barriers to a EU–US link, although a more careful assessment may be needed in order to determine the scope and impact of these design differences on prices and allowance flows between schemes.1

3.3. Compliance framework, cost-containment and intervention mechanisms As already noted, the EU has placed a priority on an absolute cap on emissions, while the USA is considering measures that would create more certainty around allowance prices in the short term. These differences in basic outlook find expression in several design features. Source-level borrowing provisions in some US proposals are more extensive than the limited possibility to use the following year’s allowances in the EU. In the EU, borrowing is not seen favourably, as it entails the risk that mitigation measures may not be taken in future periods either, for example due to a lack of enforcement or if a company goes bankrupt (Boemare and Quirion, 2002). More important, if a system with an absolute cap such as the EU ETS was linked to a system with a price cap or cost-containment auction, this would effectively act as a price cap or costcontainment auction for the combined system. In the case of a price cap, as long as the market price in the EU is higher than the price cap level, companies in the price cap system would have an incentive to sell their allowances to EU companies until prices were equalized at the price cap level. The environmental effectiveness of the combined scheme would thus suffer, since total emissions would be higher than if the two schemes were kept separate. Moreover, through linking a system without price controls to a system with price control mechanisms, the former would effectively cede control over its allowance price and emissions to the latter. It does not seem likely that the former would be willing to pursue such a policy.

4. Conclusions Creating a global carbon market is a key goal of EU climate policy, and engagement with the USA is seen as the linchpin in this strategy. The EU and the USA account for about 80% of OECD emissions. A combined EU–US market would be likely to account for a similar share of the overall market and would provide the backbone for the international climate regime. It is not possible to predict the final design of a US cap-and-trade programme. However, the goal of a combined EU–US market has had much less importance in the US debate over domestic climate legislation. It is more likely than not that a future US programme will have significant differences from the EU system. For example: ■ The caps may be significantly different in the short term, yielding different autarkic prices. By linking to a higher-cost EU system, US allowance and energy prices would increase, which may be politically untenable.

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■ While the EU has an absolute cap geared towards safeguarding emissions certainty, a US scheme may include price control mechanisms, which could lead to missing the emissions target in the short term. Also, through linking to this type of US system, the EU would cede some control to the US over allowance prices and emission reductions. ■ A US scheme would probably include at least some agricultural and forestry sink credits as well as deforestation credits, which the EU ETS currently excludes. By contrast, a US scheme may exclude CDM and JI credits, which the EU includes. ■ Limits on the allowed use of offsets may be significantly different and a US scheme may discount offsets, which the EU does not. ■ A US scheme may include borrowing provisions at the source level. It can therefore be concluded that achieving the EU’s goal of an OECD-wide carbon market is unlikely in the short term. Systems might become linked indirectly through links to third systems such as the CDM, which would yield some of the economic benefit of a direct bilateral link. However, with the conflicting views about the CDM in the USA, even this type of link is uncertain. Given this outlook, how should the EU and the USA go forward? From a European perspective, the first item for harmonization would be agreement on the ultimate objective of global climate policy. The EU has adopted the position that the increase in global average temperature should not exceed 2°C above pre-industrial levels (Council of the European Union, 2007). Once a long-term vision is in place, it can be directly translated into global emission trajectories and serve as a basis for consideration of which country should shoulder which part of the necessary effort. In turn, these considerations can ultimately be a basis for setting mutually acceptable emission caps. The USA has yet to determine its own long-term vision on climate change. Certainly a longterm aspirational goal for the USA would help to guide international discussions with the EU and key developing countries on the global architecture necessary to address climate change. On the other hand, such a goal is less helpful in the domestic US political debate, where the main focus will be on the shorter-term targets and related features that will provide some certainty about allowance prices. These domestic considerations will be the primary driver of the US position in multilateral and bilateral climate negotiations. The top US climate negotiator has noted, ‘I don’t want to repeat the experience of Kyoto, agreeing to something that has no, or an inadequate amount, of domestic support’ (Eilperin, 2009). Therefore, if linking trading systems is not possible in the short term, the USA and the EU should consider an effort to harmonize carbon prices in the USA and the EU (Kruger et al., 2007). For example, to the extent that a US system has a price cap or a specified price for a cost-containment auction, it might be possible to have this price escalate and converge with the projected EU allowance price. Movement towards convergence might also come from the EU. Thus far, there has been strong resistance to price controls from the European Commission and greenhouse gas market participants. However, substantial volatility in the EU ETS, coupled with a general concern about market integrity in the wake of the financial crisis, might conceivably lead to the introduction of mechanisms such as a price floor. This may open the door for the future harmonization of price floors in the EU and the USA. Moreover, although cost-containment measures may be necessary to get political agreement in the short term, there is less opposition in the USA to absolute caps in the longer term. Therefore, US legislation could phase out cost-containment mechanisms over some time period. The Boxer– Lieberman–Warner proposal takes this approach.

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It also should be noted that the EU ETS and the emerging US proposals are not totally incompatible. Reaching common ground seems possible with regard to offsets. While there could be differences in the allowed level of offset use and recognition of deforestation credits, strong voices in both the EU and the USA have been critical of the Kyoto Protocol’s offset mechanisms. It might therefore be possible to reach a shared US–EU view about the international mechanisms. This would remove one key obstacle to linking, and such a shared view would also be very powerful in moving the UN negotiations towards reform of the mechanism. In particular, if a US cap-and-trade programme allows the use of sectoral offsets in developing countries, this could be an important component of a joint US and EU position. Such areas of potential convergence should be strengthened and expanded. Some EU and US actors are already taking steps in this direction, for example through the International Carbon Action Partnership (ICAP), which does not, however, currently engage the federal US legislator. These dialogue initiatives should therefore be expanded further and strengthened. The proposal of the European Commission on creating an EU–US working group on the design of carbon markets is a concrete step in this direction. Finally, both US and EU policies should have mechanisms that allow periodic recalibration through changing targets, prices, or both. This will allow each side to adjust to new technology, react to developing-country climate policies, and learn from each other. In the longer term, this also will allow both sides to strive for greater policy convergence, either through linked trading systems, harmonized prices, or a transition from harmonized prices to linkage.

Acknowledgements The authors acknowledge funding support from Mistra’s Climate Policy Research Programme (Clipore). The views expressed are the authors’ alone and not necessarily those of his organization.

Notes 1.

Of course, the size of a future international offsets market is highly uncertain. Developing countries would probably be by far the largest source of offsets, taking into account the current sizes of the CDM and JI and that the room for JI projects or domestic offset projects will become ever tighter as targets become more stringent over time. The supply of offsets will depend largely on the amount of emission reduction potential in non-ETS sectors and non-ETS countries, particularly developing countries, the ability of the carbon market to mobilize this potential, and political decisions such as the level of effort required from developing countries under the post2012 regime.

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Schüle, R., Sterk, W., Anger, N., 2008, Options and Implications of Linking the EU ETS with Other Emissions Trading Schemes: Note for the European Parliament, European Parliament, Policy Department Economic and Scientific Policy, Brussels. Sterk, W., Braun, M., Haug, C., Korytarova, K., Scholten, A., 2006, Ready to Link Up? Implications of Design Differences for Linking Domestic Emissions Trading Schemes, Wuppertal Institute for Climate, Environment and Energy, Wuppertal, Germany. UNFCCC (United Nations Framework Convention on Climate Change), 2009, Total CO2 Equivalent Emissions with Land Use, Land-Use Change and Forestry [available at http://unfccc.int/ghg_data/ghg_data_unfccc/time_series_annex_i/ items/3814.php]. US CAP (United States Climate Action Partnership), 2009, A Blueprint for Legislative Action: Consensus Recommendations for US Climate Protection Legislation, January. US EIA (US Department of Energy’s Energy Information Administration), 2008, Energy Market and Economic Impacts of S. 2191, the Lieberman–Warner Climate Security Act of 2007, April. US EPA (US Environmental Protection Agency), 2008, Analysis of the Lieberman–Warner Climate Security Act of 2008, S. 2191 in 110th Congress, 14 March. US EPA (US Environmental Protection Agency), 2009, EPA Preliminary Analysis of the Waxman–Markey Discussion Draft, the American Clean Energy and Security Act of 2009 in the 111th Congress, 20 April. Wara, M.W., Victor, D.G., 2008, A Realistic Policy on International Carbon Offsets, Working Paper 74, Stanford Program on Energy and Sustainable Development, Stanford University, Stanford, CA. Weitzman, M.L., 1974, ‘Prices vs. quantities’, Review of Economic Studies 41(4), 477–491.

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■ research article

Australia’s emissions trading scheme: opportunities and obstacles for linking FRANK JOTZO1*, REGINA BETZ2 1 2

College of Asia and the Pacific, The Australian National University, Canberra, Australia Centre for Energy and Environmental Markets, School of Economics, University of New South Wales, Sydney, Australia

Australia is establishing an economy-wide emissions trading scheme, with a detailed proposal tabled by government in December 2008 and a scheme start planned for 2011. The proposal is for unilateral linking through the Clean Development Mechanism and Joint Implementation, but no initial bilateral linkages. Concerns about permit prices rising too high are prominent, and are reflected in a ban on permit sales and a price cap provision. This article evaluates the proposed Australian scheme with regard to international emissions trading and linkages. Different scenarios for the Australian permit price under unilateral linking are considered. Options for bilateral linking with the European Union and New Zealand schemes are evaluated. We argue that Australia should dismantle the obstacles to linking, including the proposed price cap, and move towards bilateral linking with suitable schemes. Keywords: Australia; carbon market; emissions trading scheme; linking L’Australie est en train de mettre en place un système d’échange de droits d’émissions couvrant l’ensemble de son économie, dont la proposition détaillée fut tablée par le gouvernement en décembre 2008 et dont le lancement est programmé pour la 2011. La proposition est pour l’établissement d’un lien unilatéral avec le Mécanisme de Développement Propre et la Mise en Œuvre Conjointe, toutefois sans lien bilatéral initial. Les préoccupations quant au prix des permis devenant trop élevé sont proéminentes, et se reflètent dans l’interdiction de vente des permis et par une clause sur un prix plafond. Cet article examine la proposition de système australien d’échange international de droits d’émissions et l’établissement de liens. Différents scénarios pour le prix du quota australien en fonction d’un lien unilatéral sont pris en compte. Les alternatives pour l’établissement d’un lien bilatéral avec l’Union européenne et la Nouvelle Zélande sont évaluées. Nous postulons que l’Australie devrait supprimer les obstacles à l’établissement de liens, telles que la proposition de plafonnement des prix, et se diriger vers l’établissement de liens bilatéraux avec des systèmes appropriés. Mots clés: Australie; établissement de liens; marché du carbone; systèmes d’échange de droits d’émissions

1. Introduction Preparations are under way for an Australian emissions trading scheme (ETS) to start in 2011. International linking will be a key factor for the emissions price, market liquidity and volatility, and for the aggregate cost to the Australian economy of achieving a given emissions target. Just as in the other countries explored in other articles in this Special Issue, Australian policy-makers are conscious of the possibilities of international linking, and are evaluating the issues according to a variety of different criteria. Australian climate policy has experienced a shift and acceleration following the 2007 election of a new government under Prime Minister Rudd. Analysis and planning for domestic emissions

■ *Corresponding author. E-mail: [email protected] CLIMATE POLICY 9 (2009) 402–414 doi:10.3763/cpol.2009.0624 CLIMATE POLICY © 2009 Earthscan ISSN: 1469-3062 (print), 1752-7457 (online) www.climatepolicy.com

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trading was already under way under the previous federal government (Prime Ministerial Task Group on Emissions Trading, 2007) and separately by the state governments (National Emissions Trading Task Force, 2006), and was taken up with greater urgency by the new federal government. Economic analysis of the effects of mitigation scenarios on the Australian economy was undertaken by the Australian Treasury (Department of the Treasury, 2008). In addition, a major governmentcommissioned independent study was carried out that made recommendations on Australia’s climate policy (Garnaut, 2008a). Detailed proposed provisions for an Australian ETS were set out in a December 2008 White Paper (Department of Climate Change, 2008a) aimed at a start date of July 2010. In May 2009 several changes were announced, including a start in mid-2011 (Prime Minister et al., 2009). This article refers primarily to the White Paper but flags the key changes of May 2009. Whether, when, and in what form the scheme will come into effect depends on the parliamentary process, the outcome of which is unclear at the time of writing in the first half of 2009. The government has a majority in only one of the two chambers of parliament. The two most likely possibilities (at the time of writing in early 2009) are either that the scheme will be adopted with modifications, or defeated in parliament and re-introduced, probably in a revised form, by a future government. The scheme, as proposed in the White Paper, aims to prevent the domestic permit price from rising ‘too high’, at least in the early years, through a ban on international permit sales, a domestic price cap, and unilateral linking with unlimited access to the Clean Development Mechanism (CDM) and Joint Implementation (JI). A cautious approach is taken to bilateral linking, with no bilateral links to start with, but with the prospect of linking to selected schemes further down the track. The European Union (EU) and New Zealand (NZ) schemes would be obvious candidates to consider linking with. In this article, we describe the key features of the proposed scheme (Section 2); analyse the provisions for unilateral linking to the CDM and JI and controlling the price in three scenarios, and reflect on the fundamental role of international linking for an open economy such as Australia (Section 3); and explore options for bilateral linking with the EU and NZ schemes (Section 4).

2. Key features of the planned Australian ETS 2.1. National target commitments and scheme caps The announced national emissions target is an unconditional 5% reduction by 2020 compared with 2000 levels; a reduction of up to 15% by 2020 ‘if advanced economies take on commitments comparable to Australia’s there is an agreement where major developing economies commit to substantially restrain emissions’; and a reduction of 25% ‘if the world agrees to an ambitious global deal to stabilise levels of CO2 equivalent at 450 parts per million’, with detailed conditions attached (Prime Minister et al., 2009). This compares with an anticipated increase in emissions by around 8% by 2010, and 26% by 2020, under official projections (Department of Climate Change, 2008c).1 The scheme would start in mid-2011 with permits issued at a fixed price of A$10/tCO2, and with a floating price from mid-2012. The scheme caps (the amount of permits issued under the emissions trading scheme) would be guided by the overall national commitment.

2.2. Coverage, other greenhouse gas policies, and permit allocation The proposed ‘carbon pollution reduction scheme’ (Department of Climate Change, 2008b), as the emissions trading scheme is called, is to cover practically all greenhouse gas emissions outside land-use change and agriculture, covering initially around 75% of Australia’s emissions, or around 450 MtCO2-equivalent in 2006 (Department of Climate Change, 2008c). Around 1,000 entities

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with emissions greater than 25 ktCO2e per year are to be directly liable for their emissions. Smaller sources of combustion emissions, including transport and residential fuel use, are to be covered through ‘upstream’ permit liability on fuel suppliers. However, petrol and gas for road transport are effectively exempt through an offsetting reduction in fuel taxes, in place initially until 2013. The government is assessing the inclusion of agricultural emissions, which account for around 16% of Australia’s emissions, from 2015, with a decision regarding inclusion to be taken in 2013. Forestry is covered by voluntary opt-in for reforestation activities from the beginning of the scheme, while land-use change (accounting for around 11% of emissions in 2006, on a steeply falling trajectory) is excluded. A range of additional policies are aimed at curbing greenhouse gas emissions. They include, first and foremost, a mandatory renewable energy target, as well as various programmes for industry, power supply and end-use efficiency, and policies for forestry, land use and agriculture. Permits are to be auctioned, except for free allocations to emissions-intensive, trade-exposed industries (EITEIs) such as aluminium, steel and liquefied natural gas, and a defined one-off amount to be granted to coal-fired electricity generators. The free allocation to EITEIs is 90% or 60% (95% and 66% after the May 2009 revisions) of historic benchmark emissions in the sector, depending on how emissions-intensive the production activity is, and includes new entrants and expanding entities.2 The threat of carbon leakage has played an important role in the industry lobbying effort and broader public debate, with fears that emissions pricing might trigger the relocation of some energy-intensive resource industries. On the other hand, there are concerns that handouts of free permits by government to industry in the proposed fashion could create an adverse political economy and could undermine the long-term viability of the scheme (Garnaut, 2008b). The issue of permit allocation is outside the scope of this article.

2.3. Banking and borrowing, and price cap Unlimited banking is to be allowed from one compliance year to the next (except fixed price permits issued in 2011–12). Short-term borrowing is allowed at a maximum of 5%, meaning that carbon pollution permits from the following year can be used to meet up to 5% of a liable entity’s obligation. A price cap is to apply until 2015, implemented by way of the government selling additional permits into the market at a predetermined price (see Section 3).

2.4. International trading and linking Permit sales from the Australian system into overseas systems are specifically excluded (outside any possible linking arrangements) in the initial years of the scheme. International Kyoto credits can be used without limits in the Australian scheme, although only non-forestry CDM (certified emission reductions, CERs), JI (emission reduction units, ERUs) and removal units (RMUs) can be used, subject to future review. The White Paper states that Australia’s scheme may be bilaterally linked with other international schemes over time, but priority is given to minimizing implementation risks and promoting price stability and predictability. Echoing earlier recommendations from the Garnaut Climate Change Review (2008), the White Paper argues that future bilateral links and deeper integration should only be undertaken with schemes that have internationally or mutually acceptable mitigation commitments; adequate and comparable mechanisms for monitoring, reporting, verification, compliance and enforcement; and that are compatible in design and market rules.

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The White Paper points out that linking rules are a key determinant of the domestic price, and that, therefore, future linking decisions should be made together with decisions regarding the national trajectory.

3. Unilateral linking and controlling the price The desire to limit the permit price in the Australian scheme is borne out of the fear of triggering too much adjustment too fast, reflected in many industry submissions to government,3 and in the government’s emphasis on a ‘measured transition’ that protects jobs – an aspect that is gaining particular importance during a time of economic slowdown.4

3.1. The price cap The Australian White Paper prescribes that a price cap is to apply in the period 2010–2015, starting at A$40/t of CO2-equivalent (CO2e) and rising at 5% per year to A$51/t by 2015, plus an adjustment for inflation.5 The level of the price cap is to be independent of the national target and scheme caps chosen. If the demand for permits drives prices up to the cap, the government will sell additional permits into the market at this fixed price. Thus, if and when in place, the price cap would loosen the Australian scheme cap and, through banking, might also loosen future caps. The idea of a price cap, often also referred to as a ‘safety valve’, is to limit the risk of higher than expected compliance costs to emitters, as a strategy to make emissions targets more palatable to domestic constituencies (Jacoby and Ellerman, 2004; Toman, 2004). Almost all of the analysis in the literature on price caps deals with the single-country or whole-world case, where there is only one quantitative constraint and a single price cap (e.g. Pizer, 2002; Philibert, 2008). For the case where different countries implement a harmonized price cap, it has been shown that efficiency gains could be distributed in a highly asymmetrical fashion and would carry substantial budgetary implications (Jotzo, 2006). The issue is more complex again in the emerging real-world situation of separate but linked trading systems in different countries, with separate price caps, and where a country needs to fulfil an internationally agreed emissions target irrespective of the operation of the price cap in its emissions trading scheme, as would be the case for Australia.

3.2. Scenarios Three scenarios are sketched below that might arise for Australia’s permit market and compliance with a future international commitment, with a more detailed analysis available in Jotzo and Betz (2009).

Scenario 1: Compliance in the scheme through international purchases Under this scenario, emitters bid up the price of domestic permits to the level of international prices and buy some amount of international units from CDM or JI. The price remains below the price cap. To the extent that other national schemes allow the use of CDM/JI units, prices are harmonized across schemes. The Australian permit price fluctuates with the international price, which is largely determined by supply and demand in other countries. The Australian government engages in international trading only to the extent that emissions levels in non-covered sectors require purchases (or allow sales) for Australia’s national emissions commitments to be fulfilled. International purchases or sales by government would also occur at (roughly) the prevailing international price, unless lower-priced so called ‘hot air’ units were available, and the Australian government were to seek national compliance by purchasing them.

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Scenario 2: Compliance in the scheme through the price cap In this scenario, the international (CDM) price is above the Australian price cap, and emitters buy extra permits issued by the Australian government at the predetermined price. They do not buy international units, and – because it is disallowed – do not sell to other countries either. However, they might choose to bank any permits already acquired or given to them by government, and substitute these permits with extra purchases at the capped price. This would be a profit-maximizing strategy if future increases in permit prices were expected, and it would further loosen the effective scheme cap. It is likely that as soon as the price cap threshold was reached, all opportunities for banking would be used.6 Total emissions from sources covered by the trading scheme are larger than under the predetermined scheme cap, by the amount of additional permits issued. In turn, Australia’s total emissions are higher, so in order to comply with Australia’s national emissions commitment, it becomes necessary to undertake more mitigation in non-covered sectors and/or to introduce regulatory measures for activities already covered by emissions trading and/or for government to purchase units in international markets. If the government purchases units eligible for acquittal by its domestic emitters (e.g. CDM or JI units), then the cost of purchasing these units will probably be greater than the revenue obtained by selling extra permits under the price cap domestically.7 Consequently, there will be a budgetary cost of the price cap.

Scenario 3: Full domestic compliance at domestic market price In this scenario, the Australian domestic permit price is below both the international price and the price cap, and all reductions needed to comply with the scheme cap are undertaken domestically. The ban on permit sales means that the domestic permit price does not rise to the international price or to that in other schemes. The price differential implies an economic inefficiency: the marginal cost of mitigation action in Australia is lower than elsewhere, and additional units of mitigation could free up permits that could be sold to other countries at prices above cost, with both parties gaining in the process.

What is the likely outcome? From the White Paper, it is evidently the Australian government’s expectation that scenario 1 would eventuate, with Australian emitters buying credits internationally at prices below the price cap. The assumption that Australia would not meet its reduction targets through domestic mitigation alone (scenario 1) is supported by the Australian Treasury’s modelling (Department of the Treasury, 2008), where all main scenarios have Australia as a net buyer in overseas markets in 2020, assuming permit prices only marginally below the proposed price cap. However, there would also be a significant chance of a price cap applying (scenario 2), as well as of full domestic compliance (scenario 3). There is significant uncertainty about the future underlying growth trajectory and the abatement response, illustrated in the relatively broad range of results from three different models shown in the Treasury’s analysis.8 If the abatement response (including measures in addition to the emissions trading scheme) is underestimated, or if underlying emissions growth is overestimated, then domestic measures alone might be sufficient for compliance with international commitments, in particular in the early years until 2015 – the proposed final year of the price cap. There is even a chance that emissions might turn out to be below Australia’s Kyoto targets, and below scheme caps in the early years of the emissions trading scheme, without any price signal from the trading scheme. In that case, the

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permit price in the early years would hinge on market expectations of future permit prices, transmitted via the banking of permits.9 An ‘upside’ scenario of the price cap applying equally appears possible, if the future international price (converted to Australian dollars) is higher than the price cap. This would not be the case at the levels of CDM prices at the time of writing, in early 2009, which are substantially below 2008 prices. However, survey results of expected future international prices (Point Carbon, 2008) and analysis of the technical and economic fundamentals (Lewis and Curien, 2008) suggest that prices might rise substantially. Grubb (2008) expected prices to be towards the lower end of the €20–40/t range. This translates to around A$40–80/t at the exchange rate prevailing in early 2009, and thus encapsulates the proposed range for the price cap.

3.3. Open economies and international linking Setting a domestic price cap implies that the government has a notion of the ‘acceptable’ permit price, irrespective of the quantity of emissions and abatement at that price level, and irrespective of prices in other countries.10 But shielding Australian producers from ‘high’ emissions prices that apply elsewhere results in less than the economically efficient amount of abatement undertaken in Australia.11 As pointed out above, the direct effect of less abatement under the scheme means more international purchases of abatement units, or extra policies outside of emissions pricing. Furthermore, where separate and only partly compatible emissions pricing regimes apply in different countries, this imposes additional transaction costs on business. Drawing on the lessons of the economic prosperity that has come with openness to international markets (Anderson, 2000), the future for a trade-intensive economy such as Australia’s is in harmonization with international emissions markets, insofar as they are mature and underpinned by stable policy frameworks. An economically efficient outcome, with comparable emissions prices to other countries, could of course be achieved in ways other than by linking emissions trading markets. But in the context of an international agreement based on quantitative emissions targets, broad access to international carbon markets would be necessary. Given its natural resource endowment, Australia is likely to continue to export emissionsintensive commodities such as minerals and agricultural products, even if strict global carbon constraints are applied over the decades to come.12 It seems implausible that resource-rich countries would be able to negotiate substantially greater per capita allocations than others. Australian emissions-intensive exports would then need to be covered by permits purchased from other countries – and the cost of those permits would be recouped as part of the export revenue.

3.4. The price cap as an obstacle to linking Options for bilateral linking will be diminished while provisions for a price cap are in place in Australia. Among fully linked schemes, if a price cap is in force in one country, it effectively caps permit prices across all linked emissions trading schemes: if the permit price in the other country’s scheme moved above the price cap, Australian permits would be exported and Australian liable entities would access their domestic price cap, until the price in the linked systems was equalized again. Such arbitrage could be unacceptable to other countries, as their own emitters would effectively be complying with emissions limits by (indirectly) buying permits from the Australian government. Conversely, the Australian government would take on a greater budgetary risk, if permits sold by domestic emitters were packaged with Kyoto units. Finally, linking bilaterally can either increase

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or decrease the probability of the price cap applying, depending on the other country’s underlying domestic emissions price. Governments from both sides would need to be comfortable with these implications. In the absence of relevant international experience, it seems reasonable to assume that bilateral linking with price caps would in practice require either the same level price cap to apply in both countries, or for any price cap to be set very much higher than the expected price, with a very low probability of applying.

4. Bilateral linking scenarios with existing schemes The opportunities and challenges are examined for bilateral linking between Australia and the EU Emissions Trading Scheme (EU ETS) as well as the New Zealand (NZ) scheme. The discussion is on the basis of the designs for the respective schemes as of January 2009.

4.1. Linking to the EU ETS Linking to schemes that may have a significant impact on the Australian permit price – such as the EU ETS, whose market size is four to five times larger – at this stage does not appear to be a realistic prospect, or one desired by the Australian government.13 The prohibition on international permit sales is obviously intended to stop the Australian permit price rising to the future level of the EU ETS permit price, if the underlying supply and demand in Australia alone would result in a lower permit price. From a political perspective, the comparability of effort may be a criterion for linking schemes. The EU has committed to a 20% reduction in 2020 emissions compared with 1990, and 30% depending on other countries’ commitments (European Parliament, 2008). The European Union aims to build an OECD-wide carbon market by 2015 (European Commission, 2009) and is thus committed to seek linking opportunities with other industrialized countries such as Australia. The Garnaut (2008) model of determining national commitments shows that the EU’s 20% reduction commitment is roughly compatible with a 10% reduction for Australia; while Australia’s target under a more ambitious international agreement would be a 25% reduction, with the EU reducing by more than 30%.14 Of course, comparability of effort could be evaluated according to many other criteria (den Elzen et al., 2008). The coverage of the EU ETS is narrower than for the Australian ETS. The EU ETS covered around 45% of GHG emissions in 2008 and excludes agriculture, waste, and the emissions of installations that are below the thresholds, as well as road transport emissions – but will include emissions from aviation from 2012. The EU may argue that some of the emissions covered in the Australian scheme cannot be as accurately measured, and linking the schemes would import this uncertainty into the European scheme. This would be especially so if Australia decided to include agriculture at a later stage. The past reluctance of Europe to include forestry in the ETS may also cause difficulties, as Australia is including forestry on a voluntary basis. The EU ETS operates in phases (second phase 2008–2012, third phase 2013–2020) and does not allow borrowing between phases, whereas Australia’s permits have annual vintages, and shortterm borrowing of 5% is allowed. Linking could allow EU companies to indirectly borrow up to the capped amount through the Australian scheme (through Australian emitters borrowing more and on-selling), causing some budgetary risk for Australia at the end of a commitment period. In contrast, Australia’s companies may be able to borrow more than the 5% within each multi-year EU phase, but this will depend on the release of allowances over time, which will change in phase 3 when the share of auctioning is to be increased to around 60% (European Commission, 2008).

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As the compliance periods differ – the Australian scheme is based on its financial year, 1 July to 30 June, whereas the EU ETS follows calendar years – the liquidity of the spot market of both schemes may benefit, whereas future markets may not gain significantly since contract settlement dates do not seem to be compatible.15 With regard to supplementarity (the Kyoto principle that flexible mechanisms should be supplemental to domestic mitigation action), the EU ETS sets quantitative and qualitative limits for the use of CERs and ERUs up to 2020, whereas the Australian scheme would not limit the use of credits, apart from excluding forestry CERs. The implication of full bilateral linking under these parameters would be that greater amounts of CERs could effectively enter the EU ETS through on-selling of Australian permits to the EU, with Australian emitters resorting to the CDM to a greater extent. The most important obstacle for short-term linking seems to be the price cap in the Australian scheme (see Section 3). Europe has a relatively high penalty of around €100/tCO2e combined with a make-good provision which ensures that the penalty is unlikely to function as a price cap.

4.2. Linking to the NZ trading scheme The Australian government considers linking in the short and medium term with New Zealand, and NZ has expressed a strong interest in linking with Australia. The two countries have set up a joint government group to work towards harmonization of the two schemes (Wong and Smith, 2009). The two countries are close geographically, a variety of economic ties and policy links exist, and both countries are interested in integrating agriculture and forestry into emissions trading. Linking to the NZ scheme is deemed not to significantly affect Australian permit prices as it is a much smaller market comprising, under a full coverage scenario, around 62 MtCO2e per year (UNFCCC, 2007) compared with around 450 Mt in Australia. Linking would also offer opportunities for sharing governance arrangements and technical resources (for example, auditors and accreditation resources, and harmonizing registries). The proposed NZ ETS was approved by parliament in September 2008 (New Zealand Government, 2008). However, its future is unclear, it being reviewed by the new government which came into power at the end of 2008 (Point Carbon, 2009). Consequently, the discussion about linking with the NZ scheme is subject to policy uncertainty. Both schemes set an absolute cap over a specified period. While the Australian scheme gives emitters more planning certainty (5-year cap plus 10-year gateways), the NZ government has not announced any cap or reduction targets for the 2013–2020 period. Any uncertainty over the NZ scheme caps would be imported into the Australian scheme if both were linked. At this stage, the only possible comparison of stringency is the effort required to meet Kyoto targets, which is probably less relevant than the period 2013–2020. Australia will require little effort to comply with its Kyoto target to 2012 (Department of Climate Change, 2008d). In contrast, the NZ government is projecting a gap of 14.7 MtCO2e per year for the first commitment period between projected and allowed emissions, which is around 5% of NZ’s assigned amount (Ministry of Environment, 2008).16 Although the stringency of caps is not, in principle, an impediment to the linking of schemes, comparable stringency is likely to be a political precondition for linking. Thus, the setting of the Australian target for 2020 may have impact on a future NZ decision about linking, and likewise any target adopted or negotiated by NZ could affect an Australian linking decision. With regard to coverage, both schemes feature a comprehensive system with a hybrid approach, covering small emissions sources, such as transport upstream, and large emitters downstream. Both countries want to bring the emissions from agriculture into the scheme, accounting for around 16% and around 48% of Australia’s and NZ’s emissions, respectively, in 2006.17 New Zealand has committed to include agriculture from 2013 onwards.18 Given the competition between those

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countries in some international agricultural markets such as dairy and wool, which both cause significant methane emissions from livestock, a common approach should be aimed for in order to minimize competitive distortions. In the forestry sector, the general approach is similar; both schemes will, in some form, bring forestry under the cap. In New Zealand, forestry is mandatory, while in Australia a voluntary opt-in is foreseen. Both schemes allow unlimited use of CERs, but do not accept CERs from forestry projects. Linking would be likely to provide advantages to New Zealand in providing greater liquidity, as it seems that the NZ government is not planning to auction any permits but envisages some sectors, such as transport, buying units in international markets. Thus, the access to the Australian auctions may prove important for the liquidity of the NZ market, as the international market – especially for AAUs – may be less liquid, with trades expected mainly by governments. Both countries allow unlimited banking of allowances into the future, but the borrowing rules appear to be different. As described in the EU context, there could be some indirect borrowing effects for both countries, which may have some budgetary implications for Australia (Betz and Stafford, 2008). As discussed in Section 3, Australia’s price cap is a major theoretical hurdle to linking. In linked schemes, NZ emitters would gain access to the Australian price cap, through on-selling of permits from Australian companies, and this could have budgetary consequences for Australia. A comparable obstacle for linking in the near future could be the difference in international units eligible under both schemes. Given that the NZ scheme would allow the unlimited use of international units – including assigned amount units (AAUs), which could potentially be ‘hot air’ – the option of exporting permits from NZ conflicts with Australia’s stance to disallow AAUs for compliance in the scheme. Essentially, the proposed NZ scheme is fully open internationally, whereas the Australian scheme has provisions to partially decouple from the international market. However, the link could reduce the risk of reaching the price cap in Australia, insofar as it would effectively allow the use of – most probably cheap – ‘hot air’ permits in the Australian scheme, again indirectly through on-selling of NZ units from NZ participants. Over the first commitment period, hot air throughout the Kyoto Protocol may amount to 8,200 MtCO2e, or 1,640 MtCO2e annually (Jotzo and Betz, 2009). However, the extent that hot air enters the Australian scheme would be capped at the total amount of covered emissions in New Zealand (around 78 MtCO2e in 2006). Table 1 summarizes the key findings with regard to linking. TABLE 1 Summary of linking the Australian ETS to the EU and New Zealand emissions trading schemes Major obstacles to linking Australian view Australia–EU

Linking partner view

Main similarities between schemes

Price cap (short term) in Australia

Price cap in Australia (short term)

Stringency of cap

Possibly high permit prices in

Unlimited CERs and ERUs

Allocation (similar to EU

EU ETS

Voluntary opt-in of forestry

ETS 3rd phase)

Potential future inclusion of

Exclusion of forestry CERs

agriculture Australia–NZ

Unlimited amount of assigned

No major obstacles

Coverage, including

amount units (AAUs) in NZ scheme

forestry approach

Price cap (short term) in Australia

Unlimited use of CERs and ERUs Exclusion of forestry CERs

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5. Conclusions Australia’s government is taking a cautious approach to international linking. The proposal tabled in late 2008 is for unilateral linking with unlimited access to credits from the CDM and JI, but no bilateral linkages to start with, although full linking with selected partners is envisaged in the future. A defining theme in scheme design is to limit the maximum domestic permit price, at least during the start-up phase. This is to be achieved through the combination of unlimited access to international emissions credits, a ban on sales out of the system, and a government-administered price cap. The expectation is that Australia would be a permit buyer at prices below the price cap threshold. But the price cap applying, or compliance purely through domestic abatement, are also possible. The price cap brings with it risks to public budgets and economic efficiency, because it can override the scheme cap but not the national emissions commitment. It is also an important obstacle to bilateral linking with other schemes. A number of hurdles to linking with Australia would exist from the perspective of the European Union. The Australian price cap, while in place during the first 5 years of the scheme, would probably preclude linking. The unlimited use of units from the Kyoto mechanisms CDM and JI would be another obstacle. Whether the EU would accept unlimited use of Kyoto units in a scheme it links to would be likely to depend on outcomes of international negotiations, including the stringency of post-2012 commitments. And whether the EU would accept the Australian provisions for voluntary opt-in for forestry and the prospect of including agriculture down the track would be likely to depend on whether Australia can demonstrate rigorous monitoring and verification in these sectors. Regarding New Zealand, assuming that the scheme will survive under the change of government and evolve as set out in the bill, linking with Australia seems likely, given the inclination by both parties towards linking, reflected in a government working group on scheme harmonization. However, the potential indirect inflow of ‘hot air’ into the Australian system could prove a major barrier from an Australian perspective and may need some modification of the NZ scheme. Another issue that would need to be resolved for linking are the interactions and budget risks arising from the Australian price cap. Australia’s longer-term opportunities lie in integration with international emissions markets. Australia, a country strongly engaged in international trade, has much to gain from an open trading regime that transmits international prices to the domestic economy. Bilateral linking would also ensure consistent access to international permit trading opportunities, and minimize transaction costs for business. In a world with strong quantitative carbon constraints, continued large-scale exports of emissions-intensive commodities from Australia would almost certainly require the purchase of permits internationally. With this in mind, it would be logical for Australia to dismantle the initial barriers to international linking of its emissions trading scheme, to search out linking opportunities with existing and emerging schemes that are compatible in design and ambition, and to work with developing countries in the region to establish and support mitigation programmes there.

Acknowledgements We thank, without implicating, Paul Twomey, Stephen Howes, Andreas Tuerk, Jeff Bennett, Oli Sartor, Rob Passey and the anonymous Climate Policy referees for their comments and suggestions, as well as participants at an April 2008 public forum on linking of emissions trading that we organized. This research was supported financially through the Environmental Economics Research Hub, which is funded by the Australian Commonwealth Environmental Research Facility (CERF) programme.

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Notes 1.

2.

3. 4. 5. 6.

7. 8.

9.

10.

11. 12.

13.

14. 15. 16.

Australia’s net emissions under Kyoto accounting remained almost unchanged from 1990 to 2000 because reductions in land-use change emissions outweighed continued increases in emissions from most other sectors of the economy. As land-use change emissions dwindle, there is no further offsetting effect, so unabated emissions growth in future years would be strongly positive. The White Paper estimates that about 30% of permits will be freely allocated (including power generators) and 70% auctioned in 2010. The free allocation share could well increase over time, as EITEI activities expand – including through bringing agriculture into the scheme – while the overall emissions budget is reduced. Submissions to the government’s Green Paper (which preceded the White Paper) are available at www.climatechange.gov.au/greenpaper/consultation/submissions.html. Remarks by Climate Change Minister Hon. Penny Wong, 20 December 2008, Adelaide (see www.environment.gov.au/ minister/wong/2008/tr20081220.html). The subsequent deferral until 2012 of emissions trading with a floating price means that the price cap would apply only from 2012; it appears unclear whether it would be extended from the outset to apply beyond 2015. The White Paper foresees that permits issued under the price cap would not be eligible to be banked, but does not preclude the banking of permits issued through auctioning or free allocations, even if the price cap applies. Therefore banking of ‘price cap permits’ could happen indirectly, to a total volume up to the amount of permits already issued through auctioning and free allocation but not yet acquitted. The exception would be if the CDM price fell over time, and the government purchased international units for compliance at a later time at prices below the price cap level. In the ‘5% scenario’, Australia’s actual emissions in 2020 would be between 6% and 20% above year 2000 levels in the three models used, at a common emissions price of A$35/t. In the ‘15% scenario’, 2020 emissions would be between 8% below and 10% above 2000 levels, at a common price of A$50/t. Data are from Department of the Treasury (2008, Table 6.4). However, the recent experience of sharp falls in EU ETS prices in response to the financial crisis (Lewis and Curien, 2008) seems to point to failures in intertemporal permit markets, or in the availability of credit for permit purchases. If a very low price occurred early on, this could erode confidence in the scheme, and effectively delay abatement. In the earlier ‘Green Paper’ (Department of Climate Change, 2008a), it was suggested that the price cap would be set ‘high enough above the expected permit price to ensure a very low probability of use’. This was modified in the White Paper (Department of Climate Change, 2008b) to ‘the price cap should be set high enough to deter widespread use’, though still raising concerns that the price cap could breach the environmental integrity of the scheme. The starting level was set at a A$40/t starting value with reference to the government’s modelling scenarios that assume international prices between A$23 and A$32/t. Experience with other schemes has shown that modelling projections of permit prices are highly unreliable (Grubb, 2008); hence there may be merit in using methods such as prediction markets to project future prices, for the purpose of policy design. As shown by Babiker et al. (2004), the economically optimal emissions price may differ between countries because of differing interactions with existing taxes, but a price cap is not intended as a tool to correct for such effects. As an illustration, consider the Treasury’s (2008) modelling results reported for 2050, again for the range of three models. Under the least stringent scenario, Australia reduces domestic emissions between 24% and 55% relative to 2000, compared with a national emissions reduction target of 60%, at a carbon price of A$115/t (real). Under the most stringent scenario, domestic emissions reductions range between 69% and 86%, compared with a 90% reduction target, at A$197/t. The latter scenario implies that actual emissions would be between 1.4 and 3.1 times larger than Australia’s allocation at 2050, with the gap made up through international permit purchases. Based on the 5% reduction target, assuming an equal burden-sharing between the 75% of covered emissions and the 25% of non-covered emissions, Australia’s allowances in 2020 would be around 374 MtCO2e (based on data in Department of Climate Change, 2008c). The EU ETS will allocate in 2020 around 1,720 MtCO2e, which is based on a 20% reduction target relative to 1990, and does not include aviation and other sources to be covered from 2013 onwards (European Commission, 2008). This model is based on contraction and convergence towards equal per capita allocations over time, thus taking into account both higher per capita emission levels and much faster population growth in Australia. In the EU ETS the settlement date is in December of each year, and in Australia it will most probably be in June. The figure of 14.7 million AAUs is the net emissions position: this differs from the net position published by the Treasury of 21.7 million AAUs – which excludes the AAUs committed to projects, amounting to 7 million AAUs

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for the first commitment period. These figures have changed significantly over time, mainly due to changes in policies and land clearing. 17. These figures are for 2006 emissions based on the 2008 submitted GHG Inventories for New Zealand and Australia, including land-use change and forestry removals, which can be viewed at http://unfccc.int/national_reports/ annex_i_ghg_inventories/national_inventories_submissions/items/4303.php. 18. The point of liability has not been decided yet. Australia is consulting and aims to decide by 2013 whether agriculture is going to be included from 2015. The main issues for both countries is the trade-off between (1) covering the emissions at the farm level, which will result in a larger number of entities and higher transaction costs, but with a more effective incentive for reductions, or (2) covering emissions on a more aggregate level (e.g. slaughterhouses) to make the scheme more manageable but at the same time reducing incentives for emissions reductions through farm-level management practices.

References Anderson, K., 2000, Australia in the International Economy, CIES Discussion Paper No. 49, University of Adelaide, Adelaide. Babiker, M., Reilly, J., Viguier, L., 2004, ‘Is international emissions trading always beneficial?’, Energy Journal 25(2), 33–56. Betz, R., Stafford, A., 2008, ‘The policy issues arising with the linking of international emissions trading schemes’, Australian Resources and Energy Law Journal 27(1), Special Issue Emissions Trading, 86–104. den Elzen, M., Hoehne, N., van Vliet, J., Ellerman, C., 2008, Exploring Comparable post-2012 Reduction Efforts for Annex I Countries, PBL Report 500102019/2008, Netherlands Environmental Assessment Agency, Bilthoven, The Netherlands. Department of Climate Change, 2008a, Carbon Pollution Reduction Scheme, Green Paper, Commonwealth of Australia, Canberra. Department of Climate Change, 2008b, Carbon Pollution Reduction Scheme: Australia’s Low Pollution Future, White Paper, Commonwealth of Australia, Canberra. Department of Climate Change, 2008c, National Greenhouse Gas Inventory 2006, Commonwealth of Australia, Canberra. Department of Climate Change, 2008d, Tracking to the Kyoto Target 2007, Commonwealth of Australia, Canberra. Department of the Treasury, 2008, Carbon Pollution Reduction Scheme: The Economics of Climate Change Mitigation, Commonwealth of Australia, Canberra. European Commission, 2008, Questions and Answers on the Revised EU Emissions Trading System, MEMO/08/796, Brussels. European Commission, 2009, Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the Committee of the Regions, COM(2009) 39 final, Brussels. European Parliament, 2008, European Parliament Legislative Resolution of 17 December 2008 on the Proposal for a Decision of the European Parliament and of the Council on the Effort of Member States to Reduce their Greenhouse Gas Emissions to meet the Community’s Greenhouse Gas Emission Reduction Commitments up to 2020, COM(2008)0017–C6-0041/2008– 2008/0014(COD)). Garnaut Climate Change Review, 2008, Emissions Trading Scheme Discussion Paper, Canberra [available at www.garnautreview.org.au]. Garnaut, R., 2008a, The Garnaut Climate Change Review, Cambridge University Press, Melbourne [available at www.garnautreview.org.au]. Garnaut, R., 2008b, ‘Oiling the squeaks’, Sydney Morning Herald, Sydney. Grubb, M., 2008, Carbon Prices in Phase III of the EU ETS, Climate Strategies Policy Briefs [available at www.climatestrategies.org/our-research/category/47/69.html]. Jacoby, H.D., Ellerman, A.D., 2004, ‘The safety valve and climate policy’, Energy Policy 32(4), 481–491. Jotzo, F., 2006, ‘Price caps for international permit trading under uncertainty with heterogeneous market participants’, presented at 3rd World Congress of Environmental and Resource Economists and ANU EEN Working Paper Kyoto. Jotzo, F., Betz, R., 2009, Linking the Australian Emissions Trading Scheme, Research Report 14, Environmental Economics Research Hub Research Reports [available at www.crawford.anu.edu.au/research_units/eerh/pdf/EERH_RR14.pdf]. Lewis, M.C., Curien, I., 2008, Now for the Carbon Crunch: Previewing the EU Summit, Deutsche Bank. Ministry for the Environment, 2008, Net Position Report 2008: Projected Balance of Kyoto Protocol Units during the First Commitment Period, Wellington.

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National Emissions Trading Task Force, 2006, Possible Design for a National Greenhouse Gas Emissions Trading Scheme, State and Territory Governments of Australia, Melbourne. New Zealand Government, 2008, Climate Change Response (Emissions Trading) Amendment Act 2008, Public Act 2008 No 85, Date of Assent 25 September 2008 [available at www.legislation.govt.nz/act/public/2008/0085/latest/ whole.html#DLM1131412]. Philibert, C., 2008, Price Caps and Price Floors in Climate Policy: A Quantitative Assessment, IEA Information Paper, December, Paris. Pizer, W.A., 2002, ‘Combining price and quantity controls to mitigate global climate change’, Journal of Public Economics 85, 409–434. Point Carbon, 2008, Carbon 2008, Oslo [available at www.pointcarbon.com]. Point Carbon, 2009, NZ Stalls on Repealing ETS, 15 January, Oslo [available at www.pointcarbon.com]. Prime Minister, Treasurer and Minister of Climate Change of Australia, 2009, New Measures for the Carbon Pollution Reduction Scheme, May, Canberra [available at www.climatechange.gov.au]. Prime Ministerial Task Group on Emissions Trading, 2007, Report of the Task Group on Emissions Trading, Commonwealth of Australia, Canberra. Toman, M.A., 2004, ‘Economic analysis and the formulation of U.S. climate policy’, in: R. Lutter, J.F. Shogren (eds), Painting the White House Green: Rationalizing Environmental Policy Inside the Executive Office of the President, Resources for the Future, Washington, DC. UNFCCC (United Nations Framework Convention on Climate Change), 2007, Report of the Review of the Initial Report of New Zealand, FCCC/IRR/2007/NZL, August [available at http://unfccc.int/resource/docs/2007/irr/nzl.pdf]. Wong, P., Smith, N., 2009, Australia and New Zealand Strengthen Climate Change Cooperation, Media Release, 19 March, Canberra.

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■ research article

Linking emissions trading schemes for international aviation and shipping emissions ERIK HAITES* Margaree Consultants Inc., 120 Adelaide Street West, Suite 2500, Toronto, Ontario M5H 1T1, Canada

International aviation and shipping emissions are large and growing rapidly. They may be regulated by domestic emissions trading schemes or by trading schemes established by the relevant international organizations. Under a domestic trading scheme, the international aviation/shipping sector would be linked to the other sectors covered by the scheme. If separate trading schemes are established for international aviation and/or shipping emissions, the administrator of each scheme could establish a unilateral or bilateral link with another scheme. The best candidate for a unilateral link would be the Clean Development Mechanism (CDM). A bilateral link would be much more difficult to implement because the schemes must be ‘compatible’ and an international treaty would probably be needed for legal and political reasons. The best candidates for a bilateral link would be the domestic emissions trading schemes in the EU and the USA. If international aviation and shipping are net buyers of allowances as expected, a unilateral link may be sufficient. Keywords: aviation emissions; bunker fuels; carbon market; CDM; emissions trading schemes; linking; maritime emissions; shipping emissions Les émissions du transport international aérien et maritime sont considérables et en rapide expansion. Elles pourraient être réglementées par des systèmes intérieurs d’échange d’émissions ou par des systèmes d’échange établis par des organisations internationales appropriées. Sous un système intérieur d’échange les secteurs internationaux du transport aérien et maritime seraient lies à d’autres secteurs couverts par le même système. Si des systèmes d’échanges séparés sont établis pour les secteurs aériens et maritimes, l’administrateur de chaque système pourrait établir un lien unilatéral ou bilatéral avec un autre système. La meilleure possibilité pour un lien unilatéral serait le Mécanisme de Développement Propre. Un lien bilatéral serait beaucoup plus difficile à mettre en place vu le besoin de « compatibilité » entre les systèmes,Ne et un traité international serait probablement requis pour des raisons légales et politiques. Les meilleures possibilités pour un lien bilatéral seraient les systèmes intérieurs d’échange de droits d’émissions de l’Union européenne ou des Etats-Unis. Si les secteurs de transport international aérien et maritime étaient des acheteurs nets de quotas comme prévu, un lien unilatéral suffirait. Mots clés: carburants de soute; émissions maritimes; émissions du transport aérien; émissions du transport maritime; établissement de liens; marché du carbone; MDP; systèmes d’échange de droits d’émissions

1. Introduction International aviation and shipping emissions are large and growing rapidly. Estimates of carbon dioxide emissions by international aviation for 2000 range between 400 and 675 MtCO2 (den Elzen et al., 2007, p.22, Box 2); Macintosh and Wallace, 2009, p.267). They are projected to grow at 2.0–4.5% per year to 2030 (Olsthoorn, 2001; Macintosh and Wallace, 2009). Emissions of other contaminants at altitude by aircraft exacerbate the climate impact by a factor of 1.7–5.1.1 Carbon ■ *Corresponding author. E-mail: [email protected] CLIMATE POLICY 9 (2009) 415–430 doi:10.3763/cpol.2009.0620 © 2009 Earthscan ISSN: 1469-3062 (print), 1752-7457 (online) www.climatepolicy.com

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dioxide emissions by international shipping in 2007 were estimated at 843 MtCO2.2 International shipping emissions are projected to grow at 1.9–2.7% per year to 2050.3 Based on CO2 emissions alone, international aviation and shipping emissions together would rank as the sixth largest emitter among the countries of the world, about the same as those of India.4 If the effects of other aircraft emissions are included, international aviation and shipping emissions would move into fifth place, with emissions similar to those of Japan. Stabilization of the atmospheric concentration of greenhouse gases requires that global emissions be significantly reduced. Due to their magnitude and projected rapid growth, international aviation and shipping emissions will probably need to be reduced as part of a global effort to stabilize the atmospheric concentrations of greenhouse gases (Grayling, 2003). To date, efforts to reduce emissions from international aviation and shipping have been unsuccessful. The Kyoto Protocol commits Annex I Parties to pursue limitation or reduction of emissions from aviation and maritime bunker fuels through the International Civil Aviation Organization (ICAO) and the International Maritime Organization (IMO).5 ICAO and IMO have studied options for reducing emissions, but have not yet adopted measures for this purpose. Emissions trading and emissions charges are among the options preferred by ICAO, IMO and independent researchers to manage international aviation and shipping emissions (Michaelis, 1997; Penner et al., 1999; Michaelowa and Krause, 2000; Tsai and Petsonk, 2000; Carlsson and Hammar, 2002; ICAO, 2007; IMO, 2008; UNCTAD, 2009). The European Union will extend its emissions trading scheme (EU ETS) to cover international aviation emissions associated with flights to and from Member States beginning in 2012. It is planning to add international shipping emissions to the scheme in 2013. Other countries may also include international aviation and shipping emissions in their emissions trading schemes. Thus, emissions from international aviation and/or shipping could be covered by one or more emissions trading schemes in the following ways: ■ One or more domestic emissions trading schemes, such as the EU ETS, that cover some international aviation and/or shipping emissions as well as emissions by other sources. ■ Emissions trading schemes that cover some or all international aviation emissions (possibly administered by ICAO) and some or all international shipping emissions (possibly administered by IMO). This article examines issues raised by linking a trading scheme that covers international aviation and/or shipping emissions with trading schemes covering other emission sources. The next section provides a brief history of attempts to manage international aviation and shipping emissions. Section 3 reviews the feasibility of managing these emissions at the international level. Options for schemes that include international aviation and shipping emissions to link with other trading schemes are analysed in Section 4. Section 5 concludes.

2. Attempts to manage international aviation and shipping emissions During the 1990s, discussions under the United Nations Framework Convention on Climate Change (UNFCCC) focused on how to allocate international aviation and shipping emissions to Parties. Agreement on an allocation has not been possible. As part of the Kyoto Protocol, they agreed to pursue limitation or reduction of emissions from aviation and maritime bunker fuels through

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ICAO and IMO. Neither ICAO nor IMO have taken any effective action on the issue yet. Recently, the European Union decided to extend its emissions trading scheme (EU ETS) to cover international aviation emissions beginning in 2012. Coverage may be extended to international shipping emissions, and other countries may implement similar measures.

2.1. Attempts to allocate international emissions to countries During the 1990s, discussions under the UNFCCC focused on how to allocate international aviation and shipping emissions to Parties. These discussions presumed that the emissions attributed to Annex I Parties would be regulated, while those attributed to non-Annex I Parties would not be regulated, consistent with the principle of common but differentiated responsibilities as applied to national emissions. Eight options were identified for allocating international aviation and maritime emissions to Parties (UNFCCC/SBSTA/1996/9/Add.2, pp. 20–22). In 1996, the following five options were selected as the basis for further work (Bode et al., 2002; Oberthür, 2003): 1. No allocation. 2. Allocation to Parties according to the country where the bunker fuel is sold. 3. Allocation to Parties according to the nationality of the transporting company, the country where the aircraft or vessel is registered, or the country of the operator. 4. Allocation to Parties according to the country of departure or destination of an aircraft or vessel or shared between the countries of departure and arrival. 5. Allocation to Parties according to the country of departure or destination of passenger or cargo or shared between the countries of departure and arrival. After more than 10 years of discussions, there has been no progress on a method of allocating international aviation and shipping emissions to Parties because countries that would have been allocated substantial emissions from bunker fuels would find themselves disadvantaged in their mitigation efforts (Oberthür, 2003). An allocation of emissions to Parties followed by differential regulation of the emissions attributed to Annex I and non-Annex I Parties will induce behaviour that reduces the effectiveness of the regulations. Under option 2, for example, bunker fuel sold in Annex I Parties would be more costly than fuel sold in non-Annex I Parties, because Annex I Parties would need to regulate the emissions associated with the fuel use. This would shift fuel purchases to non-Annex I Parties and lead to increased transport of fuel purchased there – tankering – thus reducing the effectiveness of the Annex I regulations to limit emissions. Under option 3, international emissions by aircraft and ships owned by Annex I Party companies would face regulations, while the emissions by non-Annex I Party aircraft and ships would not be regulated. The country of ownership can be changed easily for vessels, so ships could easily avoid the regulations. Airlines have less flexibility to change nationality, but traffic would shift from Annex I to non-Annex I airlines where they fly the same route. Differential regulation of the international emissions attributed to Annex I and non-Annex I Parties would induce behaviour that shifts emissions from Annex I to non-Annex I Parties – leakage – and hence reduce the effectiveness of the efforts to limit emissions. Such behaviour may be economically inefficient as well. Consistent treatment of all international aviation/ shipping emissions is the only way to avoid leakage and economic inefficiency due to differential regulation.

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2.2. Consideration of international emissions by ICAO and IMO Given the political deadlock on allocation, countries agreed during the negotiation of the Kyoto Protocol that Annex I Parties should pursue limitation or reduction of emissions from aviation and maritime bunker fuels through ICAO and IMO. Although the principal objectives of these organizations are the promotion and enhancement of international aviation and shipping, respectively, they do regulate relevant environmental matters. ICAO emphasized the need for further study of the impact of aviation emissions on climate change in the early 1990s and subsequently requested the IPCC to prepare a report on Aviation and the Global Atmosphere (Penner et al., 1999). In September 1997, the IMO adopted a resolution calling for a study of CO2 emissions from ships and identification of feasible CO2 reduction strategies (Oberthür, 2003). ICAO has studied alternative policies to regulate international aviation emissions. It has concluded that emissions trading with the option of buying additional credits from non-aviation sources, such as the Clean Development Mechanism (CDM), is the preferred policy (ICAO, 2007). ICAO has not been able to agree on steps to implement such a policy. At its September 2007 Assembly, ICAO initiated two more years of studies without agreeing to any concrete action to reduce emissions.6 IMO has also studied policies to reduce greenhouse gas emissions from shipping but has not yet implemented any measures to reduce emissions. The Maritime Environmental Protection Committee (MEPC) aims to identify and further develop options to make recommendations to the 2009 IMO Assembly. In short, neither ICAO nor IMO have taken any effective action on the issue yet and progress can be characterized as slow (Oberthür, 2003).

2.3. Domestic initiatives to cover international aviation/shipping emissions The European Union plans to incorporate domestic and international aviation emissions into its emissions trading scheme (EU ETS) beginning in 2012.7 Airlines will be required to remit allowances to a designated Member State for the emissions associated with flights to, from and within the European Union beginning in 2012.8 The allocation for international aviation will be 97% of average 2004–2006 emissions for 2012, and 95% for 2013 (European Union, 2008). Airlines will receive 90% of the allocated allowances free in 2012, and 80% in 2013, with the remainder being auctioned by the Member States. For subsequent years, the cap will probably be reduced and the share of allowances auctioned will be likely to rise to 100% by 2020. Separate aviation allowances (AAs) will be created for aviation. Airlines will be able to use AAs, EU allowances (EUAs), certified emission reductions (CERs) generated by CDM projects, and emission reduction units (ERUs) generated by Joint Implementation (JI) projects for compliance, but industrial sources will not be allowed to use AAs for compliance. International aviation is governed by the Chicago Convention (1944) and thousands of bilateral air service agreements. The Convention and most of those agreements prohibit the imposition of taxes, charges or levies on fuel consumed for international travel. This has stimulated debate concerning the legality of the EU plan to include international aviation emissions in its ETS (Cairns and Newson, 2006; Stuart and Fisher, 2007; Petersen, 2008). Legal challenges could delay, modify, or even prevent, inclusion of aviation emissions in the EU ETS as planned. Several airline industry associations have expressed their opposition to the EU plan.9 Air carriers are concerned about the effect of compliance costs on demand and profits. Independent analyses suggest that the fare increases and demand reductions will be small; generally less than 3%

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(Scheelhaase and Grimme, 2007; Lu, 2008; Albers et al., 2009). However, low-fare carriers will suffer more than full-service airlines, and European carriers will experience greater impacts than their non-European competitors.10 Extension of the EU ETS to emissions from domestic and international shipping is under consideration.11 The UK imposes an air passenger duty (APD) on passengers flying from UK airports. This duty – a charge per passenger – differs for two classes of service and for destinations within and beyond Europe. From 1 November 2009, the duty will be restructured into four distance classes, making long-distance flying significantly more expensive (United Kingdom, 2008). Charges will rise again on 1 November 2010. These changes are opposed by industry associations.12 Bills to regulate greenhouse gas emissions have been introduced in the US Congress regularly since 1998 (Paltsev et al., 2008). The bill that advanced furthest was America’s Climate Security Act (ACSA), which was defeated in the Senate in 2008 (ACSA, 2008).13 Both it and the recent draft American Clean Energy and Security Act (ACES) of 2009 include the carbon content of fossil fuels in the emissions trading scheme (ACES, 2009). The emissions associated with fuel purchased in the USA for international aviation and shipping would be included. Under the ACSA, but not ACES, fuel purchased for an international flight whose emissions were regulated by another country would be exempt.14 In short, international aviation and shipping emissions are likely to be covered by the emissions trading schemes and/or levies of a number of jurisdictions, provided that these initiatives survive the expected legal challenges. Coverage is likely to vary by jurisdiction. Although coordination to avoid double coverage may be promised, it could be difficult to achieve in practice, due to differences in design and coverage. The aviation industry is opposed to emission levies, but supports emissions trading subject to certain conditions (IATA, 2008, 2009).15 Some airlines are now supporting a global emissions trading scheme for international aviation provided that it replace the various domestic trading and levy initiatives (D. Ryan, Aviation Global Deal Group, personal communication, April 2009).

3. International management of aviation and shipping emissions Current trends suggest two options for management of international aviation and shipping emissions – a multiplicity of domestic policies or international management under ICAO and IMO. This section discusses the feasibility of emissions trading for international aviation and shipping emissions operated by ICAO and IMO.16 Treating international aviation and shipping emissions as two separate sectors allows uniform global regulation of each sector. With uniform global regulation, there is minimal scope for adjusting behaviour to avoid the regulation, with the consequent economic distortions and emissions leakage. International aviation and shipping emissions are better regulated separately because the institutional structures (ICAO and IMO), the opportunities for emissions reductions, the compliance entities, the enforcement mechanisms and the growth rates are different. It may also be feasible in the future to address the full climate impact of aircraft in the scheme for that sector.

3.1. Emissions trading for international aviation emissions An emissions trading scheme for international aviation implemented by ICAO or some other institution is technically feasible. An emissions cap would be established for the sector. Airlines

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could use international aviation allowances or internationally recognized units, such as CDM credits, for compliance. Countries would agree to collect data on fuel sales by airline for international flights and to cooperate with compliance enforcement actions.17 Each airline would report its CO2 emissions (based on its fuel use) and remit the necessary allowances and credits annually. Some or all of the international aviation allowances could be auctioned. Revenue from the auction could be used to fund emissions reduction measures in the aviation industry as well as adaptation and/or mitigation measures in developing countries. The UNFCCC estimates that auctioning allowances equal to the projected international aviation emissions could generate revenue of US$10 billion in 2010, rising to $15 billion in 2020 (UNFCCC, 2007, p.204, Table 2). To assist countries that are highly dependent on air service, such as Small Island States highly dependent on international tourism, the emissions trading system could include a threshold exemption for all airlines.18 That is very different from the exemption of flights to/from all developing countries, which would benefit mainly a small number of relatively wealthy countries with large international air hubs, such as Singapore, Hong Kong and Dubai. The importance of including all major airlines in the emissions trading scheme is shown in Table 1. This shows that 6 of the 20 largest airlines in terms of international revenue tonne kilometres in 2007 were based in developing countries: Singapore International Airlines, Cathay Pacific, Emirates, Korean Air, Thai Airways and Malaysian Airlines.

3.2. Emissions trading for international shipping emissions An emissions trading regime, similar to that described above for aviation, could be established for international shipping. Fuel purchasers or payers would be responsible for remitting allowances for the CO 2 emissions calculated from the fuel used. Data on fuel use would be provided independently by the fuel suppliers and/or ship managers. It could be implemented through a legal instrument similar to Annex VI to the International Convention for the Prevention of Pollution from Ships (MARPOL) governing air pollution from vessels (Pisani, 2002). The UNFCCC estimates that auctioning allowances equal to the projected international shipping emissions could generate revenues of US$12 billion in 2010, rising to $13 billion in 2020 (UNFCCC, 2007, p.204, Table 2). An alternative regime proposed for international shipping is the International Maritime Emission Reduction Scheme (IMERS) (Stochniol, 2009). An emission cap for all Annex I destinations would be established. A CO2 levy would be collected on ship fuel use and the proportion of cargo delivered to Annex I countries. The levy would be paid periodically by the fuel payers, typically charterers. The liability stays with the ship and would be enforced by Annex I ports. The levies would go to a fund established under the IMO and be used to: ■ fund maritime industry greenhouse gas emissions reductions ■ purchase CO2 credits equal to the actual emissions in excess of the established emissions cap ■ contribute to climate change adaptation in developing countries. For a cap 20% below 2005 emissions by 2020 for developed countries, IMERS’ annual contribution from 2013 onwards would be at least $2.5 billion for adaptation to climate change in developing countries and $1 billion for improved shipping technology. In principle, IMERS could be implemented as an emissions trading scheme rather than a levy, with fuel payers remitting the allowances rather than the CO2 levy.

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TABLE 1 The 20 largest air carriers in terms of international revenue tonne kilometres, 2007 Air carrier

1

Lufthansa

Total revenue tonne

Passenger tonne

kilometres (000,000)

kilometres (000,000)

20,449,960

11,780,614

2

Air France

17,018,157

10,742,386

3

Singapore International Airlines

15,979,484

7,956,077

4

Cathay Pacific

15,560,421

7,265,576

5

Emirates

14,244,633

8,647,699

6

KLM

12,357,608

7,448,787

7

British Airways

12,322,202

7,856,023

8

Korean Air

11,747,655

4,898,520

9

JAL

9,866,287

5,398,359

10

American

9,824,159

7,384,201

11

United

9,630,636

7,184,186

12

Qantas

8,019,473

5,591,103

13

Thai Airways

7,783,856

5,265,360

14

Northwest

7,097,057

4,859,324

15

Delta

7,022,183

5,743,212

16

Federal Express

6,706,061

–

17

Continental

6,277,859

5,158,220

18

Air Canada

6,149,127

5,053,569

19

Malaysian Airlines

5,987,765

3,402,772

20

Cargolux

5,512,023

Sum for 20 airlines

209,556,606

121,635,988

53.97%

50.42%

Share of global total

–

Notes: Total revenue tonne kilometres includes passenger tonne kilometres. Global total may not be complete. Source: ICAO data provided by Reed Business Information Limited, 19 September 2008.

3.3. Summary International emissions trading schemes that cover some or all international aviation emissions and some or all international shipping emissions, possibly administered by ICAO and IMO, respectively, are feasible.19 A workshop on emissions from international aviation and maritime transport in Oslo in October 2007 concluded that no technical obstacles related to monitoring and reporting of emissions remain that cannot be solved, so the absence of global policies is due to a lack of political will rather than technical difficulties.20 The principle of common but differentiated responsibilities can be addressed in two ways. One is through the financial flows. The regulatory costs are imposed equally on all air carriers/ships. Since most customers are from developed countries, most revenue would come from those countries

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and would be used for adaptation, mitigation and technology cooperation activities in developing countries. A second, less effective, approach is to exempt specific developing-country traffic, such as specified airline routes (e.g. routes to Least Developed Countries) and marine cargo to/from specified countries (e.g. Least Developed Countries).21

4. Linking for international aviation/shipping emissions Due to the projected growth of international aviation and shipping, and the relatively long life of the aircraft and ships, abatement costs are expected to be high relative to those in other sectors. If the trading scheme for international aviation and/or shipping is linked to another trading scheme, it is likely to be a net buyer of allowances. Emissions from international aviation and/or shipping can be covered by emissions trading schemes in one of the following ways: ■ One or more domestic emissions trading schemes, such as the EU ETS, that cover some international aviation and/or shipping emissions as well as emissions by other sources. ■ International emissions trading schemes that cover some or all international aviation emissions and/or international shipping emissions (possibly administered by ICAO and IMO, respectively). A trading scheme that covers international aviation and/or shipping emissions could have a link with one or more trading schemes covering other emission sources. This section therefore discusses options for the following cases: ■ Links between domestic emissions trading schemes that cover some international aviation and/or shipping emissions. ■ A unilateral link between a trading scheme for international aviation/shipping emissions and a trading scheme for other sources. A unilateral link means that the international aviation/shipping trading scheme would accept allowances from the linked scheme for compliance, but the linked scheme would not accept international aviation/shipping allowances. ■ A bilateral link between a trading scheme for international aviation/shipping emissions and a trading scheme for other sources. Under a bilateral link, each scheme accepts the other scheme’s allowances and credits for compliance purposes. The main effect of a unilateral link is that the market price in the other scheme will moderate the price in the scheme establishing the link (Mehling and Haites, 2009). Depending on the design of the linked schemes, a bilateral link will tend to harmonize prices in the two schemes.22

4.1. Links between domestic trading schemes If international aviation and/or shipping emissions are covered by a domestic trading scheme, the international aviation/shipping sector would be linked with the other sectors unless there are internal barriers or gateways that restrict transfers to/from the international aviation/shipping sector. Domestic emissions trading schemes could cover international aviation/shipping emissions in different ways. Regardless of how a domestic trading scheme covers international aviation/ shipping emissions, it could establish unilateral or bilateral links with other trading schemes.

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Only the EU ETS has a specific proposal to incorporate international aviation emissions into a domestic trading scheme. The EU ETS already has unilateral links to the CDM and JI. These links would be available to the airlines covered by the EU ETS and should moderate the price for aviation allowances. 23 Since other sources would not be allowed to use AAs, developments in other sectors would have a limited effect on the compliance costs for airlines.24 Growth in demand for allowances by airlines could increase the price of allowances for industry. The EU has expressed interest in linking its ETS with other domestic schemes. If such links are established, the international aviation sector in the EU ETS would be linked with the other domestic schemes directly or indirectly. If the linking agreement allows the airlines subject to the EU ETS to use the units of the linked scheme, e.g. US allowances, for compliance there would be a direct link.25 If the linking agreement does not change the list of allowances that airlines can use for compliance, there would be an indirect link through the impact on the price of EUAs.26 If coverage of international aviation and shipping emissions is implemented by the EU ETS, other domestic emissions trading schemes may also implement coverage of such emissions. The opportunity to capture some of the auction revenue collected by EU Member States would provide an incentive for such expansion. For example, flights between the EU and Switzerland would be covered by the EU ETS and some EU Member States would collect revenue for auctioned allowances purchased by airlines serving those routes. The opportunity to collect some of that revenue might induce the Swiss government to include international aviation in its emissions trading scheme. Other domestic trading schemes might use a different approach to cover international aviation and shipping emissions. Draft emissions trading legislation in the USA, for example, would cover transportation emissions by requiring fuel refiners and importers to hold allowances for the carbon content of the fuel they sell, including fuel sold for international aviation and shipping. Allowances for the emissions associated with fuel sold for international aviation and/or shipping might be rebated. Domestic schemes might agree to coordinate coverage of international aviation/shipping emissions. The simplest approach might be to agree that each domestic scheme covers outbound travel in its own manner. This would allow differences in the designs of domestic schemes, including exemptions and the share of allowances auctioned, and provide comparable treatment of carriers operating on the same route. However, the emissions for inbound and outbound travel on a given route might be treated differently. In summary, if international aviation and/or shipping emissions are covered by a domestic trading scheme, this sector is likely to be linked with the other sectors covered by the scheme. If the domestic scheme is linked with other schemes, the international aviation/shipping sector will be linked with those other schemes directly or indirectly. Revenue from the sale of allowances for international aviation/shipping emissions creates an incentive for domestic trading schemes to extend their coverage to those emissions. Different designs for the domestic trading schemes could create difficulties in coordinating coverage of international aviation and/or shipping emissions.

4.2. A unilateral link of a trading scheme for international aviation or shipping with another scheme A trading scheme that covers some or all international aviation or shipping emissions could decide to accept the allowances or credits of (establish a unilateral link with) one or more other trading schemes. The question is which scheme(s) to link with. The options are:

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■ the Clean Development Mechanism (CDM) as reformed, and other crediting mechanisms established by a future agreement; referred to here as the CDM for the sake of convenience27 ■ a domestic trading scheme in a country with an emissions limitation commitment under the Kyoto Protocol or a future agreement, such as the EU ETS or Swiss emissions trading scheme ■ a trading scheme not linked with the UNFCCC, such as RGGI or the Chicago Climate Exchange. The choice of scheme(s) with which to link depends on: ■ the perceived quality of the allowances of the target scheme ■ the ease of establishing a link with the target scheme ■ the size of the target scheme relative to the projected demand for external allowances by the trading scheme for international aviation emissions. At present, Kyoto units are perceived to have the highest quality, suggesting a link with the CDM or a domestic scheme in a country with an emissions limitation commitment under the Kyoto Protocol or a future agreement. Most existing and proposed domestic trading schemes have, or plan, a link with the CDM. Establishing a unilateral link with the CDM or most schemes not linked with the Kyoto Protocol is simple. To be credible, a link with a domestic trading scheme in an Annex I Party would need to ensure that purchased allowances led to the acquisition and cancellation of Kyoto units equal to the allowances used for compliance by participants in the international aviation/shipping scheme.28 That might require the cooperation of the Annex I Party, which could make implementation of a unilateral link similar to implementation of a bilateral link. At present only the EU ETS and the CDM would be likely to be large relative to the projected demand for external allowances by the trading scheme for international aviation/shipping emissions. A domestic trading scheme in the USA would also fall into that category. Unilateral links with a number of smaller schemes probably could not meet the projected demand for external allowances by the trading scheme for international aviation/shipping emissions. In summary, the best candidate for a unilateral link is the CDM, due to the perceived quality of the allowances, the ease of establishing a link, and its relatively large supply of allowances. A link with a large domestic scheme in a Kyoto Protocol country, such as the EU ETS, is the second choice, but it might require the cooperation of the relevant government(s). A domestic trading scheme in the USA might be a candidate in the future.

4.3. A bilateral link of a trading scheme for international aviation or shipping with another scheme A trading scheme that covers some or all international aviation or shipping emissions could establish a bilateral link with one or more other trading schemes. The options are: ■ a domestic trading scheme in a country with an emissions limitation commitment under the Kyoto Protocol or a future agreement, such as the EU ETS or Swiss emissions trading scheme ■ a trading scheme not linked with the UNFCCC, such as RGGI or the Chicago Climate Exchange.

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The CDM does not require credits or allowances to be surrendered for compliance, so a bilateral link with the CDM is not an option. The choice of scheme(s) with which to link depends on the same considerations as for a unilateral link – perceived quality of the allowances, ease of establishing the link, and size of the target scheme relative to the projected demand for external allowances by the trading scheme for international aviation/shipping emissions. Size considerations suggest that the preferred candidates are likely to be the EU ETS and a domestic scheme in the USA. The main risk associated with a bilateral link is that differences in some provisions can lead to higher (or lower) total emissions if the systems are linked than if they operate independently (Edenhofer et al., 2007, Jaffe and Stavins, 2007).29 The risk of higher total emissions can be reduced by harmonizing the relevant provisions enough to make the linked systems ‘compatible’. Much of the literature on linking trading systems focuses on the question of the ‘compatibility’ of the systems proposed to be linked (see, e.g., Haites and Mullins, 2001; Baron and Bygrave, 2002; Bodansky, 2002; Haites 2003; Ellis and Tirpak, 2006; Springer et al., 2006; Sterk et al., 2006; Jaffe and Stavins, 2007; Mace et al., 2008). Technical considerations require harmonization of only a relatively small number of provisions, such as banking. However, harmonization of several other provisions, such as allocation of allowances and use of offsets, is desirable, and possibly essential for political reasons (Mace et al., 2008). The ‘compatibility’ must be sustained as long as the link is maintained (Haites and Wang, 2009). A trading scheme for international aviation would have some unique features, which could affect the willingness of other schemes to agree to a bilateral link. These include: ■ the climate change impacts of aviation emissions ■ the status of the international aviation allowances. Aviation emissions have climate change impacts in addition to those due to the CO2 emissions. It is technically difficult to include the non-CO2 effects, such as NOx, contrails and water vapour, in a trading scheme, due to scientific uncertainties related to these effects, their duration and their variability over time and location.30 Thus aviation allowances for CO2 emissions implicitly permit a larger climate change impact. The administrators of other schemes might be reluctant to establish a bilateral link with an international aviation trading scheme because of the difference in the climate change impacts associated with their respective allowances. Most emissions trading schemes for greenhouse gases are intended to help the country meet a national emissions limitation commitment under the Kyoto Protocol or a future agreement. It is important for such trading schemes that the allowances transferred between linked schemes are units accepted for compliance under the Protocol/agreement. The allowances used by a separate international aviation or shipping emissions trading scheme would not be accepted unless this was agreed under the UNFCCC.31 A mechanism that allows the international aviation/shipping emissions trading scheme to issue compliance units is likely to be a prerequisite for a bilateral link with any scheme in an Annex I Party. A bilateral link would require an agreement between the regulatory authorities of the two schemes. The agreement must balance the competing objectives by ‘leaving each government with sovereignty over its own scheme while providing linking partners adequate authority to influence those changes in linked schemes that would materially affect their own scheme’ (Jaffe and Stavins, 2007). The fact that the schemes are located in different jurisdictions raises legal issues that vary with the jurisdictions involved.32

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A bilateral link is most likely to involve a binding agreement between an organization entrusted with the operation of a trading scheme for international aviation/shipping emissions and a trading scheme established by a sovereign state or an organization of regional economic integration, such as the EU. Such an agreement will typically be an international treaty. A treaty must reflect the consent to be bound in accordance with formal procedures set out in the constitutions and establishing treaties of the Parties to the agreement. As a treaty, a bilateral linking agreement would be binding on the regulatory authority in each jurisdiction. Its breach could result in consequences specified in the agreement or under general international law, including countermeasures and retorsion. Thus an agreement establishing a bilateral link merits careful design. Aside from a provision specifying the mutual recognition of allowances, a bilateral linking agreement will also need to include: ■ provisions to address specific legal issues such as competency and equivalence ■ a mechanism to provide assurance of the environmental effectiveness of each of the linked schemes ■ a process for agreeing on revisions to the regulations of the linked schemes ■ a process to resolve disputes arising under the agreement ■ a procedure for terminating the linking agreement. All these should preferably be included in the agreement from the outset because changes would require a renegotiation process between the parties to the agreement.

5. Conclusions International aviation and shipping emissions are large and growing rapidly. Some countries/ regions are implementing domestic emissions trading schemes that would cover these sources. These emissions also could be regulated through emissions trading schemes established by international organizations such as the ICAO and IMO. If international aviation and/or shipping emissions are covered by a domestic trading scheme, the international aviation/shipping sector is likely to be linked with the other sectors covered by the scheme. If the domestic scheme is linked with other schemes, the international aviation/ shipping sector will be linked with those other schemes directly or indirectly. If international aviation and/or shipping emissions are covered by a separate trading scheme, it could have a unilateral or a bilateral link with one or more trading schemes covering other emission sources. For a unilateral or bilateral link, the choice of scheme(s) with which to link depends on: ■ the perceived quality of the allowances of the target scheme ■ the ease of establishing a link with the target scheme ■ the size of the target scheme relative to the projected demand for external allowances by the trading scheme for international aviation/shipping emissions. Based on these criteria, the best candidate for a unilateral link is the CDM, as reformed, and other crediting mechanisms established by a future agreement. A link with a large domestic scheme in a country/region with an emissions limitation commitment under the Kyoto Protocol, or a future agreement, such as the EU ETS, is the second choice, but it might require the cooperation of the relevant government(s).

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A unilateral link would be much easier to implement than a bilateral link. A bilateral link requires that the schemes be ‘compatible’, while a unilateral link does not. A bilateral link is likely to require an international treaty, while a unilateral link can probably be implemented without a formal agreement. Other schemes might be reluctant to link with an international aviation trading scheme because of the difference in the climate change impacts associated with their respective allowances. A mechanism that allows the international aviation/shipping emissions trading scheme to issue UNFCCC compliance units is likely to be a prerequisite for a bilateral link with most other schemes. If international aviation/shipping is a net buyer, as expected, a unilateral link may be sufficient. A bilateral link would allow the sale of surplus allowances to participants in the other scheme, but if there are no surplus aviation/shipping allowances this is irrelevant. A unilateral link would allow the purchase of additional allowances by participants in the international aviation/shipping scheme. A unilateral link would also moderate the price of allowances in the international aviation/ shipping scheme.

Acknowledgements I would like to express my appreciation to Michael Mehling, Andreas Tuerk and three anonymous referees for constructive comments on previous drafts. Work on this article was partially supported by funding from Climate Strategies.

Notes 1.

The ratio of the total radiative forcing from aviation to the radiative forcing associated with aviation CO2 emissions is often called the ‘uplift factor’ (Sausen et al., 2005; Forster et al., 2006). 2. The range is 685–1,039 MtCO2 (Buhaug et al., 2008). Den Elzen et al. (2007, p.18, Box 1) reports estimated emissions for 2000 at 425–900 MtCO2. 3. The low projection is roughly constant (no growth) emissions, while emissions grow at 3.9–5.2% per year in the high projection (see Buhaug et al., 2008, p.79, Table 49). 4. Combined international aviation and shipping emissions in 2000 were probably over 900 MtCO2. The Climate Analysis Indicators Tool (CAIT) reports CO 2 emissions in 2000 (excluding land-use change and forestry) at 1,022 MtCO2 (278.4 MtC) for India. If the effects on other aviation emissions is included, the total would rise to over 1,200 MtCO2e, about the same as Japan’s emissions 1,214 MtCO2 (330.9 MtC) in 2000. http://cait.wri.org/ cait.php?page=yearly 5. Kyoto Protocol, Article 2, paragraph 2. Annex I Parties are developed-country Parties to the United Nations Framework Convention on Climate Change. Annex I Parties that have ratified the Kyoto Protocol have national emissions limitation commitments for 2008–2012. 6. The ICAO Council’s Committee on Aviation Environmental Protection (CAEP) created a Market-Based Measures Task Force (MBMTF) with a mandate of scoping out several issues related to the use of market-based measures to address air emissions from the aviation sector. 7. The European Union, as well as its individual Member States, is a Party to the Kyoto Protocol. Some flights that are international flights for Member States are domestic flights for the European Union. 8. Flights with total emissions of less than 5.7 tonnes would be excluded. Commercial airlines with emissions of less than 10,000 tonnes of CO2 or who fly fewer than 243 flights into, out of or within the EU within a 4-month period would be exempt. 9. See www.euractiv.com/en/climate-change/aviation-emissions-trading/article-139728. 10. For a given route, the compliance cost is a higher portion of the fare for low-cost carriers and demand for travel on those carriers is more elastic, so the impacts are bigger than those for air carriers with higher fares and more business travellers whose travel demand is less elastic. European carriers absorb the impacts on virtually all of their flights, while only the flights to and from Europe are affected in the case of non-European carriers.

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11. Reuters reported on 11 September 2008 that the European Parliament’s Industry Committee agreed that shipping should be included in the European Union’s Emission Trading Scheme from 2013. 12. The changes are opposed by the International Air Transport Association (IATA) and the Air Transport Association (ATA) of America, with the latter suggesting that the UK government should expect legal challenges to the rate change. See www.btnonline.com/businesstravelnews/headlines/article_display.jsp?vnu_content_id=1003916555. 13. ACSA (2008) is also known as the Boxer substitute amendment to the Lieberman–Warner bill. 14. ACSA (2008), Section 202(i) would return allowances equal to the allowances submitted for fuel purchased for international flights whose greenhouse gas emissions were regulated by another country. 15. The emissions trading scheme must be properly designed and implemented on a global and voluntary basis. It must also allow permit trading with other industries (IATA, 2009). 16. International aviation and shipping emissions occur mainly in international territory and hence should be managed internationally rather than being allocated to Parties. In effect this is option 1: no allocation. 17. Data on fuel sales by airline from the fuel suppliers would provide an independent check of the emissions reported by the airlines. If an airline fails to comply, one or more countries may support enforcement measures such as impounding aircraft. 18. For example, the first 0.5 or 1.0 million revenue tonne kilometres could be exempt. This would exclude small carriers that serve only a few small countries. And the threshold exemption would allow larger carriers that serve the same countries to match the fares, because the emissions would be exempt. 19. In principle, global schemes for aviation and/or shipping emissions, covering both international and domestic emissions, could be implemented, but such designs are not currently under discussion. 20. See www.eea.europa.eu/highlights/no-technical-obstacles-to-bringing-international-aviation-and-shipping-underpost-kyoto-protocol. See also the meeting website at www.eionet.europa.eu/training/bunkerfuelemissions and the report on the workshop by the International Institute for Sustainable Development (IISD) at www.iisd.ca/ YMB/sdosl/. 21. Such exemptions are very different in scale and distributional effects from a blanket exemption for all developingcountry air carriers and ships. 22. Depending on the relative size of each scheme, this effect can be negligible or effectively become a price cap. If a small scheme is linked to a much larger scheme, the link caps the price of the allowances in the smaller scheme at the price in the large scheme. If a large scheme is linked with a small scheme, the effect on allowance prices in the large scheme is negligible. If there is a limit on the quantity of the allowances from the linked system that can be used for compliance, the moderating effect will be further limited. 23. Projected emission reductions for international aviation in 2020 are about 200 million tCO2 and about 300 million tCO2 for other sectors. Thus, airlines would account for about 40% of the total demand. 24. High growth in other sectors could reduce the supply of surplus EUAs, CERs and ERUs, leading to a higher price for those units and for AAs. 25. Then airlines covered by the EU ETS would be able to use AAs, EUAs, CERs, ERUs and American allowances for compliance. 26. The linking agreement would have an impact on the price of EUAs. Since airlines are allowed to use EUAs for compliance and are projected to be net buyers, the impact on the price of EUAs would also affect airlines. 27. This could include sectoral crediting mechanisms and credits for reduced emissions from forest degradation and deforestation (REDD), for example. 28. If allowances, but not Kyoto units, are cancelled, higher emissions would be possible outside the domestic trading scheme while meeting the country’s Kyoto Protocol commitment. 29. In addition, each scheme has an incentive to make smaller reductions to its cap over time, so that its participants become exporters of allowances to the linked scheme. 30. For these reasons, the EU ETS proposes to cover only the CO2 emissions. 31. International aviation emissions are excluded from the emissions limitation commitments of the EU Member States under the Kyoto Protocol. Separate aviation allowances (AAs) have been created for these emissions. Other sectors cannot use AAs for compliance, so the issue of AAs being used for compliance with Kyoto commitments does not arise. 32. Reciprocal unilateral links are a way to avoid the complex issues raised by a bilateral link. A trading scheme for international aviation/shipping emissions and another scheme, such as the EU ETS, could agree to establish unilateral links with each other or with a third scheme, such as the CDM. The economic benefits of reciprocal unilateral links will not differ significantly from a bilateral linking agreement.

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Mace, M.J., Millar, I., Schwarte, C., Anderson, J., Broekhoff, D., Bradley, R., Bowyer, C., Heilmayr, R., 2008, Analysis of the Legal and Organisational Issues Arising in Linking the EU Emissions Trading Scheme to other Existing and Emerging Emissions Trading Schemes, FIELD/IEEP/WRI, London. Macintosh, A., Wallace, L., 2009, ‘International aviation emissions to 2025: can emissions be stabilised without restricting demand?’, Energy Policy 37, 264–273. Mehling, M., Haites, E., 2009, ‘Mechanisms for linking emissions trading schemes’, Climate Policy 9(2), 169–184. Michaelis, L., 1997, Special Issues in Carbon/Energy Taxation: Carbon Charges on Aviation Fuels, Annex I Expert Group on the UNFCCC, OECD, Paris. Michaelowa, A., Krause, K., 2000, ‘International maritime transport and climate policy’, Intereconomics 35(3), 127–136. Oberthür, S., 2003, ‘Institutional interaction to address greenhouse gas emissions from international transport: ICAO, IMO and the Kyoto Protocol’, Climate Policy 3, 191–205. Olsthoorn, X., 2001, ‘Carbon dioxide emissions from international aviation: 1950–2050’, Journal of Air Transport Management 7, 87–93. Paltsev, S., Reilly, J., Jacoby, H., Gurgel, A., Metcalfe, G., Sokolov, A., Holak, J., 2008, ‘Assessment of US GHG cap-andtrade proposals’, Climate Policy 8(4), 395–420. Penner, J.E., Lister, D.H., Griggs, D.J., Dokken, D.J., McFarland, M., 1999, Aviation and the Global Atmosphere, Intergovernmental Panel on Climate Change (IPCC), Cambridge University Press, Cambridge, UK. Petersen, M., 2008, ‘The legality of the EU’s stand-alone approach to the climate impact of aviation: the express role given to the ICAO by the Kyoto protocol’, Review of European Community and International Environmental Law 17(2), 196–204. Pisani, C., 2002, ‘Fair at sea: the design of a future legal instrument on marine bunker fuels emissions within the climate change regime’, Ocean Development and International Law 33(1), 57–76. Sausen, R., Isaken, I., Grewe, V., Hauglustaine, D., Lee, D., Myhre, G., Kohler, M., Pitari, G., Schumann, U., Stordal, F., Zerefos, C., 2005, ‘Aviation radiative forcing in 2000: an update on IPCC (1999)’, Meteorologische Zeitschrift 14 (4), 555–561. Scheelhaase, J.D., Grimme, W.G., 2007, ‘Emissions trading for international aviation: an estimation of the economic impact on selected European airlines’, Journal of Air Transport Management 13, 253–263. Springer, U., Oleschak, R., Suter, S., Forrister, D., Youngman, R., 2006, Linking Domestic Emissions Trading Schemes to the EU ETS, TETRIS Deliverable, Ecoplan, Berne, Switzerland. Sterk, W., Braun, M., Haug, C., Korytarova, K., Scholten, A., 2006, Ready to Link Up? Implications of Design Differences for Linking Emissions Trading Schemes, Jet-Set Working Paper I/06, Wuppertal Institute, Wuppertal, Germany. Stochniol, A., 2009, A Levy on Fuel for International Shipping, which Differentiates Responsibilities between Developed and Developing Countries, International Maritime Emissions Reduction Scheme (IMERS), London [available at http:// imers.org/files/docs/IMERS_UNCTAD_Submission.pdf]. Stuart, G., Fisher, A.M., 2007, ‘One world? International aviation and the EU Emissions Trading Scheme’, Environmental Law and Management 19(4), 170–176. Tsai, A.P.-J., Petsonk, A., 2000, ‘Tracking the skies: an airline-based system for limiting greenhouse gas emissions from international civil aviation’, Environmental Lawyer 6, 761–806. UNCTAD (United Nations Conference on Trade and Development), 2009, Maritime Transport and the Climate Change Challenge, TD/B/C.I/MEM.1/2, Trade and Development Board, UNCTAD, Geneva. UNFCCC (United Nations Framework Convention on Climate Change), 2007, Investment and Financial Flows to Address Climate Change, UNFCCC, Bonn. United Kingdom, 2008, Pre-Budget Report: Air Passenger Duty, PBRN20, HM Revenue and Customs, London [available at www.hmrc.gov.uk/pbr2008/pbrn20.pdf].

CLIMATE POLICY

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