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Act Locally, Trade Globally Emissions Trading for Climate Policy Foreword The threat posed by global warming has made climate policy one of the most important dimensions of energy policy. Rising CO2 emissions world- wide confirm the need to act and to move away from the current energy trend. At their meeting earlier this year, the energy ministers of IEA member countries recognised that “we are not bound to any business-as- usual energy future.” At the same time, governments are struggling to find practical and effective policy approaches to bring about the changes necessary to deliver a more sustainable energy future. Among them, market instruments such as emissions trading hold many promises, including lowering the cost of our global efforts to reduce CO2 emissions.

The Kyoto Protocol has introduced emissions trading in international climate policy. In 2005, the European Union established a full-fledged emissions trading system for some 11 500 industrial sources. Other countries and authorities, both within and outside the Protocol, are considering this tool as a means to cut greenhouse gases, now and beyond 2012.

This book provides a comprehensive overview and analyses of existing emissions trading systems for climate policy, their strengths and weaknesses; it shows how trading systems could be used in sectors beyond industry, and in countries beyond the developed world. It discusses the complex relationship between commercial and non- commercial energy uses, CO2 emissions, and development.

Emissions trading may not be the panacea, but, if implemented wisely, it has the power to trigger many of the local actions needed to curb the trend of global CO2 emissions, and to do so at least-cost through global trading. This book also reveals the capacity of emissions trading to accommodate a range of concerns about climate policy, including cost uncertainties, competitiveness concerns, fairness, and development.

Claude Mandil Executive Director 3 Acknowledgements This book was written by Richard Baron and Cédric Philibert, under the supervision of Rick Bradley. The following IEA staff also contributed to various parts of this volume: Martina Bosi, Katharina Hochmair, John Krbaleski, Alexandrina Platonova, Julia Reinaud, and Sierra Peterson, who also edited the final draft. The authors would also like to thank Erik Haites, Murray Ward and Peter Zapfel for useful comments. Sandra Coleman, Rebecca Gaghen and Loretta Ravera provided additional editorial input. Muriel Custodio supervised the production stage.

This publication was partly supported by France’s agency for environment and energy efficiency (Ademe).

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9 Executive Summary Effective response to the threat of climate change will require the global economy to shift to a low-carbon energy system in the coming decades. This transition may entail huge costs which policy makers want to minimise. A least-cost approach also improves public acceptability, minimises various economic impacts, and helps achieve climate stabilisation. Emissions trading is one effective means to reduce the cost of abating greenhouse gas emissions, at both international and domestic levels. Emissions trading’s underlying principle is simple – sources are liable to meet emission objectives, in the form of tradable emission allowances, which must match emission levels. A source with cheap emission reduction opportunities can sell unused allowances to another that faces high abatement costs. Such transactions reduce the compliance costs and eventually create a price for allowances, which guides all sources’ decisions to reduce emissions.

The 2005 entry into-force of the Kyoto Protocol spurred international carbon markets. Emissions trading systems are being developed, covering regional emissions from large industries, but are also being established at sub-national levels. Carbon markets promote projects in developing nations and those with economies in transition, which generate units of traceable emission reductions. With current energy policies, annual demand for allowances by OECD member countries should range between 800-1 100 million tonnes of CO2 equivalent, over 2008-2012. Emission trends of countries with economies in transition (primarily Russia and Ukraine) show enough potential supply of allowances to satisfy this demand. Projects undertaken under the clean development mechanism (CDM) will also generate emission credits for use by industrialised countries.

–  –  –

Experience to date and current research on climate policy produce the

following insights:

Emerging emissions trading systems promise active trading and a q potentially powerful price signal on the unit cost of carbon emission reduction to guide corporate budget decisions. The EU emissions trading scheme which covers the electricity sector and heavy industry caps about half of the European CO2 emissions.

The price of carbon does not currently affect all activities emitting q greenhouse gases. In theory, domestic trading schemes may expand to incorporate activities beyond large stationary emissions sources. However, policy makers should account for market imperfections in certain end-uses when expanding existing regimes.

New forms of emissions reduction goals and other features may q facilitate more international participation in GHG abatement and in emissions trading. To mitigate uncertainties in reduction costs, these new brands can be: (1) targets indexed to economic growth, (2) a cap on the price of traded carbon, and (3) non-binding targets. However, the energy realities of most developing countries make them less prone to develop broad domestic greenhouse gas trading systems.

A global market can technically incorporate domestic and regional q systems, despite divergences in design.

The current design of emissions trading systems does not yet q provide an incentive sufficient to reduce emissions at least-cost.

There is room for improvement.

Whether domestic or international, emissions trading is not the q panacea for the challenge of long term climate stabilisation.

Nevertheless, emissions trading has the potential to play an important role as one measure to promote cost-effective emissions abatement.


From an international carbon price to domestic climate policy Most existing domestic trading systems cover large energy-intensive industries and the power sector, while more than half of energy-related CO2 and other GHG emissions are emitted elsewhere. As a consequence, the international price of carbon does not permeate the broad energy market and end-users. Countries committed to mitigating climate change have introduced other policies that reduce emissions from activities that have no direct link to the international CO2 market.

Under the Kyoto Protocol, governments must meet emission targets representing all domestic emissions. The Protocol authorises international emissions trading mechanisms as a means of compliance with emission objectives, a boon to governments seeking emissions reductions at least cost. While they strive to implement domestic trading regimes and other policies to address their emissions, governments in most OECD countries will need to buy allowances on the international emissions market in order to most economically comply with their objectives. Participation will require considerable preparation and should be a priority for governments – on the buying and selling sides alike.

A number of countries – as well as private companies – have created funds to acquire emission units including via project-based mechanisms: the CDM allow generating emission credits for reductions in developing countries; Joint Implementation follows the same logic for reduction projects in industrialised countries. While there is clear demand, the supply of emission reductions, in particular from the CDM, appears to lag behind. Administration of project approval must be streamlined and scaled up to reflect this urgency, though without compromising projects’ environmental integrity.


Can domestic trading systems deliver?

Political realities, concerns for competition, uncertainties over the future of the international regime, and the thus far limited experience of authorities in charge of emissions trading systems, hamper system operation at theoretical efficiency. The national allocation plans of the EU emissions trading scheme often lack mandate beyond 2012, though long-term planning is vital to sectors with long-lived capital stocks – power plants installed in the coming decade may operate until 2040, or beyond. Short-term emissions objectives discourage investments in more ambitious GHG reductions, which can only be cost-effective over the course of decades. Greater visibility is necessary now to trigger such decisions. The free allocation of allowances to new entrants and the cancellation of allowances when plants close also undermine the efficacy of the systems, as they do not encourage investors to take full account of the carbon cost. The treatment of these questions requires harmonisation to avoid countries competing to offer better investment conditions to industry at the expense of least-cost GHG mitigation.

At the same time, industrial energy users worry about the cost of meeting their cap and the rising cost of electricity, while much of their international competitors are unscathed. Energy policy makers must address the negative implications of this situation – in particular in removing the barriers to a broader engagement in mitigation and defining appropriate incentives.

From segmented to global market Linking systems with various design features is feasible technically, although some differences in design may be harder to reconcile than others. Existing domestic systems have proven the feasibility of trade between regimes of emission objectives indexed on growth and those based on absolute caps. A broader issue relates to the emergence of


trading systems that evolved separately and led to different price levels.

Investments based on pre-existing price levels may become unfounded as linking occurs and, with it, a new equilibrium price. However, efficiency gains will argue strongly in favour of linking.

Beyond industry Several design options for systems of emissions trade enable to include domestic sources beyond industrial activities. An upstream system shifts the burden of compliance from fossil fuel users to producers and importers. These firms must surrender allowances commensurate with the CO2 content of their fuel sales inside the country. This option can be implemented in concert with existing, downstream, systems in which sources, large stationary users, are liable for emissions. Because upstream systems would function more or less as a new tax on small energy users, acceptability rests on credible ways to return the rent to the public.

Further, while a higher fuel price is conducive to less energy consumption in principle, a number of market imperfections stand in the way of an effective response to price changes. In “landlord-tenant” situations, energy users have little or no control on their energy using equipment and are therefore unlikely to react effectively to a price signal. These obstacles must be first addressed if the price signal of carbon markets is to be effective.

Transport is a priority for climate policy, being responsible for a quarter of global CO2 emissions and the second fastest growing source after power and heat generation. As an alternative to an upstream system, car manufacturers could be made responsible for the CO2 emissions of their products. This would foster quicker technical improvements in new cars, yet fuel use by these cars, the source of CO2 emissions, would not carry an additional cost. If applied, emissions trading may not sufficiently reduce CO2 emissions in road transport by itself, but provide transport, in the short run, with cheaper mitigation options from other activities.


The international civil aviation organisation endorsed the further development of emissions trading systems for international aviation open across economic sectors. It would curb these rapidly growing emissions, the bulk of which are not currently included in countries’ emission inventories.

Broadening international participation New types of emission targets will allow countries that have not ratified the Kyoto Protocol, nor have adopted emission targets yet, to participate in international emissions trading. Regardless of stance on the Kyoto Protocol, all nations would benefit from options to mitigate uncertainty surrounding GHG reduction costs. Dynamic targets, indexed to actual economic growth, could accommodate fluctuations in emissions related to changes in economic growth. Caps on the price of traded carbon could help industrialised countries to adopt more ambitious targets by adding certainty to their costs, alleviating a concern that may otherwise prevent participation.

Non-binding emissions targets allow developing countries to sell allowances on international GHG markets if their emissions are lower than an agreed level, without requiring them to buy if emissions are above. Were the international community to agree to this type of target, developing nations would be encouraged to look for domestic potentials for mitigation, which they could finance with international GHG markets, without compromising economic development.

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