As businesses, policy-makers, and other stakeholders around the world have become familiar with greenhouse gas emissions trading, it has emerged as the policy of choice to address climate change. Now—with the recent agreements in Bonn and Marrakech, with new carbon trading systems in Europe, and with private sector interest and activity across many economic sectors both here and abroad—we are beginning to see the outlines of a genuine greenhouse gas market.
In this Pew Center report, authors Richard Rosenzweig, Matthew Varilek, Josef Janssen et al. describe the various public and private programs under which many early trades have occurred, the characteristics of the emerging market including the key features of early transactions, and the potential evolution of the market given the concurrent development of domestic and international climate change policy. Case studies of actual trades between four power companies—TransAlta and HEW, and PG&E and Ontario Power Generation—help illustrate leading companies’ motivations for engaging in trading, as well as the challenges they have faced in the absence of clear guidelines in the nascent market.
Despite the impressive interest in greenhouse gas trading, the market that has developed thus far remains fragmented. For example, as originally proposed, the trading regimes put forth by the United Kingdom and the European Union differ in important respects: the former is voluntary and the latter is not; the former covers the full basket of six greenhouse gases while the latter is restricted to carbon dioxide. This results in higher transaction costs just as the market is getting off the ground. The challenge ahead, for business, policy-makers, and others, is to work together to help forge linkages between the emerging regimes, and ultimately to achieve convergence.
I am optimistic that we can meet this challenge. We are beginning to see the first glimmers of interest in the U.S. Congress, although the debate is expected to be long and difficult. Perhaps more encouraging are private sector efforts to build a greenhouse gas trading system, such as the Chicago Climate Exchange. Also, many companies have set up their own internal trading systems to “learn by doing,” and have been eager to participate in early trades. The need for certainty, for consistency, and for a level playing field all will work to encourage a merging of regimes. Policy-makers must do their best to ensure that all systems are compatible.
The authors and the Pew Center would like to thank the companies featured in this report for sharing their experiences and perspectives, and acknowledge the members of the Center’s Business Environmental Leadership Council, as well as Aldyen Donnelly of GEMCo; Erik Haites of Margaree Consultants; Richard Sandor of Environmental Financial Products, L.L.C.; and Tom Wilson of EPRI for their review and advice on a previous draft of this report.
Executive Summary
A market for greenhouse gas (GHG) emissions has begun to emerge over the past five years. This market is driven in large part by ongoing negotiations of an international global climate change treaty, which will likely impose limitations on GHG emissions. The market has been shaped by successful emissions trading programs established over the past decade, such as the sulfur dioxide (SO2) trading program incorporated in the U.S. Clean Air Act Amendments (CAAA) of 1990.
This paper describes: (1) programs and initiatives that have provided a framework for early trades and policy development; (2) characteristics of the emerging GHG market and key features of early transactions; (3) potential evolution of the market due to ongoing concurrent domestic and international climate change policy development; and (4) potential scenarios regarding the U.S. response to climate change.
Origins
Greenhouse gas trading has its origins in the United Nations Framework Convention on Climate Change (UNFCCC). Adopted in Rio de Janeiro, Brazil, in 1992, the UNFCCC established the goal for industrialized countries to return to their 1990 GHG emissions levels by the year 2000 and a long-term objective of stabilizing atmospheric concentrations of greenhouse gases “at a level that would prevent dangerous anthropogenic interference with the climate system.” In 1995, the Parties reviewed their progress and concluded that the non-binding goal would not lead to the achievement of the Convention’s objective of atmospheric stabilization. In response, Parties agreed to pursue a complementary agreement that would establish quantified emissions limitations and reduction obligations for developed countries. This culminated in the negotiation of the Kyoto Protocol in December of 1997.
The process to develop rules, mechanisms, and institutions necessary to bring the Protocol into force is ongoing, including the seventh Conference of Parties (COP-7), held in Marrakech, Morocco, during November of 2001. Though significant progress was achieved there and in previous negotiations, the Protocol has not yet entered into force, and few national governments have imposed limitations on domestic GHG emissions or established trading rules. Thus, the GHG market is evolving under a loosely constructed, ad hoc framework. To date, it has evolved from a variety of mostly project-based emissions trading programs, which have been voluntary in nature and which collectively serve as precursors to formal GHG regulation. More recently, the United Kingdom and Denmark have developed national regulatory programs.
Project-Based Programs
The UNFCCC allows industrialized countries to meet their emissions reduction commitments “jointly with other Parties” through a form of project-based emissions trading. This program became known as Joint Implementation (JI). Subsequent programs have provided practical experience with key aspects of project-based emissions trading. These programs and initiatives include the U.S. government’s Initiative on Joint Implementation (USIJI); the pilot phase of international project-based emissions trading known as Activities Implemented Jointly (AIJ); Ontario, Canada’s multi-stakeholder Pilot Emissions Reduction Trading program (PERT); Oregon’s Climate Trust; the Dutch government’s Emission Reduction Unit Procurement Tender (ERUPT); and the World Bank’s Prototype Carbon Fund (PCF), among others.
Each of these programs is governed by a unique set of rules. However, they exhibit some common elements that constitute a de facto (though non-binding) set of minimum quality criteria that govern the creation of credible emissions reductions. These common elements include: (1) establishment of a credible counterfactual emissions baseline; (2) proof of environmental additionality; (3) evidence that the reductions are surplus to existing regulatory requirements; (4) proof of permanence or durability of the reductions; (5) demonstration that the emissions-reducing project will not cause emissions to increase beyond the project’s boundaries (referred to as “leakage”); (6) establishment of credible monitoring and verification procedures; and (7) proof of ownership of the reductions.
Market Characteristics
Even though few sources of GHG emissions presently confront binding emissions limitations, a growing number of companies and governments have begun to purchase reductions generated in most part by the programs described above. Few trades of GHG emissions to date have involved an exchange of emissions permits such as “allowances” or “credits,” since these terms refer to government-issued commodities that only exist within the context of formal trading systems. Most GHG trades have taken place under a voluntary ad hoc framework involving a commodity defined by the trade’s participants and known commonly as verified emissions reductions (VERs). These carry only the possibility, but not a guarantee, that governments will allow them to be applied against future emissions reduction requirements.
The authors estimate that approximately 65 GHG trades for quantities above 1,000 metric tons of carbon dioxide equivalent (CO2e)1 have occurred worldwide since 1996. This figure includes trades of reductions as well as financial derivatives based on reductions. However, the figure probably understates actual market activity because not all trades are made public, and internal corporate trades and small trades are excluded. It is important to note also that this figure refers to purchases of emissions-related commodities and excludes countless investments in projects that either purposely or incidentally reduce GHG emissions. Prices for VERs have ranged between $.60 and $3.50 per metric ton of CO2e. Some of the price differentials between trades can be explained by differences in the features of the reductions such as their type and vintage, geographical location, and the rigor of the monitoring and verification procedures. Other factors that affect reductions’ commercial value include contractual liability provisions, seller creditworthiness, and demonstration of host country approval of the emissions-reducing project.
Two case studies provide a detailed look at actual GHG trades in this market, illustrating some of the challenges and benefits of early GHG trading as described by market participants. The first case study reviews a purchase of VERs by TransAlta, a Canadian electric utility, from HEW, a German utility. HEW generated reductions by displacing some of its fossil fuel-based generation with electricity generated by wind. The second case study examines a purchase of VERs by Ontario Power Generation, a Canadian utility, from US Gen, a subsidiary of the U.S.-based PG&E National Energy Group. US Gen created reductions by capturing and destroying methane produced at a landfill. Both case studies demonstrate that while participants benefited from these early GHG trades, the lack of clear trading rules has increased transaction costs and been a significant impediment to the development of a more robust GHG market.
National Trading Programs
Several governments have moved forward in designing domestic trading systems while international trading rules remain under development. At the national level, the United Kingdom and Denmark have each established domestic emissions trading programs. Some trading in these programs has already begun. The European Union (EU) and other countries are in various stages of domestic policy development. At the sub-national level, the state of Massachusetts, for example, will require reductions of carbon dioxide (CO2) emissions from power plants and will allow sources to use trading as a means of compliance.
The development of these and other trading programs demonstrates that emissions trading has gained acceptance as a preferred policy instrument in the world’s efforts to reduce GHG emissions. These programs will boost GHG trading activity and motivate more rapid emissions abatement than if governments had waited for the international community to conclude negotiation of the Kyoto Protocol. Already, the initiation of these programs is producing a shift in the commodity that market participants prefer to trade. Some buyers’ interest is starting to shift away from VERs, whose eligibility for use as a hedge against binding emissions limitations is uncertain. Interest is beginning to shift towards government-issued permits created by the programs, which are by definition eligible for use against an emissions limitation in their jurisdiction of origin. Permits also stand a superior chance of being transferable into foreign jurisdictions for purposes of compliance.
Significant benefits have and will result from the current development of domestic trading systems. However, some adverse impacts have also resulted from the concurrent development of international and domestic climate change policy. Emissions trading systems currently in operation or under development exhibit unique features that may render them incompatible with each other. For example, the Danish and United Kingdom (UK) systems allow for trading of different gases, cover different economic sectors, and utilize different mixes of allowance and credit-based trading. To date, they have not developed rules governing interchange and mutual recognition of their tradable units with each other, which could impede or preclude beneficial cross-border transactions. There are also significant differences between each of these systems and the one being developed in the European Union. Already, the European Commission has warned that the differences in the UK and the EU systems “could create market distortions in the future.”2 Had the treaty been concluded more rapidly, the international framework would have made it easier for Parties to conform their systems leading to increased trading. Several private-sector and nongovernmental organizations (NGOs) also have developed initiatives to help build the market and to create and take advantage of trading opportunities. They include the Partnership for Climate Action (PCA), the Emissions Market Development Group (EMDG), and the Chicago Climate Exchange (CCX).
Future Outlook
Recent international agreements negotiated at Bonn and Marrakech resolve many details concerning implementation of the Kyoto Protocol, providing greater clarity to Parties developing domestic trading programs. These agreements will increase the likelihood that future domestic climate change policy measures will be consistent with the rules of the Protocol. However, several issues still must be resolved, and, although likely, the treaty’s entry into force is not yet assured. Thus, in the near future, international and domestic GHG policy will continue to develop concurrently, with the risk that incompatibilities between regional, national, and sub-national climate change policies will lead to market fragmentation and sub-optimal economic and environmental outcomes. Such fragmentation does not mean that market participants will not trade across systems. Indeed, market participants will likely devise methods of trading across jurisdictions. However, devising such structures and mechanisms will increase costs.
Prospects for a well-functioning international GHG market have greatly improved as a result of the agreements reached in international climate change negotiations during 2001. However, significant barriers remain, including the unwillingness of the United States, the world’s largest emitter, to ratify the Kyoto Protocol. A qualitative analysis of several scenarios related to the United States’ future climate policy response reveals that, while in the near term the lack of an emissions constraint may provide an advantage to U.S. firms against foreign competitors confronting such constraints, continued policy uncertainty may be detrimental in the longer term.
In order for the market to achieve its intended environmental and economic results, much work remains to be done. The international community must make an ultimate decision on the legal nature of Parties’ compliance obligations with the Kyoto Protocol’s provisions and must resolve several other key issues. Institutions governing the treaty’s mechanisms must move forward expeditiously to implement the details of the Protocol. Such action will provide Parties with clear policy guidance allowing them to conform their domestic programs to international rules and to enjoy the full economic and environmental benefits of GHG emissions trading.