An Overview of Greenhouse Gas Trading Design Issues

1. An Overview of Greenhouse Gas Trading Design Issues Robert N. Stavins John F. Kennedy School of Government, Harvard University Cambridge, Massachusetts 02138 and Resources for the Future Presentation for Workshop Convened by The National Commission on Energy Policy Washington, D.C. September 1, 2005

2. Background and Context • Kyoto Protocol has come into force without U.S. participation -- effects on climate change will be trivial to non-existent; yet scientific and economic consensus point to need for a credible approach. • Pressing need for a credible international agreement that is scientifically sound, economically rational, and politically pragmatic. • The Kyoto Protocol is none of these. • Promising alternative international policy architectures exist, but that’s not our topic for today. • . • Ratification requirement: 55 nations, 55% of 1990 industrialized world emissions • All countries except U.S. = 63.9% • All except U.S. & Australia = 61.8% • All except U.S., Australia, & Canada = 58.5% • All except U.S., Australia, & Japan = 53.3% • All except U.S., Australia, & Russia = 44.4%

3. Background and Context (continued) • While international discussions continue, a topic of increasing importance is how will the United States respond • When it adopts national targets to reduce net emissions of greenhouse gases (GHGs). • What means -- what instruments of public policy – should the government use to bring about GHG reductions?

4. Domestic Policy Instrumentsfor Climate Change • Because of their great advantages at keeping costs low in the short term, and bringing costs down even lower in the long term, most attention has been focused on market-based instruments (MBIs). • In particular, proposals from academia, government, industry, and NGOs have frequently featured tradeable permit systems. • Because of Theory • Because of Experience

5. Experience • Great success of SO2 Allowance Trading Program (CAA of 1990) is widely acknowledged. • Does that success indicate that a similar cap-and-trade system is the best approach for CO2 and other GHGs? • Differences between SO2/acid rain and fossil fuels/climate change suggest caution before rushing to judgment. • But the differences – as well as some similarities – can help inform answers to key questions of policy design for a domestic GHG trading system. • My purpose is to highlight those key design issues for a domestic GHG cap-and-trade system.

6. Key Design Issuesfor a Domestic GHG Cap-and-Trade System • What scope of coverage? • What point of regulation? • What point of allocation? • What rules for allocation? • What about temporal flexibility: banking & borrowing? • What about enforcement? • Are there needs for government brokerage? • Are there competitiveness concerns? Barriers to entry? • Can and should there be linkages with international systems? • At a minimum, how can foolish design elements be avoided?

7. What Scope of Coverage? • What sources, what industries should be included? • A major issue of discussion and debate when the European Union’s Emissions Trading System was being designed • But not the best way to begin thinking about designing a system • Just posing this question limits the set of possible designs, and omits what may be some of the best ones. • Instead ……

8. What Point of Regulation? • Possibilities include: • Downstream (CO2 emission sources) -- CO2 emission permits • Similar to SO2 allowance trading • Very successful program – you’ve already heard about it • Upstream (producers and importers of fossil fuels) – carbon rights linked with carbon content of fossil fuels • Similar to EPA Lead Trading in 1980s • Very successful program – phased leaded gasoline out of the market in 5 years, low transaction costs, cost savings of $250 million/yr • Various midstream alternatives • How can one decide among the alternative points of regulation?

9. Criteria for Identifyingthe Point of Regulation • Breadth of coverage • Downstream CO2 emission permits likely to include electricity generators; likely to exclude motor vehicles, home furnaces, etc. • Upstream carbon rights provide complete coverage of CO2 emissions, but non-combustion uses of fuels affected (need compensating credits) • What about carbon management (separation & removal of CO2 from stack gases)? Upstream system provides no incentive; need credits. • What about biological carbon sequestration? Integrated trading system? Much more difficult, but possible (and quantitatively important). • Number of regulated entities(monitoring & enforcement, but competitiveness concerns with very small market) • Monitoring– required for market confidence, but CEM very costly • Which GHGs?A design issue itself, which can affect choice of point of regulation. • CO2 only or others as well? Inter-gas trading?

10. What Point of Allocation? • Important: the point of allocation need not be the same as the point of regulation – these are separate design issues • For example, upstream regulation can – in theory -- be combined with mid-stream or downstream allocation of the tradeable permits • Possibilities for point of allocation include: • Downstream (CO2 emission sources) -- CO2 emission permits [or even further downstream, e.g. electricity users] • Upstream (producers and importers of fossil fuels) – carbon rights linked with carbon content of fossil fuels • Various midstream alternatives • The point of allocation, combined with the nature of the allocation affects the distribution of the cost burden (later).

11. What rules for allocation? • Question #1: auctioned, given w/o charge, or a mix? • Political advantages of freely allocated can lead to efficiency problems • Usually costs under TPs are independent of initial allocation, so allocation can be left to political process (good news, and that’s why these systems are used) • But TPs can exacerbate distortions & drive up costs • And in presence of some types of transaction costs, post-trading outcome is sensitive to initial allocation • So, a successful attempt to establish politically viable program through initial allocation can increase costs • Other Issues involving Rules for Allocation: • Choice of baseline & baseline year for allocation • Specific allocation cross-sectionally and over time • Rules for allocation, point of allocation, and point of regulation do affect distribution of costs, but statutory incidence is typically not the same as the actual burden.[Depends upon market conditions: supply and demand]

12. What about temporal flexibility? • Among the rules that govern trading, those that affect temporal flexibility are exceptionally important. • Banking (saving emission permits for a future time period) has been key in both the lead trading program and the ongoing SO2 program • But programs that are phased in over time can create emissions leakage from regulated to unregulated sources • Borrowing (using emission permits from a future period) can – in theory -- increase cost-effectiveness of a program • Rules for banking & borrowing and for the length of compliance periods (1 year in the SO2 program, 5 years in the KP) should depend upon nature of environmental problem (and potential solutions) • Key reality is that global climate change is a stock externality problem of very long duration (GHG resident times in atmosphere of decades to centuries)

13. What about enforcement? • MBIs, such as cap-and-trade systems, are not deregulation, but rather more enlightened regulation – government enforcement is required. • Stiff penalties provide effective incentives for compliance, but excessive penalties are not credible • In SO2 program, penalty is $2,900/ton of excess emissions (compared with marginal abatement costs that have been 10% of that); result – near perfect compliance • SO2 program also requires emissions offset in subsequent year. If this is eliminated, penalty is a tax on “excess emissions,” and we have a “safety-valve” on costs. Another major design issue. • So, reasonable penalties are necessary, but avoid prior approval by government for trades – drives up transaction costs

14. Are there needsfor government brokerage? • No! • Private sector can and will fulfill brokerage needs.

15. What about competitiveness concerns? • Can permits in a cap-and-trade system be used as barriers to entry by incumbent firms? • Yes – in theory, firms with market power in either the permit market or respective product markets can withhold permits from the market, driving up price, and keeping out competition. What to do? • Solution in SO2 allowance trading program was a zero-revenue annual auction of about 3% of the allowances (government is a seller of last resort) • Can be a problem in theory, but has not been in lead or SO2 programs. Ultimate response is not for EPA, but the anti-trust folks at DOJ.

16. Can and Should there be Linkageswith International Systems? • Back to where I began, a domestic trading program should be part of a sensible global climate agreement (that provides for trades across national boundaries). • But in the meantime, can and should a domestic cap-and-trade program be linked with other countries? • Linking with CDM or JI projects very risky • Relative baseline, unobservable counterfactual means all claims of reductions very questionable • Perverse incentives exist for both parties to take credit for what would have happened anyway – cap is loosened, environmental integrity destroyed • Only countries that ratified KP, can trade with EU system (as of now) • The devil is in the details

17. The Hypocratic Oath of Policy Design: Avoid counter-productivedesign elements • Stakeholder involvement is fine, but design by committee can lead to some very unfortunate consequences • A sad example: EPA Emissions Trading Program for criteria air pollutants in the 1970s. • Environmental advocates insisted on infamous 20% rule • Result: discouraged trades, reduced cost savings, minimized environmental gains • Let’s not follow (Dudley) Moore’s version of Santayana’s advice: “I can remember all my mistakes, and repeat them exactly the same again.”

18. For More Information http://www.stavins.com “What Can We Learn from the Grand Policy Experiment? Lessons from SO2 Allowance Trading” “Beyond Kyoto: Getting Serious About Global Climate Change Policy”