Itʼs in the Air:On Emissions Trading as a Mitigation Policy Tool with a Case Study of the European

Emissions Trading Scheme (EU-ETS).

Andrew J. GertgeMitigation Paper

GEOG 512SN#33823089

I. Introduction 3

II. Emissions Trading: In Theory 4

Command and Control Mechanisms 6

Taxation 6

Emissions Trading: Benefits 7

III. Emissions Trading: in Practice 10

IV. EU-ETS Case-Study: As the World Watches 11

Challenges and Objectives 12

EU-ETS: Cap-Setting 13

EU-ETS: Allocation of Allowances 14

EU-ETS: Banking and Borrowing Procedures 15

EU-ETS: Linkage Provisions 18

EU-ETS: Future Deepening and Widening 19

EU-ETS: Phase 3 (2012-2020) 20

V. ETS Worldwide: A Multi-Tiered Expansion 23

VI. Conclusion 25

VII. Bibliography 27

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Introduction An effective climate change policy changes the way people think. It puts in place the incentives and drivers needed to assist a society as it incorporates the true costs of its greenhouse gas emissions (GHGs) and transitions to thriving with fewer of them. This societal transition is nothing short of revolutionary and does not occur seamlessly. Nevertheless, policy makers have at their disposal a variety of policy instruments that are designed spearhead the incremental changes needed for a steady, yet stable restructuring of their economies. This paper examines one of the most pervasive and politically popular climate policy tools at present, the Emissions Trading Scheme (ETS). This paper begins by tracing the origins of the ETS, with its cap-and-trade design, and explores the appeal of the theoretical arguments upon which they are built. This exploration will include a brief comparison between the ETS and other prominent policy tools--the Carbon Tax and other Command and Control (CaC) mechanisms. The paper then follows with a description of how an ETS is designed to function once implemented. A policy in theory can differ greatly from a policy in practice, of course, thus this paper makes a brief survey of at past and current experiences with ETS implementation. The European Unionʼs EU-ETS--the worldʼs largest of its kind--receives specific attention, particularly the policy design lessons learned from its strengths and flaws. Future prospects for the deepening (the number of sectors of an economy under an ETS) and widening (the number of economies participating in an ETS) of the ETS are explored. With the new U.S. administration ostensibly more favorable to implementing its own national ETS, and post-Kyoto negotiations slated for this year in Copenhagen, this paper will look at the prospects of a Global, Transatlantic or Canada-US ETS forging sometime soon on the horizon.

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Emissions Trading: In Theory

Two Papers in the 1960s laid the foundation of the cap-and-trade idea: T.D. Crocker in his 1966 article, “The Structuring of Atmospheric Pollution Control Systems,” and University of Toronto researcher J. H. Dales in his work two years later, “Pollution, Property and Prices”.1 Dales and Crocker considered the social problem of collective decision-making concerning a public good (air and water, in this case) and the negative externalities wrought by unrestricted use of this common property.2 Collectively they postulated that these negative externalities could be corrected in the most cost-effective manner if the governing body were to cap the amount of permissible pollution and then sell the rights to pollute.3 Indeed, modern ETS systems have taken Dales and Crockerʼs theories and rendered them more sophisticated and effective. Before delving into current ETS mechanics, it behooves the reader to understand the problem that the ETS is designed to address, the negative market externality. A negative market externality, is a cost that arises from an economic activity that has affects on others outside of that market activity, yet has no price in the market.4 Air pollution provides a textbook case of market externality in that the smoke churls out of a factory smokestack entails cleanup and various health costs, and these costs are rarely born by those involved in the primary market activity: the production and purchase of the factoryʼs products. Because the real costs to society by the smoke from the smokestack are not incorporated into the production cost calculations of the factory or the price of the products, more of these products will be bought and sold than is optimal for society, were the costs of the externality absorbed by the market. This result is often referred to as a market failure. Figure 1 below illustrates a market failure quite well.

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1 Romstad 419

2 Romstad 419

3 Romstad 420

4 Bishop, Online Version, Last Accessed 14 April 2009, URL: http://www.economist.com/research/Economics/alphabetic.cfm?LETTER=E

Figure 1 Negative Externality - Social Optimum Differs from Market Equilibrium5

When the negative externality costs of pollution are not taken into account, the market Equilibrium results in a higher quantity of goods being produced at a lower cost to consumers. This, “unfettered market causes the overproduction of GHG emissions because the costs of their damage do not show up in the prices of the goods and services that caused them.”6 The Social Optimum point shown above in Figure 1 is the new equilibrium for the market that does incorporate the costs of the damage that air pollution inflicts on society. This inclusion of costs is shown as an upward left shift of the supply curve and results in a smaller quantity of goods being produces at a higher price per good produced.

As mentioned earlier, several policy tools have been devised to correct market failures of this ilk. The bulk of these instruments fall into three broad categories: Command and Control (CaC), Taxation and ETS. Each of these three types of instruments present certain advantages and challenges in their design to influence the behavior of market actors by correcting market failures.

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5 Abowd, John. Public Choice. Cornell University Online Course-Econ 101. URL: http://instruct1.cit.cornell.edu/Courses/econ101-dl/lecture-public-choice.html. Last Accessed 10 April 2009.

6 Jaccard 11

Command and Control Mechanisms Command and Control (Cac) mechanisms are the more traditional policy tool that entails imposing general standards, limits or norms uniformly across an industry or a targeted segment of the economy.7 CaC policies present several benefits that make them very common in the area of emissions reductions. By far, CaC policies are the clearest and most transparent of emission reductions options. The outcome is easily understood and measurable by all concerned and enforcement and monitoring are also straightforward--if the standard, limit or norm is not met, the violator will pay a fine or incur a predetermined penalty.8 CaC policies carry with them, however, high administration costs and are vulnerable to inaccuracies in reporting, both deliberate and otherwise. Taxes and Subsidies differ from CaC policies in that they incorporate at least a modicum of market forces and administrative ease which helps lower the cost of curbing the negative externality.

Taxation As early as 1920, A.C. Pigou postulated that, in lieu of imposed regulation, a tax could be levied to correct negative externalities, a concept that was later applied to modern economies by Baumol in his work, “On Taxation and the Control of Externalities.”9 The goal of a tax, often simply called a Pigovian tax, is to impose a tax that raises the price of that certain activity high enough to reflect the cost of the negative externality. Like the CaC mechanism, this increase in price would reduce the amount of the activity, thereby reducing the effects of the negative externality. Contrary to the CaC mechanism, however, the imposition of the tax by the government will have garnered additional revenue that can now be used to compensate those harmed by the negative externality or to subsidize R&D projects that devise new technologies to change the way the practice is done in the first place.

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7 Anderson 1

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9 Baumol 81-92

The primary benefit of Pigouvian taxes is that they provide price certainty. Actors in the economy can easily incorporate these taxes into their decision-making models and modify their behavior accordingly and in the most cost-effective way. Additionally, taxes have the possibility of maintaining what is called the “equimarginal principle” where the cost of additional reductions are the same for everyone, which reduces the policyʼs cost for society as a whole.10 The primary challenge with Pigouvian taxes has to do with establishing the actual price of the tax, for often gauging the tax level needed to correct for the negative externality is done not without a great deal of uncertainty.11 Taxes are also often politically unpalatable among industries and therefore have to surmount political feasibility obstacles as well. If the taxes are set too high or too low relative to a certain emissions reduction target or if economic conditions change abruptly, the tax scheme will need to be adjusted via the political process--an uncertain task.12 The ETS, as a Cap-and-Trade policy tool, offers several key advantages--particularly concerning greater inclusion of market forces--that have led to its greater popularity in recent years. Emissions Trading: Benefits Whereas taxes provide price certainty (i.e. the price of emissions is known and understood by all actors), an ETS provides reduction certainty by setting an absolute cap on the total amount of emissions allowable for actors under it.13 Emissions allowances are then issued based on the set cap and allocated to the actors under the ETS (Precisely how the cap is set and how emissions allowances are allocated will be discussed below in the EU-ETS case study). These emission allowances may be freely sold and purchased amongst those in the ETS and any actor that emits more than it is able to account for via emission allowances will face a fine or some other penalty. The ultimate aim is to establish a price for these emission allowances (and thereby creating

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10 For further discussion of the equimarginal principle, see Jaccard 13.

11 Anderson 2

12 United States Climate Action Partnership 1

13 Jaccard 12

a price for the emission of the gases covered under the ETS) which will incite actors covered by the ETS to create and employ the most efficient emission reduction technologies. This works because the actors under the ETS who can most cost-effectively reduce their emissions have incentive to do so to sell their unused emissions allowances to actors who are unwilling or unable to do so as cost-effectively. Figure 2 below lucidly depicts the potential benefits of this type of emissions allowance trading.

Figure 2 Total Cost Savings from Emissions Trading Compared to a CaC scenario14

Under the CaC policy, Company A and Company B are required to reduce their emissions from 100 to 80. Company A reduces emissions at 100 Euros per ton and therefore pays 2000 Euros to meet the CaC regulation. Company B also complies with the regulation and yet can reduce emissions more cost-effectively, at the price of 70 Euros per ton. Company B only pays 1400 Euros for the same reduction of emissions. The total costs for the two actors to comply with the CaC regulation is, therefore 3400 Euros under the CaC policy. Compare now the CaC outcome to the Emissions Trading scenario in the rectangle on the rights side of Figure 2.

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14 “The Basics of Emissions Trading.” Energy Saving Network. published online 14 August 2006. URL: http://www.esprojects.net/en/policy/directives/emissionstrade/basics/. Last Accessed: 11 April 2009.

Company A and Company B have 80 emissions allowances and are now able to buy and sell their emission allowances. Since the abatement costs for Company B (70 Euros per ton) are lower than those for Company A (100 Euros per ton), Company B can reduce its emissions below 80 (70 in this example) and sell its 10 unused allowances to Company A for a price above its abatement costs (80 Euros in this example) and save 100 Euros on its total abatement costs. After buying 10 emissions allowances from Company B for 800 Euros, Company A must only actually reduce its emissions by 10 (1000 Euros in all) for a total emissions reduction cost of 1800 Euros--a savings of 200 Euros compared to the CaC scenario. Under the ETS, then, the same reduction target was met, yet at an overall savings of 300 Euros. This example also shows how important a stable and relatively high price for the emissions allowances is. If the market price for emissions allowance were 10 Euros (and not 80 Euros) , Company B would not have had any incentive to reduce below the reduction required, because each reduction would have been more costly (70 Euros) than the price received for each traded emissions allowance (10 Euros). The advantages of the ETS go beyond its reduction certainty and its lowest-cost abatement potential, as important as they may be. The ability of an ETS to incorporate “flexibility mechanisms” such as the Kyoto Clean Development Mechanism (CDM) and Joint Initiative (JI) programs, to automatically adjust to economic conditions and to be linked to comparable ETS frameworks the world over make the ETS appealing to both political and economic actors, and therefore one of the most feasible emission reduction policy tools.15 While the implementation of the ETS thus far has confirmed its potential for many of the theoretical emission reduction advantages it has also revealed serious potential pitfalls that could work to prevent its proper functioning. The following section explores the relative success of initial large-scale ETS experiences, brushes a quick tableau of the current ETS policies proposed or adopted worldwide and follows this by a more in-depth look at the lessons learned from the failures of the worldʼs largest ETS, the EU-ETS.

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15 United States Climate Action Partnership 1-2

Emissions Trading: in Practice

The New Zealand Fisheries License Trading was the first notable, large-scale use of a Cap-and-Trade system used to combat environmental negative externalities.16 Beginning in 1986, the New Zealand government capped the allowed number of commercial fishing limits based on sustainable quotas and individual fishing companies are able to trade Individual Transferable Quotas (ITQs) to meet the requirement. This system gained recognition for its comparable administration costs and heavy ITQ trading (77 percent of all ITQS allocated changed ownership before being submitted).17

The first ETS implemented on a large scale arrived under the U.S. Environmental Protection Agencyʼs (EPA) 1990 Clean Air Act. The Acid Rain Program birthed from the Clean Air Act sought to combat acid rain in the northeastern United States by reducing annual SO2 emissions by 10 million tons below 1980 levels.18 The program, that covered 110 mostly coal-burning power plants in 21 eastern and midwestern American states, deployed its efforts in two phases: Phase 1 which began in 1995 and Phase 2 which began in 2000.19 Phase 1 exceeded expectations by reducing the cost of SO2 abatement by more than half of the EPAʼs predictions and much more than costs predicted by the power industry.20 Phase 2 followed by expanding the Acid Rain Program ETS to include NOx emissions and four times the number of utility units, even smaller ones that operated on oil and gas.21 The success of the Acid Rain Program bolstered political and industrial support for the cost-effectiveness of the ETS as a policy tool and the advent of the EU-ETS afforded the world a chance to evaluate its merit as a regional, if not global instrument to transition economies to lower GHG emissions.

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16 Anderson 6

17 Anderson 6

18 United States Environmental Protection Agency 5

19 United States Environmental Protection Agency 5

20 Anderson 6

21 United States Environmental Protection Agency 5

EU-ETS Case-Study: As the World Watches

Figure 3 European Member States of the EU-ETS22

The EU-ETS is a landmark policy that constitutes the worldʼs first regional GHG ETS, applying to over 12,000 installations in 25 countries and 6 major industrial areas.23 While designed prior to signing the Kyoto Protocol, the EU-ETS is being implemented as a primary policy tool for the EU-1524 to meet its Kyoto GHG reduction commitments. In fact, in Australia, “Legislators and regulators working to develop these [ETS] systems are carefully studying the European Experience."25 The heuristic value of the EU-ETS is all the more applicable to the global challenge of devising and implementing effective mitigation policies due to the lack of any pre-existing, community-wide ETS framework

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24 The Kyoto Protocol was ratified in 2002 when the EU comprised 15 member countries, the EU will now negotiate a post-Kyoto agreement as EU-27 to reflect the subsequent addition of 12 new member countries post-hence.

25 Gardner 95

for the European Union.26 For this very reason, Phase 1 (2005-2007) of the EU-ETS bore the explicit intent of being a training period for the subsequent and current compliance phase, Phase 2 (2008-2012).27 Both phases reveal that all components of an ETS do not have to be perfect before it can be designed and implemented. The European Parliament just recently gave its assent to Directive 2008/101/EC28 in December 2008, promulgating Phase 3 (2012-2020) of the EU-ETS. To grasp how Phase 3 responds to the the lessons learned from the EU-ETS in its first two implementation phases, it is first necessary to understand its challenges and objectives.

Challenges and Objectives It should first be noted that GHG emissions present a significantly different negative externality than air pollution does. The negative externalities of air pollution typically have easily identifiable origins, are usually born within an easily demarcated geographic area, on an easily defined group of people, within an easily delimited timeframe. This relative clarity of who brings and bears the costs of the externality facilitate the creation of and participation in the policy instrument adopted. Scholars have noted the difficulty of adopting GHG emission reduction policies due to the difficulty in commodifying natural capital and then committing to present costs to pay for “future gains in human capital and future costs to natural capital.”29

Taking into account these difficulties while still enacting effective policies, it has been suggested, requires “a flexible policy infrastructure built on a sequential decision-making approach that incorporates new information.”30 The EU-ETS, therefore, contains sufficient flexibility in several key areas: (1) How the GHG cap is set, (2) The process for allocating EU emissions allowance (EUAs), (3) Banking and Borrowing procedures (4) Linkage or off-system provisions and (5) the progressive deepening and

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29 Jaccard 10

30 Aldy 351 (353-354)

widening of the ETS. These five areas of flexibility have helped the EU-ETS address its initial failures and placed it on a “benefit-cost pathway”31, to realizing real GHG emission reductions.

EU-ETS: Cap-Setting As opposed to the centrally administered Acid Rain Program, the manner by which the emissions cap is set EU-ETS is a highly decentralized process. Each Member State determines (subject to European Commission review and approval) the number of EU allowances (EUAs) that it will allocate. Each Member State, then, produces a National Allocation Plan for each of the EU-ETS Phases which included the number of EUAs, a list of the sectors and installations concerned and how the allocations will be distributed.32 And while each Member State administers the creation, transfer and surrender of the EUAs, the 2004 Registries Regulation has succeeded in maintaining high uniformity in these areas.33 Another important element of the EU-ETS cap is that it is a “cap within a cap”. The EU-ETS thus far only pertains to CO2 emissions, while the EU-15ʻs Kyoto commitments require an economy-wide reduction of the six GHGs enumerated in the Kyoto Protocol: carbon dioxide, methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons and sulfur hexafluoride. 34 For this reason, the EU-ETS only includes specific subsets of the economy--the power sector, combustion facilities and specified industries such as cement, steel and paper.35 The EU-ETS does, in fact, have the capacity to expand, however, and that is discussed below in the deepening and widening section. Prior to the implementation of Phases 1 and 2, it was difficult to truly ascertain what the long-term trajectory for the cap would be, as it wasnʼt determined until mid

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2005 for the trial Phase 1 (2005-2007) and not until late 2007 for the compliance Phase 2 (2008-2012).36 The tardiness of the cap setting process has kept activity under the EU-ETS “self-contained” within each trading period.37 This disjointing, as it were, of the EU-ETS was exacerbated by the initial banking and borrowing procedures which is discussed in more detail in the corresponding section below.

EU-ETS: Allocation of Allowances Closely linked to the cap setting process, the procedure for allocation EUAs within the European union has, perhaps, received the strongest censure during and after Phase 1. EUAs are allocated to each installation or operation based on that installation or operationʼs past emissions, a process called “grandfathering”. The grandfathering process coupled with inaccurate methods of measuring past emissions resulted in generalized over-allocation of free EUAs. This over-allocation led to windfall profits for certain installations and when combined with the “hot air” effect that filled certain former Soviet States with excess EUAs, contributed to high EUA price volatility. This price instability led many to doubt the ability of the EU-ETS to achieve its primary aim: to place a strong, stable price on CO2 and thereby send to the economic actors in the market the signals they needed to transition to low CO2-emitting processes and products.38 The IPCC, in its Fourth Assessment Report, states that price instability of allowances makes estimation of the costs much more difficult and that the distribution of allowances can affect cost-effectiveness and competitiveness.39

Economists have proposed several theoretical strategies to correct the EU-ETS price stability. Government auctioning the EUAs (in lieu of doling them out freely) is the most widely advocated option to correct the over-allocation problem while simultaneously generating funds that can be used for R&D in greener technologies and

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redistribution for sectors more adversely impacted by the ETS.40 Auctions, as opposed to “grandfathering”, minimize administrative costs, reduce tax distortions, provide more flexibility in the distribution of costs, reduce the potential for political debacles over rent allocations and provide more incentive for innovation.41 This last point, pertaining to the innovation incentive benefits of the auctioning of EUAs, is linked to the markedly higher price of EUAs when they are auctioned as opposed to when they are freely allocated.42 For this reason, industry is often reluctant to support full auctioning of allowances, and the EU-ETS had a ceiling of 5% auctioning in Phase 1, raising it to 10% for Phase 2.43

To strike a compromise and gain industry support for more auctioning, a government can impose a “safety-valve” or price ceiling that guarantees that if the EUA price exceeds a certain predetermined amount, the government will sell any remaining amount under the “safety-valve” price. If this price is triggered, however, this indicates that the emissions cap will not be met.44 Thus, the price-ceiling option may serve a purpose to assuage industry, but other measures must be in place that prevent frequent or long-term triggering of the “safety-valve” price. Thus far the EU-ETS has not implemented a “safety-valve” feature, but has integrated other flexibility features, such a banking and borrowing, to assist industrial adjustments under the EU-ETS

EU-ETS: Banking and Borrowing Procedures The EU-ETS has the distinct feature of allowing unlimited banking and borrowing of EUAs within any given trading period. Figure 4 below traces the annual EUA cycle within the EU-ETS:

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44 United States Congressional Budget Office 2

Figure 4 The Annual Cycle of Emissions Trading under the EU-ETS45

Under the EU-ETS, EUAs are issued annually in late February, an annual issuance date nearly two months before the EUAs from the previous year must be surrendered. Consequently, under the EU-ETS, any shortages in a given previous year can be covered by using EUAs from the current yearʼs February allocation. This type of year-ahead borrowing, understandably, increases the flexibility with which industry can operate to meet its reduction requirements within a given trading period. Inter-period banking and borrowing, however, is much more limited under the EU-ETS. In fact, inter-period transfers were interdicted between Phase 1 and Phase 2.46 This was intended, of course, as a way to inhibit the difficulties in the trail period from interfering with the results in the compliance period of Phase 2. Unfortunately, the period-specificity of Phase 1 trading accentuated pernicious effects that over-allocation of the EUAs had on the ability. Figure 5 below graphs the price variation of the EUAs in Phase 1 and the beginning of Phase 2:

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Figure 5 Price Variation in Phase 1 and Phase 2 of the EU-ETS47

The ability for the EU-ETS to establish a price for EUAs (i.e CO2 emissions) is evident in Figure 5 above and is especially worth noting considering that it represents the trading of nearly 80% of the worldʼs emission allowances or Certified Emission Reductions (CERs).48 Nevertheless, as discussed early, the volatility of the price, was a concern. The bottoming-out of the price for Phase 1 EUAs in 2007--shown unmistakably in Figure 5 above--can be almost entirely attributed to the restriction on inter-period borrowing or banking, for after April 2007, any and all excess EAUs were rendered useless.49 The dark blue line beginning in late 2005 and extending fairly evenly throughout the graph represents the price for the futures contracts for delivery of Phase 2 EUAs in December 2007.

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The relative steadiness of the Phase 2 EUA prices around 20 Euros reflects the increased accuracy of emissions measurement (occurring in April 2006) and more balanced expectations about the functioning of the EU-ETS.50 Unfortunately, the dramatically decreased productivity (and therefore emissions) of European industry due to the economic crisis that began in late 2008 caused a surge of surplus EUAs to flood the market, driving EUA prices to a lower-than-expected value of around 11 Euros.51 Another aspect of “banking” that emerged during Phase 2 (and will be discussed in the Phase 3 section below) was that for external offsets, particularly those established with the EU-ETS linkage provisions to the Kyoto Protocol.

EU-ETS: Linkage Provisions While most technicalities of the EU-ETS were decided by 2003, provisions for “linking” the ETS to Kyoto Protocol mechanisms—namely, Joint Implementation (JI) and the Clean Development Mechanism (CDM)—proved more debatable. The JI and the CDM are flexibility measures in the Kyoto Protocol that allow signatory countries to meet part of their required reduction targets by investing in new emission reduction projects in developing countries. In the Phase 1 of the EU-ETS, credits from JI and CDM projects were unlimited--which some scholars say exacerbated the EUA price volatility discussed in the previous section.52 It may be no surprise, then, that CDM and JI projects grew rapidly when the full EU-ETS finally came into force on 27 October 2004--by 2006, credits for CDM projects alone represented 475 million tons of carbon dioxide, valuing more than $4 billion.53 The CDM and JI mechanisms were highly criticized in Phase 1 and Phase 2 required that each Member State decide beforehand how many CDM or JI credits it would allow its companies to collectively use toward compliance. In addition, more stringent oversight was performed to ensure that the CDM projects were “additional” projects (that they

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would not have already taken place anyway) and that they were not a form of carbon “leakage” (the movement of a firmʼs activity priorly under the EU-ETS to an area with less-stringent emission standards).54 The CDM and JI proved to be a contested topic in the adoption of Phase 3 of the EU-ETS, discuss below.

EU-ETS: Future Deepening and Widening As discussed in the Cap Setting section, the EU-ETS is designed to gradually expand--deepening its reach by covering more GHG gases and more sectors of the economy and widening by linking to other ETS systems. A 2007 report by Oberndorfer and Rennings at the Centre for European Economic Research provides a fillip for this design strategy. Figure 6 below charts the most prominent modeling devised on the costs that firms under the EU-ETS have to bear to their economic competitiveness:

Figure 6 Impacts of the EU-ETS on competitiveness in Europe-Simulation Results55

Oberndorfer and Rennings conclude that the costs of the EU-ETS are modest even when compared to Business As Usual (BAU) scenarios--with the glaring exception of the electricity-intensive aluminum industry that faces fierce global price pressure and

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could be pushed out of the EU-ETS completely. The benefits of the EU-ETS as a policy tool, however, are quite substantial: it contributes to reducing CO2 emissions and to the restructuring of Europeʼs power and industrial sectors for a low carbon future.56 The positive effects of reducing emissions under the framework of the EU-ETS would increase, continue Oberndorfer and Rennings, if the EU-ETS were to cover additional sectors of the economy and link its EUA trading activity to additional regions in the world with similar trading schemes.57 The full integration of non-EU countries like Norway Iceland and Liechtenstein and the proposed inclusion of the airline industry (beginning 2010) have already shown that widening and deepening of the EU-ETS are occurring.58

To ascertain the probability of further widening, this paper will next look at the worldʼs national and regional ETS that are currently operating or will be imminently implemented. First, though, this section concludes by citing the changes in store for Phase 3 of the EU-ETS.

EU-ETS: Phase 3 (2012-2020)

Phase 3 Cap Setting Directive 2008/101/EC has improved the cap setting process of the EU-ETS by providing well in advance--four years, in this instance--the target reduction of 21%. Beginning in 2013, the EU will reduce each year the absolute cap on CO2 emissions on a linear and systematic basis, to reach the 21% reduction goal based on 2005 emissions.59 The EU pledge to commit to a 30% reduction goal, if an international climate agreement is concluded, will need first to be approved via the traditional co-decision process (i.e between the Council and Parliament).60

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Phase 3 Allocation of EUAs EUA Allocation will be drastically altered in Phase 3. Phase 3 will scrap the National Allocation Plan (NAP) procedure and deploy “Community wide and fully-harmonized implementation measures”.61 In an effort to reduce EUA price variation and the bottoming out of EUA prices during periods of low economic activity, higher levels of auctioning will be phased in, and at differing rates according to the industrial sector. As a general rule, 30% of EUAs will be auctioned in 2013, increasing to 70%-100% by 2020 and 100% for all sectors by 2027.62 Phase 3 will allow 100% free-allocation for industries with a high risk of “carbon leakage”, a list of such industries (which may cover up to 95% of non-power industries) will be published in December 2009 and every 5 years following.63 Additionally, the Commission will monitor more closely the price of EUAs in Phase 3, allowing Member States to carry over auctioning to the following year if ever EUA prices exceed three times their average price.64 This establishes a price ceiling of sorts, but does not provide a price floor for the EUAs.

Phase 3 Banking and Borrowing Procedures Phase 3 will double the duration of the trading period and allow actors under the ETS to profit from increased flexibility and stability in its banking and borrowing provisions. Most importantly, whereas inter-period trading and banking was proscribed between Phases 1 and 2, any unused or “banked” EUAs from Phase 2 are transferrable to Phase 3.65

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Phase 3 Linkage or Off-System Provisions Given the green light for inter-period banking and borrowing, “banked” CDM or JI credits are applicable to Phase 3 targets. Some scholars estimate that between 2008 and 2020, such off-system credits may comprise up to 50% of the reductions declared by a firm, industry or country.66 This component of Phase 3 has drawn harsh criticism from environmental NGOs such as the World Wildlife Fund (WWF) who see the linkage provision as a European cop-out and failure to commit to the domestic industrial changes needed for a true transition to a low-carbon economy.67

Phase 3 Deepening and Widening of the ETS. In tune with the EUʼs expressed intention to include more of the transport sector under the EU-ETS, Phase 3 commits the EU-ETS to incorporate all EU maritime shipping by 2013, in the absence of an international agreement with regards to maritime shipping emissions.68 Phase 3 adds CO2 emissions from petrochemicals, ammonia, aluminum, and aviation, as well as nitrous oxide emissions from acid production and PFC emissions from the aluminum sector.69

In October 2007, the European Commission and several Member States were founding members of the International Carbon Action Partnership, an organization aiming to foster compatibility among the worldʼs existing trading systems.70 Directive 2008/101/EC calls for this type of rapprochement among the worldʼs ETS, stating that from 2013, the EU-ETS could establish links not only with third countries, but also with other ETS at regional and state levels as well.71 This paper now leaves the EU-ETS to brush a brief survey of the current status of ETS developments outside of Europe.

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67 Euractiv.com 14 April 2009

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ETS Worldwide: A Multi-Tiered Expansion Figure 7 below provides an interesting visualization of the ETS patchwork forming in different parts of the globe.

Figure 7 The GHG Emissions Trading Universe as of 200772

These ETS represent different levels of governance and each entail different degrees of emissions reduction stringency. The EU-ETS is at the center of the three concentric circles in Figure 7, surrounded by the ETS designed by other signatories to the Kyoto Protocol, circumscribed, in turn, by the ETS developing outside of the Kyoto Protocol framework (Primarily Australia, New Zealand and regional ETS in the US). Among these ETS, the New South Wales GHG Reduction Scheme is the oldest (2003), the EU-ETS is the largest (EU-27 + Norway, Switzerland, Iceland and Liechtenstein) and the Chicago Climate Exchange (CCX) is the first ETS to include all greenhouse gases.73

The establishment of region ETS in Australia (New South Wales) and the United States (RGGI, WCI, CCX and the more recent MGGRA) reveal how compelling the ETS

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idea has become in economics, environmental and political circles.74 These regional schemes emerged in the absence of and at times against political will at the national level and are providing impetus for the formation of national ETS policies. This is particularly pertinent on the North American continent and has profound implications in light of the recent administration changes in the US federal government.

Initiative Reduction Effective Dates Participating Provinces

Regional Greenhouse Gas Initiative (RGGI)

10% below 2009 levels 2009 (1 Jan)

Members: CT, MA, ME, MD, RI, VT DE, NH, NJ, NYObservers:New Brunswick, Nova Scotia, Newfoundland & Labrador, Ontario, Prince Edward Island, Quebec, PA

Western Climate Initiative (WCI)

15% below 2005 levels 2015-2020

Members: British Columbia, Manitoba, Ontario Quebec, AZ, CA, MT, NM, OR, UT, WAObservers:Saskatchewan, AK, CO, ID, KS, NV, WYBaja California,ChihuahuaCoahuila, Nuevo Leon, SonoraTamaulipas

Midwest Greenhouse Gas Regional Accord(MGGRA)

15% - 20% - 25% below 2005 levels TBD

Members:ManitobaIA, IL, KS, MI, MN, WIObservers:Ontario, IN, OH, SD

Chicago Climate Exchange (CCX) Voluntary per annum

300 members from all sectors and Offset Projects worldwide-linked to European Climate Exchange (ECX) with 65 business members

National Policy Reduction Effective Dates

Canada Current20% below 2006 levels 2010

United States (Wax-Markey Bill)

20% below 2005 by 2020, 42% by 2030, 83% by 2050 TBD

Figure 8 Regional ETS Initiatives and National ETS Policy in North America75

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74 Antes XV

75 Sources: Regional Initiatives - www.rggi.org, www.midwesternaccord.org, www.westernclimateinitiative.org, www.chicagoclimatex.com National Policies: “Turning the Corner Planʼ: http://www.ec.gc.ca/cc/default.asp?lang=En&n=A3CB096D-1, Broder 1, Last Accessed 16 April 2009.

This is particularly pertinent on the North American continent and has profound implications in light of the recent administration changes in the US federal government. Figure 8 above delineates the regional ETS schemes in North America, their reduction targets and the provinces and states involved. Indeed, much of the voluntary participation in the CCX stems from private sector responding to pressure from their clients and a desire to "gain early experience with emissions trading on the assumption that mandatory U.S. systems will sooner or later be created."76 The spread of regional initiatives is propelled by a similar response from state and provincial government leaders with more environmentally sensitive constituents. The pressure these regional initiatives place on national governments, however, is just as much economic as it is political. The largest of North Americaʼs regional ETS, the WCI covers 70% of Canada's economy and 50% of its GHG emissions, as well as 20% of the US economy and 90% of the regionʼs GHG emissions.77 The inclusion of such a substantial portion of the two already heavily integrated economies under just one of North Americaʼs regional schemes has greatly increased the likelihood of a North American Emissions Scheme. The Canadian federal government recognized this and expressed immediately following the 2008 federal elections its support for a such a continental ETS.78

Conclusion

The world is poised for the post-Kyoto agreement negotiations that will take place in Copenhagen, Denmark later this year. At the top of the policy tools to cost-effectively reduce emissions, the ETS will figure prominently in the discussions. Since the first Kyoto discussions in 1997, the ETS has undoubtedly increased its efficiency, influence and integration both within and without the Kyoto Framework. The EU-ETS brings to

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76 Gardner 94

77 Stockholm Environmental Institute (SEI), “Western Climate Initiative.” 29 January 2009. URL: http://www.sei.se/programmes/climate-a-energy/projects/1383-western-climate-initiative-wci.html Last Accessed 14 April 2009.

78 Ljunggren 1

the table invaluable insight into the implementation of mechanisms of the ETS: cap setting, emissions allowance allocation, banking and borrowing procedures, linkages to off-system provisions and the progressive deepening and widening of the ETS. While mitigating the impact of climate change ultimately hinges on changes in human activity on a global scale, the ETS has revealed its potential to be an effective signal-sender : that the costs of GHG emissions are hence forth anchored in economic activity and that future success implies devising ways to reduce them.

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