Linking emissions trading schemes is not a viable flexibility mechanism

In order to reduce greenhouse gas emissions, linking emission trading schemes will no longer be desirable, says Gareth Brydon Phillips.

Emission Trading Schemes or Systems (ETS) are the tool of choice amongst many policy makers to tackle growing emissions of greenhouse gases (GHG). They work by setting a cap on the total amount of emissions from an entire economy e.g. the Kyoto Protocol (KP) or one or more sectors of an economy e.g. the EU ETS.

The cap is presented to the economy in the form of allowances (Assigned Amount Units under the KP and EU Allowances under the EU ETS) which are then allocated or auctioned to the participants. The participants must periodically surrender allowances equal to their annual / periodic emissions and they can trade allowances, enabling the market to allocate resources to the least cost abatement options. Participants may or may not have access to purchase emission reductions from project based activities outside the scope of the ETS which they can use to offset emissions instead of surrendering allowances.

Linkage of Emission Trading Schemes has been a popular topic for almost as long as I can remember. It is supposed to provide liquidity and depth to markets; flexibility for captured entities (companies or countries); help bring markets and prices into line and, perhaps even help to achieve the ultimate goal of a global carbon market. Commentators have sounded notes of caution about the risks of linking due to assimilation of the lowest standards whereby, for example, units which would be excluded from one scheme but permitted in the other scheme can be swapped or laundered into allowances for transfer between the schemes; and the legalities of linkage have certainly kept plenty of lawyers engaged.

But the challenge of linking is much more fundamental than this. It relates to our experience of emissions trading to date – which is just that – emissions trading. Whilst entities have allowances to trade, linking seems like a good idea. The financial community and policy makers have embraced emissions trading because, so far, we have been able to use a business model which we know very well – buy low / sell high. Or in slightly more detail, receive allowances for free, implement abatement options and sell the excess allowances for a profit. In this business, participants generate profits by increasing revenues and with a rising forward price curve for allowances and an excess of low cost abatement opportunities, it is an easy business case to make.

However, free allocation is already becoming a thing of the past and if we fast forward to 2025, by then we might have full auctioning of allowances. At this time, the business model changes very significantly and trading and transfer of emission reductions, and hence linkage, will not be so popular.

Under full auctioning, capped entities must buy all of their allowances at auction or purchase from other capped entities who have an excess. Depending on the rules, entities may or may not have access to project based emission reductions for use as offsets. Which entities will have an excess of allowances and how will they have obtained them? Excess allowances have in the past come from un-used free allocations. Without free allocations, excess allowances will only come entities who bought too many at auction. I propose that this will not be the norm because the business model under full auctioning changes from buy low / sell high to buy as few as you need and reduce emissions or in other words, generate profit or competitive advantage by reducing costs. Yes, there will be speculators and traders who see specific opportunities, and capped entities who for one reason or another need to buy more allowances than they expected, but under full auctioning, Emission Trading Schemes will become much less about trading and much more about implementing low carbon technology so that capped entities do not need to buy the allowances in the first place.

And that is exactly what we want to happen and what must happen if we are going to reduce GHG emissions significantly.

Merging of emission trading schemes to allow capped entities access to auctions in other schemes would deliver on some of the original objectives of linking – more participants at auction, greater flexibility for buyers, bringing the cost of emissions into line, but it would also interfere with burden sharing between capped and non-capped sectors of an economy and the surrender of significant sovereignty.

With the above objective in mind, linkage between schemes may not be helpful. If linkage provides access to excess allowances, then the question is where did those allowances originate? Are they:

a)      The result of un-necessarily generous free allocations?
b)      The result of a downturn in economic output? Or
c)       The result of real reductions created by investments in low carbon technology?

If they originate from a) or b) then they have less or little environmental value and if they are from option c), then they are good but they could mean that management got their calculations wrong and the compliance team bought too many allowances – which happens but is not the norm.

Alternatively, the allowances could have been freed up by the use of emission reductions as offsets, or they could be offsets issued under one of the schemes.

Under the California – Quebec linkage for example, both allowances and offsets approved under either scheme can be transferred between schemes. Quebec is expected to be a net importer from California because it has a more ambitious target and there are apparently relatively few emission reduction opportunities in Quebec (presumably this is at the prevailing price of around USD10 per tonne CO2e). But going to the extent of linking ETS is a roundabout way of gaining access to emission reductions from project-based activities for use as offsets; and why would the Quebecois sign up to a scheme which results in the systematic transfer of wealth from Quebec to California in return for allowances which have been created on the basis of historic emission levels? In this case, the linkage hampers the development of a market price for carbon in Quebec which triggers domestic action. In other words, as long as California remains long, the Quebec ETS will fail to promote investment in low carbon technologies.

Finally, the allowances could also be the result of speculative actors in the market but with (hopefully) less volatility in prices as the policy landscape settles down, speculation will have less role to play.

In 2025, buying allowances at auction will be like buying any other commodity for consumption. Profit-seeking manufacturers will turn their attention to ways in which they can continue to produce the same goods with fewer inputs and lower costs and hence higher profits. Emission trading and transfer will be a minor activity.

Linking is not part of this story. Merging of emission trading schemes to allow capped entities access to auctions in other schemes would deliver on some of the original objectives of linking – more participants at auction, greater flexibility for buyers, bringing the cost of emissions into line, but it would also interfere with burden sharing between capped and non-capped sectors of an economy and the surrender of significant sovereignty. The domestic power sector in the EU ETS, for example, might not be too happy if emitters outside the EU started to compete for EUAs.

Linkage only works if entities have allowances to sell. Entities only have material amounts of allowances to sell if they are given them at low or zero cost and then take steps to reduce their emissions. Regulators are moving away from free allocation which means linkage is not a viable flexibility mechanism for the future.

Gareth Brydon Phillips is a consultant for Sindicatum. This post originally appeared on the Sindicatum blog here.

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