Cap and Trade - A Quick Tutorial
EU ETS is an emissions allowance cap-and-trade system. All such systems establish a cap on annual emissions (or if banking is allowed, on the annual allocation of emission allowances), identify those entities whose emissions will be regulated, and set a few rules. In most contexts, one allowance is required for each ton of emission. Allowances are usually freely transferable, although in some programs constraints on trading have been imposed. Allowances can be initially distributed in the market through free allocation based on some metric or another, or sold through an auction. A key question is whether allowances that are not used in the year they are issued can be banked for use in a subsequent year.
EU ETS Structure
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The EU ETS began in January 2005 and includes the 27 countries of the European Union.
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The program is run in two phases. Phase 1 from 2005-2007 was intended to be a trial period to work the bugs out of the system; however, in all respects, it is a real cap-and-trade system. Phase 2 (2008-2012) coincides with the Kyoto commitment period.
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The cap covers only carbon dioxide (CO2), although other greenhouse gases (GHGs) may be added in the future. (CO2 accounts for 80% of all GHGs).
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About 12,000 CO2 emissions sources are covered by the cap, accounting for some 40% of all EU CO2 emissions. Covered emissions sources include iron and steel; cement, glass, and ceramics; pulp and paper; and energy (electric power generation and refineries).
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Transport is not currently included in the system, although the EU will include air transport in the EU ETS in 2011.
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Each country submitted a National Allocation Plan (NAP) for approval for Phase 1. The European Commission is in the process of finalizing NAPs for Phase 2. NAPs describe three decisions each country must make:
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How much of a country's Kyoto target is assigned to the sectors participating in the trading system (by implication, the remainder of the target must be met by sectors outside the system - for example, transport). The EU offers strong guidelines and regulatory oversight to require that at least the major sources such as those listed above be included in the program.
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How much of the cap will be assigned to each sector - determining how much of the burden and cost sectors will have to bear.
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How the sector allocation is then further subdivided among individual companies.
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EU ETS rules allow countries to auction an upper bound of 5% of the allowances; only Denmark chose to auction the full 5%, the remainder being allocated gratis. More auctioning is likely to occur in Phase 2.
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Emissions sources covered by the EU ETS may satisfy their commitments by surrendering allowances in an amount equal to their emissions or may supplement the EU ETS allowances with JI (Joint Implementation) and CDM (Clean Development Mechanism) credits (which are generated by undertaking CO2 reduction projects outside the European Union in accordance with Kyoto Protocol rules).
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As a result, the price and availability of CDM credits will have bearing on the price of EU allowances.
EU ETS Market Performance
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Early in Phase 1, allowance trades were handled by brokers outside of formal exchanges. Currently about ½ the trading volume occurs on exchanges and the other ½ over the counter.
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In 2005 about 8 billion dollars of trades took place in the EU ETS. By the end of 2006, this is thought to have grown to 25-27 billion. Trades in the worldwide carbon market for 2006 may be on the order of 30 billion dollars - with the lion's share owing to the EU ETS.
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Prices March 20, 2007
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The current spot price is 1.00 Euro, $ 1.33
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The December 08 Future price (Phase 2) is 15.60 Euros, $ 20.75
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Lessons Learned
There are three features of a cap-and-trade system that are important when evaluating its policy effectiveness.
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Cap-and-trade systems establish a new class of asset - the emissions allowance - and these assets will have immediate value once the system is established; therefore, initial allocation of allowances is an allocation of wealth.
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Cap-and-trade emissions-reduction policies impose a cost on society, and once the initial allocation is made, the distribution of that cost will be determined by the market, not government policy.
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The allowance prices are visible signals regarding the current cost of CO2 reductions (the spot price) and expectations regarding the future cost (futures prices). These expectations take into account expectations regarding the policy decisions determining the required reductions and the future cost of abatement - closely linked to abatement technology.
The performance of the market hinges on accurate monitoring, reporting and enforcement. At the outset of the ETS in Phase 1, many nations lacked reliable data reporting systems, which contributed to the extraordinary price volatility.
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Lesson - inclusion of sectors and sources should be preconditioned by the development of strong monitoring and accounting systems.
The ability of government to distribute the economic burden a cap-and-trade system will impose on the economy is greatest during the allowance allocation stage.
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Lesson - think twice, allocate once
Allowances are assets that can have significant value. Allowances that have fixed lives, like Phase 1 of the EU ETS, must have asset values that go to zero at their terminal points. This raises difficult issues of asset management for those required to hold allowances.
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Lesson - develop banking rules, or least short-term overlapping rules
Investments in technology needed to radically lower GHG emissions are likely confined to the energy sector, where they tend to be large and very long lived. In that case, allowance prices are intended to incentivize these investments and must have as little non-market uncertainty as possible. At the current time in the European Union, there is considerable uncertainty concerning the level of emissions reductions required post 2012.
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Lesson - governments need to be as clear as possible about emissions-reduction targets, the "commitment" periods need to be as long as feasible - certainly longer than Kyoto periods, and banking is required.
