Environmental Commodities Markets and Emissions Trading

Towards a Low-Carbon Future

Blas Luis Pérez Henríquez

• Publisher: Routledge
• Year: 2013
• eBook ISBN: 9781136521782
• Topic: Biological Sciences
• Subtopic: Ecology
• Index: Biological Sciences

Market-based solutions to environmental problems offer great promise, but require complex public policies that take into account the many institutional factors necessary for the market to work and that guard against the social forces that can derail good public policies. Using insights about markets from the new institutional economics, this book sheds light on the institutional history of the emissions trading concept as it has evolved across different contexts. It makes accessible the policy design and practical implementation aspects of a key tool for fighting climate change: emissions trading systems (ETS) for environmental control.

Blas Luis Pérez Henríquez analyzes past market-based environmental programs to extract lessons for the future of ETS. He follows the development of the emissions trading concept as it evolved in the United States and was later applied in the multinational European Emissions Trading System and in sub-national programs in the United States such as the Regional Greenhouse Gas Initiative (RGGI) and California's ETS. This ex-post evaluation of an ETS as it evolves in real time in the real world provides a valuable supplement to what is already known from theoretical arguments and simulation studies about the advantages and disadvantages of the market strategy.

Political cycles and political debate over the use of markets for environmental control make any form of climate policy extremely contentious. Pérez Henríquez argues that, despite ideological disagreements, the ETS approach, or, more popularly, 'cap-and-trade' policy design, remains the best hope for a cost-effective policy to reduce GHG emissions around the world.

Chapter 1
Introduction

Make no mistake, climate policy is energy policy. If we are to preserve our planet and make it sustainable indefinitely for future generations, then we must transform our energy systems and make the transition to a low-carbon economy. Energy is a necessity in all of the world’s societies. Thus it is not surprising that energy policies are often crucial for a country’s leaders—when successful resulting in an ample and affordable supply and when unsuccessful leading to conflict, war, and tragedy. Now we have discovered that even the peaceful burning of fossil fuels to create energy threatens to devastate our planet in another way—through the threat of climate change caused by the accumulation of greenhouse gases in the atmosphere.

Regulation is not enough to push the transition to a low-carbon, green economy. Rather, a systems approach is needed, one that is mutually supportive of government, business, and civil society action on climate change. Energy conservation, expansion of renewable sources, and increased energy efficiency are some of the complementary programs and measures that should be implemented to lower worldwide greenhouse gas (GHG) emissions. These efforts will require major investments and will have long-term implications, particularly in the developing world if these countries are to avoid the historical carbon-intensive development patterns of industrialized countries. Alternative growth strategies for emerging nations will require enhancing the flow of capital and developing new technological pathways to make the concepts of green growth and a clean economy a reality. A mature, well-integrated global carbon market can assist in achieving these policy objectives.

This book introduces a review of the theory, practice, and future of emissions trading from the policy analysis perspective. It reflects on the most salient policy design and implementation lessons from the emission trading systems (ETS) implementation experience to date. It is a study based on the institutional development history of creating environmental commodities markets, first focusing on pioneering experiences implementing cost-effective air pollution regulation in the United States (US), and later looking at the European Union’s (EU’s) efforts to combat global climate change. In this later context, policies governing environmental commodities markets have proven to be one of the key policy mechanisms supporting the civil transition to a low-carbon economy.

While there is concern that regulating GHG is costly to the business sector, so too is the lack of certainty about the institutions to be developed to address climate change at the national and international level. Increasingly, a new paradigm for economic development is gaining favor among national, regional, and local governments based on three main ideas: First, climate action offers an opportunity for social and economic transformation towards a clean economy. Second, through ingenuity and innovation, new engines of prosperity from economy-wide transformation based on low-carbon growth development strategies will emerge. Third, the planet’s natural assets will be conserved for future generations to enjoy—the essence of the concept of sustainability.

Laggard nations with large carbon footprints will eventually pay the price through the reduced competiveness of their economies. They will also become vulnerable on the energy security front if they continue to depend heavily on expensive and dirty sources of energy. The transition from conventional fossil fuels is going to take time—at least several decades. However, first movers in developing cost-effective regulatory frameworks for GHG emission reductions, like the multinational emissions trading system, and clean sustainable energy policy guidelines such as those devised by members of the EU are betting on the future benefits of the catalyzing effect of these policies and programs to their economies and the environment. Similar efforts are being implemented at the national and local level, for instance in Australia and California respectively, to introduce a price on carbon into their economies as well as to make the concept of sustainability an attractive—and profitable—business proposition. Rethinking energy policy as a basis for economic prosperity through green growth and clean energy technological developments is occurring voluntarily in emerging nations such as Brazil, China, India, Mexico, and South Korea even without a legal requirement under current international agreements. The emergence of a global carbon market creates the incentive for early action, as these efforts can be recognized under United Nations Framework Convention on Climate Change (UNFCCC) flexible policy mechanisms. Moreover, the multinational, regional, and local systems currently in place demand emission reduction projects as part of their cost-minimization strategies through the voluntary market for emission reduction credits.

Not only are there financial benefits to early action, but there are also avoided future costs. Early emission reductions may prove to be more valuable than those achieved at a later time. The Stern Review (2007) widely publicized the idea that if nations take “strong action now” the world can avoid, at a much reduced cost, the “serious impacts on growth and development” that climate change threatens to impose from necessary adaptation efforts in the future. Analysts, however, have pointed out the weaknesses of a top-down approach under the UNFCCC for global collective climate action. Popular buy-in will be needed to clear the key hurdles to advancing effective international climate and energy policy, which include: the disconnect between science and policy action, significantly higher damage and mitigation cost estimates than those put forth by the Stern Review, the threat of slowing economic growth, and the large fiscal transfers from the industrialized world to the developing world that a strong global climate action plan would require (Helm 2008).

Making the emerging United Nations (UN) compliance carbon market system efficient and effective will take time, as the multilateral process is slow, cumbersome, and complex. Nations will continue to debate how best to improve the UN system’s performance in stabilizing GHG emissions as well as how to finance such efforts, as the discussions during the UN climate summit in Durban in 2011 on New Market Mechanisms (NMMs) attest. The goal is to increase the scale of the KP’s Clean Development Mechanism (CDM), which allows for compliance credit to be given to developed nations that pay for emission-reduction projects implemented in developing countries. The next phase in the UNFCCC negotiations aims to enable advanced developing economies to gradually make the transition away from the current CDM path and to take on more ambitious emissions reduction targets either at the national level or by industrial sector through the NMMs and voluntary implementation of Nationally Appropriate Mitigation Actions.

Clear rules and standards will have to be devised to avoid market fragmentation as the market approach expands. But in the meantime, a transitional institutional development phase is required. This period of several decades will require a credible political commitment to a global carbon market by key governments beyond the EU in order to underpin this policy approach’s capacity to support the greening of national economies around the world.

Whatever the preferred sequence of integration, a price on carbon emissions is the most practical solution to address the dangers and risks of climate change. A well-functioning global carbon market can provide the lowest cost solution to mitigate greenhouse gas emissions. But more importantly, it can provide regulatory certainty on the environmental goal while incentivizing managerial and technological innovations as well as the financial flows necessary for humanity to transit to a low-carbon future. Swift and decisive action is needed at the regional, national, and international level in order to enable the green economy concept. However, as Stavins (2000) suggests:

No particular form of government intervention, no individual policy instrument—whether market-based or conventional—is appropriate for all environmental problems. Which instrument is best in any given situation depends upon a variety of characteristics of the environmental problem, and the social, political, and economic context in which it is being regulated. There is no policy panacea. Indeed the real challenge for bureaucrats, elected officials, and other participants in the environmental policy process comes in analyzing and then selecting the best instrument for each situation that arises.

Environmental economists have produced results showing that economic incentives for pollution control improve efficiency. Empirical studies have shown how to make incentive-based programs more efficient at controlling pollution. Ultimately, more study will be necessary to find out how new emission trading mechanisms operate in the real world, in particular whether they deliver their theoretical efficiency gains.¹ With time, policy lessons will emerge from experimentation in increasingly diverse and complex contexts of implementation as we move toward a global carbon market. Because GHG are evenly distributed in the atmosphere, a cap-and-trade ETS is “especially well suited to addressing the problem of climate change.”²

At the time when governments around the world started to experiment with market-based solutions for environmental control, policy analysts from the Organisation for Economic Co-operation and Development (OECD) argued that theoretical decision-making models for choosing among alternative policy instruments tend to be too abstract to function as a basis for making actual policy choices. In order to effectively implement a policy instrument, a more practical approach is needed, one that takes into account institutional concerns such as administrative and political feasibility. While the neoclassical economic framework underscores externalities, marginal costs, and marginal benefits of pollution abatement, an institutional perspective takes a more comprehensive approach to formulating policy (OECD 1997). Thus, it is useful to analyze the patterns of implementation of past market-based environmental programs to extract policy implementation lessons for future application. This book presents suggestions for developing efficient and cost-effective market policies to protect the environment and the global commons based on an examination of previous market experiences with air pollution emissions controls in the US, the EU, and elsewhere.

1.1 Research questions

The working hypothesis of this book is that policy analysts, policy entrepreneurs, and policy managers can design more effective control policies to improve current and future market-based environmental programs by paying attention to the expected interplay of interests in the design and implementation stage and to the findings of the historical review of use of the ETS concept through the lens of institutional economics. Policymakers designing market-based environmental programs should ask:

• i) Are specific market design features (i.e., fine-tuning, contextual adaptation, market enhancing institutions, use of information technology, rates of policy participation among target population, etc.) necessary to make a market-based policy feasible?
• ii) To what degree does the interaction of social and institutional factors (i.e., politics, lobbying, electoral cycles, etc.) interfere with or limit the efficiency potential of these mechanisms?
• iii) How transferable is the policy know-how derived from actual implementation of environmental market-based programs, given that what works in one context may not work in another?

1.2 Unit of analysis: emissions trading systems

This book seeks to examine what has worked and not worked in market-based air pollution control programs, in particular the ETS approach. Such decentralized programs are judged by the criteria of cost, as well as capacity to achieve the set of predetermined policy goals mandated by a federal legislature, state legislatures, or an international multilateral agreement. This book looks at programs that seek to control emissions at the national, sub-national, regional, and international level.

Joskow et al. (1998, 669), announced a triumph in the evolution of ETS programs when they concluded that the market created by the US Environmental Protection Agency (EPA) for sulfur dioxide (SO₂) emissions had “become reasonably efficient.” However, when the 1990 US Clean Air Act Amendments (CAA) were enacted, its Title IV (also known as the Acid Rain Program or ARP)—designed to reduce acidic depositions by controlling emissions of SO₂, the main precursor of acid rain—proved difficult to implement. Almost two decades of experimentation and halfhearted attempts to jump-start environmental markets to support air pollution control policies had preceded this program.

The creation of allowances for SO₂—a kind of property rights for emissions—and the ability to trade those allowances, promised cost-minimizing opportunities in pollution abatement. Electric utilities burning fossil fuels produce 70 percent of US SO₂ emissions and are highly regulated. The ARP ETS introduced flexibility into their compliance with emissions regulations. However, these potential efficiency gains hinged on the establishment of a well-functioning, fluid market for SO₂ allowances. By achieving this milestone, the ARP initiated a new era in the use of incentive-based regulation.

In the early 1990s, it was not clear if or how the new market-based program was going to perform in the US institutional setting. For instance, Bohi and Burtraw (1991, 676) warned of potential “regulatory gridlock,” given the structure of the electric utility regulatory framework, which is a patchwork of state and regional regulations.

The annual auctions for the permits held by the EPA provided valuable price information, and the financial markets rapidly acknowledged the potential of a secondary air pollution allowance market. By 1993 financial intermediaries had already standardized transaction procedures and developed financial instruments for inter-temporal market transactions such as options, futures, and “swaps” (Joskow et al. 1998, 683). Based on lessons from pioneering experiences developing environmental commodities exchanges, Sandor (2012) reminds us that: “Both standardization and the use of a central marketplace lowered transaction costs, leaving both buyers and sellers better off.”³

The successful implementation of the ARP ETS established the US as the leader in market-based environmental policy. Introduced by the Republican President George H. Bush, the program was initially touted by business leaders as the most business-friendly approach to environmental protection and was also endorsed by important environmental groups. It was even presented as the American way to solve environmental problems since the market, not central commands or taxes, was the mechanism for achieving a clear environmental policy goal set by an emissions cap.

However, policy approaches and priorities are highly vulnerable to political cycles and politics. In the US, since the 2008 presidential election, the use of the ETS cap-and-trade design has fallen out of favor. Some conservative politicians campaigning against federal climate policy have described the ETS approach as a “cap-and-tax scheme”—and green taxes are notoriously difficult to introduce in the American policy formulation process.

It was the EU that decided to implement the first multinational ETS to address the issue of climate change. Ironically, the EU’s ETS is largely based on the policy design parameters used in the US cap-and-trade model developed for the ARP. Politically, the EU is more amenable to environmental taxes than the US, and it also has a lower tolerance for risk because of a lack of policy action under a statutory requirement known as the precautionary principle. The EU and its Member States have taken the lead in market-based pollution design, giving their industries and citizens a head start in preparing for a carbon-constrained world. In doing so, they expect to gain a competitive edge by becoming more energy efficient and independent and by developing new clean, sustainable energy technologies.

1.3 Policy diffusion and accumulated policy know-how

The US historical experience developing emission trading systems for air pollution and the EU’s ETS to reduce GHG emissions, along with the emergence of national, sub-national, regional, and sectoral ETS institutional developments in North America, the Asian-Pacific Rim, and in major developing countries provide us with a catalogue of lessons for designing and implementing decentralized global governance structures for environmental control using ETS and the commodities markets infrastructure. The experience from these programs is informing market-based environmental programs worldwide.

Other important precedents for market-based environmental programs were set by a US lead (Pb) trading program for gasoline and by the phasing out of chlorofluorocarbon emissions under the Montreal Protocol. The institutional limits to the market approach in environmental policy within the US were revealed by the failure to establish fluid emission allowance markets when regulatory “bubbles”⁴ for air pollution control were created under the EPA’s 1986 Emission Trading Policy Statement (Kete 1994).

Still, an increasing number of nations and private and public organizations are currently experimenting with emission trading programs, from the intra-firm, national, and sub-national, to the multinational level. In all cases, these trading programs eventually will require authorization...

Table of contents

• Cover
• Title
• Copyright
• Dedication
• Contents
• List of illustrations
• Preface
• List of acronyms
• 1 Introduction
• 2 Theoretical foundations
• 3 Creating efficient environmental commodities markets
• 4 The first generation of air pollution trading systems
• 5 State-of-the-art market-based environmental policy
• 6 Local market-based environmental policy
• 7 Interstate market-based environmental policy
• 8 International market-based environmental policy
• Notes
• References
• Index