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Learning from Europe: Designing Cap-and-Trade Programs that Work

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Cynics on both sides of the Atlantic are quick to ridicule the various glitches in Europe’s new cap-and-trade program for greenhouse gas emissions, with some detractors going so far as to question the overall efficacy of cap-and-trade as a market-based mechanism to combat global warming. However insightful their critiques, decrying the system as a failure is premature. From the very beginning, this first phase of the European Union Emissions Trading Scheme, or EU-ETS, was intended to be a learning period to work out the kinks and entice major greenhouse gas emitters on board.

On January 1, 2005, the EU-ETS came online—a cap-and-trade program covering approximately 12,000 installations (including electricity production and some heavy industry) in all 27 member countries of the European Union and representing roughly 45 percent of total EU CO2 emissions. Phase 1 of this new program, which runs from 2005 through 2007, was designed to prepare the European Union to meet its commitments under the global Kyoto Protocol during Phase 2 of the EU-ETS rollout, from 2008 to 2012.

The European Union anticipated that a new, complex, and wide-ranging marketplace would encounter glitches and inefficiencies upon inception, which is why they designated Phase I of the EU-ETS as a “trial and error” period. The lessons learned from these initial three years will help Europe improve Phase 2 of the EU-ETS. Moreover, these lessons will prove valuable for the United States as it designs and implements its own nationwide cap-and-trade program.

Before turning to Europe’s experience with cap-and-trade, however, it’s important to note that these lessons will in fact complement a wealth of existing knowledge here in the United States. We actually “wrote the book” on cap-and-trade and have seen it work extremely well. The oldest and arguably most successful emissions trading system in place is for sulfur dioxide under the acid rain program of the 1990 Clean Air Act Amendments, which has reduced SO2 emissions at a fraction of anticipated costs and engendered health benefits exceeding program costs by more than 40 to 1.

More recently, the voluntary Chicago Climate Exchange came online in 2003 and is currently North America’s only greenhouse gas emission registry, reduction, and trading system. Even the EU-ETS electronic allowance transfer system was developed with U.S. expertise.

Although the U.S. government failed to act, other American entities continue to push ahead with market-based systems for pollution abatement, including cap-and-trade. Already in the planning stages are mandatory cap-and-trade systems for 10 Northeast States (the Regional Greenhouse Gas Initiative, or RGGI) and five Western States (the Western Regional Climate Action Initiative). California is set to receive a blue-ribbon panel of experts in June to make recommendations to its Air Resources Board on the design of a market-based compliance program to facilitate the GHG reductions codified by state law in 2006.

We do markets well in this country, possess a wealth of expertise, and should not retreat from our next challenge because of a few hiccups in Europe. Indeed, we can profit handsomely from the lessons learned there over the past several years implementing the EU-ETS.

Any analysis of the EU-ETS should start with the acknowledgement that at least it is up and running. It was no easy feat to muster the political will, navigate the internal politics of EU member states, and push forward an acceptable agreement to reduce pollution from thousands of sources.

Second, the Europeans have dramatically improved their greenhouse gas emissions registries, which were initially incomplete and distorted with dubious data. The registries now provide reliable baseline data from which to determine allowance (or emissions credit) allocations, and necessary reductions, during Phase 2. Emission credits or allowances are permits to emit one metric ton of CO2 or the equivalent in one of the other five principal greenhouse gasses when they are incorporated into the system during Phase 2.

Partly as a result of the improvements in the baseline registries, several assessments of the market for the coming year—including assessments conducted by private banks and this one done by the World Bank—have concluded that the EU-ETS will be short anywhere from 0.9 billion to 1.5 billion metric tons during Phase 2, a development which is sure to support a higher price for carbon throughout the coming phase.

Third, the EU-ETS has improved their monitoring, reporting, and verification procedures to track individual installation and country compliance, and overall progress toward emission reduction requirements.

Finally, the so-called “Linking Directive” of the EU-ETS has been instrumental in driving investments in Clean Development Mechanism and Joint Initiative projects, which facilitate the transfer of billions of euros and clean technology to developing and transitional economies while providing low-cost emissions offset options to regulated installations, such as utilities and heavy industry, under the EU-ETS.

These are some of the successes achieved by the EU-ETS, but perhaps even more valuable to us are the problems Europe has run into during its initial introduction of a cap-and-trade program. Consider the following problems and the lessons learned.

Market Price of Emission Allowances

Phase 1 of the EU-ETS was plagued by a high degree of volatility in the market price of emissions allowances. The price for a metric ton of CO2 equivalent, or MTCO2e, fell from €30 during mid-2006 to less than €2.0 in March of 2007. This volatility made it difficult for participating installations to effectively plan their abatement strategies.

The causes of this volatility, however, are now well understood. First, a very tight timetable for developing National Allocation Plans, or NAPs, for greenhouse gas emissions following the passage of the EU Directive in October 2003 meant that many of these NAPs were not approved until after the EU-ETS start date of Jan 1, 2005. A stream of NAP approvals throughout 2005 and into 2006 caused market uncertainty and volatility as new sets of allowances entered the trading scheme.

Second, the market price of emission allowances took a serious hit when it became apparent in mid-2006 that the number of allowances had actually exceeded total emissions, thus undermining the cap altogether. Allowances exceeded emissions by around 80 million MTCO2e, or about 4 percent of a total market of 2 billion MTCO2e. This mistake was caused by a combination of incomplete and inaccurate EU emissions registries and individual governments showing way too much latitude in their allocations to politically-connected polluters.

These problems are not inherent flaws in a cap-and-trade system. The United States can avoid the same fate by beginning a mandatory registry now so that we have good data on which to base initial allotments when our national program is begun. And we can avoid over-allocation resulting from political interference by auctioning the large majority of the emissions credits—the next lesson we can learn from Europe.

Emission Allowance Giveaways

The allowance allocation process embraced by the European Union for both Phase 1 and Phase 2 has come under considerable scrutiny. The EU Directive permitted member states to auction only 5 percent of their emissions allowances to regulated installations during Phase 1 (only three countries did even that), with the rest given away for free. Phase 2 only allows for auction of no more than 10 percent of the allowances.

Problem is, emissions allowances are assets with immediate value once the cap-and-trade system is underway. Allowance allocation, therefore, involves a transfer of substantial wealth and must be handled wisely to ensure equitable and efficient distribution. The result of allocating so many allowances for free in Phase 1 was that EU electric utilities earned windfall profits while continuing to pass on higher energy costs to industrial and residential consumers.

Understandably, this has caused a great deal of consternation in Europe, and for good reason. The explanation for why so little auctioning was permitted or performed is complicated and beyond the scope of this assessment, but needless to say a great deal is related to the influence of the European utility lobby. The most important lesson here, though, is that a far higher percentage of emissions allowances must be auctioned.

 

Most economists agree that auctioning is the most efficient allocation mechanism. Auctioning prevents windfall profits, avoids rewarding polluters and penalizing early adopters of clean or efficient technologies, is transparent and immune to political lobbies, and creates a new source of government revenue that can be used to compensate consumers for higher energy costs or to invest in clean energy research and development.

In fact, the economic literature suggests that shareholder equity can be maintained and electric utilities adequately compensated with a modest 6 percent to 10 percent free allocation of allowances. The rest should be auctioned.

A recent Washington Post article exposed widespread European outrage over higher electricity costs since the implementation of the EU-ETS. The same article, however, revealed that European utilities charged customers for the entirety of their emissions allocations—even though they have been handed out gratis. Consumers bore the burden while utilities reaped windfall profits.

Still, the EU-ETS is not the only factor at play in higher energy prices in Europe. As Jill Duggan, head of International Emissions Trading for Britain’s Department for Environment, Food, and Rural Affairs, told Congress in her testimony in late March, higher energy prices in the United Kingdom are only partially attributable to the EU-ETS:

“In addition to the allocation decisions of Member States there are many influences on the cost of carbon [in the EU-ETS] including the relative cost of gas, coal, and oil; weather; economic growth; improvements in energy intensity; and the price and limit on the use of credits from the Clean Development Mechanism or Joint Implementation.”

Considerable debate has occurred on the success thus far of the EU-ETS in CO2 emissions. Unfortunately this debate is tainted by misleading information. A Dec. 14 Wall Street Journal opinion piece noted that emissions growth in the so-called EU-15—the 15 member nations of the European Union before its expansion in May 2004—from 2000 to 2004 exceeded that of the United States during the same period, yet placed full blame on the EU-ETS, which didn’t even come online until 2005. Besides, counting emissions from only the heavily-emitting EU-15 negates the distributional benefits of the trading system extending throughout the current 27-member European Union.

Still, it has been difficult to reach a conclusive answer on CO2 emissions in Europe. Serious imperfections in the historical emissions data make it very difficult to produce an accurate “business as usual” trajectory against which to compare current emissions levels. A 2006 study conducted by the Massachusetts Institute of Technology, however, estimated that 2005 CO2 emissions from sources covered by the EU-ETS represented a reduction of approximately 130 million to 200 million tons, or 7 percent to 10 percent below the “business-as-usual” trajectory.

This does not constitute a net reduction in emissions. The European Union still has substantial progress to make towards its Kyoto targets. Yet abating these projected emissions is a laudable achievement, especially considering the significant glitches experienced during this first year of the EU-ETS.

Problems with the Clean Development Mechanism

Legitimate concerns also have been raised over the failure of the Clean Development Mechanism—which facilitates the transfer of billions of euros and clean technology to developing and transitional economies around the globe while providing low-cost emissions offset options to regulated installations, such as utilities and heavy industry, under the EU-ETS—to distribute market opportunities to the least developed countries in an effective an equitable manner.

Particularly troublesome for many in the United States is the fact that China has dominated the CDM market to date, successfully attracting billions of dollars for inexpensive technological interventions to reduce industrial pollution at chemical factories, which critics say allow China to game the CDM. Still, these inexpensive fixes and the resulting carbon transactions have produced major abatements of a severely potent greenhouse gas called triflouromethane, or HFC-23—reductions that would probably not have happened without CDM sales to China.

And China, to its credit, is showing a willingness to negotiate on phasing out these types of controversial CDM deals. Although the U.S. cannot participate in the CDM unless it ratifies the Kyoto Protocol, a well-designed U.S. international offset system can avoid these international carbon market inefficiencies by incorporating policy measures that prioritize sustainable development and steer offset investments toward poorer, disadvantaged countries.

Insights for the United States

As the U.S. cap-and-trade legislation moves forward in Congress, there are some preparatory steps we can take, and important policy considerations for the design of our own cap-and-trade system:

  • The United States needs to start by developing a mandatory national greenhouse gases emissions registry now so that a cap-and-trade program can be seamlessly implemented based on reliable baseline emissions. Some progress has already been made on this front: Thirty-one states, representing over 70 percent of the U.S. population, have joined the Climate Registry, a voluntary effort to measure, track, and publicly report greenhouse gas emissions in a transparent and verifiable manner. Moreover, power plants have been required to register CO2 emissions for a dozen years under the Clean Air Act, and thus provide good historic data.
  • A U.S. commitment period for greenhouse gas reductions must be as long as possible to allow for investor confidence, which is why many bills introduced in Congress sets a commitment period through 2050. European industries, likewise, have insisted on long-term clarity and consistency regarding future carbon constraints in order to make sound investments in low- carbon technologies, many of which are capital-intensive and have a long lifespan.
  • The vast majority of emissions allowances should be auctioned, and their revenue “recycled” back into the economy and dedicated (with flexibility) to remedying higher energy costs, reducing taxes on income, funding energy innovation and efficiency, and helping the most vulnerable, disadvantaged communities around the world adapt to the environmental impacts of climate change.
  • The cap-and-trade system should be designed to link up with the international emissions offset trading markets, and to improve upon methods of aggregating carbon offsets in developing and transitional economies to optimize clean development pathways.
  • Price caps or “safety valves” on the price of emissions credits should not be allowed because they would potentially hinder the linkage of the U.S. market with the EU-ETS which has rejected price caps. Price caps would also be detrimental to U.S. competitiveness in the emerging clean energy sector because they do not allow the market to function freely and do not set an effective carbon price signal to drive the necessary investments in efficiency and clean energy technologies.
  • A cap-and-trade program should be accompanied by complementary policies that increase renewable energy production and encourage supply- and demand-side efficiency in electricity, natural gas, and transportation fuel consumption. This ought to include the adoption of a 25-percent renewable electricity standard by 2025. The program should also commit federal investments to clean energy research and development, consumer education, and “green” vocational training.
  • Coal-fired power plants will require special treatment alongside a cap-and-trade system, as the early price signal for CO2 emissions may not be strong enough to drive investments in carbon capture and storage technology. In May, the Center for American Progress released a report, “Global Warming and the Future of Coal,” that advocates mandatory capture and storage of the CO2 produced by coal combustion so that new coal plants do not worsen global warming.

Learning from the EU experience with cap-and-trade, and building upon the United States’ substantial expertise with emissions trading for pollution abatement, we know that a cap-and-trade system can thrive here. As California Governor Arnold Schwarzenegger argues, cap-and-trade provide two elements of successful environmental regulation: “Mandates and markets.”

The only element in the equation still lacking is political will.

Benjamin Goldstein is a Research Associate at the Center for American Progress.

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