Emission Trading System Outlook

Methodology

When it comes to evaluation methods, there is no one clear cut method for analysis. The most comprehensive analysis is the World Bank’s Handbook of Emission Trading Schemes Design.[2] This taxonomy includes ten characteristics of an ETS. These design features characterize the entirety of an ETS system which include: decide the scope, set the cap, distribute allowances, consider the use of offsets, decide on temporal flexibility, address price predictability and cost containment, ensure compliance and oversight, engage the stakeholders, communicate, and build capacities, consider linking, and implement, evaluate, and improve.[3] While this provides an ideal model for the policymaker, and this has been adopted within some of the literature, this method fails to account for the incremental changes which occur after each planning period.

Additionally, there are many factors to include within an analysis including: political reception, effectiveness, time, budget, expertise, and equity, to name a few. As such, the methodology will adopt a chronological framework due to the continual change of these iterations of policy. This is due in large part due to the difficulty of not being able to analyze a moving target. After each phase, there will be a brief analysis of how the literature viewed each iteration, followed by a more comprehensive overview of the current evaluations and problems and outlook. This overarching goal is to pinpoint lessons learned and illustrate how continual improvements reinforce emission trading systems, not merely a viable climate change adaptation strategy but as the primary climate adaptation strategy. The methodology will also take into account a policy perspective of balancing the overall goal of reducing emissions without harming a country’s economic growth. Indeed, there are more efficient ways when instituting carbon an emission reduction policy, but there is always a larger picture that must account for outside influences as well. Much like other policies, there is a robust academic literature to pull from when initially creating a market. However, there are certain instances where the literature has been ignored, resulting in inefficiencies as well. These implementational failings will also be added within each analysis.

Theory

The cap-and-trade theory is predicated on the belief that some firms can afford to invest in carbon-cutting measures, and some cannot. If the cost of investment is higher than the cost of CO2 emission, then the firm will buy carbon rights from another firm. In the opposite approach, the firm which can invest in new technology will be able to produce more efficiently and would be incentivized to sell their carbon credits.[4] Economists cite this as a much more efficient alternative to a simple carbon tax. Problems with taxes in general deal with the study of incidence, or whom the tax harms. All taxes harm the consumer either directly or indirectly, and the consensus among the literature is businesses pushing the carbon tax directly upon consumers.[5] In practice, these programs have been both effective and ineffective due to the differences in implementation. Historically this trading system first originated within the United States in their push to remove lead from gasoline in an EPA program started in 1982. This system saved the EPA about $250 million, and by 1987, the lead had been removed from gasoline. This case study created three very critical lessons for any emissions trading system. First, it provided a proof of concept both environmentally and economically cost-effective. Second, it created the idea of banking of credits, which has been a necessary factor since this was created. Furthermore, the need to be as transparent as possible when creating an artificial supply and demand market, rules should be clearly defined upfront, without ambiguity.[6] The first time a market-based approach was proposed for international carbon markets began during the Kyoto Protocol discussions.

European Union

The EU ETS is the most robust international trading system and has gone through multiple phases of development, and it is now in its third phase. Since this initial program’s success, there have been many new cap-and-trade systems since. The European Union’s Emission Trading System was first implemented in 2005 after the ratification of the Kyoto Protocol by Russia. This system was the first international emission’s trading system and currently accounts for 15% of all the world’s carbon emissions. The ETS is composed of 28 E.U. member states along with three E.U. trading partners. Historically there have been three phases of the ETS with the fourth being ratified for 2021-2030. The E.U.’s system, although not a perfect system, provides an ideal model for the policymaker looking to create carbon reductions with minimal negative economic growth.

The first phase, like any other new policy implementation, began within an implementation phase. The framework for the EU ETS system was created here and while it has adapted to various criticisms, much of it has not changed. This is, first and foremost, the most important phase solely due to how policymakers view precedents. A new ETS must pull from the academic literature during the implementation stage because once a policy is created it is seldom radically overhauled and only gradual changes are made. This initial phase was able to establish a price for a European Union Allowance (EUA) which grants the holder the right to emit one ton of carbon dioxide (CO2), or the equivalent amount of two more potent greenhouse gases, nitrous oxide (N2O) and perfluorocarbons (PFCs). It created a system that allowed for free trade throughout the E.U. and created a monitoring, reporting, and verifying (MRV) system to track all of these trades. All told, approximately 200 million tons of CO2 or 3% of total verified emissions were reduced due to the ETS at nominal transaction costs during the pilot phase. The biggest failing from the first phase was an overallocation of EUAs which eventually resulted in the EUA credit valuing at zero. At this point, there were both economists, journalists, and politicians criticizing the effectiveness of the ETS. This problem of establishing a competitive carbon price still eludes all ETS’s due to carbon’s continual low value. The economics literature has made a strong efficiency argument in favor of banking and auctioning rather than a free distribution of permits.[7] Nevertheless, due to the uncertainty of mass adoption, the more risk averse policy has resulted in an overallocation. The second phase lasted from 2008-2012. The aviation sector was added as well as the members of Iceland, Liechtenstein, and Norway. This period was the most crucial phase due to both the financial crisis of 2007-2009 and the inability to pass a significant global climate policy at Copenhagen. There were even deep fears of Europe abandoning this system altogether. Persistence paid out in the end, and the system was ratified for a third phase. The E.U. is still currently in its third phase, which began in 2013 and will last until 2020. Within this phase, a single, EU-wide cap on emissions was applied in place of the previous system of national caps. Most notably, the centralized cap becoming increasingly stringent (20 percent below 1990 emissions). Also, auctioning became a default method for allocating allowances (instead of free allocation), which is what the literature had been recommending. Finally, 300 million allowances set aside to fund the deployment of innovative renewable energy technologies: carbon capture and storage.[8] The fourth phase was recently ratified last year in 2018. The revised ETS directive sets out the parameters for the period 2021-2030 on essential elements such as the cap, the split between auctioning and free allocation, and the size and operation of the Modernization and Innovation funds. The revision created the Market Stability Reserve (MSR), which began operating in January of 2018. It aims to neutralize the negative impacts of the existing allowance surplus and to improve the system’s resilience to future shocks. Thresholds: Allowances will be added to the reserve if the total number of allowances in circulation (TNAC) is higher than 833 million allowances and reinjected to the market if the number of allowances in circulation falls below 400 million.[9] In short, it adjusts the short-term supply of EUAs to be auctioned by establishing a reserve of unauctioned allowances that are auctioned later. The aim is to increase short-term scarcity without fully creating a price floor.

Problems

Concern continues in the E.U. regarding relatively low allowances prices. These low prices largely reflect the slow pace of European economic recovery, as well as the fact that other E.U. climate policies, such as renewable portfolio standards and energy efficiency standards, reduce emissions and thereby reduce demand for allowances. A price floor and ceiling still does not exist for carbon and could be the answer to the low allowance price. While a price floor and ceiling would fix the carbon’s low price, there are other factors to consider. If too ambitious, it would instantly increase the level of E.U. climate policy ambition, thereby triggering political opposition from reluctant actors. Politicians are still critical of the ETS because of the impacted industries affecting their voter base.[10] In contrast, the MSR was quickly adopted, perhaps precisely because it was clear to relevant players that it would not increase the level of ambition of the EU ETS. While the MSR mechanism acts as a pseudo price floor and ceiling, this was a weak measure passed due to the inability to tighten the supply of EUAs. The supply and demand relationship is an important issue where a run-in period is required in order to establish an initial equilibrium price.[11] As the E.U.’s case has been made apparent, creating an artificial market for carbon has posed difficult both from the supply and demand side. Research has also found that market participants have planning horizons of a maximum of 5–6 years.[12] Information is vital for these competing firms in order to stay competitive, but as behavioral economics has proven, it must also be noted to not overload the firm with too much information or extended planning periods due to humans having trouble thinking that far ahead. Inside these different phases which the E.U. has developed, the literature shows that firms cannot think that far ahead. These multi-decade planning phases which pose attractive to the policymaker creates an undue burden on these participating firms. Simply halving each of these phases could create better forecasting models for these businesses investing in carbon reduction. Lastly, is the persistent problem of carbon leakage. Carbon leakage naturally occurs due to our globalized economic system, and firms will naturally leave the E.U. and into emerging markets where carbon emission legislation does not exist. This problem will continue to exist for the foreseeable future, but as more emerging economies adopt their own emission trading systems, this problem will continue to decrease.

​ Aside from problems of the system itself, there are still broader implications this policy has created. Between 2010 and 2015, there were still new coal plants under construction, about 15 gigawatts of coal power generation capacity was added to the EU-28 power system.[13] Also, a lack of innovations in new carbon abatement technologies has been identified. This has been hypothesized to be directly correlated due to the oversupply of allowances.[14] This simple fact shows how even the most thoughtful policy still has flaws. Alternatively, this fact might show the ineffectiveness of the ETS due to the continued reliance on coal for electricity. As a society, we are at a time when scientific advancement is here in many of these energy-efficient measures, but the cost differential has not quite gotten there to move away from fossil fuels entirely.

​ Irrespective of its failings, the EU ETS has reached its carbon emission reduction goals. Between 2004 to 2014 GHG emissions from the ETS sectors decreased by 24% (European Environment Agency, 2015). Future forecasts estimate there will be a 43% emission reduction by 2030 compared to 2005.[15] The E.U. system withstood both the financial crisis of 2007-9 and the collapse of the Copenhagen Accord along with the scrapping of the Kyoto Protocol. While the criticisms of the first five years of negligible impact are well founded, extenuating circumstances prevented a smooth transition from the pilot period into the subsequent phases. While proof of concept has continually been provided with historical examples, this has occurred only within much more developed countries. The next goal will be the implementation within developing or emerging economies and adopting various strategies due to context.

China

Once fully implemented, China’s national ETS will become the world’s largest carbon market: the C-ETS would cover about 3.5 billion tons of CO2 emissions annually. This is twice the size of the European Union Emissions Trading System (EU ETS) and nine times the size of California’s Emissions Trading Scheme.[16] The C-ETS would double the worldwide volume of CO2 emissions facing a carbon price in one fell swoop.[17] While this plan has not been fully implemented yet, it is presently in its rollout phase. The next few years look to be the make or break period for the effectiveness of this policy and China is the country where this will all occur.

Pilot Program

China first discussed the implementation of an emissions trading system on 29 October 2011 within their Five-Year Plan in the “Notice on Carrying out the Carbon Emissions rights Trading Pilot Work.”[18] This initial announcement eventually led to the start of seven pilot schemes of emission trading in 2013. the regions were: Shenzhen, Shanghai, Beijing, Guangdong, Tianjin, Hubei and Chongqing. The geographic region of these cities resides in the more developed eastern coastal regions, which played to China’s strength. As of September 2016, the seven pilot carbon markets covered nearly 3,000 key enterprises from more than 20 industries and traded 197 million tons of carbon dioxide equivalent (tCO2e), involving a total turnover of about 4.516 billion yuan.[19] These pilots demonstrated that emissions trading was a viable means for reducing their carbon emissions. Drawing from past programs, these pilot programs successfully incorporated an allowance distribution with auction elements.

The most significant problem encountered in the pilot system has been the lack of national-level legislation to hold firms accountable to their accounting. Currently, there is a lack of penalties within the monitoring system, which should be fixed within the national system. Also, since these pilot programs were not linked, there will be additional time needed to integrate them into the national system while they continue to operate. Lastly, there were continual lapses in transparency by governmental institutions and a lack of precise communication mechanisms.[20]

China’s ETS System (C-ETS)

In 2015, after several years of deliberation, China’s government officially announced its intent to create a national emissions market. Although its intention was published in 2015, It was not until 19 December 2017, when China officially announced the beginnings of its national emissions trading system plan. According to information released within China’s NDRC, its emissions trading system will cover eight sectors ”electricity, building materials, iron and steel, non-ferrous metal processing, petroleum refining, chemicals, pulp and paper, and aviation.” Companies with an annual energy consumption of more than 10,000 tons of coal equivalent, or roughly 26,000 tons of carbon dioxide, in the eight sectors must participate in the emissions trading system. This will cover about half of China’s total CO2 emissions. China’s scheme would encompass around 5 GtCO2 per year. When comparing it to the EU ETS, which covers around 11,000 installations and around 1.8 GtCO2, China’s system will regulate approximately 6,000 enterprises, covering one-half of China’s total carbon dioxide emissions. [21] Like the seven ETS pilot programs, China’s national emissions trading system will regulate only carbon dioxide emissions, not other greenhouse gases (GHGs). These emissions account for 83.2% of China’s total GHG emissions.[22] Also, there will also be a transition of ETS pilots to the national ETS. The regions within China that have ETS pilots will be moved into the national ETS, and this will place them under the new national management. The pilot programs will continue to operate, and will gradually transition to the national ETS when they are ready.[23]

Both academics and journalists have noted a lack of a clear overarching vision for China’s national trading system, with many details still unknown. What is publicly known is the initial phase timeline. This plan is an ambitious one with it slated to be up and running by 2020. China has announced within its NDRC report of its emission trading plan that there will be three different phases of implementation of their national system to get it up and running. The first period has already past, which focused on creating the infrastructure for accurate data reporting, a carbon registry, a trading, and management system. This mirrors the case of the E.U. because a carbon market must be able to report and monitor trading accurately. The second period which will last for the year 2019, brings its national pilot phase for trading, which it calls its mock operations period and will initially be an entire year of fine tuning. Imagine a system much like the practice stock trading financial students do in undergrad. Finally, the third phase will begin in 2020, with real trading occurring on a national scale for the power sector. Once the carbon market in the electricity sector is stable, more sectors and participants are likely to be added much like the different phases of the E.U. example. Currently, the literature has a weak grasp on how this plan will likely proceed. Many of these questions should be answered in China’s 14th Five-Year Plan for the years (2021–2025). Until then, it is anyone’s guess for how China will formulate its system.

Problems

There is a general consensus among researchers and practitioners that the Chinese ETSs currently do not demonstrate the properties of a well-functioning market. The fact that they remain financially immature and result in price abnormalities may be explained in terms of market liquidity and information uncertainties.[24] One of the intriguing possibilities within the context of China is the top-down approach to regulating its ETS system. While this has been cited as a strength in terms of fighting climate change, Cong and Lo found that this led to excessive state intervention into trading emission options which inhibited the Shenzen pilot program. The notion of laissez-faire economics and the invisible hand cited by Adam Smith, which is repeatedly echoed by free market pundits, might prove a solution to this potential problem. China’s top-down government could pose a long-term problem of over intervention simply due the ease of intervention. The largest problem of China’s ETS is the imbalance in economic development throughout its country. There is a great economic disparity between certain regions within China’s borders and adopting a national system where carbon intensive industry is still emerging and maturing. As it has been seen within the context of South Korea efforts, need to be focused upon stimulating market growth within developing areas and then incorporating these developing areas back into the more developed ones.[25] Solving regional imbalances when trading emissions will be the major obstacle for a successful rollout. This is the last frontier literature wise of emission trading schemes due to lack of potential viability in developing economies. There are three common approaches in setting caps: top-down, bottom-up and hybrid.[26] It is currently unknown how China will set its carbon cap. While the pilot system utilized a bottom-up approach by adding all of the emissions from the various firms this is still undetermined for the national system.

Currently, in China, not many enterprises and investors have expressed a keen interest in trading emission allowances for profits.[27] Instead, state intervention and regulation are the most crucial factor affecting allowance prices due to a majority of the market falling within governmental oversight. The other potential problem is the forecast for 2030 being the year of China’s peak emissions. While there are positive signs of meeting this projection, but this can only be realistically achieved at the cost of economic growth.[28] In the context of long term planning, this will impact how the cap will be reduced year over year as well as demonstrate how accurate China’s projections are. Continued efforts of maintaining transparency are needed to ensure adequate support for the market industries. The biggest potential roadblock for the C-ETS is a long-term commitment from the Chinese government. As it has been shown in the E.U.’s case, commitment to this system has won out over numerous speedbumps and problems China will no doubt encounter. While the current global trend of emission trading has become popular, it only takes one political leader to reverse course and end a policy. Continual reaffirmation of this policy adoption will need to be reiterated from governmental officials in order to assuage fears of policy reversal.

Global Implications

Since the subsequent rise in emission trading systems after the post-Paris Accords, understanding their inner workings are vital to preventing the global temperature increase. While Emission Trading Systems have been proven as an effective policy in combatting climate change, the amount of management involved in maintaining the system is something that cannot be overlooked. Also, both the academic literature and current state of ETS systems primarily encompass OECD countries. As many of these emerging economies adopt an emission trading system, new challenges will need to be overcome. In the process of selecting a cap-and-trade system, both a developing economy and an emerging economy may face unique hardships. In addition to the incomplete development of financial markets and auctioning mechanisms within certain regions, something left unaddressed is a power imbalance between different governmental industries facilitating these exchanges.[29] Furthermore, with climate policy being a political process that requires an extended time frame of implementation, these policies could backfire. As this literature has shown, although this policy measure is not a perfect or the most effective policy measure for reducing global emissions, this system has proven to be the most politically viable policy due to the continual disregard of a carbon tax among opposition groups. The next five to ten years will be an exciting period because this is the make or break period we have finally reached. Either this global adoption of emission trading systems will take hold due to its rise in popularity (constructivist approach), or this policy will ultimately fail to prevent the global temperature increase of 1.5 degrees, and we will be in much greater peril as a human race. Being able to improve these as problems arise is the most needed avenue for future research. As long as there is the political will to fix these issues, emission trading systems will remain a viable mitigation policy. Lastly, it must be reminded that while carbon markets have been seen as the answer to combat climate change, they neglect the other 50% of the market, which is related to individual consumption. In addition to the required success of policy measures in combating climate change, human consumption behaviors will need to change drastically in concert with these policy measures.

[1] William Pizer and Xiliang Zhang, “China’s New National Carbon Market”, Nicholas Institute for Environmental Policy Solutions, WP 18-01. (2018): 2.

[2] PMR & ICAP, “Emissions trading in practice: A handbook on design and implementation.” 2016.

[3] See Appendix Figure 1

[4] J. Kruger, W. E. Oates and W. A. Pizer, “Decentralization in the EU Emissions Trading Scheme and Lessons for Global Policy,” Review of Environmental Economics and Policy 1, no. 1 (2007), 112-133.

[5] Williams et al, “The Initial Incidence of a Carbon Tax Across US States.” National Tax Journal 67 (2014): 807-830.

[6] Richard Schmalensee, “The Design of Environmental Markets,” Oxford Review of Economic Policy 33, no. 4 (2017), 572-588.

[7] Frank Jotzo et al., “China’s Emissions Trading Takes Steps Towards Big Ambitions,” Nature Climate Change 8, no. 4 (2018), 265-267.

[8] European Commission, “Report on the functioning of the European carbon market” (2017), 3-6.

[9] Ibid, 16-18.

[10] British Steel: EU Emissions Trading Scheme (EU ETS). 2019 .

[11] Guochang Fang et al., “How to Optimize the Development of Carbon Trading in China—Enlightenment from Evolution Rules of the EU Carbon Price,” Applied Energy 211 (Feb 1, 2018), 1039-1049. doi:10.1016/j.apenergy.2017.12.001. https://www.sciencedirect.com/science/article/pii/S0306261917317117.

[12] Karsten Neuhoff et al., “Banking of Surplus Emissions Allowances: Does the Volume Matter?” SSRN, no. DIW Berlin Discussion Paper No. 1196 (March 8, 2012), 1-23.

[13] Sabine Fuss et al., “A Framework for Assessing the Performance of Cap-and-Trade Systems: Insights from the European Union Emissions Trading System,” Review of Environmental Economics and Policy 12, no. 2 (Aug 1, 2018), 220-241. doi:10.1093/reep/rey010.

[14] Eugénie Joltreau and Katrin Sommerfeld, “Why does Emissions Trading Under the EU Emissions Trading System (ETS) Not Affect Firms' Competitiveness? Empirical Findings from the Literature,” Climate Policy 19, no. 4 (Apr 21, 2019), 453-471. doi:10.1080/14693062.2018.1502145. http://www.tandfonline.com/doi/abs/10.1080/14693062.2018.1502145.

[15] European Commission (EC). “Report on the functioning of the European carbon market” 2003/87/EC; (January, 2017). 22.

[16] Mengya Zhang, Yong Liu and Yunpeng Su, “Comparison of Carbon Emission Trading Schemes in the European Union and China,” Climate 5, no. 3 (2017), 70.(Stoerk, Dudek, and Yang, “China’s National Carbon Emissions Trading Scheme: Lessons from the Pilot Emission Trading Schemes, Academic Literature, and Known Policy Details,” 478-79)

[17]Pizer, William A., and Xiliang Zhang. 2018. “China’s New National Carbon Market.” Duke Nicholas Institute WP 18-01 2.

[18] Qingqing Weng and He Xu, A Review of China’s Carbon Trading Market, Vol. 91, 2018), 613-619. doi://doi.org/10.1016/j.rser.2018.04.026. http://www.sciencedirect.com/science/article/pii/S1364032118302442.

[19] (NDRC 2017a)

[20] Fang, “How to Optimize the Development of Carbon Trading in China—Enlightenment from Evolution Rules of the EU Carbon Price,”, 1039-1049

[21] Thomas Stoerk, Daniel J. Dudek and Jia Yang, “China’s National Carbon Emissions Trading Scheme: Lessons from the Pilot Emission Trading Schemes, Academic Literature, and Known Policy Details,” Climate Policy 19, no. 4 (Apr 21, 2019), 472-486. doi:10.1080/14693062.2019.1568959.

[22] Pizer, William A., and Xiliang Zhang. 2018. “China’s New National Carbon Market.” Duke Nicholas Institute WP 18-01 2.

[23] NDRC 2017.

[24] Ren Cong and Alex Y. Lo, “Emission Trading and Carbon Market Performance in Shenzhen, China,” Applied Energy 193 (May 1, 2017), 414-425.

[25] Hyungna Oh, Junwon Hyon and Jin-Oh Kim, “Korea’s Approach to Overcoming Difficulties in Adopting the Emission Trading Scheme,” Climate Policy 17, no. 8 (Nov 17, 2017), 947-961. doi:10.1080/14693062.2016.1213696.

[26] PMR & ICAP, “Emissions trading in practice: A handbook on design and implementation.” 2016.

[27] Feng Dong et al., “Can a Carbon Emission Trading Scheme Generate the Porter Effect? Evidence from Pilot Areas in China,” Science of the Total Environment 653 (Feb 25, 2019), 574.

[28] Feifei Li, Zhe Xu and Hui Ma, “Can China Achieve its CO2 Emissions Peak by 2030?” Ecological Indicators 84 (2018), 337, 339-340.

[29] Oh, Hyon, and Kim, Korea’s Approach to Overcoming Difficulties in Adopting the Emission Trading Scheme," 947

Appendix

​ Figure 1 (PMR & ICAP, 2016).

i. It should be noted that a large limitation within this literature review is its ever changing nature of this topic. Within the next five years this review will be out of date and unable to provide a comprehensive overview of global developments.

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