Moving toward Stringency Moving toward Stringency in Emissions Tradingin Emissions Trading

Professor Lesley McAllisterProfessor Lesley McAllisterUniversity of San Diego University of San Diego

School of LawSchool of Law

RoadmapRoadmap

Emissions Trading (Cap & Trade) Emissions Trading (Cap & Trade) BasicsBasics

Slack in Program CapsSlack in Program Caps Empirical Evidence of SlackEmpirical Evidence of Slack Sources of SlackSources of Slack Comments on the California Market Comments on the California Market

Advisory Committee (MAC) Advisory Committee (MAC) Recommendations of June 2007.Recommendations of June 2007.

Cap and Trade BasicsCap and Trade Basics

Program Cap: The limit on the total Program Cap: The limit on the total amount of pollution that a set of amount of pollution that a set of sources may emit over a period of sources may emit over a period of time (the reporting period).time (the reporting period).– Sources are allocated shares of the cap Sources are allocated shares of the cap

in the form of “allowances” or “tradable in the form of “allowances” or “tradable permits.”permits.”

– An allowance is the right to emit a An allowance is the right to emit a certain quantity of pollution over the certain quantity of pollution over the reporting period.reporting period.

Cap and Trade Basics (cont.)Cap and Trade Basics (cont.)

Trading: Once allowances are Trading: Once allowances are allocated to sources, sources may allocated to sources, sources may buy and sell them. buy and sell them.

Banking: If a program allows Banking: If a program allows banking, a source that doesn’t use banking, a source that doesn’t use allowances in one time period, can allowances in one time period, can hold, or “bank,” them for use in a hold, or “bank,” them for use in a future time period.future time period.

Typical Story of Cap and TradeTypical Story of Cap and Trade

The emissions of a set sources that currently The emissions of a set sources that currently produce x tons of pollutant are capped at some produce x tons of pollutant are capped at some level below x. Each source then receives level below x. Each source then receives allowances that give it the right to emit less allowances that give it the right to emit less pollution than it currently emits. pollution than it currently emits.

Three paths to compliance - A source may:Three paths to compliance - A source may:– reduce emissions to meet the number of allowances, reduce emissions to meet the number of allowances, – reduce their emissions below the number of reduce their emissions below the number of

allowances and then sell the rest, or allowances and then sell the rest, or – emit at a level higher than the number of allowances emit at a level higher than the number of allowances

and purchase allowances to make up the difference.and purchase allowances to make up the difference. Emissions reductions & Economic efficiencyEmissions reductions & Economic efficiency

But what if…But what if… The program cap is higher than the amount of The program cap is higher than the amount of

emissions currently produced; many or most emissions currently produced; many or most sources are allocated more allowances than they sources are allocated more allowances than they need to cover their emissions. need to cover their emissions. – Would allowances have any value on the market? Would allowances have any value on the market? – Would the program lead to emissions reductions? Would the program lead to emissions reductions?

At the end of the year, it is likely that all sources At the end of the year, it is likely that all sources will be in compliance and the costs of compliance will be in compliance and the costs of compliance will be very low – sources would spend little or no will be very low – sources would spend little or no money to comply because each source had money to comply because each source had enough allowances to cover its emissions. enough allowances to cover its emissions. – But would the program be effective in terms of But would the program be effective in terms of

its environmental outcomes?its environmental outcomes?

Defining “Slack” in Program CapsDefining “Slack” in Program Caps

Slack is present when the aggregate number of Slack is present when the aggregate number of allowances available to sources exceeds the allowances available to sources exceeds the emissions that the sources produce.emissions that the sources produce.

Slack can be measured as a percentage: the Slack can be measured as a percentage: the percentage by which allowances available for use percentage by which allowances available for use in a given reporting period exceed the actual in a given reporting period exceed the actual emissions. emissions.

e.g. If 990 allowances are available to be used in e.g. If 990 allowances are available to be used in the reporting period, and sources in the program the reporting period, and sources in the program only emit 900 tons, the overall cap for that period only emit 900 tons, the overall cap for that period can be said to have a slackness of 10%. can be said to have a slackness of 10%.

RECLAIMRECLAIMAnnual cap exceeded actual emissions for the first five years of the program. Annual cap exceeded actual emissions for the first five years of the program.

With large-scale noncompliance in the California electricity crisis (2000-With large-scale noncompliance in the California electricity crisis (2000-2001), direct regulation was adopted to force major emitters to reduce 2001), direct regulation was adopted to force major emitters to reduce

emissions.emissions.

0

5000

10000

15000

20000

25000

30000

35000

40000

45000

1989 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Annual Cap Emissions

Slack in RECLAIMSlack in RECLAIM

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

ERMSERMS

The cap was significantly higher than emissions The cap was significantly higher than emissions in all years of the program.in all years of the program.

0

20,000

40,000

60,000

80,000

100,000

120,000

2000 2001 2002 2003 2004 2005

Cap Emissions

Slack in ERMSSlack in ERMS

0%

20%

40%

60%

80%

100%

120%

140%

160%

2000 2001 2002 2003 2004 2005

The Acid Rain ProgramThe Acid Rain Program The number of allowances available for use each year (which includes unused The number of allowances available for use each year (which includes unused

allowances banked from previous years) was significantly greater than actual allowances banked from previous years) was significantly greater than actual emissions in all years of the program.emissions in all years of the program.

0

5,000,000

10,000,000

15,000,000

20,000,000

25,000,000

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Annual cap Total allow able w ith bank Emissions

Slack in the Acid Rain ProgramSlack in the Acid Rain Program

0%

50%

100%

150%

200%

250%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Effects of Slack CapsEffects of Slack Caps

Low allowance pricesLow allowance prices– Emissions reductions don’t happen Emissions reductions don’t happen

because it is cheaper to buy allowances because it is cheaper to buy allowances than to reduce emissions. than to reduce emissions.

Build up of a large bank if banking is Build up of a large bank if banking is allowedallowed– Allows more emissions in future yearsAllows more emissions in future years

Minimal emissions reductions that Minimal emissions reductions that can be attributed to program can be attributed to program

Market Price of AllowancesMarket Price of Allowances

If the cap is not slack, market price If the cap is not slack, market price of an allowance should reflect the of an allowance should reflect the marginal cost of reducing an marginal cost of reducing an allowance-worth of pollution.allowance-worth of pollution.

If the cap is slack, market price of If the cap is slack, market price of allowance will be very low, reflecting allowance will be very low, reflecting merely the cost of the transaction merely the cost of the transaction and perhaps some speculation. and perhaps some speculation.

Sources of SlackSources of Slack

““when a market is created through when a market is created through political action rather than emerging political action rather than emerging

spontaneously from the needs of spontaneously from the needs of buyers and sellers, business will seek buyers and sellers, business will seek

to influence market design for to influence market design for commercial advantage.” commercial advantage.”

-- John Kay, Financial Times, 5/9/06John Kay, Financial Times, 5/9/06

Sources of Slack (cont.)Sources of Slack (cont.)

Allocations of allowances based on Allocations of allowances based on historical emissions opens the door historical emissions opens the door for strategic behavior.for strategic behavior.– Sources have been allowed to choose Sources have been allowed to choose

which year will be their historical which year will be their historical baseline from a range of years (i.e. ARP, baseline from a range of years (i.e. ARP, Reclaim).Reclaim).

– Sources have been able to get extra Sources have been able to get extra allowances by showing that they made allowances by showing that they made pre-program reductions.pre-program reductions.

Sources of Slack (cont.)Sources of Slack (cont.)

Availability of offsets: sources can acquire Availability of offsets: sources can acquire allowances by enabling emissions allowances by enabling emissions reductions external to the program. reductions external to the program.

Handling of shutdowns: Shutdowns may Handling of shutdowns: Shutdowns may not reduce cap; allowances may be not reduce cap; allowances may be continued to be allocated (ERMS, Reclaim).continued to be allocated (ERMS, Reclaim).

Failure to adequately consider the impact Failure to adequately consider the impact of co-existing direct regulations that lead of co-existing direct regulations that lead to emissions reductions (ERMS).to emissions reductions (ERMS).

Recommendations of California’s Recommendations of California’s Market Advisory Committee Market Advisory Committee

Factors that introduce slack:Factors that introduce slack:– Envisions the use of offsetsEnvisions the use of offsets– Envisions allowances for early Envisions allowances for early

reductionsreductions– Envisions some allocation based on Envisions some allocation based on

historical emissionshistorical emissions– Envisions co-existence with direct Envisions co-existence with direct

regulationregulation– Envisions unrestricted bankingEnvisions unrestricted banking

Recommendations of MAC (cont.)Recommendations of MAC (cont.)

Factors that work against slack:Factors that work against slack:– Envisions that program cap will be set Envisions that program cap will be set

independently from the allocation independently from the allocation process.process.

– Envisions some use of auctioning, Envisions some use of auctioning, increasing over time.increasing over time.

– Identifies the creation of market scarcity Identifies the creation of market scarcity as an important design feature as an important design feature

“The Motion has been made and seconded that westick our heads in the sand.”