EMISSIONS TRADING: Learning from experience

Andrew C. Byers
Black & Veatch Corporation, Overland Park, Kansas, USA

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The European Union (EU) is facing truly formidable and unique challenges in its effort to establish an internal emissions trading programme to help achieve its commitment under the Kyoto Protocol. With limited experience in developing, implementing, and administering a market based emissions trading programme, the EU can look to the experiments undertaken in the USA to determine what may work best.

In signing the Kyoto Protocol, the EU and its Member States committed to reducing greenhouse gas emissions by eight per cent below 1990 levels. One approach for achieving these reductions is the development of a greenhouse gas emissions trading programme.

The USA has been experimenting with emissions trading since the mid-1970s. It now has several cap-and-trade programmes in operation on a national, regional, and metropolitan basis, although the Acid Rain Program is the only one that has been operating long enough to provide market development and implementation lessons.


In an effort to address long-range acid deposition from coal fired and oil fired power plants, the US Congress developed the Acid Rain Program under Title IV of the 1990 Clean Air Act Amendments. It is the most comprehensive cap-and-trade programme to be implemented on a national level, and brought a fundamental change in the regulatory framework governing air pollution in the USA.

The goal of the Acid Rain Program was to effect a 10 million tons per year reduction in SO2 emissions from 1980 levels by the year 2000. To achieve this, the law created a cap on SO2 emissions from electric generating plants of 8.95 million tons per year, effective in the year 2000 and beyond. The cap was to be achieved in two phases: Phase I (1995-2000) and Phase II (2000 and beyond).

Compliance with the Acid Rain requirements has been remarkable. In the first three years of Phase I, every affected unit surrendered the requisite number of allowances for its annual SO2 emissions, without any exceptions, exemptions, or waivers being granted. In fact, total SO2 emissions during this period were less than the number of allowances issued.

An additional benefit was realised by the geographic distribution of aggregate emission reductions being achieved in the areas where they mattered most from an environmental standpoint: the Ohio Valley and Midwest. These areas are recognized as the primary sources of acid rain precursor emissions that were causing extensive environmental damage and health risks in the northeastern Atlantic states.

The most significant factor in the programme’s success was the development of an efficient free market for trading allowances. If fluctuation and long-term structure of allowance prices with regard to spot and future market trades provides an objective measure of an efficient market, then an efficient market for SO2 allowances emerged in the US within a few years.

European plans

The EU is a unique party to the Kyoto Protocol in that it is the only bloc of several countries making a common commitment to greenhouse gas reductions. In Article 4 of the Protocol, it was agreed that the EU could redistribute its targets among the Member States as long as the outcome still amounted to an overall reduction of eight per cent. Political agreement on that redistribution was reached in June 1998, and is referred to as the ‘burden sharing’ agreement.

An important element of EU climate change policy is the cost effectiveness of different policies and measures, as well as political acceptability, fairness between sectors, social barriers, and industrial competitiveness.

In light of these considerations, the EU launched its European Climate Change Programme to promote the implementation of an emissions trading system. On March 8, 2000, the European Commission published a Green Paper on greenhouse gas emissions trading within the EU. This launched a Community-wide debate on greenhouse gas emissions trading within the EU.

The Green Paper promotes the Commission’s position that emissions trading, both within the EU and between the EU and the rest of the industrialized world, should be an important element of the EU’s implementation strategy for the Kyoto Protocol.

The Commission believes that an emissions trading programme should be established for participation by all Member States, as opposed to individual national trading schemes. It argues that a Community approach is necessary to ensure that competition is not distorted within the internal market.

There are several complex technical, administrative, and policy issues that must be addressed in setting up an EU emissions trading programme. In hope of working though these issues for implementation by the 2008 compliance deadline, the Commission has proposed a step-by-step approach to development. It is advocating that a trading scheme should be implemented by 2005 in order to give the EU experience in preparation for international greenhouse gas emissions trading scheduled to begin in 2008.

Defining the market

Due to the administrative difficulties in regulating emissions of all greenhouse gases from all sources, and as carbon dioxide emissions constitute approximately 80 per cent of the EU’s greenhouse gas emissions, the Commission has decided to confine its emissions trading programme to large fixed point sources of carbon dioxide, where monitoring and supervision is more feasible.

Figure 1. US cap-and-trade emissions programmes
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The Commission has chosen to begin with a relatively small number of economic sectors and sources that contribute significantly to total CO2 emissions. Conveniently, those sectors already regulated under the Large Combustion Plant (LCP) and Integrated Pollution Prevention and Control (IPPC) Directives offer a “useful starting point for defining the trading system population”. Accordingly, the likely industry sectors to be included in the EU’s emissions trading system include electricity and heat production; iron and steel; petroleum refineries; chemicals; glass, pottery and building materials; and paper and printing industries.

Once pollutant and sectoral coverage is decided, equitable allocation of allowances presents the most contentious challenge.

Two methods of allocation, auctioning and grandfathering, are currently being considered. Grandfathering, or free allocation of allowances on the basis of performance standards or benchmarks, alleviates stranded costs that otherwise will be sustained by existing facilities drawn into the trading scheme. Periodic auctioning, favoured by the Commission, avoids having to make difficult and politically delicate decisions about how much to give each company.

Development of a trading scheme will need to be coordinated and complement existing regulations, environmental agreements, and other policies such as energy taxes.

The system will also need to be designed to extend and adapt to the admission of new Member States as they join the EU, and will need to be structured to ensure that allowances are available for new market entrants on equal terms.

Critical compliance

The Green Paper acknowledges that, for a community scheme to function properly, adequate monitoring, tracking, and reporting are critical. Verification and control of the data provided should lead to the detection of noncompliance, against which enforcement action must then be undertaken. Penalties should exceed the cost of complying to have a deterrent effect. Specific sanctions under consideration include exclusion from the trading system and monetary penalties.

In keeping with current EU environmental legislation, the Member States would be primarily responsible for assessing compliance by companies. Minimum penalties to be assessed by Member States to noncomplying parties would be established by the EU. Companies would have to monitor and report their actual emissions to national authorities, who would in turn track allowances traded.

Aggregate results for each Member State would be communicated to the Commission. Emissions of greenhouse gases in Member States would be monitored at the Community level on the basis of aggregate data for each Member State. Legal actions could be brought against a Member State that fails to take enforcement measures by either the Commission or another Member State under the procedures set forth in the EC Treaty.

Essential elements

Drawing from US experience, the essential elements to any successful emissions trading programme are:

  • Establishing an equitable regime for the initial allocation of allowances
  • Minimizing regulatory or market restrictions to freely trade allowances among affected sources and across jurisdictional state lines, and
  • Implementing a system to assure that emissions at each source can be accurately verified against allowances held by each source.

Equitable allocation: Auctioning does provide the simplest and most politically free process for allocating allowances. On the other hand, not allowing existing utilities to recover damages for stranded assets is clearly inequitable, not to mention unimaginable under a scheme where individual Member States ultimately determine how and to whom allowances will be distributed. The methodology for initial allocation of allowances in the USA was clearly influenced by geopolitical considerations, and employs mostly a grandfathering with benchmarks approach with some annual auctions. As the trading market matured in the USA, the annual auctions’ role in and influence on the emissions trading programme steadily decreased.

Given the breadth of sources and multiple sovereignties that must be encompassed in an EU trading market, auctioning would appear to provide advantages for immediate implementation. Nevertheless, a mix of auctioning and grandfathering will probably be necessary to accommodate both the practical and political considerations that must be addressed to obtain consensus. No allocation method will be totally fair. But as the USA’s experience has shown, the more open the market, the more it will act to correct the remaining inequities.

Minimizing restrictions: The Commission expressed its belief that an emissions trading programme should be established for participation by all Member States, as opposed to individual state trading schemes. The key advantage in developing a Community-wide scheme is that restrictions to trading allowances among affected sources and across jurisdictional state lines can be limited and controlled. However, development of an EU trading scheme will also need to be coordinated with and complement existing technical regulations, environmental agreements, and other policies to minimize indirect and consequential restrictions to trade.

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Another common theme shared by existing US and proposed EU emissions trading programmes is their mandates that the electric generation industry must participate. The inclusion of more sectors and expansion to encompass emissions of all greenhouse gases will serve to make the market more efficient.

Verification and enforcement: Perhaps the element deserving most immediate attention is compliance and enforcement. The USA has long instituted environmental regulatory regimes built upon the deterrent effect of severe penalty provisions. The Acid Rain Program embraces this element in requiring installation of Continuous Emissions Monitoring Systems at all affected sources, and imposition of stringent calibration and verification procedures. Most importantly, the vigorous enforcement through imposition of both civil monetary and criminal incarceration penalties provides strict, but effective, incentives for compliance.

Under most major environmental laws, the US EPA is authorized to institute enforcement actions where states fail to sufficiently act. Additionally, private citizens are authorized in certain situations to initiate enforcement actions where the US EPA fails to take such actions.

The validity and effectiveness of emissions monitoring and reporting systems are especially critical for instilling confidence in allowance transactions by certifying the existence and quantity of the commodity being traded. In the Green Paper, the Commission acknowledges that the strength and integrity of an emissions trading programme depends upon its compliance provisions and enforcement regime, which will require a harmonization of rules for monitoring, reporting, and verification between all Member States.

The Green Paper seems particularly thin on its discussions regarding how equitable enforcement can be assured. Disparate treatment in this regard by individual Member States of resident companies poses perhaps the greatest threat to establishing a fair and equitable Community-wide trading regime.

Obviously, the willingness of companies and regulated industries to support such schemes by their individual or collective efforts to assure compliance will contribute to the efficiency of the market. However, inherent market forces will also cause companies and industries to seek favourable business environments and set up operations where advantages over their competitors are available. Harmonization of compliance and enforcement laws will provide the framework for equitable enforcement by the collective States.

However, this does not in itself assure that Member States will vigorously enforce these laws to the same extent. The ability of the EU to act quickly and effectively to correct inequities arising from lax enforcement by individual Member States is not readily apparent. If the EU cannot effect such corrections, confidence in the price of allowances being accurately reflected in the emissions trading market will quickly erode.

With the clock ticking on the Kyoto ratification deadline and such serious disagreements and divisions between the signatory developed countries, the likelihood of having an international greenhouse gas emissions trading programme in operation by 2008 appears doubtful. Nevertheless, if it is accepted that commitments to reduce greenhouse gas emissions will eventually be universally accepted and implemented, Europe has nothing to lose in moving forward with its efforts to establish an EU-wide emissions trading programme.

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