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5 Domestic policies in the European Union, the United States and Australia.

As discussed, while Kyoto Protocol obligations ultimately fall to governments, the architecture of the agreement relies on markets to mobilize capital, technology and foreign direct investment. Doing so is expected to reduce the cost of meeting the framework's environmental objectives. Still, while project cycle rules for CDM and track-two JI projects are explicit and apply to all parties, domestic rules and policies are relevant. Because tradable permits have value to private firms primarily because they can be used to meet regulatory rules, differences in domestic rules can also lead to price differences for otherwise equivalent offsets. In the case of the United States, which has not ratified the Protocol, and Australia, which only recently ratified the Protocol, separate voluntary and regional markets have evolved that are not be entirely distinct from Kyoto markets. We discuss policies related to carbon markets for these three countries in anticipation of the market discussion in the next section.

EU Emissions Trading Scheme

The European Union's Emissions Trading Scheme (EU ETS) is one of the principle instruments that the EU relies on to meet its GHG emissions reduction requirements under the Protocol--an 8 percent reduction compared to 1990 levels by the first commitment period. Presently, the plan covers carbon dioxide emissions from more than 10,000 installations from the EU's 27 Member States plus, as of 2008, Norway, Iceland and Liechtenstein, members of the European Economic Area. (54) Together the installations account for about 40 percent of the EUs greenhouse gas emissions. Legislation that eventual launched the EU ETS in 2005 was approved by the European Council and the European Parliament in 2003. (55)

To date, the policy has covered two periods. Phase 1 (2005-2007) of the cap-and-trade program was intended as a trial prior to the first commitment period of the Kyoto Protocol, which coincides with Phase 2 (2008-2012). Emission allowances, called EU allowances (EUAs), are permits equivalent to one ton of emitted carbon dioxide. During the first two phases, Member States allocated allowances to their regulated installation in accordance with a National Allocation Plan (NAP). At the end of each year, regulated installations must surrender allowances equivalent to their emissions. Surplus and short-falls can be matched through sales and purchases.

Under current rules, NAPs are subject to European Commission oversight and the Commission can (and has) reduced the number of overall EUAs under national plans if the plans appear inconsistent with business-as-usual scenarios and climate change framework obligations. The back and forth between national planners and the Commission has generated delays and regulatory uncertainties. (56) Moreover, differences and inconsistencies in the process by which national governments allocated allowances created distortions and inefficiencies, which are discussed later in this section. Under a current proposal national plans would be abolished and replaced with an EU-wide cap based on harmonized rules. The proposal would also extend the system beyond 2012 and cover additional industries and two additional greenhouse gases, nitrous oxide and perflurocarbons. Proposed rules would also allow Phase II EUAs to be carried forward into future periods.

Although the second phase of the EU ETS has only recently begun, a growing literature assesses the early effects of the policy. The research focuses primarily on the two-stage process by which overall levels of national allowances were set and distributed to regulated installations. One area of study focuses on the bureaucratic process itself and the motivations for decisions. For example, the volume edited by Ellerman, Buchner and Carraro (2007) looks at the process of setting Phase I allowances and decisions taken by the EC. The volume also contains country case studies.

During the first phase of the EU ETS, exchanges emerged to trade contracts derived from Phase I and Phase II. As the first phase ended, contracts based on Phase I allowances drifted down to near-zero values after a dramatic price collapse in April 2006. The low ending price for Phase I contracts is taken as an indication of an over-allocation; the structural break in the contract pricing has been attributed to a poorly developed system for measuring emissions and uncertain policy (Ellerman and Buchner, 2007). As discussed in Alberola, Chevallier and Cheze (2008), allocations were based on emission projections rather than verified emission data and when initial results on verified emissions became public, demand expectations for Phase I EUAs were revised downward. Moreover, an initial decision by France and Poland to allow firms to carry over (bank) Phase I allowances for use in Phase II was reversed during the planning of Phase II NAPs, further reducing the value of Phase I EUAs.

The sequential nature of EU policy making creates moral hazard problems when firm behavior can affect future permit allocations. This topic is discussed in the case of power generation by Neuhoff, Keats-Martinez and Sato (2006). Along a similar line, Demailly and Quirion (2006) contrasts the affects of allowance allocation rules based on historic emissions (grandfathering) with the effects of output-based rules for the cement industry. Not all industries fall within the EU ETS and differences in regulatory rules between firms inside and outside the EU ETS creates distortions as discussed in the context of German regulations by Bohringer, Hoffmann and Manrique-de-LaraPenate (2006). The free allocation of permits creates wealth transfers and these are measured in the context of power generators by Keats-Martinez and Neuhoff (2005). They argue in favor of increased permit auctions, a topic also discussed by Hepburn et al. (2006).

Integration with the climate change framework

The EU ETS is intentionally designed to work well with rules established under the Kyoto Protocol and the Marrakesh Accords.57 In general, CERs or ERUs generated by Kyoto projects can, be exchanged one-to-one with EUAs, although offsets generated from nuclear energy projects and, importantly, land-use projects are excluded. However, as discussed, most greenhouse gas emissions in the EU are regulated outside of the trading scheme and these rules work to limit the extent to which firms can rely on Kyoto project offsets under Phase II. For one, under EC rules on supplementarity, Member States must meet at least 50 percent of their emission reductions domestically. In practice, Member States have placed additional (and varying) limits on the share of total emission reductions that can be met by purchasing tradable units, ranging from 8 percent (i.e. the Netherlands) to 50 percent (i.e. Spain and Ireland). Moreover, recall that countries must keep inventories of offsets in line with the commitment period reserve rule. This creates complications for managing Kyoto-projects offsets since these national supplementarity targets could be exceeded if firms regulated under the EU ETS were allowed to purchase CERs and ERUs without limit. As a way of managing supplementarity, Phase II NAPs under the EU ETS place explicit caps within the national plans. In the aggregate, the national plans allow member states to supplement their allowed emissions under the EU ETS by no more than 13.36 percent. The limits vary among countries, ranging from zero (Estonia) to 20 percent (Lithuania, Norway and Spain). In addition, in order to avoid direct and indirect "double counting", ERUs allowed into the EU ETS must originate in sectors not covered by the EU ETS.58 These limitations potentially affect price arbitrage opportunities among the tradable permits, a topic we return to later in the paper.

Regional initiatives and the US voluntary market

In the absence of federal regulation, alternative state, municipal and corporate initiatives to manage greenhouse gas emission in the US have emerged. The programs encompass a range of standards for environmental and investment additionality. In general, comprehensive and binding regulations of the type found among countries that have ratified the Kyoto Protocol are absent. Nevertheless, large regional schemes are under discussion and some innovative programs predate the EU ETS. Even so, in contrast to the European trading system, studies of US systems are not well represented in peer-reviewed economic journals.

One example stems from experience with offsets tied to the Oregon Carbon Dioxide Emissions Standard for New Energy Facilities, enacted in 1997 by Oregon, the first State to regulate GHG emissions. The statute requires all new power plants (and large energy facilities) to meet a carbon dioxide emissions target that is 17% better than the most efficient base-load gas plant currently operating in the U.S. Any emissions exceeded that standard must be matched by financed or purchased project offsets or by a fee of US$0.85 per short ton of C[O.sub.2] paid into The Climate Trust, a non-profit group established to manage offset projects on behalf of its members. There are no limitations on the geographic location or type of project providing the offsets. So far, the Climate trust manages a portfolio of 15 projects that will offset 2.7 MtC[O.sub.2]e(of which 1.5 MtC[O.sub.2] are linked to the compliance with the Oregon Standard). In addition to common offset classes such as energy efficiency (supply side), renewable energy and sequestration, the Climate Trust has sponsored more innovative projects, especially in the transportation sector. Some of its portfolio has besides been sold to the voluntary market.

The Chicago Climate Exchange (CCX) is a voluntary cape-and-trade scheme, where members make a voluntary but contractually binding commitment to reduce GHG emissions. By the end of Phase I (December, 2006) all Members were to have reduced direct emissions 4% below a baseline period of 1998-2001. Phase II, which extends the CCX reduction program through 2010, will require all members to reduce GHG emissions 6% below baseline. There are more than one hundred members in the exchange, from all sectors of the economy (including entities such as universities or municipalities). Not all (though most) are based in the US. Their baseline emissions amount to some 230 MtCO2e--a few percent of US GHG emissions. As new regional initiatives began to take shape in the United States, CCX attracted new members (both compliance members and offset providers), who expressed their interest in familiarizing themselves with emissions trading. New participants joining in the scheme can directly assume the target for the end of phase II, viz. 6% reduction in emissions below baseline by 2010. Post 2006 vintages (2007, 2008, 2009 and 2010) were listed from mid-April onwards and while activity has increased on the CCX, trading has been concentrated in the post 2006 vintages (69% of volumes from April '06 to Dec '06), reflecting growing carbon market interest in the United States.

CCX trades the six Kyoto gases, converted along one currency, the Chicago Financial Instrument (CFI), which represents 100 tCO2e. CFIs can be either allowances issued to members according to their baseline and emissions reduction commitment, or offset credits, from third-party-verified projects. Offset categories include the following: agricultural methane, landfill methane, coal mine methane, agricultural soil carbon, rangeland soil carbon management, forestry, renewable energy and energy efficiency and fuel switching. (59) Renewable Energy Certificates and CERs can also be traded. A limited activity for CERs trading (futures) has been reported in the second half of 2007, with prices on average slightly higher than those observed in Europe. CFIs come primarily from soil management projects (60%) and coal mine methane (15%). For the most part, projects are based in North America.

Two regional efforts are worth mentioning as well. The Regional Greenhouse Gas Initiative (RGGI) is the US cape-and-trade scheme closest to operation. It targets CO2 emissions from electric power generators (25MW or more and which burns 50% or more of fossil fuel) in ten Northeastern States: Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island, and Vermont. In addition, the District of Columbia, Pennsylvania, the Eastern Canadian Provinces, and New Brunswick are observers in the process and could opt-in at some point. Initial discussions started in April 2003 and after a two-year design process that included extensive stakeholder and expert input and detailed and comprehensive technical analyses by the states, the governors of seven states agreed in December 2005 to move forward with the implementation of RGGI in their states. (60) The Model Rules, first issued in August 2006, are to be adapted by each participating state in its own legislation. (61) NY was the first to do so by December 2006. Burtraw, Kahn and Palmer (2006) describe the regional program and analyze its potential effect on electricity prices.

The second regional initiative, the Western Regional Climate Action Initiative, was formed in February 2007, through a coalition uniting Oregon, California, Washington, New Mexico and Arizona to establish a regional target for reducing GHG emissions by fall 2007 and to design by fall 2008 a cape and trade scheme to this end. Among these states, California may take unilateral action before the initiative is fully designed. In August 2006, the state passed the California Global Warming Solution Act, which calls for a reduction in greenhouse gas emissions to 1990 levels by 2020.

Permit markets in Australia

Australia has only recently ratified the Kyoto Protocol but in recent years a number of initiatives to reduce GHG emissions have emerged at the state level, mostly based on the mandated use of renewables. However, there have also been trade-based programs as well. For example, since 2003, Australia's New South Wales (NSW) has operated a program based on tradable permits, called the NSW Greenhouse Gas Abatement Scheme (GGAS), which is intended to reduce greenhouse gas emissions from the power sector. Under the program, retailers and large electricity customers in NSW (and since 2005 in the Australian Capital Territory) are required to meet mandatory intensity targets to reduce (or offset) the emissions of GHG arising from the production of electricity they supply or use. They can meet their targets by purchasing certificates (NSW Greenhouse Abatement Certificates or NGACs). NGACs are generated through the following activities: low-emission generation of electricity and improved generator efficiency, activities that result in reduced consumption of electricity or on-site generation of electricity and carbon sequestration into biomass.

Renewable Energy Certificates are also eligible (62). No other form of credit (e.g. JI or CDM) is eligible at this time. A buy-out penalty applies, set at AU$11.50 (currently approximately US$9) for compliance year 2006. So far, all participants have been in compliance (eventually by carrying forward part of the shortfall--up to 10% of the benchmark). After the EU ETS, the NSW GGAS is the second largest greenhouse gas abatement market with about 20.2 million certificates exchanged through 2006 for a value estimated at US$225.4 million. The 2006 market represented a 3.3 times increase over the volumes transacted in 2005 and about 3.8 times increase in the value for 2005.

As of end of February 2007, 201 projects were accredited, for the most part under the "generation" and "demand side abatement" rules. Credits issued from carbon sequestration also entered the scheme in 2005. Over 40 million NGACs had been created by the end of March 2007, with "generation" certificates dominating at 70% of volumes followed by "demand side abatement" certificates at 25%. So far, taking into account the certificates that have been surrendered, there is currently an oversupply of over 13 million NGACs. Participants expect that the demand may exceed supply by 2009; however, the demand supply balance could quickly reverse as some participants may decide to hedge their position forward. In addition, there is growing interest in the voluntary market for the NGACs. The key to the supply/demand balance may in fact reside in the eligibility of NGACs under the future national scheme under discussion (see below). As long as no firm decision is made upon transition arrangements, some volatility is to be expected as has been the case in recent months.

Looking ahead, a national trading scheme is under discussion, to start no later than 2010 with the detailed design to be finalized by the end of 2008. Key inputs will be provided by the Garnaut Climate Change Review (with a final report due by end of September 2008). Meanwhile, an interim report released in February 2008, stated that Australia should promote strong global action on climate change and be prepared to match the commitments of other developed nations. Among other interim recommendations, one could read that nations should move ahead on unilateral and regional climate agreements before a post-Kyoto deal and calls for a South Pacific regional emissions trading scheme that helps prevent deforestation in Indonesia and Papua New Guinea.

As with the US programs, the analytic literature is not well represented in peer-reviewed journals. With Australia's recent ratification of the Protocol, this is likely to change as current programs are accommodated within a national and international system.
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Title Annotation:Carbon Markets, Institutions, Policies, and Research
Publication:Carbon Markets, Institutions, Policies, and Research
Date:Oct 1, 2008
Previous Article:4 Expected outcomes from the climate change framework.
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