Emissions Trading: Latest News from Outside Japan

Date May 11, 2010
Speaker Henry DERWENT(President and CEO, International Emissions Trading Association)
Speaker David LUNSFORD(Policy Leader, Emissions Trading, International Emissions Trading Association)
Moderator ARIMA Jun(Deputy Director-General for Environmental Affairs, Industrial Science and Technology Policy and Environmental Bureau, METI)
Materials

Summary

David LUNSFORDHenry DERWENT
The main message I want to communicate as Japan contemplates a domestic emissions trading scheme is that right now, while the news is full of apparent setbacks in the United States and Australia, in Europe, the commitment to emissions trading and cap and trade as a centerpiece of climate change policy remains unshaken.

Although the original objective of creating a uniform global scheme may be a long way off, cap and trade policies remain a key weapon in the process of achieving global emission reductions. Even though some developing countries are taking steps backward, there are some major developing countries which are prepared to try emissions trading as part of their policies.

From the perspective of the carbon market, Copenhagen was pretty bad news. Many of the things that the carbon market wanted to see did not happen. We did not get certainties about time scales and levels of emissions reductions. We did not get any clarity about new private finance mechanisms that would go beyond the clean development mechanism. We received no sign whatsoever of the means by which governments were prepared to engage with the private sector to facilitate the massive injection of private investment necessary to meet the numbers being spoken of. We achieved some reforms to the Clean Development Mechanism (CDM), but not as many as we would have liked. The result of all of this is that the current trading world is in a spell of stormy weather.

It may look at first sight that there are many trading schemes being implemented around the world, but nearly everywhere you look storm clouds are gathering. In Europe, there is contention, not so much over the principles of trading but over peripheral issues. There have been a lot of serious fraud problems driven by tax regimes which have nothing to do with the principles of trading but nonetheless have damaged the reputation of the EU-ETS. In the United States, we are hoping for the passage of a bill tomorrow, but we expect that it will be much less ambitious than the ideas initially put forward by President Obama. In Australia, to the surprise of many, Mr. Rudd has decided that he does not want to fight an election on emissions trading. In New Zealand, the government is beginning to question if they should not slow down what they are doing as well. In Canada, the confusion surrounding emissions trading is just as bad as it ever was. In California, we are seeing a new referendum against the entire climate policy of Governor Schwarzenegger, including policy on emissions trading. I would say that there is a cloud of some size over Japan because of the political difficulties that Mr. Hatoyama's government is feeling at the moment and because of the uncomfortable nature of being a leader when so many others in the front rank seem to have stepped back. South Korea is also not moving as fast as one would have thought.

On the other hand, if one is looking for rays of sunshine, I am happy to say that at last the CDM seems to be catching on in Africa. In India there is an energy efficiency scheme which seems to be close to starting, and a similar use of trading for energy-efficiency purposes seems to be spoken of more and more firmly as a possibility for China.

That is an overview of the global situation; David Lunsford will now talk about the specific situation in the United States and some other locations.

Henry DERWENTDavid LUNSFORD
I would like to start by pointing out a few of the recent bills that have been presented in the U.S. Congress over the past year. There is one bill entitled Waxman-Markey that was passed last summer in the House of Representatives. In order for proposed bills to become law, the Senate side of Congress must also propose a bill that is somehow similar, and then those two bills will be reconciled in order to form a substantial policy. At this point of time, there has recently been the Kerry-Boxer bill proposed in the Senate, as well as the Cantwell-Collins bill.

These bills are all very different. Waxman-Markey proposes a cap and trade scheme that covers approximately 75% of the economy. Kerry-Boxer also proposes a very big cap and trade scheme to cover the economy and to help the United States reach Obama's proposed reduction targets. The Cantwell-Collins bill on the other hand has been drawing a lot of attention because it is very short and only covers the electricity sector.

You may wonder why there is so much activity in Congress while at the same time we are hearing a lot of discussion about how there are not enough votes to pass a bill anytime in the near future. There is a very good reason for this. It has to do with a finding published by the U.S. Environmental Protection Agency (EPA), nearly two years ago, known as the "Endangerment Finding." The EPA found that CO2 is a pollutant for all of society. Under the Clean Air Act passed in 1990, the EPA has an obligation to implement domestic measures in order to reduce CO2 pollution from 2011. In the United States, there are three methods being discussed for emission reductions. A cap and trade scheme, a carbon tax, or a command and control approach. Basically there is quite widespread support within Congress for a cap and trade scheme. If you look at carbon taxes, very few congressmen or women support such taxes. Looking at command and control, there is almost no support. The Senate therefore is looking for a cap and trade bill which can be reconciled with the Waxman-Markey bill to avoid the risk that the EPA might step in with a command and control approach. This is why we are seeing so much movement. There is a deadline to be met, and the Senate intends to do so.

The impact that the Enron scandal had on the electricity markets in California, the Wall Street meltdown and skepticism about carbon markets in relation to inefficient oversight are also likely reasons why we are seeing so much action on carbon trading. If you followed the European Union Greenhouse Gas Emission Trading System (EU-ETS) over phase I, you will know that the carbon price eventually dropped to close to zero because of the over-distribution of allowances. The U.S. feels that this was due to poor oversight. Furthermore, a number of academic institutions have recently published studies claiming that the additionally tests implemented in the CDM process were insufficient, that the CDM executive broad is not doing its job correctly, and so on and so forth. For these reasons we are seeing additional layers of oversight being put into bills such as the Kerry-Boxer bill. These added layers of oversight may be very detrimental to an efficient carbon market if there are a lot of different carbon markets around the world which also put in such layers.

The U.S. Congress will need to deal with a number of questions at some point in this whole process. Many of these questions have to do with the reach of any oversight body established for carbon markets. Who will clear what carbon is allowed to be traded? How will standardized forms for trades be decided upon? What will the standards of conduct for carbon trading in the United States be? How will the U.S. track all of the carbon trades going on? The U.S. seems to be proposing measures stricter than what we see in Europe and even more conservative than what we see in financial markets. It is worth noting that there is financial reform going on right now, and that this reform is probably going to impact the future carbon market. Although the details of financial reform are not yet clear, how this evolves over the next couple of months will definitely impact the structure of the U.S. carbon market.

Turning away from the activity at the federal level in the United States, there are a number of initiatives underneath federal schemes that have already become quite developed. For instance, the Regional Greenhouse Gas Initiative (RGGI) was launched in 2005. Probably the most significant of all regional schemes is the Western Climate Initiative (WCI). It covers several U.S. states and a high proportion of the Canadian population. It was signed in 2007, but no trading will begin until 2012. The WCI is developing protocols for offsets and designing a carbon-market oversight body. It is a collaborative process. It is very likely that the findings and protocol being developed here will feed into what happens in Washington DC.

Looking at state initiatives, California has been at the vanguard of developing climate policy for quite some time. Potentially, there will be an election in November this year whereby climate policy may be postponed until employment levels are raised significantly. You can see that there is an extreme linkage in California between how the economy and jobs are doing and whether climate policy will be passed. California has decided to mainly back command and control, but the state is also endorsing a small cap and trade scheme covering about 20% of the economy. That cap and trade scheme would include a lot of auctioning, but it would only allow a very small amount of offsets. How offsets would be developed has yet to be defined. This is the current situation in California, and I think that we will need to wait until November to understand how things are going to develop.

Canadian Federal Policy is almost in lockstep with whatever happens in the Untied States. Whenever the Environment Minister announces some new direction for Canada, it is usually because the United States has decided to go in the same direction. I would not expect for you to hear much else coming from Canada other than the prolongation of policies until they see the U.S. passing some laws. The only thing that is happening at a federal level is the discussion to increase renewable energy mandates. This discussion will probably move forward over the course of the next year.

Lastly, I will just touch on the Carbon Pollution Reduction Scheme (CPRS) and the New Zealand ETS schemes as well. I am sure many of you have heard the unfortunate news over the past month that the carbon pollution reduction scheme in Australia has been put on the shelf until at least January 2013. The scheme progressed very far in its design and legislation. Kevin Rudd ran a platform in favor of climate policy. The development of the CPRS scheme happened throughout 2008 and 2009, and then unfortunately, due to changes in parliament, Kevin Rudd decided that the issue would be shelved and that he would focus on public healthcare legislation.

The New Zealand ETS is still in place. Policy was changed in late 2009, but there is still a cap and trade scheme in place. The only major change that happened at that time was that it was decided that sectors other than forestry would be phased into the scheme at later periods of time. One interesting thing to note is that for the next two years, there will be a fixed price within New Zealand's cap and trade scheme of NZ$12.50 per ton. This will not change until 2013, the same year Australia will likely push forward with new climate change policy. You can expect that what New Zealand decides will mirror the decisions of Australia.

Henry DERWENT
I will discuss what is happening in the global cap and trade headquarters, Europe. In the European Union, phase III of the emissions trading scheme which started in 2005 is now being prepared for. This phase will start in 2013 and will run through to 2020. The major issue being discussed in relation to this phase is how the EU-ETS has been affected by the recession. Emissions were reduced very substantially in energy-intensive industries between 2008 and 2009. As a result, the price of emissions reduction permits went down. They did not go down as far as might have been expected because provisions for banking had been already established, and this means that people will not necessarily sell unneeded units due to the belief that by 2020 they may have some use for them. That said, the recession did have an impact on price and did create oversupply. Although the low price of carbon may be viewed as a useful negative cost at a time when companies need it, it has nevertheless been a testing time for confidence in the scheme. Additional topics being discussed include how auctioning is to be designed, what role benchmarking is to play, how to deal with market oversight issues, whether to go for tougher targets, and the use of international border adjustments. There are many political and administrative figures in Europe which are questioning the notion that all you need is trading. It is clear that Europe will go for many different policies rather than just the trading scheme.

I will comment on three of these issues in a little more detail, starting with auctioning. This was supposed to be the phase in which the EU-ETS rid itself of free allocations and moved to the economically efficient alternative basis of auctioning, but it has not done so quite as fast or as comprehensively as initially imagined. There are some major exceptions. Auctioning was brought in for the power sector comparatively quickly but there are some special derogations for Eastern European countries dependant on coal. Perhaps more interestingly, there is a major set of derogations from auctioning which is being delivered in the form of free allocations to sectors which are considered to be heavily trade-exposed and at risk of trade dislocation if the cost implications of the scheme are too high. As a result, more than 75% of the total emissions of the EU are now regarded as in principle being eligible for some form of derogation. However, that is not the end of the story, because you may only qualify for these derogations if your industry has been shown to pass certain benchmarks.

The second area that I will highlight is market oversight. In this area we see similar arguments being made to those in the United States. Most of these issues will be settled based on decisions made about financial sector regulation rather than about carbon sector regulation.

The third area that I will pick up is that of future ambitions. There is a draft communique from the climate change Director-General of the EU circulating at the moment. It is a set of proposals which starts from a reexamination of whether Europe should go to a -30% by 2020 instead of the current target of -20%, and it adds a lot more to current proposals in the form of international climate change-directed ideas as well. Other topics discussed include further restrictions on the CDM, international linking systems, border tax adjustments, and the validity of calculating the economic impact of going to a target of -30% purely on the basis of economic modeling.

Allow me to make a couple of points about the clean development mechanism. There are still many CDM projects being formulated, and this has been argued by some EU representatives as being an indication that everything is well. However, as a result of the narrowing of EU interests in the CDM, both in terms of quantitative limits and qualitative restrictions, and as a result of putting off the point at which the United States may enter the market, there are many firms who are leaving the business or finding different projects worth pursuing. Although the CDM is still the senior international offset mechanism, it is becoming clear that the future will be one of a whole variety of different offset methodologies. There are some reforms still going on in the CDM. Clifford Mahlung, the new head of the Executive Board, has turned out to be more sympathetic to the reform cause than was expected. However, there is still some poor news, including that there has been a comprehensive McKinsey Report on the management and efficiency of the Executive Board system, but that it will not be published.

In the meantime, many are calling for discussion about new instruments. The IETA, for one, is trying very hard to make sense of the new instruments. One thing we know is that we need to work out ways to appeal for the levels of private investment which are going to be necessary to support the CDM moving forward.

Questions and Answers

Q: There are so many different schemes being contemplated around the world. I believe that Japan should also pursue a scheme appropriate to its situation. The role for Japanese companies should be to maintain and improve the world's highest energy efficiency, to contribute to mitigation in all sectors by providing low-carbon materials and products to users, to diffuse manufacturing technology worldwide to contribute to global reductions, and to promote further R&D. I do not think that the role of Japanese companies should be one of one-sided buyers for foreign credits, as this would deprive companies of funding for investment. What do we want the objectives of an emissions trading system to be? I believe that the main objective should be to encourage actual abatement within Japan by promoting low-carbon investments in the long run.

As for my question, I have heard a lot of people say that the EU-ETS has been successful in promoting fuel-switching in the power sector. Beyond that, do you think it is safe to say that the EU-ETS has already been successful in promoting long-term low carbon investment in other industrial sectors, or do you think that this is something that the EU-ETS is still trying to figure out?

Henry DERWENT
I think it is important to understand that the EU-ETS is a tool for reducing the economic costs of regulations to reduce pollution. Nobody would dream of introducing it unless there was an agreed upon need to reduce carbon emissions worldwide. If the market tells you that the cheapest way of achieving a given level of reduction is fuel-switching, then fuel-switching is exactly what you should do, and you should exhaust fuel-switching before you do anything more expensive.

If the task of the EU-ETS was to reduce emissions in 2008 from a 2005 start, quite clearly investment was never going to have such an effect. For a 2012 objective as well, the focus was very short-term. But once you start talking about from now to 2020 you can actually see that the emissions reductions benefits of some investment could be felt within that period. In fact, the EU's target at the moment does go beyond 2020. Part of the policy is to reduce emissions by 1.74% per annum over a multi-decadal framework. There are a number of people still unsure about how their investment decisions should be informed by the post-2020 situation, but when industry gets the message that this price will increase over multiple decades, investment responses will come into their own.

In the meantime, the EU-ETS has been successful at doing what it was asked to do, which was to impose not terribly substantial levels of emissions reductions. In the last few weeks there has been an absolutely comprehensive analysis published by MIT, University College Dublin and the Paris Dauphine University which applies econometric analysis to phase one of the emissions trading scheme and concludes that a 2-5% emissions reduction cannot be explained any other way than by the impact of phase I. Frustratingly, it is very difficult to find numbers that show quite clearly the results of the emissions trading scheme later than that period.

A few points on your introductory remarks - I entirely agree that countries should not deal with their obligations to reduce emissions just by going to the global market and buying credits at the cheapest rate. However, I think the balance between make or buy is very similar to the sort of make or buy decisions that companies across the world make on a daily basis - should we produce this good ourselves or should we go on to the global market and buy it? Should we temporarily go onto the market and buy while at the same time building the capacity to allow us to produce it ourselves? The purpose of carbon pricing is to create out of carbon reductions a factor of production. If it is successful, then people will implement make-or-buy decisions about carbon as they do about other goods or services.

Q: You raised the possibility that the EU would go for a 30% reduction target. Is the IETA going to promote this?

Henry DERWENT
We have a breadth of membership which includes companies which are sympathetic to the notion of increasing the level of reduction across the world, and companies who fear that they will have a lot to lose from this. IETA represents supporters of achieving emissions reductions at the lowest economic cost. Whether the target is 20% or 30%, provided it is big enough for there to be a liquid market in emissions reductions, we are fairly neutral.

Q: I believe that the necessary carbon price to promote carbon capture and storage (CCS) is more than 40 euros. CCS is necessary for the EU and other parts of the world to realize real reductions. What other instruments are there to promote CCS, and does the IETA work to promote CCS?

David LUNSFORD
Allow me to tie this to the earlier question about whether the carbon price is working and whether it is driving new investment. I think there is a lot of empirical evidence that it is. CCS is one of the most expensive technologies on the abatement-cost curve. I think with CCS, we are seeing a lot of corporate activity and research, and certainly a lot of IETA members are involved in setting up demonstrations. So far in the EU-ETS, the current carbon price is not high enough to prompt individual companies to pursue CCS projects on their own. Thus the approach that has been taken is to take some credits stored in a set-aside account and to essentially use them as collateral to additionally credit companies that undertake demonstrations. The result is that you might receive two allowances for sequestering carbon, raising the price to double what it is now.

What I think we have been doing in the IETA is to encourage ways to fund CCS projects through, for example, the clean development mechanism. Although the technology is still expensive, deploying some of these technologies and techniques in developing countries, especially for companies to understand geological formations, is extremely valuable. It is only after these projects are on the ground that we will see the impact of the carbon price over the long-term. I think there is a lot of corporate activity in R&D, but for deploying CCS, I think the government has to play a bigger role in the short-term.

Q: Europe has a carbon tax. Does there need to be two systems in place - carbon taxes on the one hand, and carbon emission trading on the other? How do you reconcile these two different systems?

Henry DERWENT
Everybody has carbon taxes of one sort or another. What is transport-fuel duty but some form of energy tax with a major and often very effective carbon component? There is probably no country in the world where there is a completely separate set of taxes for separate parts of the economy without some form of overlap. Broadly, taxes and specific pollution control arrangements have existed side-by-side in many countries for a long time. If you want to look at differentiation, than I think the picture that you see in Europe at the moment is actually reasonably differentiated. There are proposals in the new communique that I mentioned for harmonizing and rationalizing carbon taxation so that it applies to those sectors of the European economy which are outside the coverage of the EU-ETS. That then begs the question of whether the EU-ETS, which was always intended to spread into other sectors, is going to stop where it is because everything else is going to be covered by a tax, or whether that is something that is going to be addressed year-to-year or as opportunities to review the situation arise. There ought to be a much better body of academic analysis to determine the precise circumstances, sectors, value chains, and positions on the value chain where you would get better response from a tax as opposed to a price or other forms of intervention, because there are elasticities of demand associated with tax and price and regulation which are different depending on where they are applied. Unfortunately, as of right now, there is not an authoritative academic body for research into this issue, and I challenge everyone to consider working on this.

*This summary was compiled by RIETI Editorial staff.