RIETI Report April 2010

The Numerous Unprecedented Challenges of GHG Emissions Trading

The author of this month's RIETI Report, RIETI Fellow Kazunari KAINOU, is a professor at Osaka University Research Institute for Sustainability Science and an expert on climate change. Professor Kainou has participated in numerous international conferences and was a lead author for the 2006 National Greenhouse Gas Inventories Programme (NGGIP) of the Intergovernmental Panel on Climate Change (IPCC).

Professor Kainou's article focuses on the numerous challenges Japan faces as the government investigates how best to identify and develop an institutional framework for the trading of greenhouse gas emissions. He focuses on several critical issues including: the pros and cons of various regulation systems, how to set the initial allocation of emission allowances and who should bear the costs, and the possible penalties for non-compliance.

This month's featured article

The Numerous Unprecedented Challenges of GHG Emissions Trading

KAINOU KazunariFellow, RIETI / Professor, Osaka University

Questions surrounding GHG emissions trading

An internal study is currently underway within the government to identify and develop an institutional framework for the trading of greenhouse gas (GHG) emissions within Japan. Whether or not to introduce such a system is a political issue, however, as an administrator who has spent years doing practical tasks - including the development of General Energy Statistics - for the assessment of GHG emissions from energy sources and diverse economic analyses of energy-related issues, I see a daunting task ahead. Designing an institutional system for GHG emissions trading involves solving a range of complex problems. And each one of them looks to me like a mountain of unprecedented challenges. In what follows, I would like to provide an outline of the major challenges facing us. I hope that this will help deepen the understanding of the issues among the parties concerned and contribute to the designing of the system. Needless to say, there are many issues and views other than the ones I will discuss here, but due to space limitations, I will narrow my focus to certain critical issues. I hope that readers - particularly experts in their respective fields - understand that.

Question 1: Who should be regulated and where?

Broadly defined, there are two types of approaches for regulating GHG emissions, namely, the upstream approach in which emissions allowances would be allocated to the importers or producers of fossil fuels and the downstream approach in which such allowances would be allocated to fossil fuel users.

In the upstream approach, all the fossil fuel imported to or produced in Japan would be regulated whereby relevant costs - including the cost of purchasing emission rights - incurred by fossil fuel importers would be transferred to those who actually consume the fuel downstream. That is, all the users, whether households or companies, would bear their share of the costs in the form of energy prices. Under this type of system, only importers and producers would be subject to monitoring and therefore it is relatively easy to enforce and ensure compliance by regulated entities with their emission reduction requirements. However, because this is tantamount to awarding the sole distributorship of emission rights to fossil fuel importers, strict monitoring would be required to prevent excessive cost transfers and withholding to raise prices. It would also give rise to the question of what sort of safety net to provide to guard against risks associated with an event of force majeure, for instance, the shutdown of nuclear reactors caused by a major earthquake.

In contrast, the downstream approach would regulate GHG emissions at the point of fossil fuel combustion and energy consumption whereby the scope of regulated entities would be limited to large companies and establishments in practice. The effectiveness of such a system would be called into question because the household sector where GHG emissions have risen sharply since the 1990s and a large part of the service sector comprised of numerous small and medium-sized enterprises (SMEs) would be left unregulated. Applying emission control regulations to SMEs at the moment would not be a viable option because, even though it has been four years since I began collecting data on energy consumption and other relevant activities by SMEs, I still face difficulties dealing with numerous erroneous data entries. Even if we attempt to forcibly implement a far-reaching system to regulate not only major companies but also SMEs at this point in time, we would just end up creating confusion, rather than achieving goals. I believe that it will take considerable time before we can include SMEs as regulated entities.

Question 2: How to account for indirect GHG emissions associated with the sale/purchase of electricity and heat?

The adoption of a regulation system based on the downstream approach would give rise to the question of how we should account for indirect GHG emissions associated with the sale/purchase of electricity and heat. According to Article 2 of the Act on Promotion of Global Warming Countermeasures, "greenhouse gases generated in conjunction with - the use of electric power or heat - that is supplied by others" should be counted as greenhouse gas emissions from the users of electric power or heat. Likewise, it has long been established under the relevant law and regulations, including the Act on the Rational Use of Energy, that energy loss associated with the generation of electricity and heat should be accounted for as incurred by users. This type of approach is referred to as the "indirect method."

Meanwhile, in designing its emissions trading system, the European Union adopted the "direct method," under which GHG emissions associated with the use of electricity and heat are accounted for as emissions not from users but from providers, i.e. utilities that burn fossil fuel to generate and provide electricity or heat. The EU chose this method in order to facilitate the smooth operation of its emissions trading mechanism by avoiding some tricky issues regarding "emission factors," or the amount of GHG emissions per unit activity, to be discussed later.

The use of the direct method would make the emissions trading system less complicated and easier to implement. At the same time, however, it would cut off the linkage between energy saving efforts by users and the achievement of emissions reduction goals, nullifying the efforts of those companies that have moved quickly to invest in energy saving technologies in line with the Act on Promotion of Global Warming Countermeasures and the Act on the Rational Use of Energy as well as of those consumers who have bought green home appliances. The direct method is also problematic in that it would enable certain regulated entities to achieve "fake" reductions. Specifically, a company that has in-house power generation or cogeneration plants would be able to achieve reductions simply by switching from those in-house power sources to purchasing from power utilities.

The indirect method, however, also has a big problem, namely, how to determine and apply emission factors for electricity and heat.

Suppose that the value of the emission factor for electricity supplied by a certain power utility changed due to a shutdown of a nuclear power reactor or for other reasons attributable to the utility. It would be unreasonable if this resulted in changes in the amount of GHG emissions from users. Therefore it is necessary to take adequate measures to prevent this, for instance, establishing a base year and having the emission factor for users locked to the base year value, while at the same time introducing rules that would enable power and heat utilities to receive the allocation of emission allowances equivalent to the amount of emissions reduced by improving the emission factor. It should be noted, however, that fixing an emission factor value over a long period of time could result in significant deviation from actual emissions associated with the use of electricity and heat.

Question 3: How to set the initial allocation of emission allowances and who should bear the costs involved?

Whether we pursue the upstream approach or the downstream approach, setting the initial allocation of emission allowances is a critical issue. Broadly speaking, there are two kinds of problems, i.e. those associated with the design of the emissions trading system and those associated with cost sharing.

Design-related problems include which year should be selected as a base year in setting the initial allocation of emission allowances and what percentage of the actual amount of GHG emitted in the base year should be allocated as an initial allowance. Should Japan choose a year as long ago as fiscal 1990 (April 1990 through March 1991) as a base year, it would be impossible to allocate initial allowances based on historical emissions due to the lack of necessary data. In such a case, auctioning would be about the only possible allocation approach. On the other hand, if the average annual emissions in the past five years are defined as the base year value, it would be possible to allocate allowances on the basis of historical emissions. But this approach is also problematic because it would work to penalize forerunners, nullifying the efforts of those companies that have achieved high energy efficiency and reduced GHG emissions ahead of regulatory requirements by making significant investments and taking extensive measures in line with Keidanren Voluntary Action Plan on the Environment.

But this does not justify the government to dictate the allocation of emission allowances to individual regulated entities by "taking all circumstances into account." Such an approach, which represents nothing but the idea of a "controlled economy" as often referred to by Nippon Keidanren (Japan Business Federation), is the worst choice that must definitely be avoided in view of the experience of the EU with its dominantly grandfathering approach. In introducing its emissions trading program, the EU effectively left it to each member state to decide the initial allocation of emission allowances. As it turned out, countries tended to be generous in allocating allowances to exporting industries out of consideration for the need to maintain international competitiveness, while taking a strict attitude toward domestic industries. We must remember that this opaque and distorted allocation approach caused a sudden collapse of emission allowance prices in the second half of Phase I of the EU emissions trading program.
Cost-related problems concern such questions as whether the initial allocation of emission allowances should be free, and if not, whether the allocation should be done by means of auctioning. Free allocation under the upstream approach is a prescription for windfall profits for fossil fuel importers because they would be given the sole distributorship for free. Therefore, if the upstream approach is to be adopted, the initial allocation of allowances must be paid for and, if at all possible, should be done by means of auctioning. But in auctioning, prices are inevitably unstable and unpredictable. Thus, the full-scale introduction of auctioning would entail the risk of unreasonably driving up domestic prices for energy and other goods and services. On the other hand, under the downstream approach, the introduction of a paid-for system from the very beginning would impose undue burdens on regulated entities because it would be difficult for those in the downstream sectors to transfer the costs onto others. Thus, in case of the downstream approach, it is perceived necessary to allocate significant portions of allowances free of charge in the initial stage. From the viewpoint of maintaining the international competiveness of export industries, free allocation is a very attractive option. But we must not forget that such allocation is just another instance of vested interests, which could pose problems to competition unless properly reviewed over the medium- to long-term period.

In Phases I and II of the EU emissions trading program, for which significant portions of the emission allowances were allocated for free, electricity rose to abnormal levels, posing serious challenges for competition policy. Learning lessons from this experience, the EU is now trying to shift to an auctioning system. However, once vested, interests are difficult to rebalance and the EU seems to be having a very tough time coordinating the interests of regulated entities.

Question 4: What penalties for noncompliance?

Though this point is rarely focused upon in Japan, what penalties should be applied in case of noncompliance is just as critical as the question of how to allocate initial allowances.

Imposing relatively lenient penalties would minimize damage on the real economy in the event of unsuccessful implementation due to "incipient faults" such as those attributable to operational flaws or caused by an unexpected incident. However, this would create a loophole for regulated entities because they could get away just by paying nominal fines without taking any effective measures to reduce emissions.

On the other hand, imposing severe penalties may turn out to be a dangerous scenario. In addition to producing effects opposite to those discussed above, there are two possible outcomes. First, it could place Japan in a situation where it could be taken advantage of by other countries, and second, it may effectively force Japanese manufacturers to give up on maintaining domestic production. In Japan, where extensive energy-saving measures have already been implemented, taking additional GHG abatement measures is relatively costly and time-consuming. And it is generally deemed reasonable that Japanese emitters purchase relatively cheap certified emission reduction (CER) credits from developing countries under the Clean Development Mechanism (CDM) of the Kyoto Protocol in the foreseeable future. But then, if severe penalties were imposed on Japanese emitters, CER credit issuers would be able to take advantage of the situation to force big-ticket purchases. That is, using the amount of penalties as a yardstick, they would be able to adjust the quantity of credits to offer to manipulate prices, just like the Organization of the Petroleum Exporting Countries (OPEC) manipulates oil prices through production adjustments among member countries. Particularly given the fact that major credit issuers under the CDM are limited to only a few countries such as China, Russia, and Ukraine, it is important to pay careful attention to the behavior of these countries so as to avoid making expensive purchases.

Regarding the second possible outcome of imposing severe penalties mentioned above, i.e., that Japanese manufacturers abandon domestic production, the reason for such action is obvious and therefore needs no explanation from me.

Worst scenario

In introducing an emissions trading system, it is necessary to prevent the occurrence of the following two events on a short-term time horizon:

  • - Weary of arbitrary and inconsistent regulations and/or requirements to achieve targets that are unacceptably high in view of international competition, export industries move operations overseas, resulting in declines in employment as well as in the vitality of the national economy.
  • - Higher energy prices - whether as a result of the unreasonably high cost of CER credits or the abuse by fossil fuel importers of their status as a de facto sole distributor of emission rights ? create an undue economic burden.

As a way to prevent the occurrence of these events as much as possible, it is considered reasonable that Japan, as in the EU, introduces a tentative system based on the downstream approach with the free allocation of emission allowances and relatively lenient penalties. However, in order not to repeat the failure of the EU, initial emission allowances must be allocated in an objective manner based on the historical emissions over the last 10 years or so, definitely not in an opaque manner on the discretion of the government.

My personal view is that Japan would be better going ahead with an easy-to-implement emissions trading system - even if it is somewhat problematic in design and likely to cause some friction - than opting for what I perceive as the worst scenario. Even a system with design flaws at the beginning would eventually take root in Japan as the understanding of the necessity of the system would gradually spread, provided that it is made subject to regular review and adjustments. For instance, the government could conduct a policy evaluation every five years to steadily improve the system, such as gradually expanding the scope of regulated entities to include SMEs, increasing the penalties, shifting to a paid-for system, and if necessary making amendments to the reduction targets.

The worst scenario is that the government, once having established an emission trading system and emission reduction targets, becomes so rigidly wedded to them that it fails to review and make necessary changes. This would result in the disappearance of manufacturing plants and the bizarre sprouting of inefficient, small establishments below the threshold for emissions control in regional areas in the regional areas of Japan, whereas it would become customary practice for entities located in the urban areas to get away with just paying penalties. Should this happen, no progress would be made on the development of effective energy-saving and new energy technologies, whereby the government would have no choice but to pursue its fruitless policy of endlessly continuing to purchase unduly expensive CER credits from developing countries.

>> The original column was published in Japanese on February 23, 2010

References:

  • Maeda, Akira. Haishutsuken Seido no Keizai Riron [An Economic Theory of Emissions Trading Systems]. Iwanami Shoten. 2009.
  • Saijo, Tatsuyoshi, Hidenori Niizawa, and Kazunari Kaino. Chikyu Ondanka no Keizaigaku [An Economic Theory of Global Warming]. Osaka University Press. 2009.

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