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CO2 Markets

This brings us to the question of CO2 emissions and cap-and-trade markets for CO2. The first serious stab at reducing CO2 emissions came with the Kyoto Protocol. The Kyoto Protocol set binding targets for 37 industrialized countries and the European Community for reducing greenhouse gas (GHG) emissions. The goal was to reduce the GHG emissions of these countries in 2008-2012 to a level of 5 percent below the level of emissions of 1990. The detailed rules for the implementation of the Protocol were adopted at COP 7 in Marrakesh in 2001 and came into effect on February 16, 2005. Under the UNFCCC, the countries needed to meet the emissions standards with national measures. However, the Protocol created flexibility. As we noted in Chapter 2, it allowed each country to meet the targets with additional measures: (1) cap-and-trade, (2) Clean Development Mechanism, and (3) Joint Implementation (JI). Below we discuss the CDM and the JI in brief. The most important element of the Kyoto Protocol, the cap-and-trade markets, is discussed in greater detail at the end.

Under the Clean Development Mechanism, emissions-reduction projects in developing countries can earn certified emission reduction credits. Industries in the developed countries can use these saleable credits to meet a limited part of their emissions reduction targets under the Kyoto Protocol.

One key element of the CDM is the mechanism for verifying compliance. Some are easy to verify. For example, one of the projects funded for the CDM was the Delhi Metro. It was fairly easy to calculate the benefits of CO2 accrued due to the project. Similarly, another project funded was the 2012 extension ofthe Mexico City Metro. For these kinds of projects, compliance is not a problem.

There are, however, potential problems with the CDM. It has been argued by some advocates of small-scale developments that the CDM would allow large companies in developed countries to impose projects that are not in the best interests of host countries. The CDM now requires that host countries verify that CDM projects contribute to their own sustainable development. Such certification processes are also not without problems. Since developing country government officials are more susceptible to bribes, it is possible that such processes can be corrupted easily.

Joint Implementation means one country in Annex I[1] can implement a project in another country in Annex I to reduce CO2 emissions to earn credits for reducing emissions. The aim of the JI is to encourage clean energy technology use in the so-called “transition economies”—the countries of the former “Eastern Bloc” (countries such as the Russian Federation and Ukraine that lack modern technology for power generation and other areas).

The logic behind the Kyoto Protocol can be illustrated by the following (see Figure 7.4). In 2010, total emissions in the world were about 43 gigatons of CO2. By 2050, they are slated to grow to over 70 gigatons per year if nothing is done. The emissions would not change much in the European Union over the next forty years. They would go up marginally in the US and the rest of the OECD. However, the main growth of the emissions would come from the BRICS (Brazil, Russia, India, China, and South Africa) and from the rest of the world if nothing is done. Therefore, to make any headway into a possible future reduction, two things have to happen. First, there has to be an absolute reduction in emissions in the developed world, which accounts for nearly 40 percent of the emissions today but contains less than 20 percent of the world’s population. Second, the developing countries need to have the technology of the developed world today in order to reduce their emissions.

In this section, we will discuss two separate markets: one compulsory (European Union Emissions Trading System (EU ETS)) and one voluntary (Chicago Carbon Exchange (CCX)). As a direct result of signing of the Kyoto Protocol, the European

CO2 emissions up to 2050 by blocks of countries

Figure 7.4 CO2 emissions up to 2050 by blocks of countries

Union set up an emissions trading system for 11,300 energy-intensive installations across the 27 Member States. In the Kyoto Protocol, the EU has set its emissions reduction target to 8 percent by 2012 compared with the level observed in 1990. This goal has been modified into emissions reduction objectives at the Member State level following the so-called “Burden Sharing Agreements.” In 2003, Directive 2003/87/EC established a scheme for greenhouse gas emission allowance trading within the Community and amending Council Directive 96/61/EC creating the European Union Emissions Trading Scheme. It explicitly recognized the following six gases as greenhouse gases: Carbon dioxide (CO2), Methane (CH4), Nitrous Oxide (N2O), Hydrofluorocarbons (HFCs), Perfluorocarbons (PFCs), and Sulfur Hexafluoride (SF6). The scheme covered about half of all GHGs at the EU level.[2]

There were three phases of the market envisioned in the plan. Phase I went from 2005 to 2007—the so called warm-up period prior to the introduction of the Kyoto Protocol. Phase II went from 2008 to 2012. It is concomitant to the Kyoto Protocol. Phase III is supposed to go from 2013 to 2020. Phase III corresponds to the objectives of the EU “Energy-Climate Package” introduced in January 2008 to reduce emissions by 20 percent by 2020 along with increasing energy efficiency by 20 percent and increasing the share of renewable resources in the energy mix to 20 percent. This plan became known as the “20-20-20 target.”

EUA 2007 and EUA 2008 prices in the EU ETA market

Figure 7.5 EUA 2007 and EUA 2008 prices in the EU ETA market

The allowance for one contract exchanged on the EU ETS corresponds to one ton of CO2 released into the atmosphere. It is called a European Union Allowance (EUA). For the Phase I, 2.2 billion allowances per year were distributed (20052007). During the Phase II (2008-2012), 2.08 billion allowances per year were distributed.

Figure 7.5 displays the movement of daily EUA prices between 2005 and 2008 for the contracts expiring in 2007 and 2008. The first notable feature of the prices is that they were volatile. The price covered an enormous range over a relatively short period of time. The second feature is that the EUA 2007 and EUA 2008 prices moved in tandem and close to each other over a year before the dramatic fall of the EUA 2007 price. Since EUA 2007 contracts did not have much value after 2007, it was expected that the prices would diverge at the end. But when they were both valuable, both the prices were close. In economic terms, these products were close substitutes for a while and therefore had very similar prices. This phenomenon is called the “law of one price” in economics.[3] It is often used as an acid test for understanding the pricing of a product. As we will see below, the price in other

Co-movement prices of different contracts in the EU ETA market

Figure 7.6 Co-movement prices of different contracts in the EU ETA market

parts of the world for one ton of carbon has not been the same. This illustrates that the price is critically dependent not just on the current laws governing the market but also future expectations about the legal status of the market. For example, we saw how the successful challenge of CAIR in the courts caused the collapse of the SO2 market in the US.

Each year, the EU ETS issued more permits with expiry dates and then they were traded in the markets. In Figure 7.6, we examine the co-movement of three such contracts over time: EUA2008, EUA2009, and EUA2010. Once again, the prices show closeness that shows us that they were being treated very similarly in the marketplace.

In addition, we performed correlation analysis between the EUA2009 and EUA2010 prices. It shows that the correlation between the prices is 0.9988. It can also be seen when we plot these two prices together in Figure 7.7.

The EU ETS market was a compulsory market—the companies in the EU were forced to participate. In addition, in the US, another experiment was conducted by a voluntary market called the Chicago Carbon Exchange. This was the brainchild of Robert Sandor.[4] He took his cue from an observation of the economist Ronald Coase.[5] Coase observed that while economists have argued that economic agents would not pay for public goods with positive externalities (such as the maintenance of a lighthouse), in fact, the Trinity House, a private consortium, has been building lighthouses in England for five centuries and making profits.

Law of one price in EU ETA

Figure 7.7 Law of one price in EU ETA

While this was a voluntary market, over time it managed to capture 17 percent of the value of the companies listed in the Dow Jones Index. It represented 25 percent of the power industry, and during the peak year, it managed to reduce more CO2 than France did (which operated under the compulsory market of the EU ETS).[6] The CCX not only managed to do business in the US market, but it also helped to generate CO2 reductions in far-flung places like Kerala, India.

In a number of villages in Andhra Pradesh and Kerala, the CCX helped develop collection of waste from cows that were used for capturing methane to be used for cooking. For doing it, families received a financial incentive of about USD 2 per month. As a result, the amount of GHG reduced more than offset the “cost” of carbon capture by other means, as wood burning became unnecessary. It also generated a bonus. In those villages, small school-age girls were used to fetch wood and sticks to burn for cooking. Their time was freed up, allowing them to attend school. Moreover, the use of methane burning stoves reduced the air pollution inside the huts, improving the health of those villagers.[7]

Sandor sets out the requisites for a successful launch of financial products. First, the financial products have to be traded in a well-defined exchange. Second, the trades have to be completely transparent to all the market participants. Third, they have to be regulated. Here, he noted that it does not have to be regulated by the government. The exchange can be self-regulated (such as the lighthouses in England). Finally, there should be a central clearing system in the market to minimize counterparty risk. He notes that these conditions are sufficient for a market to work, but all conditions are not necessary. Products such as interest-rate and foreign-exchange swaps are not centrally cleared, but they work well.[6] He also insists that there has to be a standard product for the market to work well. Without a well-defined product, the market would collapse. There is also a need for evidence of ownership of the product. If property rights are not well established, the market will not work.

Sandor explained why a volunteer market like the CCX would work. There is no single reason why all the parties came to trade. Some companies traded because they had business to conduct in the EU. That was the case with the Ford Motor Company. Baxter Laboratories traded in the market because they wanted to create goodwill. They wanted to be part of the green market. Other companies came in because they anticipated that sooner or later the market will be implemented across the entire nation. They wanted to have a practice run. In Figure 7.8, we display the entire experiment between 2003 and 2011 with volumes that were traded in the CCX, along with the prices at which they were traded.

The EU ETS and CCX markets are not the only two in the world. There are a few others. For example, within the US, California started operating a market on November 14, 2012. Its stated goal is ambitious: California wants to reduce the 1990 level of CO2 emissions by 80 percent by 2050. California’s plan faces numerous challenges. California imports about 30 percent of its electricity from neighboring states. Consequently, the California Air Resources Board (CARB) crafted the cap-and-trade program to account for the emissions of out-of-state generators in an attempt to ensure it does not lead to greater emissions from power plants elsewhere (the so-called carbon leakage problem). That has resulted in a complex set of rules applying to “first deliverers of electricity”—companies in

Chicago Climate Exchange market price and volume

Figure 7.8 Chicago Climate Exchange market price and volume

California that receive power from sources outside the state. Under those rules, first deliverers must account for the greenhouse gas emissions of power sources located outside California and comply with the cap-and-trade scheme accordingly.

They are also prohibited from “resource shuffling”—or making changes that reduce the emissions reportable to CARB, but do not actually lower the total level of emissions they produce. For example, if a firm in Arizona now supplies electricity from a coal-fired plant to California and from a wind farm to Nevada, it might switch these around, rerouting electricity from the coal-fired power plant to Nevada and from the wind farm to California. The rules are designed to prevent such occurrences. However, there are a number of challenges pending in the courts against these rules. It is also being challenged in the federal courts for violating the US Constitution because it is seen as an impediment to interstate commerce.

The Regional Greenhouse Gas Initiative (RGGI) is another mandatory program to reduce greenhouse gas emissions in the US. The RGGI is a cooperative effort among nine eastern states of the US: Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New York, Rhode Island, and Vermont. Together, these states have capped and will reduce CO2 emissions from the power sector by 10 percent by 2018. Originally, New Jersey was also part of the RGGI. In 2012, New Jersey pulled out of the program after the Governor argued that it was not an effective way of capping emissions.

The Australian government started pricing carbon by imposing a carbon tax on July 1, 2012. The ultimate policy goal is to create a market-based emissions trading scheme in three to five years. The tax began at a fixed price of AUD 23 per metric ton of CO2e. Due to political pressure, the floor price later was dropped to AUD 15 for 2015. The long-term goal is to reduce emissions to 5 percent below 2000 levels by 2020. Critics have argued that the policy to cut emissions is regressive: low-income households carrying a relatively higher burden. To reduce the burden for the low-income households, the government has introduced a rebate and refund system.

Imposing a carbon tax (as they did in Australia) raises a question about supply: how will the existing supply be affected by a carbon tax? This question has been studied in Brito and Curl. They show that, in the US, if the price of CO2 is USD 10 or below per metric ton, it affects very few power units. However, with a CO2 price between USD 30 and USD 40, over 70 percent of the production units will shut down. Thus, indefinitely raising the price of carbon in the short run can generate a huge shortage. Therefore, any carbon tax has to be announced well in advance, as it takes several years to build electrical power generating plants.[9]

Unlike the quantitative target of a cap-and-trade system, Australia has introduced a tax on the price of carbon. As we discussed in Chapter 6, in theory both types of measures achieve the same goal of reducing consumption. However, with a price mechanism it is much more difficult to reduce the quantity consumed by some

Price and consumption of gasoline per capita in OECD

Figure 7.9 Price and consumption of gasoline per capita in OECD

given amount in the long run, since the short-run and long-run demand curve for energy consumption vary substantially. The short-run price elasticity is much lower than the long-run price elasticity because substitution of one form of energy by another is more difficult to achieve in the short run. We illustrate the relationship between price and quantity of energy related product in Figure 7.9. It shows that a higher (equilibrium) price in the market is associated with a lower (equilibrium) level of consumption.

Australia has also announced that by 2015 it will introduce a cap-and-trade system and that it will link the market to the EU ETS market.[10] In fact, in November 2012, Australia’s Securities and Investments Commission granted the first 11 licenses to trade emission permits in Australia. However, the opposition party has vowed that it will dismantle the whole carbon tax and related policies if it gets elected in the next Federal election (due by 30 November 2013).

In our discussion above, we observe that the price of carbon differs in different countries. The law of one price does not seem to hold. There is a clear reason for it. The future viability of carbon markets is not clear in many places. There are potentially fatal lawsuits that could invalidate the operations in some markets (such as California). There are legislative threats coming from the opposition in Australia. But, in Australia, we will not have a market-determined price of carbon until 2015. Moreover, if the opposition gets into power that prospect may be doubtful. Progress in multilateral treaty negotiations also is doubtful, with a very limited number of countries agreeing to extend their participation in the Kyoto Protocol (see Chapter 2). All of this makes the same ton of CO2 emissions different in different jurisdictions. This explains why prices are not (yet) equalizing across countries and regions.

In two other OECD countries, carbon taxes and cap-and-trade markets have been implemented: Ireland and Norway. Ireland has imposed a straight carbon tax (like Australia), but the main purpose has been to use the money to bridge the budget deficit. It has generated results on both counts. It has produced taxes to the tune of 25 percent of the budget deficit. It has also reduced carbon emissions by 18 percent compared with 2007. Norway, on the other hand, has closely followed the cap-and-trade model of the EU ETS.

China has proposed pilot programs of cap-and-trade in five provinces and two cities for 2013: Beijing, Shanghai, Tianjin, Chongqing, Shenzhen, Guangdong, and Hubei. Some of them are cities with large industries and others are states with large industrial hubs. In addition, in April 2013, China announced a joint initiative with the US. The indications are that China is examining both the Australian carbon tax scheme and the SO2 market in the US.

Chan et al. perhaps provide the best summary of what we can learn from the SO2 market for the CO2 case:

Ironically, the cap-and-trade model seems especially well suited to addressing the problem of climate change, in that emitted GHGs are evenly distributed throughout the world’s atmosphere. Emissions reductions anywhere make identical contributions to helping alleviate the problem, and there are no pollutant concentration hot spots. The sheer number and variety of GHG-emissions sources heightens the practical difficulty of developing a comprehensive and effective command-and-control approach and magnifies the cost savings that could be achieved by enlisting the market to find the least costly abatement options.

It is difficult to achieve an international agreement to limit GHG emissions, however, for precisely the same reasons—many countries, hosting many emissions sources, must agree to take action. Given the complexities of either developing a domestic U.S. cap-and-trade system for GHGs or obtaining congressional approval for an international system in which the United States participates, it is likely that at least as much bipartisan collaboration would be required as was evident in the . . . process [to enact the Clean Air Act Amendments that established the Acid Rain Program]. Instead, we have much less.

The stakes for a broad-based GHG policy—economic, political, and environmental—are much higher than they were for SO2 policy in 1990. While the debate over federal policy to address climate change is currently in hiatus, the lessons of the SO2 allowance-trading program will prove useful and relevant to future deliberations about climate change policy when the time arrives for serious reflection.[11]

If the fragmented CO2 markets of China, Australia, the EU, RGGI, and California band together, they can produce a vast market for CO2. In that market, they would compete for clean energy technology and buy up permits to drive up the demand for clean air technology. The experience with the SO2 market in the US suggests that such an approach would be an effective means to achieve emissions reductions and clean energy technology dissemination and adoption. It would be even more effective with more players. Indeed, if the countries that account for the majority of GHG emissions could negotiate such an agreement, it would represent a big step forward.

  • [1] Annex I countries as of the end of 2012 are: Australia, Austria, Belarus, Belgium, Bulgaria,Canada, Croatia, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary,Iceland, Ireland, Italy, Japan, Latvia, Liechtenstein, Lithuania, Luxembourg, Malta, Monaco, Netherlands, New Zealand, Norway, Poland, Portugal, Romania, Russian Federation, Slovakia, Slovenia,Spain, Sweden, Switzerland, Turkey, Ukraine, United Kingdom, and the United States of America.
  • [2] Directive 2003/87/EC establishing a scheme for greenhouse gas emission allowance tradingwithin the Community and amending Council Directive 96/61/EC (October 13, 2003) (accessed January13, 2013).
  • [3] Law of one price has been tested in different markets. In the commodities markets, there is someevidence that the law of one price holds: John Pippenger and Llad Phillips, “Strictly Speaking, Law ofOne Price Works in the Commodities Markets” (2007) Working Paper, University of California,Santa Barbara. However, there are well documented anomalies in the financial markets: OwenA. Lamont and Richard H. Thaler, “Law of one price in the financial markets” (2003) 17 Journal ofEconomic Perspectives 191.
  • [4] Robert Sandor, Good Derivatives (John Wiley & Sons, Hoboken NJ 2012).
  • [5] Ronald H. Coase, “Lighthouse in Economics” (1974) 17 Journal of Law and Economics 357.
  • [6] Sandor, Good Derivatives.
  • [7] CCX Project 1021, Biogas Digester Project, Angamaly, Kerala, India, 2003—2008.
  • [8] Sandor, Good Derivatives.
  • [9] Dagobert L. Brito and Robert F. Curl, “Economics of Pricing the Cost of Carbon DioxideRestrictions in the Production of Electricity,” James Baker Institute, Rice University Working PaperJuly 2010, 13 Fig. 3.
  • [10] On April 16, 2013, in a surprise move, the European Parliament voted down a proposal tocontinue the support of the ETS. It might cause the collapse of the entire ETS cap and trademechanism. This may not doom the cap and trade globally. As we have noted in Chapter 1, there isa US—China joint initiative in the offing. The collapse of the ETS may encourage the European Unionto back the new US—China initiative.
  • [11] Gabriel Chan et al., “The SO2 Allowance-Trading System and the Clean Air Act Amendments”(2012) 65 National Tax Journal 419.
 
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