Course:CONS200/2021/Cap and Trade: What It Is, How It Works, Does It Work, and More.

Introduction

The cap-and-trade carbon emission regulation program is a new method of reducing carbon emissions from polluters using a market-based system. One such system was implemented in California in 2013, and has since been successful in helping the state achieve their 2020 emission reduction goal in 2016. The program functions in a market style. The government places a “cap” on greenhouse gas (GHG) emissions, which they reduce year by year. Companies can then obtain permits for every ton of carbon they emit, either by purchasing them or receiving a grant from the state. As well, if a polluter has an excess emission allowance, they can use it for trade with another polluter, incentivizing companies to lower emissions. This system helps polluters reduce their GHG emissions at a sustainable level, and it also directs reduction efforts to the most accessible solutions. The revenue that the state earns from selling emission permits is put towards other programs that work to reduce GHG emissions. To date, cap-and-trade has slowly been implemented in many other nations/regions across the globe such as China, the European Union, Australia, New Zealand, South Korea, and Quebec.

How Cap-and-Trade Systems Work

Figure (1): This graphic depicts a simple cap-and-trade system. The lower producer of emissions benefits from income, and the higher producer gains an increased emission allowance.

The cap-and-trade system functions through two main components. The “cap” portion is a strictly imposed limit on GHG emissions, progressively lowered over time. The “trade” portion is a market where companies can purchase, sell, or trade emission allowances.

In California, an emissions cap is set statewide. Over time, the cap is lowered at a sustainable rate, California typically reducing the cap by 3% each year. This offers companies the chance to gradually reduce their GHG emissions, making reduction a more attainable goal.

The cap is distributed among companies using allowances. An allowance is a permit with a unique serial number that allows a holder to “emit one metric ton of carbon dioxide equivalent greenhouse gas emission“. Allowances are initially granted for free but are later purchased from the state at auctions.

If a company is able to efficiently achieve their goal and reduce emissions quickly, they can offer excess allowances in trade with other companies. This system rewards companies that innovate and cut emissions efficiently, and it allows more flexibility for companies that struggle with reducing their emissions. The trade method also targets the simplest and cheapest ways to cut carbon emissions first, improving the efficiency of reduction methods. The market encourages companies to create new technology and innovative methods to reduce their GHG emissions, so that they can use the allowances as capital to put towards other components of their business.

The revenue generated by sale of allowances at state auctions is placed in the Greenhouse Gas Reduction Fund (GGRF), which uses the funds to implement and improve other programs that aim to reduce greenhouse gas emissions. Some of these programs include long-term sustainable development plans, and improved public transportation like high-speed rail.

Industries and Companies That Participate

The California Air Resources Board cap-and-trade program consists of around 450 participating entities, spread across the electrical, industrial, transportation and natural gas sectors. The program began in 2013 with electricity generators and large industrial facilities, increasing scope in 2015 to include distributors of transportation, natural gas, and other fuels. In total, this system places a cap on around 85 percent of the state’s GHG emissions.  Some notable entities that participate in the program are listed here:

• Anheuser-Busch
• California Institute of Technology
• Chevron U.S.A.
• Frito-Lay
• Royal Bank of Canada
• Tesla Motors

Regulation, Monitoring, and Enforcement

Regulations Within Different Trading Systems

Every cap-and-trade system is unique in the way GHGs are measured, how rules are enforced, and how the participating parties are regulated. However, the general method of regulation and enforcement are similar across all systems as all schemes require standard measuring, reporting, and verification for a market emissions market to function fairly and efficiently. In every trading system GHG measurements are reported to a regulating party who is in charge of maintaining a registry of all emission inventories at the national and regional level. These measurements have to be made in accordance with international standards set in the Kyoto protocol. It is also important to note that the type of GHG that companies can trade is dependent on the system in which they reside. Systems located in Japan and Europe prefer the limited model, while those located in North America and the Pacific tend to prefer a model that covers all seven Kyoto gases ( carbon dioxide (CO₂), Methane (CH₄), nitrous oxide (N₂O), hydrofluorocarbons (HFCs), perfluorocarbons (PFCs), sulfur hexafluoride (SF₆), Nitrogen trifluoride (NF₃). The limited model accounts only for CO2 and is easier to monitor, whereas the model covering CO2 plus other gases gives entities greater flexibility to achieve emissions reductions. For trading between regional systems, the inventories of GHG must be consistent with equivalent units and measurement techniques. Compliance and transparency policies are decided and agreed upon by the two or more inter-linked systems to ensure fair and equitable trading protocol. Every system is defined by the status of regulation, regulation coverage, allowance allocation, compliance flexibility, emissions reporting and verification, compliance and enforcement, and inter-systems linkages. The California Air Resources Board (CARB) adopted the first set of regulations in 2011 which has now been used and adopted by many other trading systems.

Measurement

Every emissions trading system requires effective monitoring, reporting, and verification (MRV). Monitoring involves emissions quantification through calculation or direct measurement, which must then be consolidated in an emissions report. Measurement reports are done by the participating business entities and need to be verified by independent service providers or through similar audit processes depending on the trading system. The International Carbon Action Partnership (ICAP) recommends that regulators must provide a complete guideline that includes the following key elements of an MRV system:

1. Methodologies for accounting and quantification of emissions and other necessary data
2. Guidance on monitoring methodologies
3. Templates for reports
4. Rules for the accreditation and use of verifiers
5. Details on the exchange and management of data

Monitoring

Regulators are also responsible for implementing and operating a monitoring system that refers to the process of collecting the data necessary to quantify emissions. There are a variety of different approaches to monitoring trading systems across jurisdictions due to the differing capabilities of regulators and participating entities. The Intergovernmental Panel on Climate Change (IPCC) encourages the use of a tier based system which is based upon the amount of GHG emitted. Less rigorous requirements are imposed on smaller emitters whereas larger emitters will need to complete more complex reporting and monitoring reports. Regulators are encouraged by the IPCC to balance a need for accurate and robust data while limiting the potential for gaming, ensuring a fair and open market. This is especially important in the early phases of an emissions trading system when there is a lack of historical time series of monitored and reported data.

Reporting

Regulated entities that participate in emissions trading systems need to report their monitoring data to the regulator in a standardized and transparent form that complies with set time frames and jurisdictional law. ICAP (2021) recommends that regulators need to design a successful and efficient reporting process by implementing the following protocols:

1. Providing regulated entities with clear guidance about reporting requirements
2. Standardizing emissions reports to ensure consistency over time and across reporters
3. Aligning timing of emissions reports with existing financial reporting cycles and compliance time frames
4. Creating electronic reporting formats to cut down on processing time and transcription errors

Verification

Verification of the reporting process is an integral part of each trading system as businesses have major incentives to under or over report their emissions in order to gain allowances or to dodge penalties. The verification process is similar to an audit as it includes the use of an independent party who reviews the emissions report and determines its accuracy based on the available data. ICAP (2021) explains that quality assurances varies across trading systems but occurs in three forms:

1. Self-certification: where the reporting entity makes a formal assertion of the accuracy of its emissions report (often comes with large punishments for non-compliance)
2. External review by program administrators, to assess accuracy
3. Third-party verification done by an accredited third party.

Third party verifiers and external reviewers have to be accredited by regulators to ensure compliance with standardized practices and policies. The Clean Development Mechanism Executive Board and the International Organization for Standardization are two different parties that provide internationally recognized standards that a regulator will use to accredit third party verifiers. Businesses face penalties such as fines and suspensions if they submit unverified reports or the reports that did not meet verified standards.

Enforcement

An effective enforcement approach is an integral part of a cap-and-trade system to ensure incentivized compliance from all participating business entities. Regulators are in charge of  enforcing various penalties depending on the non-compliance or illegal actions and, in the event of noncompliance with penalties, regulators are able to prosecute through fines or other civil or criminal sanctions in line with jurisdictional law. The penalties that are dealt out due to non-compliance vary across regional systems; however, they involve similar elements and are severe enough to encourage compliance as they incur a substantial additional cost compared to the cost of complying with the standardized rules.

Actions of Non-compliance

ICAP (2021) identifies three categories of non-compliance that carry penalties:

• emitting in excess of the number of allowances surrendered
• misreporting or not reporting emissions and other data before specified deadlines
• failing to provide, or falsifying, information to the regulator, verifiers, or auditors

Penalties

Non-compliance with standardized rules will lead to one or a combination of the following ICAP recommended penalties:

• “Naming and shaming”: The names of noncompliant entities can be published and a company’s reputation can be affected by such a statement.
• Fines: The value of the fine can be set by reference to the observed market prices for allowances. A fine may be higher for intentional noncompliance than for unintended mistakes.
• “Make-good” requirements: Buying allowances from the market or borrowing from their future allocation at an unfavorable exchange rate.

International Cap-and-Trade Market(s)

Figure (2): Green: Carbon emission trading implemented or scheduled, Blue: Carbon tax implemented or scheduled, Yellow: Carbon emission trading or carbon tax under consideration

The future of cap-and-trade will be defined by a global trading system. Cap-and-trade systems are now emerging world-wide in places such as Australia, New Zealand, Canada, Japan, and Switzerland which can be seen in figure (2). The emergence of new markets paired with growth of existing markets in the United States, EU, and China creates new opportunities for the emergence of an international market. Direct bilateral links between regional cap-and-trade systems have been proposed as an option to strengthen market efficiency and politically reinforce emissions trading policy as a way to combat climate change.  Instead of a top-down approach situated in an international treaty agreement, it is much more likely that a global system will emerge from the linkages between regional systems. This perspective was widely acknowledged in trading discussions at the 2009 Copenhagen conference as they agreed that an international decision would be inefficient and hampered by political and economic disagreements. In order to build these linkages policy makers, regulators, lawyers, and economists have to focus on technical aspects of market integration. Explicit contracts about the conditions under which permits generated in one system might be recognized in another system are complex and require international cooperation.

Types of Linkages

Linkages can occur in various types with regards to two different elements: 1) the direction of flow of allowances; 2) whether there are restrictions placed on allowances from the linked system.In regards to the first element, linking can be bilateral, where all systems recognize the allowances of the other system(s), or unilateral, where the flow of allowances goes in only one direction. In regards to the second element, systems may or may not place qualitative or quantitative restrictions on allowances from the linked system to limit certain trades and to encourage best practices.

Benefits and Risks Posed by Linkages

The International Carbon Action Partnership (ICAP) helps create alignment and linking of emissions trading systems, with a view to moving towards a global carbon market in the long term. ICAP suggests that linkages provide several economic, environmental, political, and administrative benefits. The organization also recognizes potential economic and environmental risks that can jeopardize the effectiveness of trading systems and hurt business entities. Linkages allow for systems to aggregate compliance and administrative costs which increases efficiency in the same way as trade between two companies. Furthermore, linking also increases market liquidity and depth, promotes price stability, and can reduce the risk of carbon leakage. The organization also recognizes potential economic and environmental risks that can jeopardize the effectiveness of trading systems and hurt business entities. These risks relate to the potential chance of importing shocks, misconduct from linked jurisdictions, and the potential for resource transfers to incentivize low environmental ambition.

Current Linkages

There are currently many regional and national linkages between cap-and-trade systems across the globe. In 2014, California and Québec linked their system and was briefly joined by Ontario who exited the next year after a change in government. In Japan, Tokyo and the province of Saitama have been operating a joint carbon market since 2011. The European carbon market is the largest and is continuing to expand with a new linkage with Switzerland in 2020. Another market in the north eastern U.S has recently grown to the size of ten states, the Regional Greenhouse Gas Initiative (RGGI) have been operating a joint carbon market since 2008, and more states are set to join in the coming years.

Current Remedial Action(s)

Figure (3): This graph depicts California's GHG emission caps and business-as-usual emission projections. In red: business-as-usual emission projections. In green: emission allowance budget ('cap'). In blue and pink: emission offsets.

Cap-and-Trade in California: Goals for the Program

The main goal of California’s cap-and-trade system is to cost-effectively reduce GHG emissions. The success of the program is monitored by the establishment of emission goals: specific milestones with determined emission levels. By enforcing a statewide emission limit, the state can regulate the quantity of GHG emissions, ensuring it remains under an acceptable level. The statewide emission limit is then lowered by about 3 percent annually, creating a gradual decrease in annual GHG emission levels. This allows the state to assuredly reach their program goals in a sustainable manner.

California’s cap-and-trade program is its main instrument in administering Assembly Bill 32 (AB 32). AB 32 is the 2006 Global Warming Solutions Act, and it requires California to reduce GHG emissions to 1990 levels by 2020. The state achieved this goal in 2016, decreasing their emissions two million metric tons of CO₂ equivalent (MMTCO₂) lower than 1990 levels.

California also has other goals they plan to accomplish using the cap-and-trade program. Under Senate Bill 32 (SB 32), the state is required to reduce emissions to at least 40 percent below 1990 levels by 2030. Executive Order B-55-18 establishes a goal for California to achieve carbon neutrality by the year 2045, moving the state to 100 percent clean energy.

While these objectives will be reached using a variety of emission reduction and other environmental programs, the leading strategy is the cap-and-trade system. Funds generated from auctioning allowances in the cap-and-trade program are also re-invested into these other programs.

Comparing Cap-and-Trade to Carbon Levy Programs

This comparison is based on data from Ontario, Canada. Ontario is unique in the fact that it once utilized a cap-and-trade program, but later reverted to a carbon levy system when the current incumbent party was elected. The incumbent party cited lowering gas prices and providing annual savings to households, among others, as the primary drivers for repealing the cap-and-trade system. As stipulated by the federal government, a province that does not have their own carbon pricing framework will be subject to the federal carbon pricing system. The federal system is composed of two separate levies: the fuel charge, and the output-based pricing system.

cap-and-trade functioned in Ontario as such: participants were able to purchase allowances at quarterly auctions that would permit them to emit a corresponding level of pollutants. The pool of emissions allowances would shrink as greenhouse gas emission targets decreased.

The Financial Accountability Office of Ontario (FAO) estimated that by 2022 the price per tonne of carbon would rise to $23.9 from the 2018 level of $18.7/tonne. Under the federal government’s program, the prices would be dictated by the federal benchmark, which when it was established in 2019 placed the price at $20/tonne and outlined an increase to $50/tonne in 2022. The pricing of carbon under a cap-and-trade system is driven by scarcity of allowances. As emissions caps decrease, the availability of emissions allowances also shrinks. Supply limitations will trigger corresponding increases in auction sale prices. Projections estimated the price of carbon under a cap-and-trade system in Ontario to increase to $50/tonne by 2026 and $70/tonne in 2028, whereas the corresponding federal benchmarks would be at $95/tonne and $140/tonne, respectively.

Regarding the impact of federal carbon pricing on households and businesses, in 2019 there would have been roughly a $2.1 billion cost to households and businesses under cap-and-trade which would have grown to $2.4 billion in 2022. Estimates using federal carbon pricing place the cost at $2.0 billion for 2019 and $5.0 billion for 2022. Here is an example of how that pricing translates to the price of gasoline: in 2019, under cap-and-trade the additional cost would be 4.7 cents/litre, and with federal carbon pricing it would be 4.4 cents/litre. For the year 2022, under cap-and-trade the added cost to gasoline would be 5.5 cents/litre, and 11.1 cents/litre with the federal carbon pricing system.

When it comes to estimates calculating the monetary impact per household, the Financial Accountability Office of Ontario reported figures of $264 and $258 per household in 2019 under cap-and-trade and federal pricing, respectively. Estimates of pricing in 2022 by the FAO place the cost at $312 and $648 per household under cap-and-trade and federal pricing, respectively.

In terms of impacting business, the higher pricing of the federally backed carbon pricing system increases the risk of high-emission entities exiting Ontario which negates any attempts to decrease global emissions. With cap-and-trade there is greater price uncertainty and increased complexity of implementation.

Considerations for Ensuring the Success of Existing and New Cap-and-Trade Systems

A formal report composed by Richard Schmalensee and Robert Stavins examined 30 years of cap-and-trade systems and proposed several recommendations and considerations geared towards ensuring that existing and new cap-and-trade systems function as intended.

First and foremost, if they have not already done so, it is likely advisable for governing bodies to design future cap-and-trade systems as, or convert existing systems to, hybrid cap-and-trade systems much like California’s. A hybrid cap-and-trade system makes use of something called price collars. A price collar guarantees that the price of allowances will not fall or rise past predetermined points; this is especially important in times when favourable economic conditions push companies to increase production, and, by extension, emissions, because that increase will be coupled with a sharp rise in emissions allowance prices. Similarly, when emissions decrease to a point where the existing cap becomes ineffective, the demand for allowances decreases along with their price. Though some sacrifice is made in terms of the probability of emissions reductions, what is gained in terms of price stability serves to promote confidence in the system and increase efficiency by way of reducing compliance overhead.

Listed below are additional recommendations/points of consideration by Schmalensee and Stavins presented in no particular order:

• Without imposing emissions caps that are well below the average emissions outputs of a market, cap-and-trade systems are unlikely to yield favourable results (e.g., emission reduction); this particularly applies to strong and established markets.

• Requiring governmental approval for trades of emissions allowances discourages their trade and harms the system’s overall efficacy.

• Ensuring that emissions producing entities abide by the outlined caps can be greatly aided by the installation and use of accurate emissions monitoring systems. See regulation, monitoring, and enforcement for more details.

• The stability of allowance pricing can be encouraged by outlining rules clearly and providing detailed information prior to the new system and its regulations taking hold; this provides all parties with ample time to become familiar with how the new system will function.

  • Price stability can also be encouraged by allowing entities to retain their unused emissions allowances across varying timeframes. The exact implementation of allowance banking is subject to the unique circumstances of each cap-and-trade market.

• The use of sizeable penalties in response to failures to operate within the allowed emissions limits is effective in promoting and maintaining compliance.

Conclusion

Cap-and-trade systems can and have been effective in curtailing the emission of pollutants into the air across the globe by imposing emissions caps and facilitating the trading/distribution of emissions allowances.

Since their creation, knowledge of cap-and-trade system design has continued to incrementally improve and produce insights into what conditions are most likely to allow a cap-and-trade system to function effectively.

The success of a cap-and-trade system is dependent on the specifics of its implementation, with one of the most important factors being whether the system has been designed in a way that is conducive to stable emissions allowance pricing.

All in all, in a dynamic world that requires equally dynamic solutions, cap-and-trade systems appear to be an attractive choice in the fight against air pollution and climate change.

References

Brown, Edmund G. (September 10, 2018). "Executive Order B-55-18" (PDF). Government of California. Retrieved December 2021.

"Cap and Trade: A Financial Review of the Decision to Cancel the Cap and Trade Program". Financial Accountability Office of Ontario. October 16, 2018. Retrieved October 14, 2021.

"ARB emissions trading program". California Air Resources Board. September 2, 2015. Retrieved December 2021.

"California Greenhouse Gas Emissions for 2000 to 2017" (PDF). California Air Resources Board. 2019. Retrieved October 14, 2021.

"Cap-and-Trade in Canada: An Overview" (PDF). RBC Capital Markets. 2017. Retrieved October 14, 2021.

"CITSS Registrants Report September 2021". California Air Resources Board. September 30, 2021. Retrieved December 2021.

"Ontario Introduces Legislation to End Cap and Trade Carbon Tax Era in Ontario". Ontario Newsroom. Ontario, Canada. July 25, 2018. Retrieved October 14, 2021.

Plumer, Brad (June 5, 2012). "Around the world, cap-and-trade is still alive and kicking". The Washington Post. Washington, United States. Retrieved October 14, 2021.

"Premier Doug Ford Announces the End of the Cap-and-Trade Carbon Tax Era in Ontario". Ontario Newsroom. Ontario, Canada. July 3, 2018. Retrieved October 14, 2021.

Roberts, David (December 13, 2018). "California's cap-and-trade system may be too weak to do its job". Vox. Retrieved October 14, 2021.

"How cap and trade works". https://www.edf.org/climate/how-cap-and-trade-works. Environmental Defense Fund. Retrieved October 14, 2021.

Goulder, Lawrence; Schein, Andrew (November 18, 2013). "Carbon taxes versus cap and trade: A critical review". Climate Change Economics. 4 (3): 28. doi:10.1142/S2010007813500103. Retrieved October 14, 2021.

Kintzele, Jonathan (2017). "Easy come, easy go: a guide to California cap-and-trade spending. Southern California Law Review". Southern California Law Review. 90 (3): 23. Retrieved October 14, 2021.

Yang, Tseming (July 1, 2013). "An introduction to California's greenhouse gas emission trading program". Santa Clara University School of Law Legal Studies Research Paper Series: 7. doi:https://doi.org/10.2139/ssrn.2281821 . Retrieved October 14, 2021.

"The federal carbon pollution pricing benchmark". canada. September 5, 2021. Retrieved November 7, 2021.

Schmalensee, Richard; Stavins, Robert (March 11, 2017). "Lessons Learned from Three Decades of Experience with Cap and Trade". Review of Environmental Economics and Policy: 20. doi:https://doi:10.1093/reep/rew017 . Retrieved December 7th, 2021.