An Introduction to Market-Based Regulation of Greenhouse Gas Emissions

1. CAP AND TRADE FUNDAMENTALS
An Introduction to Market-Based
Regulation of Greenhouse Gas Emissions
GENEVA | HOUSTON | KANSAS CITY | LONDON | MIAMI | ORANGE COUNTY | SAN FRANCISCO | TAMPA | WASHINGTON, D.C.
Presented by Kevin Haroff
Shook Hardy & Bacon LLP – San Francisco
CLE International 2008 California Climate Change Law Conference
(UPDATE AND EXPANDED -September 2009)
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2. Overview
• What Is Cap And Trade
• Who Cares
• Does It Work
• How Does It Work
• Where’s The Catch
• What’s Next
• Questions/Discussion
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3. What is Cap and Trade?
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4. Cap and trade is a market-
based policy tool for protecting
human health and the
environment by controlling
large amounts of emissions
from a group of sources.
U.S. Environmental Protection Agency
(April 9, 2009)
http://www.epa.gov/captrade/basic-info.html
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5. Who Cares?
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6. I will implement a market-
based cap-and-trade system
to reduce carbon emissions
by the amount scientists say
is necessary: 80 percent
below 1990 levels by 2050.
Democratic Presidential
Candidate Barack Obama
(August 30, 2008)
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7. To dramatically reduce
carbon emissions, I will
institute a new cap-and-
trade system that over time
will change the dynamic of
our energy economy.
Republican Presidential
Candidate John McCain
(September 15, 2008)
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8. • American Clean Energy
and Security Act of 2009
– H.R. 2454 (Waxman
Markey)
– Passed House on June
26, 2009
– Sent to Senate
Legislative Calendar on
July 7, 2009
• Senate Environment and
Public Works Committee
– Chaired by Barbara Boxer
(D-CA)
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9. Waxman Markey
• Amends the CAA to require EPA to promulgate regulations to cap
and reduce GHG emissions from capped sources to
– 97% of 2005 levels by 2012
– 83% by 2020
– 58% by 2030
– 17% by 2050
• Requires EPA to establish a federal GHG registry
• Requires EPA to establish specified emission allowances (annual
tonnage limits) for separate vintage years:
1. Each of 2012‐2049
2. 2050 and thereafter
• Requires covered entities to demonstrate compliance through: (1)
holding emission allowances, or (2) using offset credits.
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10. Does It Work?
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11. An Alternative Regulatory Strategy
• First proposed in 1980’s as alternative to traditional
command and control regulations based on market-
oriented economic principles
• In theory, cap and trade programs can
– Be effective and administratively efficient
– Reduce emissions quickly
– Promote innovation
– Work in concert with other regulatory approaches
• Projected to work best in situations where
– Aggregate impact is principal concern
– Costs differ across a range of options
– Strong regulatory institutions and financial markets exist
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12. Precedent - U.S. Acid Rain Program
• Growing recognition during 1980’s of detrimental environmental
impacts of acid deposition from the atmosphere (acid rain)
– Caused when emissions of sulfur dioxide (SO2) and nitrogen
oxides (NOx) react with water, O2, and other atmospheric
constituents
– Primary source – coal-fired electric power plants in eastern and
midwestern states
• Title IV of 1990 Clean Air Act Amendments
– Regulation of SO2 emissions in two phases
§ Phase I (beginning in 1995 - affecting 110 mostly coal-fired
plants)
§ Phase II (beginning in 2000 - tightened restrictions and new
limits on coal, oil and gas-fired facilities)
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13. U.S. Acid Rain Program - Results
Wet Sulfate Deposition Wet Sulfate Deposition
Average 1989 - 1991 Average 2001 – 2003
Sulfur deposition and concentrations down 40% across the
Eastern United States at lower than projected costs
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14. How Does It Work?
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15. Basic Elements of Cap and Trade Policy
• Government establishes a cap
(caps) that limits total amount of
emissions allowed in a given time
period, e.g., each year.
• Government issues permits
(allowances) giving “rights to
emit” that can be traded like
private property.
• As the total amount of capped
emissions declines from year to
year, demand for permits
increases.
• Since supply is controlled by law,
price of traded permits is a
function of demand and
substitution cost.
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16. An Analogy – The Game of Musical Chairs*
• Each chair represents a “right to emit” one metric ton of carbon
(CO2) or carbon equivalents.
* From Holmes Hummel PhD
(November 21, 2007)
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17. An Analogy – The Game of Musical Chairs
• At the start of the game, everyone who needs a chair has a chair
(because there are no caps yet or because everyone has a permit).
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18. Musical Chairs – Year 1
• In the first year of the program, the initial cap goes into effect and
the number of permits (chairs) is reduced.
• As a result, somebody doesn’t get a chair.
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19. Musical Chairs – Year 1
• Players have a choice:
– Reduce emissions to eliminate need for a chair (by adding control
technologies or switching to less-carbon intensive production).
x
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20. Musical Chairs – Year 1
• Players have a choice:
– Reduce emissions to eliminate need for a chair (by adding control
technologies or switching to less-carbon intensive production), OR
– Pay money to buy a chair (permit) from someone else.
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21. Musical Chairs – Year 1
• Burden to reduce emissions falls on the party who sells his chair
(permit).
x
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22. Musical Chairs – Year 1
• Burden to reduce emissions falls on the party who sells his chair
(permit).
• Either way, total amount of carbon emissions is reduced.
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23. Using Market Incentives to Achieve
Reduction Targets
• Emission allowances are traded in a carbon market that sets the
price according to supply and demand.
• Since supply is fixed, market sets the price based on the marginal
cost of emissions reductions (implementation of emission control
measures).
• Example:
– Company A can reduce emissions by spending $1 per/MTC on emission
controls or alternative production technologies,
– But Company B can only reduce emissions by spending $2/MTC on
control measures.
– At a market price of $1.50 per emission credit,
§ Company A installs new technology, sells credit, and makes $.50
profit.
§ B buys A’s credit and avoids the cost of more expensive controls.
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24. Using Market Incentives to Achieve
Technological Innovation
• As the total number of available permits goes down, the price of
remaining permits goes up.
• As the cost of permits goes up, so does the cost of doing business
for companies needing permits.
• Incentives are created to identify alternative technologies with lower
carbon emissions and therefore lower total costs, such as green
building technologies, solar and wind power, nuclear energy,
alternative fuels.
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25. Musical Chairs – Year 2
• In the second year of the program, the initial cap is lowered and the
number of available permits (chairs) is reduced even further.
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26. Musical Chairs – Year 2
• In the second year of the program, the initial cap is lowered and the
number of available permits (chairs) is reduced even further.
• As a result, more and more players don’t get chairs.
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27. Musical Chairs – Years 3, 4 . . . .
• Fewer chairs means fewer total emissions.
x
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28. Musical Chairs – Years 3, 4 . . . .
• Fewer chairs means fewer total emissions.
• And higher . . .
x
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29. Musical Chairs – Years 3, 4 . . . .
• Fewer chairs means fewer total emissions.
• And higher . . .
. . . and higher prices for the chairs (permits) that remain.
x
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30. Musical Chairs – Years 3, 4 . . . .
Until the final objective (cap) is achieved.
x x x x
x x x
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31. Musical Chairs – The End Game
• At the end of the day, the players remaining in the game are
– Those who can afford to pay the most for emission credits.
– Those who have the least flexibility in how they play the game.
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32. Where’s the Catch?
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33. Issues for Policy Makers
• Who is Covered?
• How are allowances initially Allocated?
• The problem of Offsets
• The problem of Leakage
• How much Market Freedom should be
allowed?
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34. Who is Covered
• Theoretically, any emitter of carbon or carbon equivalents can be
covered.
• As a practical matter, most proposals only cover large emitters
(and fossil fuel suppliers).
• Covered entities under Waxman Markey include: electricity
sources, fuel producers and importers, industrial gas producers
and importers, geological sequestration sites, industrial stationary
sources, industrial fossil fuel‐fired combustion devices, natural
gas local distribution companies and nitrogen trifluoride sources.
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35. Allocation – Auction v. Free Distribution
• Most economists advocate initial
distribution of allowances by auction v.
free distribution.
– Protects against unfair competition,
since new players with innovative
technologies cannot compete with
existing players receiving allowances
as a subsidy.
– Protects against windfall profits, since
players receiving subsidized
allowances can sell them at the same
price as other players buying
allowances on the market.
– Generates revenue that governments
can use to mitigate negative impacts.
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36. Allocation – Free Distribution v. Auction
• Some parties advocate free distribution v.
auction on equitable grounds.
– Mitigates against loss of profits existing
players would have realized in the
absence of cap and trade.
– Mitigates against impacts to consumers
from players passing on costs of
acquiring allowances in an auction.
• Optimal approach:
– Mix of auction and free distribution to
accomplish multiple public policy goals
and accommodate political realities.
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37. Allocation – Waxman Markey
• Most allowances initially are distributed “for the benefit of electricity,
natural gas, and/or home heating oil and propane consumers,” i.e.,
to public utilities.
• Relatively few allowances to be sold at auction, with proceeds used
for the benefit of low income consumers and for worker investment.
• Remaining allowances are distributed:
– For supplemental emissions reductions from reduced deforestation;
– To energy‐intensive, trade‐exposed industries;
– For the deployment of carbon capture and sequestration technology;
– To invest in energy efficiency and renewable energy;
– To Clean Energy Innovation Centers;
– To invest in the development and deployment of clean vehicles;
– To domestic refiners;
– For domestic and international adaptation;
– For domestic wildlife and natural resource adaptation;
– For international clean technology deployment.
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38. The Problem of Offsets
• Offsets are credits given for reductions in
present or future emissions from sources not
otherwise subject to cap and trade program
requirements.
– Sources outside covered industrial sectors,
e.g., agriculture and forestry projects.
– Sources outside government jurisdiction,
e.g., Clean Development Mechanism
(CDM) projects in other countries.
• Use of offsets is controversial because of
difficulties in
– Project validation.
– Emissions quantification.
– Monitoring and enforcement.
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39. Offsets under Waxman Markey
• Authorizes EPA to designate an international
climate change program as a qualifying
international program for purposes of
international emission allowances provisions,
if certain conditions are met.
• Establishes the Offsets Integrity Advisory
Board and requires EPA, considering the
Board's recommendations, to promulgate
regulations establishing a program for the
issuance of offset credits.
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40. The Problem of Leakage
• Leakage occurs when the cost of operating under a cap and trade
regime exceeds the cost of relocating and operating outside the
regime.
• Leakage undermines the efficacy of cap and trade in two ways:
– Reduces the number of sources covered by the program,
– Disrupts the price signal for emission credits to remaining
market participants.
• Moral – national (or regional) cap and trade policy may be
ineffective in the absence of strong international agreements.
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41. Market Issues - Banking and Borrowing
• Banking allows market participants to defer
using current allowances until a later period.
– Banking reasonable when emissions have
a long residence time in the environment.
– Allows holders to profit from later sales of
allowances at higher market prices.
• Borrowing allows market participants to
“borrow” or use future allowances in the
current period.
– Creates risk that participants may not be
able to afford market prices later on.
• Waxman Markey provides that allowances
may be traded, banked and borrowed (up to
15%).
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42. Market Issues – Regulation
• Emission credits will comprise an entirely new class
of marketable securities.
• Waxman Markey would:
– Require the Federal Energy Regulatory
Commission (FERC) to promulgate regulations
for the establishment, operation, and
oversight of markets for regulated allowances;
– Require EPA to establish an interagency
working group on carbon market oversight;
– Amend the Commodity Exchange Act to
provide for transactions in derivatives that
involve energy commodities;
– Give the Commodity Futures Trading
Commission (CFTC) jurisdiction over the
establishment, operations, and oversight of
markets for regulated allowance derivatives.
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43. What’s Next?
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44. What’s Next
• In Congress
• Internationally
• At the State and Regional Levels
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45. Questions/Discussion
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46. GENEVA | HOUSTON | KANSAS CITY | LONDON | MIAMI | ORANGE COUNTY | SAN FRANCISCO | TAMPA | WASHINGTON, D.C.
CAP AND TRADE FUNDAMENTALS –
An Introduction to Market-Based Regulation of Greenhouse Gas Emissions
Presented by
Kevin Haroff, Shook Hardy & Bacon LLP (San Francisco)