Carbon Market Analyst

North America

A US Cap-and-Trade Program: Options for Compliance

RESEARCH
April 2, 2009

TO THE POINT CONTENT

The Emission-to-Cap in the cap and trade program proposed 2 Executive summary
by Rep. Waxman would be 205 million tons in 2012, growing to 2 Introduction
1.4 billion tons by 2020.
2 Sizing up the gap
This gap could be cut in half if complementary policies 6 Compliance options
promoting clean energy and energy efficiency standards are
also passed. The long term impact of the economic recession 10 Market implications
coupled with ambitious policies could create a long market for 12 Conclusion
the first compliance period.
13 Contacts
In 2012, the domestic offsets supply will be too scarce to fill
in the gap. Certified Emission Reductions (CERs) could help
meet the gap, placing US facilities in competition against other
international buyers.

In 2016, because of the limited domestic offset supply, some

fuel switching may be needed, rapidly pushing prices up.
To remedy high prices, we anticipate the development of a
new international offset programs, where sectoral and REDD
credits could play a much larger role.

In 2020, a large reliance on fuel switching would bring prices

UPCOMING REPORTS
up over $50 a ton. These high prices would render economically
attractive most other compliance options, including purchases • Assessing the Impact of the Reces-
of international allowances and a wide range of internal sion on US GHG Emissions
abatement measures • A Post-2012 Global Climate Change
Agreement
• What Role for International Forestry
and REDD credits

POINT CARBON RESEARCH All rights reserved © 2009 Point Carbon

Carbon Market Analyst North America CMA April 2, 2009

Executive summary
This report provides an overview of compliance options
under a US cap-and-trade program using the discussion
draft proposed by Rep. Waxman on March 31st, 2009.
We first estimate the size of the emission-to-cap (E-t-C),
or the difference between projected US greenhouse gas
emissions and the cap – this is the amount by which
covered entities collectively will have to reduce their
emissions to comply with the carbon limits. We estimate
this gap at 205 million tons in 2012, growing to 1.4 bn
tons in 2020, if ‘business-as-usual’ projections follow the
path forecasted by the Energy Information Agency.
20 million tons per year, we foresee a shortage of these
credits.
International offsets are also unlikely to fill in their quotas,
although we forecast a potential supply of Certified
Emission Reductions (CERs) of over 700 million tons
globally in 2015. US facilities would have to compete
with European emitters and Kyoto countries for these
credits. Other forms of international offsets could be
developed, notably sector-based credits and Reduced
Emissions from Deforestation and forest Degradation
(REDD) credits and help make up the shortfall.

The bill includes a wide array of complementary
policies to reduce emissions, notably a renewable
electricity standard, an energy efficiency standard, and
improvements to fuel economy and carbon-intensity of
transportation fuels. These policies could cut the E-t-C in
half, reducing the gap to 87 million tons in 2012, a mere
1.2 percent of the total cap. Coupled with the effect of
the economic recession, the program could start long in
the first compliance period (2012-2013). We forecast the
2020 gap at roughly 760 million tons, 15 percent of the
cap that year.
We then investigate the main compliance options for
filling this gap: offsets and internal emission reductions.
The bill authorizes 2 bn offset credits for compliance,
evenly split between domestic and international offsets.
In terms of internal abatement, fuel switching has the
largest potential – aside from energy efficiency. The
cost of fuel switching can rise rapidly depending on fuel
prices. A high price of carbon would trigger a negative
feedback loop and incentivize other internal abatement
measures, such as industrial energy efficiency,
improvement to chemical processes, etc. This would
bring prices back down to a level where fuel switching is
the most economical available option.
High carbon prices would also create an incentive to
‘link’ with other carbon markets, such as the European
or the Australian emission trading systems. LInkages
with other markets would not necessarily bring prices
down but could help dampen price volatility.

Domestic offsets will likely constitute the least expensive

compliance option, but with a pipeline currently below

Introduction This report provides an analysis of carbon market, assuming no major

The prospects for a carbon market in
the US are looking better by the day.
Lawmakers in Congress are actively
discussing a climate bill, and hopes
are high that cap-and-trade legislation
may be passed by the end of the
year.
This issue of Carbon Market Analyst
North America looks at compliance
options under a US cap-and-trade
program. We first estimate the size
of the emission-to-cap (E-t-C), or
the difference between projected
emissions under a business-as-usual
(BAU) scenario and the cap, and then
investigate the main compliance
options to close this gap: offsets and
internal emission reductions.
supply and demand dynamics under
a US cap-and-trade program and sets
up the conceptual framework for
price formation in a future US carbon
market.
Hopes are high that
cap-and-trade leg-
islation will pass by
the end of the year
We provide snapshots of three
milestone years during the first
decade of the program - 2012,
2016 and 2020 - and discuss which
compliance option is likely to be
preferred in each of these years.
We look at the carbon price range
involved and implications for the
technological breakthrough occurs in
this time frame.
Sizing up the gap
Under a compliance program,
demand for emission reductions is
derived from the gap between the
emission cap established by the
government and actual emissions
from covered sources.
Setting the cap
In the White House budget proposal
released February 27, President
Obama stated his reduction targets
– 14 percent below 2005 levels by
2020; 83 percent below 2005 levels

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Carbon Market Analyst North America CMA April 2, 2009

by 2050. More recently, on March

31st, Representative Waxman (D- Table 1: E-t-C in the Waxman-Markey draft proposal
CA) and Markey (D-MA) released a
discussion draft setting even more BAU projections, total BAU projections, Emission-to-Cap
ambitious medium-term targets US emissions covered sectors Cap (EtC)
starting in 2012 at 3 percent below 2012 7 294 4 975 4 770 205
2005 levels, declining to 20 percent
2013 7 301 4 979 4 666 313
below 2005 levels by 2020 and 80
percent below 2005 levels by 2020 2014 7 273 5 506 5 058 448
(see Figure 1 and Table 1). While 2015 7 282 5 513 4 942 571
these targets may change in the final 2016 7 307 6 175 5 391 784
climate bill, we take them as the
2017 7 336 6 199 5 261 938
best available indication of the depth
of the cuts to be expected and use 2018 7 364 6 223 5 132 1 091
them in this analysis. 2019 7 378 6 235 5 002 1 233
2020 7 380 6 236 4 873 1 363
Waxman sets ambi- 2030 7 894 6 671 3 533 3 138
tious medium and
long term emission
reduction targets Agency’s (EIA) Annual Energy existing state renewable portfolio
Outlook released in December 2008. standards. In Figure 1 we chart total
BAU emissions for the US as a whole US emissions (top dotted line) and
We also use the scope proposed are projected to increase from 7,294 emissions from covered sources only
in the Waxman discussion draft, an million tons (mt) in 2012 to 7,380 mt (solid line) against the cap.
economy-wide coverage of all sectors in 2020, a 1.2 percent growth.
except for waste and agriculture. Emission-to-Cap
Some sectors are phased into the These projections account for
program over the first years, creating the new Corporate Average Fuel As shown in Table 1, we find that in
steps in the curves representing the Economy (CAFE) and the renewable 2012, covered sources will have an
cap and the emissions from covered fuel standard passed in the estimated annual emission-to-cap
sectors in Figure 1. December 2007 Energy bill. They (E-t-C) shortfall of approximately
also include the reductions from 205 MmtCO2e, or 4.1 percent of
The sector phase in provision means
only 68.2 percent of US emissions
are covered in 2012-2013, but this Figure 1: Emission-to-Cap in the Waxman-Markey proposal
number increases to 75.7 percent in
2014-2016 when industrial facilities
9,000
are phased in, to eventually reach
8,000
its maximum at 84.5 percent in 2016
as the requirement extends to local 7,000
Million tons CO2e

distribution companies. The scope 6,000

remains at 84.5 percent of total 5,000
emissions through the rest of the 4,000
program.
3,000

Business as usual emissions 2,000

1,000
We use with the business as usual -
(BAU) emissions projections, which
14

16

22

24

30
12

18

20

26

28

illustrate the path US greenhouse gas

20

20

20

20

20
20

20

20

20

20

emissions levels are expected to take

Business-as-usual projections, total US emissions
given existing environmental policies
Business-as-usual emissions from covered sectors
and regulations. The projections are
Waxman reduction targets from covered sectors
based on the US Energy Information

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Carbon Market Analyst North America
their estimated BAU emissions.
This gap is anticipated to increase
to approximately 571 million tons by
2015 and up to nearly 1.4 billion tons
by 2020. The shortfall in 2020 is then
22 percent of BAU emissions from
covered sectors.
Lower Emissions?
Actual emissions will likely be lower
than even the most recent EIA
forecasts because of recently-passed
policies, proposed policies, and the
impact of the economic recession.
Enacted Policies
The Obama administration has
passed important policies and large
investment programs in the past
two months, notably the American
Recovery and Reinvestment Act,
better known as the ‘stimulus bill’, and
the proposed 2010 federal budget.
Both packages contain significant
investments in clean energy and
energy efficiency, and could by one
group’s estimate reduce business-
as-usual emissions by 61 million tons
annually from 2012 onwards (see
Textbox 2).
BAU projections do
not fully account for
the deepening eco-
nomic downturn
Furthermore, the Annual Energy
Outlook projections, dated December
2008, likely do not fully account for
the deepening economic downturn
and its lasting effect on greenhouse
gas (GHG) emission levels. Analyses
of the recession’s effect on Europe’s
emissions have estimated close to
six percent reduction in emissions
from 2007 to 2008, partially due to
decreased industrial output from
energy-intensive sectors such as
cement and pulp and paper. The
4 All rights reserved © 2009
CMA April 2, 2009
Textbox 1: Energy efficiency: the answer to it all?
Many studies show the potential savings from energy efficiency – most recently,
McKinsey’s report “Reducing US Greenhouse Gas Emissions: How Much at What
Cost?” announced close to one billion tons of GHG emissions could be reduced
from energy efficiency measures alone, at a cost of zero or less (negative cost, i.e.
a net saving). If this is true, why do we even need energy efficiency standards?
Economically, energy efficiency appears to be an obvious investment, yet the shifts
toward better-insulated buildings and ultra low-energy appliances are not occurring
on the massive scale that their economic profitability would suggest. Three types
of hurdles typically get in the way of efficiency improvements according to energy
efficiency experts Arthur Rosenfeld and Paul Stern. First, structural issues, like the
tenant/landlord dilemma, prevent useful investments from taking place because
the decision-makers and the beneficiaries are disconnected. Second, the economic
profitability of efficiency investments is not always as clear cut as economic theory
would imply. Discount rates (the time-value of money) and interest rates faced by
individuals can be significantly higher than those used by economists in calculating
the worth of energy efficiency investments. Finally, individuals and companies do
not always behave rationally in the economic sense and may elect to keep pricier
incandescent light bulbs because they prefer the quality and color of the light to that
of cost-savings compact fluorescent lights.
Because economic rationality is often not enough to trigger these energy efficiency
investments, standards and public action are needed to overcome structural and
financial hurdles. Cap-and trade can also trigger some energy efficiency investments,
but only if carbon prices are high enough to make a large difference on the energy
bill.
speed at which the economy will levels in the US. Two sectors are the
recover from the current recession is most likely targets for broad-reaching
unknown. regulations: the power sector and
the transportation sector. New
We do not attempt to capture this climate-oriented regulations in both
potential “recession effect” on US
sectors would evoke large amounts
emission levels but consider possible of emission reduction.
that emissions would be lower than
projected during the first years of Power sector
the program. This would reduce the
gap between emissions and the cap A national renewable electricity
even further. The effects on long term standard (RES), mandating that a
emissions, however, would probably minimum percentage of electricity be
be negligible. generated from renewable energy, is
under discussion in Congress and
Proposed Policies could be passed as early as this
summer. A proposal introduced by
In addition to the effects of the Sen. Bingaman (D-NM) early 2009
economic slowdown, US GHG would require that 20 percent of
emissions, and therefore the E-t-C, electricity sold in the US come from
could look dramatically different if renewable sources by 2025. A similar
some further energy command-and- bill proposed by Rep. Markey aims
control measures are passed ahead for 25 percent renewables by 2025.
of or in conjunction with legislation This provision was included in the
establishing a cap-and-trade Waxman-Markey draft and would
program. Such regulations are under reduce emissions by an estimated
discussion and would have a large 57 mt in 2012, growing to 279 mt by
effect on long term GHG emission 2020 (see Textbox 2).
Point Carbon
Carbon Market Analyst North America CMA April 2, 2009

Energy efficiency standards are

also being discussed in Congress. Table 2: Effect of mandated emission reductions on E-t-C
The Save American Energy Act, All numbers in million metric tons of CO2e
introduced by Rep. Markey (D-MA)
and Sen. Schumer (D-NY) establishes
E-t-C Stimulus RES Energy Efficiency New E-t-C
a federal energy efficiency resource
standard, requiring utilities to 2012 205 61 57 0 87
reduce electricity demand by 15 2013 313 61 52 5 195
percent and natural gas demand by 2014 448 61 104 18 265
10 percent by 2020. This mandate
2015 571 61 103 39 368
could lower emissions by 39 mt in
2015, increasing to 262 million tons 2016 784 61 156 58 508
by 2020 according to the ACEEE (see 2017 938 61 151 88 638
Textbox 2). Other measures included 2018 1,091 61 220 117 693
in the draft bill promote appliance
2019 1,233 61 210 214 747
efficiency standards, improved
building efficiency standards, etc. 2020 1,363 61 279 262 761
and would also reduce emissions.

The E-t-C could be Smaller gap – long market?

halved by comple-
mentary energy pro-
visions in the climate bill
Transportation sector
President Obama lists two key
measures for the transportation sector
in his energy agenda: increasing fuel
efficiency standards and passing a
low-carbon fuel standard (LCFS). As
a Senator, Barack Obama supported
the Fuel Economy Reform Act, which
proposed a four per cent per year fuel
economy improvement beginning in
2009 for passenger cars and 2012 for
light trucks. The proposed LCFS set
targets of fuel carbon-intensity at 10
percent below 2005 levels by 2020.
The National Commission on Energy
Policy has estimated the combined
effect of both proposals at 550 million
tons worth of reductions by 2020.
Table 3 -E-t-C by compliance period
We account for the emission
reduction potential of the ‘big ticket’ Compliance period Annual E-t-C
items in the Waxman-Markey bill and 2012-2013 141
estimate the size of the new gap in
2014-2015 316
the short and medium-term, up to
year 2020. Hence we exclude the 2016-2017 573
effects of transportation policies, 2018-2019 720
as the main measures are either
2020 761
unspecified or only take effect after
Textbox 2: Sources for Emission Reduction Estimates
Reduction forecasts for the stimulus bills are drawn from an analysis commissioned
by Greenpeace in January 2009. Consultancy ICF evaluated sixteen energy,
environment, transportation and technology provisions included in the initial
Economic Stimulus Package and quantified the expected emission reductions from
each of them.
The emission reductions from renewable electricity standards are detailed in a
Point Carbon report dated February 23, 2009: Greenhouse Gas Reductions from
Renewable Electricity Standards.
For energy efficiency, we used the American Council for an Energy Efficiency
Economy (ACEEE) report: Laying the Foundation for Implementing a Federal Energy
Efficiency Resource Standard, published March 18, 2009.

The Waxman-Markey bill contains an
LCFS provision that only takes effect
when the Renewable Fuel Standard
ends, in 2022, and mandates the
EPA to harmonize fuel efficiency
standards building on California’s
tailpipe emission standards (the
“Pavley bill”), but does not set
specific targets.
Our estimate for transportation is based on a memo dated June 2007 by the National
Commission on Energy Policy and the International Council for Clean Transportation.
The study quantifies reductions from a low carbon fuel standard (LCFS) and the Fuel
Economy Reform Act and finds the combined measures would yield 550 million
tons by 2020. This forecast is likely overestimated because it does not account for
the Energy bill passed later that year and uses the 2007 AEO BAU forecast.
Point Carbon does not support or promote any of the policies studied, nor does it
associate with the policy positions from the authors of these studies.

5 All rights reserved © 2009 Point Carbon

Carbon Market Analyst North America
2023. As shown in Table 2 and Figure
2, the new E-t-C is roughly halved by
the complementary policies, leaving
only half the initial gap to be reduced
by market forces.
Another way to look at these numbers
is by compliance period (Table 3). The
Waxman-Markey bill establishes two-
year compliance periods, allowing
companies to borrow and bank from
one year to the other within the two-
year periods. By smoothing out the
differences created by the phase-in
provision, compliance periods provide
a clearer picture of the reduced but
growing gap over the first nine years
of the program.
The Waxman-Markey
bill sets a generous
ceiling of up to 2 bn
tons for offsets
Because the E-t-C constitutes such
a small percentage (2-5 percent) of
the total cap from 2012 to 2014, it
is possible that the program could
actually be over-allocated in its early
years. Should the impact of the
recession be lasting on emission
levels, and should the transportation
provisions yield early reductions, US
emissions could be lower by a few
hundred million tons, potentially
making the system long. This over-
allocation would be unlikely to last
because of the steeply declining cap
and therefore would not threaten the
long-term integrity of the program.
Conversely, the forecasts could
be overestimating the expected
reductions from the policies – by
using an outdated baseline, or
because of overlap between the
policies - making the sum less than
the parts. In this case the gap would
be larger and a larger role left to
markets.
6 All rights reserved © 2009
CMA April 2, 2009
Figure 2: What’s left to markets?
6,500
6,000
Million tons CO2e
5,500 Remaining
gap
5,000
4,500
4,000
12 013 014 015 016 017 018 019 020
20
2012 22013 22014 2 20152 20162 2017
2 2018 2 2020
2 2019
RES Energy Efficiency Stimulus
Compliance Options switching. For each we offer, to the
extent possible, a volume and price
We now turn to compliance options: assessment.
ways to fill the gap between actual
emissions and the cap, under a price- Buying offsets: the cheap way
driven, market-based mechanism.
out?
Companies regulated under a cap-
Offsets are emission reduction
and-trade program typically face
credits from project-based activities
three main compliance options:
that can be used to meet compliance
as a supplement or alternative to
• reduce their own emissions
reducing one’s own emissions. The
(‘internal abatement’);
use of offsets is usually subject to
• purchase allowances;
a quantitative limit, or quota, known
• buy offset credits. as ‘supplementarity.’ The Waxman-
Economic theory warrants that Markey bill sets a very large ceiling
companies will opt for the least cost for offsets of up to 2 bn tons annually,
option first, moving up the marginal evenly split between domestic and
abatement cost curve until their international offsets.
emissions match their allowances.
In other words, a company will only The total amount of offsets allowed
into the system is roughly 1.5 bn tons
attempt to reduce its emissions
per year from 2012 to 2015, then 1.7
if it anticipates that doing so will
bn from 2016 to 2020, amounting
cost less than buying offsets or
to 30% of the cap in average. The
allowances. If the market functions
draft bill also suggests a 20 percent
without distortions, allowance prices
discount rate for offset credits,
should reflect the marginal cost of
calling for 1.25 offset credits to claim
abatement.
one ton of CO2e (one allowance).
We take a closer look at the
compliance options most likely to
Domestic offsets
be on the margin: offsets and fuel
The offset market is developing fast
Point Carbon
Carbon Market Analyst North America
Figure 3: US carbon offset pipeline with likely eligibility
25 Fuel Switching
Energy Efficiency
Renewable Energy
Industrial Processes
20
Geosequestration
Biosequestration
Million tons CO2e
Forestry
15 Soil Sequestration
Fugitive Emissions/CMM
Agricultural Waste
Landfill Gas
10
Likely-Eligible
5
y2000 y2001 y2002
in the US, largely in anticipation of
a regulated market. Point Carbon’s
offset database Carbon Project
Manager North America lists most
offset projects in the US and Canada.
The current pipeline of projects is
about 20 mt annually in 2012.
Not all offset credits currently traded
on the voluntary markets would
qualify under a compliance program,
however. Restrictions on project
types and quality would likely weed
out a significant number of projects,
from which offset credits are currently
generated. Projects in capped sectors
(such as energy efficiency) would not
qualify as ‘offsets’ anymore but as
internal abatement.
The Waxman-Markey bill does not
establish an exhaustive list of eligible
project types. We use elements
from previous cap-and-trade bills to
distinguish between projects likely
to make the cut or not, and conclude
that five offset type categories are
7 All rights reserved © 2009
y2003 y2004 y2005 y2006 y2007 y2008
most likely to qualify under a federal
compliance program: agricultural
waste, forestry, fugitive emissions
(coal mine methane), landfill gas
and soil sequestration. (See our
previous report, US Offsets: Outlook
for Supply and Demand, published
January 22, 2009, for more details).
As illustrated in Figure 3, only about
half of the projected volume would
qualify if screening out the non-
eligible projects, bringing the supply
to about 10 mt in 2012.
It is highly unlikely
US offsets could ever
come close to filling
the E-t-C gap
Could US offsets ever come close
to filling the E-t-C gap? It is highly
unlikely, if not impossible. Even
though we anticipate investment in
offsets to rise sharply as the beginning
CMA April 2, 2009
25000000
20000000
15000000
10000000
5000000
0
y2009 y2010 y2011 y2012
of the cap-and-trade program nears,
the increase in available credits is
unlikely to get even near the limit. US
offset supply will be constrained by
sheer physical limitations - there are
only so many sites (landfills, farms,
and fields) that could potentially
qualify and host offset projects. If
offsets are discounted at a ratio of
5 to 4 as suggested in the Waxman
bill, the amount of credits would be
even less adequate. The suggested 1
billion ton limit on domestic offsets in
the bill hence sets a theoretical limit
on demand, but the real limitation
will be on the supply side.
The role of domestic offsets will be
determined by how they compare
financially to other compliance
options. Current average over-the-
counter offset prices vary from $4.00
to $9.00 a ton depending on project
types and certifications, and CCAR
futures (Dec12 delivery) trade at
roughly $7.00 a ton on the Chicago
Climate Futures Exchange.
Point Carbon
Carbon Market Analyst North America CMA April 2, 2009

International offsets from JI projects), will be issued by

In addition to domestic offsets,
international offsets are also likely
to qualify as a compliance option in
the US. Again, the Waxman-Markey
bill allows up to one billion tons in
international offsets for compliance.
The dynamics for international
credits are much more complex, as
US emitters will be competing with
entities covered by the EU Emission
Trading Scheme and parties to the
Kyoto protocol for those reduction
credits.
Sectoral credits enjoy
strong political sup-
port on both sides of
the Atlantic
The current international offset
system is the Clean Development
Mechanism (CDM) and Joint
Implementation (JI) under the Kyoto
Protocol. Point Carbon’s database
Carbon Project Manager anticipates
that around 1,850m Certified
Emission Reductions (CERs, credits
from CDM projects) and Emission
Reduction Units (ERUs, credits
2012. After 2012, the forecast is Table 4 - International allowances
much more uncertain (see Textbox 2012 prices are future prices traded on
3), as the future of the CDM will the exchange (2011/12 for Australia)
be renegotiated in Copenhagen in Point Carbon forecast for Phrase 3 EU
December 2009. However, given ETS prices and traded 2012/13 futures
for the Australian CPRS
Point Carbon’s main policy scenario
for post-2012, CER volumes could
AEUs
increase to 715 mt in 2015, before EUAs (Europe)
(Australia)
down to 75 mt in 2020 (see our CMA
The Future of the CDM: Supply 2012 15€ ($19) A$21.75
($14.50)
Forecast to 2022, November 26,
2008). 2015 48€ ($63) A$23.25
($15.50)
Prices will play a determining 2020 48€ ($63) Not available
factor in the final use of CERs.
Secondary CERs (Dec12 delivery)
credit types by allowing their use for
are forecasted by Point Carbon at
€21 ($28) and usually track European
compliance. Sectoral credits are still
at an early design stage but enjoy
Union Allowances (EUAs) at a
strong political support on both sides
discount. If EUA prices are higher
of the Atlantic (see Textbox 2 and our
than a US allowance price, the use of
Analyst Update: EC’s sector crediting
international offsets will be secure in
proposal, from March 19, 2009).
Europe - but if EUA prices are close
to US prices, US emitters could have REDD also enjoy political support but
a shot at securing some of these face with major challenges related
credits. to accounting, monitoring, and
enforcement. We have no indication
International negotiations are
of volume or prices for either of these
increasingly focusing on two new
mechanisms, but we expect they will
types of international credits:
play a large role in compliance post-
reduced and avoided deforestation
2012.
(REDD) projects and ‘sectoral credits’
(see Textbox 3). The Waxman-Markey
bill signals a strong interest in both

Textbox 3: Wither the Clean Development Mechanism?

The future of the CDM will be renegotiated in Copenhagen in December 2009, in an attempt to address concerns about the
quality of projects, the countries where they are located, and efforts to redefine eligible project types. An important source of
supply uncertainty stems from the discussion on project types and reforming the approval process. Stricter approval criteria
could lead to a dwindling of the supply, possibly matched by tough import limits by the EU ETS in Phase 3.

Another source of uncertainty comes from the fact that countries currently hosting most of the CDM projects – China, India,
Mexico, South Korea, etc. – might take on mandatory targets after 2012 in a successor agreement to Kyoto, which would
end the supply of offset credits coming from those countries. The emissions reduced by CDM projects taking place in those
countries would then count toward the respective country’s achievement of its emission reduction obligation. This expectation
that more countries will take on legally binding reduction commitments post-2012 explains the dramatic fall in supply between
2015 and 2020.

CERs could be replaced by sectoral credits, a proposed mechanism based on a no-lose target for a set of industrial installations
in advanced developing countries. Under this proposal, the group of installations, ideally covering a whole industrial sector,
would have an emission target below its business-as-usual emissions. If it reduces emissions below the target, it will be given
credits equal to the difference between the target and actual emissions. But there would be no penalty if the targets are not
met. The mechanism is anticipated to generate larger volumes of reduction credits than the CDM.

8 All rights reserved © 2009 Point Carbon

Carbon Market Analyst North America
International allowances
The Waxman bill also permits
emitters to use allowances from
other emission trading programs
for compliance. Until recently, this
would have applied to the EU ETS
exclusively, but the implementation
of a “carbon pollution reduction
scheme” by 2010 in Australia, as
well as the expectation that other
countries (New Zealand, South
Korea) may follow suit, opens up new
possibilities.
The limitation on the
use of international
allowances will come
from prices
Volumes are potentially large, since
the entire pool of allowances from the
other trading programs could be used
for compliance. The Waxman-Markey
bill does not set any limitation on the
use of international allowances for
compliance, so that the limitation is
more likely to come from prices.
At current prices, European Union
Allowances (EUAs) and Australian
Emission Units (AEUs) could
constitute an attractive compliance
option. Figure 4 plots prices for EUA
futures (Dec 12 delivery). However,
Point Carbon anticipates prices will
increase in the EU ETS, as the cap
for its next compliance phase (Phase
3, 2013-2020) is very strict. We
forecast prices at €42 in 2013 and
€48 on average over the whole phase
(assuming no linkage with the US).
To conclude – domestic offsets will
not fill much of the gap as they are in
short supply. US offsets are currently
the least cost option but this might
change if we see the same trend
as in the CDM market. CERs are
priced based on their value in use
(i.e. as substitutes for EUAs) and not
based on marginal production costs.
US offsets would then track US
allowance prices at a discount.
9 All rights reserved © 2009
CMA April 2, 2009
Textbox 4: Towards a global market?
Our analysis of the role of international allowances assumes that US emitters could
purchase allowances from Europe or Australia, but that the reverse is not true. In the
long term, however, one could foresee increasingly integrated global markets where
allowances would be freely traded from one compliance program to another. The
European Commission suggested in a recent Communication that it ambitioned to
see an OECD-wide market - including all major industrialized countries – by 2015.
If there are no restrictions on the use of allowances in other markets, this would
lead to a global, unique carbon price. In practice, countries are likely to set a limit,
or quota, on how many ‘foreign’ allowances can be used for compliance – creating
different subsets of prices.
Even if direct trading of allowances is not allowed, international offsets could
indirectly link different programs, as emitters in each country would be competing
for the same credits. Hence policy developments abroad could play a role in price
formation and market dynamics in the US in the medium to long term.
The role of international offsets is Internal Abatement
more uncertain. The CDM may not
be the right vehicle for the long term We now consider ways to reduce
supply of credits to the US market. If emissions for large compliance
an agreement is found in Copenhagen players, ‘internal abatement’.
on sectoral credits and / or on REDD,
these would likely constitute the bulk As the import limits of offsets and
of the credit flow into the US. international allowances are de facto
almost unlimited, the split between
International allowances could play offset credits and internal abatement
a large role if the various emission as compliance option will mainly
trading programs establish linkages depend on prices.
allowing free trade from one program
to the other. Emitters have many emission
reduction options, including
Figure 4: EUA future prices
40
EUA 2012
35
30
25
Price €/tCO2e
20
15
10
5
0
08 08 08 08 08 08 08 08 08 08 08 08 09 09 09
an- eb- ar- pr- ay- un- Jul- ug- ep- ct- ov- ec- an- eb- ar-
J F M A M J A S O N D J F M
Point Carbon
Carbon Market Analyst North America
Figure 5: Fuel switching curve in the US, spot and 2012 future prices
We use NYMEX spot and 2012 future fuel prices as of March 24, 2009
$50
$40
USD per ton of CO2e
$30
$20
$10
$0
0 50
improvement of industrial processes,
reducing methane leaks in pipelines
and refining, limiting the use of high
“global warming potential” (GWP)
gases – fluorocarbon gases, etc. We
focus on fuel switching exclusively
because it is more likely to deliver
large numbers of emission reductions
and thus be on the margin.
Fuel switching
Large reductions can come from the
power sector: as the price of carbon
penalizes more carbon-intensive
fuels (coal, petroleum) than natural
gas or carbon-free generation, the
economics start working in favor of
the less carbon-intensive fuels (see
our report The Power of Carbon, June
2008 for a detailed analysis of this
issue).
The amount of reductions at any
given carbon price varies with the
relative price of the fuels. Point
Carbon created a simplified model
to evaluate the amount of reductions
associated with fuel switching from
coal to gas by applying a carbon price
to the electric generation fleet by
10
US Fuel switching curve
fuel spot prices
$50
$40
USD per ton of CO2e
$30
$20
$10
$0
100 150 200 250 300 350
Million tons CO2e
region. Switching varies by region,
but the model assumes that price
would trigger the switch regardless
of any technical impediments.
Reductions from fuel
switching are ex-
tremely sensitive to
fuel prices
Figures 5a and 5b show emissions
reductions from fuel switching in
$5 increments. Figure 5a uses spot
fuel prices from March 2009 ($4.35
natural gas, $49 coal, $63 SO2, $625
Nox) while Figure 5b plots the fuel
switching curve using future prices
for December 2012 delivery, as of
March 24, 2009 ($7.45 natural gas,
$67 coal, $35 SO2, $650 Nox.)
The figures illustrate the extreme
sensitivity of fuel switching to actual
fuel prices. A carbon price of $10 a
ton yields over 120 mt of reductions
in GHG emissions in one case, and
a mere 10 mt in the other. If natural
gas is relatively more expensive than
coal, it takes a higher carbon price
CMA April 2, 2009
US Fuel switching curve
future fuel prices (2012 delivery)
0 50 100 150 200 250
Million tons CO2e
to make the switch economical on
power markets.
Fuel switching has a potential for large
volumes of emission reductions.
However, if coal prices are low, the
carbon price needed to realize this
potential can climb very rapidly, as
seen in Figure 5b. If fuel switching is
expensive and is setting prices on the
carbon market, it will provide a strong
signal for emitters to look into other
internal abatement measures. These
abatement measures would create
a negative feedback loop that would
eventually pull back down prices,
to the point where fuel switching
is more economical than any other
abatement strategy.
Market Implications
Price formation
Prices on the carbon market are set,
like those of other commodities,
by the intersection of supply and
demand. Figure 6 represents a
conceptual marginal abatement cost
curve. In this example, we assume
All rights reserved © 2009 Point Carbon
Carbon Market Analyst North America
domestic offsets are the lowest
cost compliance option, followed by
international offsets. Fuel switching
(internal abatement) comes next,
with international allowances at the
higher end of the range.
The demand intersects the marginal
abatement curve at 205 million
tons (the 2012 E-t-C without
complementary policies), calling
for some amount of fuel switching
and bringing prices to around $30
a ton. Should energy efficiency and
renewable electricity standards be
adopted, the demand curve would be
lower, and would intersect the MAC
curve at 87 million tons. International
offsets would be on the margin, no
fuel switching would be needed, and
prices would be below $15 a ton.
Conversely, as the size of the E-t-C
gap grows over time, the demand
curve will shift to the right because
US emitters will have
to compete with
other countries for
the international credits
emitters will need more allowances
to cover a greater shortfall. This will
push prices up the fuel switching
curve if no other type of reduction
takes place. As discussed above, the
MAC curve is itself subject to change
as offset supply and fuel prices
change over time.
We now tie the pieces together and
discuss likely compliance strategies
for selected compliance periods in
the first decade of the cap-and-trade
program.
2012-2013 – Few reductions
needed
The first compliance period would
require about 140 million tons of
reductions each year. US offsets
will not suffice to meet the gap.
11
Figure 6: Conceptual MAC curve
Price
$60
Demand goes up
as EtC grows
$50
USD per ton of CO2e
$40
$30
$20
Int’l Offsets
$10
US Offsets
$0
0 100
CERs would constitute the next
most attractive compliance option.
If prices on the EU ETS have not
recovered, EUAs could also be part of
the compliance mix and would bring
prices on the US market to about
$20 a ton. If emissions and prices
recover in Europe by 2012, prices in
the US would likely be set by CERs
and could therefore track EUAs at a
discount. This would constitute the
first hint of market linkages.
It is also possible that the scheme
would be somewhat over-allocated if
the recession has an enduring effect
or if energy efficiency investments
deliver their theoretical emission
reduction potential. The program
would not be compromised if
it started with a brief period of
over-allocation, provided that over-
allocation is small: participants would
likely bank allowances for later years,
when the caps get tighter. This would
prevent prices from crashing to
zero. The bank would create a small
cushion to help buffer volatility from
fuel prices or unforeseen exogenous
events.
CMA April 2, 2009
Marginal Abatement
cost curve (supply)
Int’l Allowances
Fuel switching
Demand curve
200 300 400 500 600 Volume
Million tons CO2e
If the effect of complementary
policies is lower than expected,
market participants will have
to procure more offsets and
international allowances or turn to
internal abatement.
2016-2018 – A wide array of
abatement strategies
By the time the third compliance
period rolls in, the gap will have
grown to over 550 million tons:
this strong demand for allowances
calls for a wide array of reduction
strategies. All available US offsets
will be tapped and the demand for
international offsets will increase.
The gap could still potentially be met
through international offsets, possibly
including the new credit types from
sectoral and forestry programs.
If the competition for international
offsets was such that offsets could
only cover half the gap, 250 million
tons of reductions would be needed.
Such volume of fuel switching would
call for very high prices, up to $85 a
ton. Hence other compliance options
would likely come into the mix –
All rights reserved © 2009 Point Carbon
Carbon Market Analyst North America
Figure 7: Meeting the E-t-C
6400
6200
6000
5800
5600
5400
5200
BAU Stimulus RES EnEf Remaining Dom.
emissions offsets
other internal abatement measures.
International allowances, even priced
at €50 a ton, could remain attractive.
Figure 7 shows the wide array of
compliance options that will be
necessary to meet the gap in the
medium term.
2020: The breaking point?
In 2020, with a gap close to 800
million tons, we would approach the
point where meeting the gap under
current technological constraints
becomes very costly – unless the
supply of international credits is
sustained and affordable.
High carbon prices could also raise
the interest in creating linkages
with a large number of countries.
The larger market could help
dampen the volatility derived from
fuel prices and would theoretically
enable all participating countries to
take advantage of the lowest cost
reductions through the market.
This is especially true if countries
like South Korea or Mexico set up
their own trading program, where
reduction costs could be lower than
in Europe or in the US.
12
Int'l Fuel
Offsets switching
What to expect post-2020
Our analysis was focused on the
short to medium term as it allowed
us to project the impact of policies
currently under discussion and to
assume no major technological
breakthrough would occur. But with
a rapidly declining cap, change within
the system will quickly become very
costly, providing a strong incentive
for technologies in the development
stage today like carbon capture and
storage or electric cars. Offsets
play a key role in helping keeping
prices down while this transition
takes place, since investments in
cleaner power plants and new energy
systems take time. Whereas offsets
provide a temporary fix and a useful
cost-containment mechanism, they
do not substitute for necessary long
term changes.
Conclusion
All signals indicate that the new
administration and Congress are
serious about their commitment
to lower GHG emissions. The
dominant strategy involves a mix of
command-and-control and market-
based mechanisms. The regulatory
All rights reserved © 2009
CMA April 2, 2009
provisions – energy efficiency and
clean energy standards for the power
and transportation sectors – have the
capacity to evoke large reductions
at a fairly low cost, especially for
energy efficiency measures. These
provisions are not only crucial for the
US to meet its target; they will also
lower significantly the price of carbon
on the traded market.
US offsets are unlikely to play a
large role as a cost-containment
mechanism because their supply
is very constrained. An increase
in investment will help increase
the available volumes, but the key
Cap
limitation is physical rather than
financial.
The degree to which the internal
abatement option of fuel switching
is deployed largely depends on the
level of reductions achieved by the
other options. Some amount of
switching will occur, but the carbon
cost at which fuel switching becomes
economical is very volatile and does
not provide the clear, predictable price
signal needed to redirect investments
towards clean technology in the long
term.
These limitations put the spotlight on
international offsets and allowances,
where larger amounts of emission
reductions could come from
developing countries at lower costs.
But uncertainties related to the
upcoming international negotiations
still cloud forecasts both for volumes
and prices. The experience with
the CDM shows, however, that
maintaining high standards and
submitting projects to a stringent
evaluation process raises prices
even for initially low-cost projects.
International allowances and linkages
with other emission trading system
could also help temper prices in the
medium term. The outcome of the
Copenhagen negotiations will thus
have significant implications for the
US carbon market.
Point Carbon
Contacts CMA April 2, 2009

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