Cap and Trade: Managing Decisions around Allocation

Jennifer Morgan Director, Climate and Energy Program June 23, 2011
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BASIC BUILDING BLOCKS OF CAP-AND-TRADE

ENFORCEMENT & PENALTIES FOR NON-COMPLIANCE SOURCES TRUE UP AT END OF EACH COMPLIANCE PERIOD ESTABLISH COMPLIANCE PERIOD FOR SOURCES DISTRIBUTE OR AUCTION ONE ALLOWANCE FOR EACH TON IN BUDGET DETERMINE THE REDUCTION OVER TIME (i.e., SUCCESSIVE BUDGETS REDUCED)

ESTABLISH ANNUAL EMISSIONS CAP (OR ANNUAL ALLOWANCE BUDGET)

ESTABLISH AGGREGATE EMISSIONS BASELINE FOR SOURCES REQUIRE ENTITIES TO MEASURE, MONITOR & REPORT EMISSIONS IDENTIFY ENTITIES TO BE COVERED IN ONE OR MORE SECTORS

Allowance Distribution Key Concepts

Allowances are assets created by government Value is not known in advance Distribution is much like handing out money Distribution is inherently a political exercise

Allocate Allowances to Sectors

Should allowances be divided among covered sectors and/or other entities or should they be put up for auction? If apportioned among sectors, then how many allowances does each covered sector get?
What are the key criteria for dividing up allowances among sectors to establish sectoral allowance budgets?
Emissions baselines for each sector? Relative competitive posture of each sector? Relative ability to reduce emissions? Ability to pass through costs? Other?

How will subsequent sectoral allowance budgets be determined? i.e., what reductions will take place where?
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Distributing Allowances to Covered Entities

How should allowances be distributed?
Allocate to covered entities based on:
Past emissions, or grandfathering? Recent emissions relative to output on an updating basis? Output only

Auction?

Will amount auctioned increase over time?

Summary of primary distribution options

Type
Grandfathering Output-based, Updated

Description
Allocations to existing sources, based on past emissions. Allocations to existing emissions sources, based on recent emissions per unit of output; updated every X years

Examples
U.S. SO2 Program; Most EU ETS Members Certain Northeast States in NOx Program, WaxmanMarkey for industry

Input-based, Updated Auction

Allocations to existing Certain Northeast sources, based on States in NOx recent heat input; Program. updated every X years Allowances sold at auction Most RGGI states; Partial Auctions in EU; Small US SO2 Auction

Pros and Cons of Distribution Options

Type Pros Cons
Familiar approach, May penalize early insures proportional action, reward large distribution for all emitters emitters Rewards and incentivizes May generate windfalls efficiency for low-emitters Avoids penalizing cogeneration Price discovery, revenue generation for cost mitigation, other programs Does not fully reward efficiency May adversely affect GHG intensive sources in early years, international competitiveness issues

Grandfathering
Output-based, Updated Input-based, Updated Auction

Allocation to non-regulated entities

Allowances can be distributed to mitigate cost to affected groups Examples
Consumers States Displaced workers Local governments Internationally competitive industries

Allowances can also be distributed to reward GHG reductions Examples:

Increased carbon sequestration Low carbon technology deployment Energy efficiency
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Allowances are directed to dozens of purposes

Example: Waxman Markey Allowance Distribution

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Why Auction?
Avoids politics of allocation but introduces politics of revenue distribution Price discovery Raise revenue for complementary purposes Most economically efficient way to distribute allowances but not always most politically viable
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RGGI approach: Nearly 100% auction

Deregulated electricity market means states cannot control generators electricity bids Value of allowance ends up in bid because allowances have value Therefore, consumer pays cost whether allowance is given to generators or the generators pay for them at auction Revenue for program administration, energy efficiency, renewables
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Cantwell-Collins: 100% auction w/ dividend

Auction all allowances to regulated entities (with minimum and maximum prices) 75% of proceed are divided equally among all lawful U.S. residents Other 25% set aside for Congress to use for a variety of purposes through the appropriations process.

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Key features of EU ETS

Cap and trade scheme covering energy intensive industries
Direct emissions approach - liability placed on the entity responsible for emissions and therefore most able to take action Currency is European Union Allowances (EUA) One EUA = one metric tonne of CO2 Allowances freely tradable throughout EU states

EU ETS Timeline
2005 2006 2007 EU ETS PHASE 1 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 EU ETS PHASE 2 1st KYOTO COMMITMENT PERIOD EU ETS PHASE 3? EU ETS PHASE 4?

KYOTO PROTOCOL POST-2012 FRAMEWORK?

January 2005 - EU ETS commences

Phase 1 EU ETS 2005-2007 learning phase Phase 2 EU ETS 2008-2012 Kyoto Commitment Period Phase 3 and beyond.

Sector Coverage
Covers CO2 emissions from combustion processes
(approximately 50% of EU CO2 emissions, 30% of EU greenhouse emissions)

Covers approx 12,000 installations across the EU from these sectors:

Electricity generators Other combustion installations (heat & steam production) Mineral oil refineries Iron and steel production and processing Cement & lime Glass & ceramics Pulp & paper sector
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Allocation of Allowances
National Allocation Plan (NAP) sets out the total number of allowances to be issued and distributed to national installations Member States may auction up to 5% of allowances for Phase I, up to 10% for Phase II Majority of allowances allocated for free
Member States used a range of methods for allocation including historical emissions, projected emissions, sector benchmarks etc

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% difference between Member State allocations and emissions in 2005

Ireland UK Spain Austria Italy Greece Slovenia

Member State

Portugal

Surplus of allocated allowances

Germany Belgium Netherlands France Sweden Hungary

Shortfall in allocated allowances

Czech Republic Slovak Republic Estonia Finland Latvia Denmark Lithuania -50 -40 -30 -20 -10 0 10 20

Percent emissions below allocation

Percent emissions above allocation

Impact of EU ETS to date

Very high compliance in first 2 years Improved emissions data across Europe

Internalising cost of carbon in price of electricity generation

Driving investment in Kyoto project credits (CDM) Behavioural change mainstreaming?
Carbon dioxide has moved out of the domain of the environmental officer at a company to the boardroom and the chief financial officer and the chief executive officer
Head of Director General Environment, European Commission

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Future of the EU ETS

Phase III: 2012-2020 At least a 21 percent reduction from 2005 levels for covered sources New: single EU-wide cap instead of 27 caps set by Member States

CO2 allowances available in 2020: 1720 Mt Linear decrease

predictable trend-line to 2020 and beyond can be adjusted to stricter target

Emissions from all flights taking off or landing in the EU to be included

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Phase 3 allowance distribution

Harmonised allocation rules ensure level playing field across the EU Basic principle for allocation is auctioning:
Eliminates windfall profits Simplest and most transparent allocation system

Full auctioning for sectors able to pass on costs

E.g. Power sector

Partial free allocation to industry as a transitional measure

Phased out by 2020 for normal industry Exception: possibly higher levels (up to 100%) of free allocation to industries particularly vulnerable to international competition (carbon leakage) to be determined in 2010

European Commission to report on carbon leakage by 2011 and make a proposal, if appropriate:
To review free allocation levels and/or To introduce system to neutralise distortive effects
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Allowance distribution in 5 steps

Simplified Allocation Decision Tree
Will allowances 1 be distributed free of charge? yes Government auction Distribution of revenue

no

ALLOCATION FORMULA
3 allowances be

On what basis will pro-rated among recipients?

Will allowances be designated for special incentives? new entrants renewable energy CCS efficiency

upstream fuel suppliers downstream emitters & non - emitters

carbon content market share emissions fuel input output efficiency load consumption per capita discretionary lump sums
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2 Who will

receive the allowances?

consumers & end - users

gov. agencies / states

mitigation of price impacts international programs

Will the allocation formula be updated over time? How?