Moving toward Stringency in Emissions Trading Professor Lesley McAllister University of San Diego School of Law

Roadmap  Emissions Trading (Cap & Trade) Basics  Slack in Program Caps  Empirical Evidence of Slack  Sources of Slack  Comments on the California Market Advisory Committee (MAC) Recommendations of June 2007.

Cap and Trade Basics  Program Cap: The limit on the total amount of pollution that a set of sources may emit over a period of time (the reporting period). –Sources are allocated shares of the cap in the form of “allowances” or “tradable permits.” –An allowance is the right to emit a certain quantity of pollution over the reporting period.

Cap and Trade Basics (cont.)  Trading: Once allowances are allocated to sources, sources may buy and sell them.  Banking: If a program allows banking, a source that doesn’t use allowances in one time period, can hold, or “bank,” them for use in a future time period.

Typical Story of Cap and Trade  The emissions of a set sources that currently produce x tons of pollutant are capped at some level below x. Each source then receives allowances that give it the right to emit less pollution than it currently emits.  Three paths to compliance - A source may: –reduce emissions to meet the number of allowances, –reduce their emissions below the number of allowances and then sell the rest, or –emit at a level higher than the number of allowances and purchase allowances to make up the difference.  Emissions reductions & Economic efficiency

But what if…  The program cap is higher than the amount of emissions currently produced; many or most sources are allocated more allowances than they need to cover their emissions. –Would allowances have any value on the market? –Would the program lead to emissions reductions?  At the end of the year, it is likely that all sources will be in compliance and the costs of compliance will be very low – sources would spend little or no money to comply because each source had enough allowances to cover its emissions. –But would the program be effective in terms of its environmental outcomes?

Defining “Slack” in Program Caps  Slack is present when the aggregate number of allowances available to sources exceeds the emissions that the sources produce.  Slack can be measured as a percentage: the percentage by which allowances available for use in a given reporting period exceed the actual emissions.  e.g. If 990 allowances are available to be used in the reporting period, and sources in the program only emit 900 tons, the overall cap for that period can be said to have a slackness of 10%.

RECLAIM Annual cap exceeded actual emissions for the first five years of the program. With large-scale noncompliance in the California electricity crisis ( ), direct regulation was adopted to force major emitters to reduce emissions.

Slack in RECLAIM

ERMS The cap was significantly higher than emissions in all years of the program.

Slack in ERMS

The Acid Rain Program The number of allowances available for use each year (which includes unused allowances banked from previous years) was significantly greater than actual emissions in all years of the program. The number of allowances available for use each year (which includes unused allowances banked from previous years) was significantly greater than actual emissions in all years of the program.

Slack in the Acid Rain Program

Effects of Slack Caps  Low allowance prices –Emissions reductions don’t happen because it is cheaper to buy allowances than to reduce emissions.  Build up of a large bank if banking is allowed –Allows more emissions in future years  Minimal emissions reductions that can be attributed to program

Market Price of Allowances  If the cap is not slack, market price of an allowance should reflect the marginal cost of reducing an allowance-worth of pollution.  If the cap is slack, market price of allowance will be very low, reflecting merely the cost of the transaction and perhaps some speculation.

Sources of Slack “when a market is created through political action rather than emerging spontaneously from the needs of buyers and sellers, business will seek to influence market design for commercial advantage.” -John Kay, Financial Times, 5/9/06

Sources of Slack (cont.)  Allocations of allowances based on historical emissions opens the door for strategic behavior. –Sources have been allowed to choose which year will be their historical baseline from a range of years (i.e. ARP, Reclaim). –Sources have been able to get extra allowances by showing that they made pre-program reductions.

Sources of Slack (cont.)  Availability of offsets: sources can acquire allowances by enabling emissions reductions external to the program.  Handling of shutdowns: Shutdowns may not reduce cap; allowances may be continued to be allocated (ERMS, Reclaim).  Failure to adequately consider the impact of co-existing direct regulations that lead to emissions reductions (ERMS).

Recommendations of California’s Market Advisory Committee  Factors that introduce slack: –Envisions the use of offsets –Envisions allowances for early reductions –Envisions some allocation based on historical emissions –Envisions co-existence with direct regulation –Envisions unrestricted banking

Recommendations of MAC (cont.)  Factors that work against slack: –Envisions that program cap will be set independently from the allocation process. –Envisions some use of auctioning, increasing over time. –Identifies the creation of market scarcity as an important design feature

“The Motion has been made and seconded that we stick our heads in the sand.”