Transcript What Point of Allocation?

An Overview of Greenhouse Gas Trading
Design Issues
Robert N. Stavins
John F. Kennedy School of Government, Harvard University
Cambridge, Massachusetts 02138
and
Resources for the Future
Presentation for Workshop Convened by
The National Commission on Energy Policy
Washington, D.C.
September 1, 2005
Background and Context
• Kyoto Protocol has come into force without U.S.
participation -- effects on climate change will be trivial to
non-existent; yet scientific and economic consensus point
to need for a credible approach.
• Pressing need for a credible international agreement that is
scientifically sound, economically rational, and politically
pragmatic.
• The Kyoto Protocol is none of these.
• Promising alternative international policy architectures
exist, but that’s not our topic for today.
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Background and Context (continued)
• While international discussions continue, a topic of
increasing importance is how will the United States
respond
– When it adopts national targets to reduce net emissions of greenhouse
gases (GHGs).
• What means -- what instruments of public policy – should
the government use to bring about GHG reductions?
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Domestic Policy Instruments
for Climate Change
• Because of their great advantages at keeping costs low in
the short term, and bringing costs down even lower in the
long term, most attention has been focused on marketbased instruments (MBIs).
• In particular, proposals from academia, government,
industry, and NGOs have frequently featured tradeable
permit systems.
– Because of Theory
– Because of Experience
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Experience
• Great success of SO2 Allowance Trading Program (CAA of 1990) is
widely acknowledged.
• Does that success indicate that a similar cap-and-trade system is the
best approach for CO2 and other GHGs?
– Differences between SO2/acid rain and fossil fuels/climate change suggest
caution before rushing to judgment.
– But the differences – as well as some similarities – can help inform
answers to key questions of policy design for a domestic GHG trading
system.
• My purpose is to highlight those key design issues for a domestic GHG
cap-and-trade system.
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Key Design Issues
for a Domestic GHG Cap-and-Trade System
• What scope of coverage?
• What point of regulation?
• What point of allocation?
• What rules for allocation?
• What about temporal flexibility: banking & borrowing?
• What about enforcement?
• Are there needs for government brokerage?
• Are there competitiveness concerns? Barriers to entry?
• Can and should there be linkages with international systems?
• At a minimum, how can foolish design elements be avoided?
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What Scope of Coverage?
• What sources, what industries should be included?
• A major issue of discussion and debate when the European Union’s
Emissions Trading System was being designed
• But not the best way to begin thinking about designing a system
• Just posing this question limits the set of possible designs, and omits
what may be some of the best ones.
• Instead ……
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What Point of Regulation?
• Possibilities include:
– Downstream (CO2 emission sources) -- CO2 emission permits
• Similar to SO2 allowance trading
• Very successful program – you’ve already heard about it
– Upstream (producers and importers of fossil fuels) – carbon rights
linked with carbon content of fossil fuels
• Similar to EPA Lead Trading in 1980s
• Very successful program – phased leaded gasoline out of the market
in 5 years, low transaction costs, cost savings of $250 million/yr
– Various midstream alternatives
• How can one decide among the alternative points of regulation?
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Criteria for Identifying
the Point of Regulation
• Breadth of coverage
– Downstream CO2 emission permits likely to include electricity generators;
likely to exclude motor vehicles, home furnaces, etc.
– Upstream carbon rights provide complete coverage of CO2 emissions, but
non-combustion uses of fuels affected (need compensating credits)
– What about carbon management (separation & removal of CO2 from stack
gases)? Upstream system provides no incentive; need credits.
– What about biological carbon sequestration? Integrated trading system?
Much more difficult, but possible (and quantitatively important).
• Number of regulated entities (monitoring & enforcement, but
competitiveness concerns with very small market)
• Monitoring – required for market confidence, but CEM very costly
• Which GHGs? A design issue itself, which can affect choice of point of
regulation.
– CO2 only or others as well? Inter-gas trading?
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What Point of Allocation?
• Important: the point of allocation need not be the same as the point
of regulation – these are separate design issues
– For example, upstream regulation can – in theory -- be combined with
mid-stream or downstream allocation of the tradeable permits
• Possibilities for point of allocation include:
– Downstream (CO2 emission sources) -- CO2 emission permits [or even
further downstream, e.g. electricity users]
– Upstream (producers and importers of fossil fuels) – carbon rights linked
with carbon content of fossil fuels
– Various midstream alternatives
• The point of allocation, combined with the nature of the allocation
affects the distribution of the cost burden (later).
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What rules for allocation?
• Question #1: auctioned, given w/o charge, or a mix?
– Political advantages of freely allocated can lead to efficiency problems
• Usually costs under TPs are independent of initial allocation, so allocation can
be left to political process (good news, and that’s why these systems are used)
• But TPs can exacerbate distortions & drive up costs
• And in presence of some types of transaction costs, post-trading outcome is
sensitive to initial allocation
• So, a successful attempt to establish politically viable program through initial
allocation can increase costs
• Other Issues involving Rules for Allocation:
– Choice of baseline & baseline year for allocation
– Specific allocation cross-sectionally and over time
• Rules for allocation, point of allocation, and point of regulation do
affect distribution of costs, but statutory incidence is typically not
the same as the actual burden. [Depends upon market conditions: supply
and demand]
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What about temporal flexibility?
• Among the rules that govern trading, those that affect temporal
flexibility are exceptionally important.
– Banking (saving emission permits for a future time period) has been key
in both the lead trading program and the ongoing SO2 program
• But programs that are phased in over time can create emissions leakage from
regulated to unregulated sources
– Borrowing (using emission permits from a future period) can – in theory -increase cost-effectiveness of a program
•
Rules for banking & borrowing and for the length of compliance periods
(1 year in the SO2 program, 5 years in the KP) should depend upon nature
of environmental problem (and potential solutions)
– Key reality is that global climate change is a stock externality problem of
very long duration (GHG resident times in atmosphere of decades to
centuries)
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What about enforcement?
• MBIs, such as cap-and-trade systems, are not deregulation, but
rather more enlightened regulation – government enforcement is
required.
• Stiff penalties provide effective incentives for compliance, but
excessive penalties are not credible
– In SO2 program, penalty is $2,900/ton of excess emissions (compared with
marginal abatement costs that have been 10% of that); result – near perfect
compliance
– SO2 program also requires emissions offset in subsequent year. If this is
eliminated, penalty is a tax on “excess emissions,” and we have a “safetyvalve” on costs. Another major design issue.
• So, reasonable penalties are necessary, but avoid prior approval by
government for trades – drives up transaction costs
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Are there needs
for government brokerage?
• No!
• Private sector can and will fulfill brokerage needs.
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What about competitiveness concerns?
• Can permits in a cap-and-trade system be used as barriers to entry
by incumbent firms?
– Yes – in theory, firms with market power in either the permit market or
respective product markets can withhold permits from the market, driving
up price, and keeping out competition. What to do?
– Solution in SO2 allowance trading program was a zero-revenue annual
auction of about 3% of the allowances (government is a seller of last
resort)
– Can be a problem in theory, but has not been in lead or SO2 programs.
Ultimate response is not for EPA, but the anti-trust folks at DOJ.
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Can and Should there be Linkages
with International Systems?
• Back to where I began, a domestic trading program should be
part of a sensible global climate agreement (that provides for
trades across national boundaries).
• But in the meantime, can and should a domestic cap-and-trade
program be linked with other countries?
– Linking with CDM or JI projects very risky
• Relative baseline, unobservable counterfactual means all claims of reductions
very questionable
• Perverse incentives exist for both parties to take credit for what would have
happened anyway – cap is loosened, environmental integrity destroyed
– Only countries that ratified KP, can trade with EU system (as of now)
– The devil is in the details
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The Hypocratic Oath of Policy Design:
Avoid counter-productive
design elements
• Stakeholder involvement is fine, but design by committee
can lead to some very unfortunate consequences
– A sad example: EPA Emissions Trading Program for criteria air
pollutants in the 1970s.
• Environmental advocates insisted on infamous 20% rule
• Result: discouraged trades, reduced cost savings, minimized
environmental gains
• Let’s not follow (Dudley) Moore’s version of Santayana’s
advice: “I can remember all my mistakes, and repeat them
exactly the same again.”
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For More Information
http://www.stavins.com
“What Can We Learn from the Grand Policy Experiment?
Lessons from SO2 Allowance Trading”
“Beyond Kyoto:
Getting Serious About Global Climate Change Policy”
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