In December 1997, members of the United Nations Framework Convention on Climate Change (UNFCCC) negotiated the Kyoto Protocol that established emissions reductions for the developed and developing nations that ratified the Protocol.  The Protocol went into force in 2005.  Today’s global carbon markets include compliance markets based on a “cap-and-trade” system whereby emissions are “capped” and then emission rights are freely “traded”.  A related but separate emission credit creation system (sometimes called a “baseline-and-credit system”) whereby reductions achieved in third-world countries are available for sale under “cap-and-trade”, and a much smaller voluntary system.  The principal example of the cap-and-trade system is the European Union Emissions Trading Scheme (EU-ETS).  The principal examples of the baseline-and-credit system are the Clean Development Mechanism (CDM ) used in projects in China, India, and Africa, and the Joint Implementation (JI) system, primarily used in Eastern Europe and the countries of the former Soviet Union.  According to the research group New Carbon Finance , in 2008 the global carbon markets reached $118 billion, an 84% increase from 2007 levels.

In the United States, President Obama has said that he favors a cap-and-trade carbon emission system.  A cap-and-trade and offset spending bill sponsored by Senators Joe Lieberman and John Warner (“Lieberman-Warner bill ”), as amended on May 20, 2008 by Barbara Boxer (“Lieberman-Warner-Boxer ”), did not muster enough votes on the floor of the Senate during the first week of June to prevent a potential filibuster.  A significant problem with the Lieberman-Warner-Boxer was that it contained “green pork” to the tune of over $5 trillion between passage and 2050.  (The original Lieberman-Warner bill, S.2191, was estimated by the Congressional Budget Office to cost $1.12 trillion.)  Both bills had the goal of reducing greenhouse gas emissions from covered facilities by approximately 70% between 2012 and 2050.   S. 2191 was considered essentially neutral revenue by the CBO because its costs to the government were expected to be offset by the sale of emission credits.  However, it had an estimated cost to the private sector of $90 billion annually from 2012 to 2016.  Annual costs to the private sector after 2016 would have likely increased due to an increasing portion of credits being sold; as opposed to being awarded and progressively fewer credits being available.   Although Lieberman-Warner-Boxer did not pass, talks are continuing and the House is working on its own bill.  Understanding how Lieberman-Warner-Boxer was structured (apart from the green pork) should be of help in understanding whatever carbon trading bill is finally passed.

An Overview of How the Markets Work

Cap-and-Trade

Under a cap-and-trade system, an overall cap is set on carbon dioxide emissions and a finite amount of emission allowances; they are either auctioned off or handed out by governments starting from an agreed base.  Each year, fewer allowances are available and thus, over time, carbon emissions are reduced.  As discussed in more detail below, the goal of the EU-ETS is a 20% reduction by 2020 from 1990 levels and the goal of the Lieberman-Warner-Boxer bill is a 70% reduction by 2050 from 2012 levels.

In such a system, carbon emission allowances are freely tradable until they are turned over to the government to cover a company’s carbon emissions in a given year.  Companies not achieving sufficient emission reductions in any one year (needing credits) can buy emission credits from companies that exceed required reductions, from brokers, or from others on the open market.  Conversely, companies exceeding emission targets can sell the credits directly to those needing them, to brokers, or to others on the open market.  The largest such market presently is London’s European Climate Exchange (ECX).

Baseline-and-Credit

Under the baseline-and-credit system, credits are generated with a new construction or carbon emission control project in a developing country that achieves an emissions reduction.  This reduction is known as “additionality”.  The host country in which the project is carried out must support the claim.  Subsequently, an independent third party must verify the “additionality” of the emission reduction.  The reduction is then certified by a UN body. 

The baseline-and-credit system can be used in connection with a cap-and-trade system.  For example, the CDM mechanism, which was established under the Kyoto Protocol, allows companies to implement projects in developing countries (i.e. China, India, etc.) that emit less than would otherwise be the case under local law.  The sponsor must also show that the project would not have been built “but for” the credits.  When the additionality has been certified, the sponsor (or any buyer of the credits) may sell the carbon credits in the EU-ETS. 

The idea behind the CDM is that emission reductions achieved in China, India, etc. benefit the global environment as much as emission reductions in Europe and may be cheaper to implement.  As also discussed below, there are significant risks associated with these projects.  At present, the EU-ETS limits certified emission credits to 14% of the total. 

The EU-ETS – Presently the Leading Cap-and-Trade Compliance Market

The International Emission Trading Association (IETA) estimates that the EU-ETS comprises two-thirds of the volume of global emissions trading and three-quarters of the financial value.  According to the research group New Carbon Finance, in 2008, carbon trading in the EU-ETS reached $94 billion. Under the EU-ETS, the European Union (EU) committed to achieving a reduction in greenhouse gas emissions of 20% relative to 1990 levels by 2020, as well as achieving a 20% improvement in energy efficiency and consuming 20% of all primary energy in 2020 from renewable resources. 

The EU-ETS is divided into three phases: Phase I began in 2005 and ended in 2007, Phase II started January 1 of 2008 and continues through 2012, and Phase III begins in 2013 and continues through 2020.  According to the European Commission, approximately 10,000 installations are covered by the EU-ETS that account for approximately half of the EU’s carbon dioxide emissions. They include combustion plants, oil refineries, coke ovens, iron and steel plants; they also include factories making cement, glass, lime, brick, ceramics, pulp, and paper.  Trade is done in carbon dioxide emissions EU allowances and also in Certified Emission Reductions from CDM projects and Emission Reduction Units (ERUs) from JI projects.  The value of EUAs traded on the ECX has varied over time.  EUAs traded at $27 per metric ton of carbon dioxide in April of 2007.   In May of 2008, EUAs traded at $40.50 per metric ton of carbon dioxide. In November of 2008, the price of EUAs dropped to $20.64 per metric ton of carbon dioxide.  This most recent drop is due in part to the lower exchange rate for the Euro against the dollar and to the slowing EU economy.

Because of the complex nature of EU governance, each Member State establishes a National Allocation Plan (NAP) to determine the total quantity of carbon dioxide allowances for each phase.  The European Commission then has to evaluate the NAPs based on criteria laid out in Annex III to the Emission Trading Directive. These criteria include ensuring that the proposed total quantity of allowances meets with Member States’ Kyoto targets and that Member States have assessed the potential for emissions reductions in all sectors.  After NAPs are approved by the European Commission, Member States can make final allocation decisions.  During Phase I of the EU-ETS, Member States allocated 95% of the allowances free of charge.  The penalty for non-compliance in Phase I was $62 per excess ton.  In Phase II, 90% of allowances are allocated free of charge.  The remainder of allowances (i.e. 10%) may be auctioned off by the Member State.  Registries keep track of the issue of the allowances, as well as the holding, transfer, and cancellation of allowances.  The penalty for non-compliance in Phase II is $155 per excess ton.  Also in Phase II, companies are able to bank the EUA for future compliance periods.

On December 17, 2008, the EU revised the Emissions Trading System.  The revised EU-ETS calls for a reduction in emissions of at least 20% in Phase III relative to 1990 emissions.   However, if other industrialized countries commit to comparable efforts post-2012, then the goal would be to reduce emissions by 30% from 1990 levels.  There will be one EU-wide cap on emission allowances instead of 27 national caps - NAPs will no longer be needed. This annual cap will decrease along a linear trend line of 1.74% in relation to the Phase II cap.  For example, based on current data the cap in 2013 will be set at 1.974 million tons of carbon dioxide, the cap in 2014 at 1.937 tons, the cap in 2015 at 1.901 million tons, and so on.  This linear cap will continue to apply beyond Phase III.  A portion of the allowances (apparently not yet determined) will be auctioned beginning in 2013 and the proportion will increase in subsequent years to 70% in 2020 with a view to reaching 100% by 2027.  Ten percent of auction allowances will be redistributed from the Member States with high per capita income to those with low per capita income. 

As noted above, besides EU allowances, certified emissions credits from the baseline-and-credit systems (i.e. CERs from the CDM mechanism and ERUs from the JI mechanism) are also traded under the EU-ETS.  During Phase II, these credits are limited to 14% of aggregate allocations.  In Phase III, based on a 20% emissions reduction by 2020, it is expected that up to half of the emissions reductions required in Phase III can be achieved by their use.  This should reduce the pressure on European industry since, in effect, it will be able to buy 50% of needed credits from developing world projects.  However, only credits accepted by all Member States during 2008 to 2012 can be used under this proposal. 

The CDM Baseline-and-Credit System

The Clean Development Mechanism offers a way for companies subject to EU-ETS to earn CERs for projects implemented in developing countries.  According to the IETA, CERs sell for between $15 and $24 per ton.  There are several types of projects that can generate CERs such as: biological sequestration, destruction of industrial gases with high global warming potentials, methane capture, projects that increase energy efficiency, and renewable energy projects.  However, not all types of projects are accepted in each trading system.  For example, nuclear and forestry projects, as well as some hydropower projects, are not eligible for EU-ETS compliance credits.  Companies that finance the projects take on risk because approval of the projects can be denied by the UN’s CDM Executive Board. Riskier still, when the project is completed it may not achieve the emissions reductions called for in the planning documents. 

During the planning phase of a project a feasibility study is conducted and a methodology is established to determine a project’s baseline and additionality.  A Project Design Document is completed that describes the project in detail.  The project then must be must be validated by an independent UN-approved third-party auditor, called Designated Operational Entities (DOEs).  Currently, three auditors dominate the business: Det Norske Veritas , based in Norway; Tüv Süd AG , based in Germany; and SGS Group , based in Switzerland.  After a project is validated by a DOE, it must be approved by the host country as well as by the CDM Executive Board.  In 2007, the UN’s CDM Executive Board approved 91% of proposed projects.  After approval, a project is implemented and monitored.  Once a project is completed, it has to be verified that the planned carbon emissions reductions are taking place.  This verification is done by a different DOE than the one that conducted project validation.  If it is clear that emissions were reduced, then CERs are issued.

Under the CDM mechanism, there may be a failure to deliver purchased carbon credits.  The risk of failure to deliver credits is typically allocated by contract.  Some contracts relate to credits already generated, while others relate to credits expected to be generated and may or may not be guaranteed.  Although some effort is being made to develop more uniform contracting, wide variations exist in contracts as to the allocation of risk (including the risk of project failure and the credit risk that the seller becomes insolvent before the date of delivery or otherwise defaults in the delivery of certified credits in the agreed quantity.) 

Generally, contracts fall into one of three categories: (1) immediate delivery of existing credits, (2) future delivery at a pre-determined price and time of credits from an existing project that is already producing certifiable credits, and (3) future delivery of credits that do not yet exist that are expected to be produced from a specified project(s).  The first category of contracts are the least risky, the last the most risky.  Therefore, a buyer needs to examine closely the exact terms on which a specific set of CDM credits are being offered.  There are also various non-contractual ways of managing risk.  These include having a portfolio of projects, employing independent experts to oversee projects, buying more credits then are actually needed on the assumption that the delivery of some will fail, and taking out an insurance policy.  Each of these ways of managing risk involves additional cost.

The Lieberman-Warner-Boxer Bill

Lieberman-Warner-Boxer (S. 3036) was a very complex bill that can only be briefly summarized here.  Matters are made more complex because the Report accompanying the substitute, including CBO cost estimates, are based on an earlier version of the bill (S. 2191) and do not track the version actually reported. 

Like the original Lieberman-Warner bill, the goal of Lieberman-Warner-Boxer was a 70% reduction in carbon emission by 2050 from a cap of approximately 5.8 billion tons of carbon dioxide in 2012.  No later than two years after the bill’s enactment, the Administrator of the EPA was to promulgate rules establishing a Federal Greenhouse-Gas Registry specifying how covered entities were to submit data on emissions.

An interagency working group, the “Carbon Markets Working Group” would have been established and made up of the Administrator of the EPA, the Secretary of the Treasury, the Chairman of the Securities and Exchange Commission, the Chairman of the Commodity Futures Trading Commission, the Chairman of the Federal Energy Regulatory Commission, and other Executive branch officials as may be appointed by the President.  The Carbon Markets Working Group’s function was to identify issues related to the cap-and-trade program and submit progress reports to the President and Congress.   A Carbon Market Efficiency Board, composed of seven members appointed by the President with the advice and consent of the Senate, would have been established to study the operation of the greenhouse gas market and oversee the orderly functioning of the market.  A Climate Change Technology Board would also have been established as an agency of the Federal government to “accelerate the commercialization and diffusion of low-and zero-carbon technologies and practices”.

The carbon allowances (each allowance being equal to the right to emit one metric ton of CO₂) would have been distributed by EPA by grant or auction for each year between 2012 and 2050.  The available number of allowances was specified for each year and would decrease every year between 2012 and 2050.  By 2050, the cap would have been 30% of the 2012 cap (for example, a 70% reduction from 2012 levels.)  The Carbon Market Efficiency Board would have had some authority to borrow credits from future years and have those auctioned by EPA to temporarily moderate market prices as needed to avoid hardship - provided the credits are recaptured in later years so as to avoid changing the ultimate cap.  The entities required to have emission credits included entities that: use more than 5,000 metric tons of coal in the United States; produce and process natural gas in the United States; hold the title to natural gas at the time it is imported to the United States; manufacture petroleum-based liquid or gaseous fuel, petroleum coke, coal-based liquid, or gaseous fuel; hold the title to petroleum-based liquid or gaseous fuel, petroleum coke, or coal-based liquid or gaseous fuel when it enters the United States; manufacture more than 10,000 carbon dioxide equivalents of non-HFC greenhouse gas; hold the title to more than 10,000 carbon dioxide equivalents of non-HFC greenhouse gas when it enters the United States; and manufacture HFC.

The percentage to be auctioned would have increased each year.  Under the original Lieberman-Warner bill by 2036, and thereafter until 2050, 73% percent of the allowances would have been auctioned.  However, under Lieberman-Warner-Boxer there was no one single chart showing how much would have been auctioned and how much would have been awarded.  The Wall Street Journal has estimated about half of the allowances would have been auctioned.  Owners and operators of facilities would have been able to sell or trade the allowances or bank the emissions allowances until such time as they needed them for compliance.  Emissions allowances could also have been borrowed from future years under limited conditions provided they were repaid with interest.  The passage of time would not have diminished the compliance value of the emission allowance, except that at the end of each year an enterprise would have been required to turn in sufficient allowances to cover its prior year’s emission.  Those credits would have been destroyed.  Failure to turn in sufficient credits would have resulted in a kind of treble damages (based on the market price of the credits) and the loss of the omitted credits the following year.

Lieberman-Warner-Boxer would also have established a domestic offset program allowing an owner or an operator of a covered entity to satisfy 15% of the total allowance submission requirement by buying those credits.  The projects could have included agriculture, rangeland sequestration, and management practices; changes in carbon stocks attributed to land use change and forestry activities, manure management and disposal, and any other terrestrial offset practices identified by the Administrator of the EPA.  To receive offset allowances, the project developer would have had to submit a petition to the Administrator with a copy of the monitoring and quantification plan, a greenhouse gas initiation certificate that showed that greenhouse gas reductions had taken place, and any other information the Administrator deemed necessary.  An EPA accredited verifier, listed in a publicly accessible database, would have been required to submit a verification report for an offset project.  The Administrator would have then had 90 days to decide whether or not a project developer would receive offset credits for a specific project. 

If the quantity of domestic offset allowances used in a calendar year was less than 15% of the total allowances for that year, then covered entities could have used international allowances from a cap-and-trade system (such as EU-ETS) to make up the difference.  Unlike the EU-ETS, however, these emission allowances from other nations would have come from a nation with a cap-and-trade program of similar stringency to the US.  This would restrict the ability to obtain credits based on projects (i.e. India or China) unless they implemented a program similar to that being proposed.  Covered entities also could have used international forest carbon credits to satisfy up to 10% of the total allowance submission requirement.  If the quantity of forest offset allowances was less than 10%, then covered entities could have used permissable international allowances to make up the difference up to 10%.    In addition, international offset allowances originating from projects in other nations (similar to the EU-ETS) could have been used.  The international offset allowances would have been approved by EPA and could not have come from a project at a facility that competes directly with a US facility.  Thus, the use (purchase) of domestic farming credits and international allowances and credits, could have satisfied up to 30% of the required emission credits needed by a covered facility.

In order to protect American jobs and to eliminate unfair competition from countries not having a stringent cap-and-trade system, Lieberman-Warner-Boxer authorized the President to negotiate with other countries to develop a carbon cap-and-trade system of similar stringency.  However, if by 2020 that had not occurred, the President would have been authorized to require that manufacturers from those countries (in industries of a type subject to the cap-and-trade in the US) purchase carbon credits from the US system in order to import into the US goods originating in those countries.  The proposed system, however, would have provided no competitive protection between 2012 and 2015, and was potentially subject to being defeated by the re-routing of goods to third world counties.

Finally, both bills contained opportunities to receive additional allowances for early action.  There is no comparable provision in EU-ETS.  Early actors would have received approximately a total of 1.8 billion allowances between 2012 and 2025 that would be worth approximately $30.7 to $45 billion.  These allowances would have gone to entities that achieved verified greenhouse gas emissions reductions after January 1, 1994.  The verified and credible reductions would have had to be made before the date the bill was enacted.  Assuming that some similar provision to reward early actors will be in any bill that passes, companies now have a limited time window to establish and document such programs.  (EPA already has a voluntary program - qualifying under that program or under a similar regional program would likely be sufficient).  The early action allowances would also have gone to entities holding Regional Greenhouse Gas Initiative emission allowances or emission allowances issued by the State of California for compensation of costs incurred in obtaining and holding those allowances.  Owners or operators of electricity generating facilities that repowered from coal prior to 2005 pursuant to a consent decree would also have received emission allowances from the Early Action Program.

The Future

The Kyoto Protocol by its terms ends in 2012.  A plan adopted at the Bali conference lays out the procedures to be implemented to achieve a post-Kyoto agreement over the next year and a half.  The plan anticipates a new agreement being reached in Copenhagen in 2009.  Given the EU planning for Phase III (2013 to 2020), the commitment of President Obama to a carbon cap-and-trade system in the US, the legislation likely to emerge from Congress in 2009, and the enormous sums already invested in the carbon markets, there is little doubt that the carbon markets will continue to evolve, expand and provide investment opportunities while over time reducing global carbon emissions.