Emissions and efficiency: cap-and-trade systems around the world

JP Casey 2 November 2020 (Last Updated November 2nd, 2020 12:49)

May's emissions allowance auction in California saw settlement at minimum prices and practically no revenue for the state. The struggles have raised questions about the viability of the process, and whether it can be replicated around the world, from China to Colombia.

Emissions and efficiency: cap-and-trade systems around the world
Cap-and-trade systems have been touted as one of the most effective means to reduce commercial emissions of greenhouse gases. Credit: David Monniaux

Cap-and-trade systems have been touted as one of the most effective means to reduce commercial emissions of greenhouse gases. The method consists of a two-pronged approach: a cap on the amount of carbon dioxide produced, and a system where firms who cut their pollution faster can sell ‘allowances’ to bigger polluters to provide financial incentives to cut emissions.

The system has been in place in the US since the 1990 Clean Air Act, with the first deal coming two years later for $250 per ton of carbon dioxide produced. Since then, emissions trading has expanded considerably, and nowhere more so than in California, where total emissions auction revenues reached close to $600m in June 2020 alone.

However, the Covid-19 pandemic has triggered a fall in global energy demand, dragging down industrial production and, consequently, the value of these allowances, exposing flaws in the cap-and-trade system both in California and around the world. From Colombia’s promising new system, which is hampered by oversights and exemptions, and China’s inability to disentangle environmental need from political interest, cap-and-trade systems globally have come under considerable scrutiny in recent months.

California: historically effective, but recently unstable

While it is difficult to say that the cap-and-trade system has single-handedly lowered emissions in California, the approach has coincided with a significant decline in the state’s harmful emissions. California’s greenhouse gas production has fallen 5.3% between 2013, when the state launched its own cap-and-trade policy, and 2017, as California targets economy-wide carbon neutrality by 2045. This improvement has not come at the expense of industrial output either, with the economic output of the state’s manufacturing industry increasing from $250bn to $299bn over the same period.

However, the system has struggled in recent months, with the Covid-19 pandemic triggering a downturn in global energy demand. In turn, this reduced the need for allowances as the state’s largest polluters have been producing fewer emissions. This combination led to a significant fall in allowance sales at the latest auction, held in May, which saw zero permits sold at current allowance prices.

In response, the state has reduced the number of allowances available for purchase in line with this new demand, a conventional response that could have negative consequences due to California’s unique cap-and-trade laws. Most of these lost allowances come from the state itself, rather than private power and utility companies, creating an unbalanced system where the state alone is responsible for supporting the allowance price floor, and loses many of its own allowances in the process.

James Bushnell, writing for the Energy Institute Blog, likened the situation to OPEC deciding that “we need to reduce world oil output by 20 million barrels a day, so Saudi Arabia should cut its production by 20 million, so the rest of us can continue on as usual.”

This reduction in the power of the state, the body ultimately responsible for implementing the cap-and-trade system in the first place, could raise questions about the long-term viability of the system, even if the cause of this disruption is a unique event, such as the pandemic.

Colombia: a promising start, but structural problems

While California’s system has had years to entrench itself in the economy of the state, Colombia’s emissions trading programme is much younger, having only been adopted in 2018. The system is largely similar in concept to that in California, with the Ministry of Environment and Sustainable Development tasked with setting the number of allowances available to be sold off at regular auctions, and failure to comply with allowance limits resulting in fines of up to double the auction price.

Colombia’s system also includes an additional clause that allows polluting companies that exceed their allowances to offset their emissions instead of paying a fine, which supporters hope will encourage firms to invest in renewable infrastructure, rather than just face financial penalties in an industry that has recently been shaken by Covid-19. The International Emissions Trading Association noted that this feature “established a hybrid market mechanism, stimulated a market for offsets, and strengthened the learning of the different market instruments, how they co-exist, and its environmental objectives.”

Yet it is difficult to assess the long-term effectiveness of such a new programme, and there are concerns as to how well the approach fits into wider Colombian energy policy. For instance, a carbon tax came into force at the beginning of 2017, a move which promised to further disincentivise fossil fuel production. Yet the coal industry was exempt from all such taxes, leaving 82.2 million tonnes of coal produced in 2019 tax-free.

Indeed, a 2017 report, ‘Lessons Learned from Cap-and-Trade Experience’, written by researchers from MIT and Harvard, found that a complex network of overlapping policies can lead to “significant adverse economic and environmental effects,” exposing loopholes in legislation, rather than strengthening it. With the relationships between Colombia’s cap-and-trade system and existing environmental policy not yet clear, there are concerns that Colombia could suffer from these consequences.

China: political need trumps environmental ideals

Another relatively new cap-and-trade system is that used by China, which aims to curb its vast carbon dioxide emissions. Between 2000 and 2018, Chinese carbon dioxide emissions from coal-fired power plants alone increased from 1.4 gigatons of carbon dioxide to 4.6 gigatons, close to half of the world’s 10.4 gigaton total carbon dioxide production from coal-fired facilities, leading to the announcement of the emissions trading system in 2017.

In a report published in June this year, the International Energy Agency (IEA) noted that the economic benefits of an emissions trading system could be the most influential part of the policy, by encouraging coal producers to adopt more efficient technologies and burn higher-quality coal.

However, while Colombia and California’s systems have struggled with external pressures, the drive of the Chinese Government itself could present a barrier to a cap-and-trade system, creating a unique internal form of pressure. Despite China’s nominal commitment to reducing its carbon footprint, its 14th five year plan, set to be announced in early 2021, is expected to include targets that could allow hundreds of new coal-fired power stations to be built, following industry pressure.

Indeed, the IEA’s reporting found that, in both potential allowance benchmark options regarding how best to allocate allowances to plants of different sizes, “the benchmark values are the most lenient for larger conventional coal-fired power plants.” While the details of this cap-and-trade system have not yet been finalised, the fact that large-scale coal burning may not be effectively disincentivised, regardless of the policy ultimately implemented, threatens to fundamentally undermine the system and its environmental goals.

Europe: greater unity and greater impacts

One of the more successful cap-and-trade systems has been the EU’s Emissions Trading System. Implemented in 2005, the programme involves 14,000 energy facilities across the continent that are responsible for almost half of the bloc’s greenhouse gas emissions, and has aimed to lower emissions through international collaboration and financial incentives. Between 2005 and 2012, the EU reported a 10% reduction in carbon emissions, with particular improvements in the chemicals, mineral production, and electricity sectors, as the cap on carbon emissions tightened towards the end of the period.

The system also yielded economic benefits, with a report from the Organisation for Economic Co-operation and Development (OECD), published in December 2018, noting that the programme led to “led to a statistically significant increase in revenue and in fixed assets of regulated firms”. The report highlighted companies being encouraged to invest in carbon-saving technologies, which could in turn improve operational efficiency and further increase productivity in the long-term. While it was noted that putting a number on these gains is difficult, the report estimated that companies saw an increase in revenue of around 6% or 7% over the period.

Perhaps most significantly, the system has delivered results beyond its original scope. The OECD report found that total emissions across the EU between 2005 and 2015 fell from around 2,000 million tonnes of carbon dioxide to around 1,800 million tonnes of carbon dioxide. Additionally, total emissions have been well below the cap since 2009, despite the cap falling from over 2,250 million tonnes of carbon dioxide in 2005 to around 2,000 million tonnes of carbon dioxide a decade later, suggesting that European emissions are falling in line with the limits set upon them.

Among the OECD’s conclusions were that the system had been so effective as it explicitly targeted some of the larger-scale power facilities in Europe, unlike the Chinese approach, and was not burdened by some of the structural confusion that impeded the success of the Colombian model. While the European system is older than these other approaches, and so its impacts can be more fully understood, potentially colouring these conclusions, this cap-and-trade system establishes a pattern that others can aim to follow.