Regional Cap-and-Trade Programs May Be the Solution

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By Brian J. Donovan

Cap-and-trade was first tried on a significant scale 20 years ago under the first Bush administration as a way to address the problem of airborne sulfur dioxide pollution — widely known as acid rain — from coal-burning power plants in the eastern United States. A limit was imposed on emissions from the power plants, and utilities were allowed to buy and sell permits to comply.

These reductions in power plant emissions of sulfur dioxide (SO2) and nitrogen oxides (NOx) were achieved at a significantly lower cost than originally assumed. Today, this cap-and-trade program is considered one of the most efficient and cost-effective environmental initiatives ever implemented.

Environmentalists and industries resurrected the idea in recent years as a centerpiece of measures to address global warming and growing oil imports. Reps. Henry A. Waxman of California and Edward J. Markey of Massachusetts, both Democrats, built their climate change bill last year in large measure around it. But in trying to assemble a majority to pass it, Mr. Waxman and Mr. Markey dished out a cornucopia of concessions and exemptions to coal companies, utilities, refiners, heavy industry and agribusinesses. The original simplicity was lost, replaced by a bazaar in which those with the most muscle got the best deals.

Two senators, Maria Cantwell, Democrat of Washington, and Susan Collins, Republican of Maine, have proposed an alternative that they call cap-and-dividend, under which licenses to pollute would be auctioned to producers and wholesalers of fossil fuels, with three-quarters of the revenue returned to consumers in monthly checks to cover their higher energy costs.

Ms. Cantwell said that cap-and-trade had been discredited by the Wall Street crisis, the Enron scandal and the rocky start to a carbon credits trading system in Europe that has been subject to dizzying price fluctuations and widespread fraud. She said her bill would require every pollution permit to be auctioned rather than given away and was 39 pages long, compared with Waxman-Markey, which weighs in at some 1,400 pages. The Cantwell-Collins plan is almost exactly what President Obama proposed in the campaign and after first taking office — a 100 percent auction of permits and a large tax rebate to the public.

Sens. Lindsey Graham (R-S.C.), John Kerry (D-Mass.) and Joseph Lieberman (I-Conn.) have worked for months to develop an alternative to cap-and-trade, which the House approved eight months ago. The three lawmakers plan to introduce legislation next week that would apply different carbon controls to individual sectors of the economy instead of setting a national target.

They are looking at cutting the nation’s greenhouse gas output by targeting, in separate ways, three major sources of emissions: electric utilities, transportation and industry. Power plants would face an overall cap on emissions that would become more stringent over time; motor fuel may be subject to a carbon tax whose proceeds could help electrify the U.S. transportation sector; and industrial facilities would be exempted from a cap on emissions for several years before they are phased in. The legislation would also provide new incentives for domestic oil and gas drilling, nuclear power plant construction, carbon capture and storage, and renewable energy sources like wind and solar.

Graham recently declared, “Economy-wide cap-and-trade is dead.” He told reporters,

“We’re looking at a sectoral approach to replace the cap-and-trade. There will never be a cap-and-trade bill passed by the United States Senate. I will continue to work with Senators Kerry and Lieberman to produce a new bill that has a new focus that will lead to energy independence, create the jobs that we will need to become a vibrant, viable economy in the 21st century, and a green economy and clean up the air.”

As Sens. Graham, Kerry and Lieberman try to resuscitate the climate change bill, 23 U.S. states are already actively participating in the design and implementation of three regional cap-and-trade programs to reduce greenhouse gas emissions. Participating U.S. states account for approximately one-half of the U.S. population and Gross Domestic Product (GDP), and one-third of all U.S. greenhouse gas emissions.


Northeastern Regional Greenhouse Gas Initiative (RGGI)

RGGI was the first regional cap-and-trade program for greenhouse gases in the United States. It covers 10 Northeastern and Mid-Atlantic states (Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island and Vermont).

The program limits, or “caps,” carbon dioxide (CO2) emissions from large fossil-fuel-fired electric generating units, with the goal of stabilizing emissions from 2009 through 2014 to a level roughly equivalent to recent historical emissions. The program then reduces the cap by 2.5 percent per year over the next four years so that in 2018 there is a 10 percent reduction from the baseline.

RGGI took effect and began regulating CO2 emissions on Jan. 1, 2009. The first auction for allowances was held on Sept. 25, 2008. Subsequent auctions have been and will be held quarterly. Since September 2008, RGGI has raised $583 million for the states in these quarterly auctions of permits with between 65 and 70 percent of cap-and-trade proceeds going back into the clean energy economy.

Overview of RGGI
• Gases: CO2 emissions
• Sources: Large electric generators
• Coverage: 28% of CO2 emissions

Western Climate Initiative (WCI)

WCI covers seven U.S. states (Arizona, California, Montana, New Mexico, Oregon, Utah, and Washington) and four Canadian provinces (British Columbia, Manitoba, Ontario, and Quebec). Another six U.S. states, one Canadian province, and six Mexican states are formally observing this process.

The WCI released a design document laying out its basic program parameters in September 2008. That agreement calls for a program that will cover nearly 90 percent of the region’s greenhouse gas emissions when it is fully implemented (commonly referred to as an economy-wide program). The program will reduce emissions fifteen percent below 2005 levels by 2020. Member jurisdictions are moving forward with program implementation. The cap-and-trade program will begin regulating emissions in January 2012. To ensure the program is founded on sound emissions data, mandatory emissions monitoring will commence in January 2010.

Overview of WCI
• Gases: All 6 Kyoto gases
• Sources: In 2012 – electricity generators and large industrial sources; In 2015 – expanded to emissions from residential, commercial, and other industrial combustion, and transportation fuels
• Coverage: In 2012 – 50% of emissions; In 2015 – nearly 90% of emissions

Midwestern Greenhouse Gas Reduction Accord (Midwestern Accord)

Midwestern Accord covers six states (Illinois, Iowa, Kansas, Michigan, Minnesota, and Wisconsin) and one Canadian province (Manitoba). Three other states and one Canadian province are formally observing this process.

In early 2008, participating jurisdictions appointed an Advisory Group comprised of representatives from environmental groups, industry, and the participating jurisdictions to develop recommendations on a regional cap-and-trade program. In May 2009, the Advisory Group released its draft final design recommendations. These recommendations call for an economy-wide program that would reduce emissions 20 percent below 2005 levels by 2020, and 80 percent below 2005 levels by 2050, though the 2020 target may decrease to 18 percent if allowance prices increase too much.

The Advisory Group will meet to finalize its recommendations after regional economic modeling is completed in early fall 2009. A model rule, which is the proposed set of GHG trading rules upon which participating jurisdictions base their own rules, is being developed. The Midwestern Accord cap-and-trade program is scheduled to launch in January 2012.

Overview of Midwestern Accord
• Gases: All 6 Kyoto gases
• Sources: Economy-wide including: electric, industrial, residential, commercial, transportation combustion, and industrial process emissions
• Coverage: Nearly 90% of GHG emissions; Manitoba will phase-in coverage in manner similar to WCI.


RGGI: A Case Study

RGGI proves that a regional market-based price on power-sector emissions is both possible and effective in the United States. While opponents of clean energy reform falsely claim that a cap-and-trade system would harm the economy, RGGI provides a working model and active case study of how reducing pollution can actually drive economic growth. By 2018, the 10 RGGI states will have reduced their power sector carbon emissions by 10 percent, created thousands of homegrown clean energy jobs, and driven billions of dollars of public and private investment into the clean energy technologies of the future.

The RGGI cap-and-trade system works by auctioning a limited number of carbon pollution allowances — each representing one short ton of carbon pollution to power generators in Connecticut, Delaware, Maine, Maryland, Massachusetts, New Jersey, New Hampshire, New York, Rhode Island and Vermont each quarter. The total amount of pollution allowances sold may not exceed 188 million tons per year through 2014. After 2014, the amount of allowances shrinks gradually by 2.5 percent per year over four years for a total reduction of ten percent by 2018. Power plants are required to submit a number of allowances equal to their total emissions at the end of each three-year compliance period. If they don’t have enough allowances to cover their emissions they must purchase more or face a penalty. If they find they have a surplus they can sell the extra allowances to other power generators who may need them.

The market-based carbon-reduction system in RGGI works because proceeds from allowance auctions provide a much-needed revenue source to jumpstart public and private investment in the clean energy economy. The $583 million in auction proceeds dispensed to state energy programs to date are already hard at work facilitating the deployment of clean energy technologies and energy efficiency programs that benefit consumers – reducing energy bills and creating jobs at the same time. A list of the clean energy programs being funded through auction proceeds can be found on RGGI’s website.

Perhaps most important, the unprecedented transparency measures implemented under RGGI have shown it is possible to trade carbon efficiently while preventing the worst practices of market manipulation and unnecessary financial speculation. Each and every allowance auction under RGGI undergoes a rigorous third party verification process that reviews the administration of the auctions and monitors the conduct of market players.

In the most recent auction that took place on March 10, 2010, the Market Monitor Report found:

    • ”No material evidence of collusion of manipulation by bidders.”
    • ”The auction was administered in a fair and transparent manner in accordance with the noticed auction procedures and limitations.”
    • ”The auction results were consistent with the market rules and the bids received.”
    • ”Sensitive information was treated appropriately by the auction administrator.”
    • ”There were no indications of hardware or software problems, communications issues, security breaches, or other problems with the auction platform.”

The Market Monitor Report also tracks the quantity and identity of market participants and does analytics to ensure that the conditions exist for a competitive and economically efficient bid pool. In the most recent auction, the Market Monitor Report found that 51 bidders competed fairly for the 40 million carbon allowances, and that no one bidder acquired more than 12 percent of the overall pool of available allowances. RGGI’s auction protocol also contains a provision that prevents any one bidder from acquiring more than 25 percent of the allowances in order to prevent market manipulation and fraud. Participation by a large number of bidders for a small slice of the overall pie of available allowances leads to the most economically efficient outcome.

The RGGI experience also shows that all this is possible without exposing consumers to the worst practices of financial speculators, growing the size of government, or increasing the national debt. In fact, despite the seemingly complex task of implementing a U.S. carbon market, administrative costs for RGGI are only 0.5 percent of the overall emissions allowance revenue. RGGI Inc., the administrative organization that manages implementation of the program, has accomplished what many claim to be impossible with a very lean staff of just five individuals — proving that better governance does not necessarily mean bigger government or more bureaucracy.

An analysis by Point Carbon, a carbon market watchdog group, shows that a network of regional carbon markets including RGGI and the Western Climate Initiative could achieve 41 percent of the United States’ pollution-reduction commitments under the Copenhagen accord by 2020 and generate as much as $100 billion in revenue for clean energy investments at the state level. While many may argue that the economic benefits of comprehensive federal legislation are clear, a network of interlinked state and regional carbon markets building off the existing institutional infrastructure of RGGI, WCI, and MRGGRA could be a better solution.


Factors Determining Abatement Costs

The marginal costs of reducing (or abating) emissions depend on technological, behavioral, and policy-related factors. Compliance entities and consumers are likely to make a variety of adjustments to reduce emissions, e.g., fuel-substitution and opportunities for process change, reduced output and developing new technologies.

Fuel-Substitution and Opportunities for Process Change

Firms can reduce emissions by substituting low-GHG fuels for other fuels, or by undertaking other changes in the methods of production. In the short run, opportunities for fuel substitution may be limited because of the type of production capital in place; however, in the long run the opportunities can be considerable. Consider in particular the incentives for fuel substitution among fossil-fired power plants. With a price of zero on CO2 emissions, coal plants have lower marginal costs than natural gas plants, but as the price on CO2 increases, the marginal cost for coal increases faster than for natural gas because coal has roughly twice the emissions per kilowatt-hour of generation.

Reduced Output

Another way to reduce emissions is to reduce the output of the good being produced. Pricing GHGs will increase the prices consumers pay for greenhouse-gas-intensive products. These higher prices will elicit a reduction in the quantity demanded for these products, leading to a reduction in greenhouse gas emissions.

Developing New Technologies

Over the long term, capital adjustments can occur in the electricity supply technology and other production activities. Pricing GHG emissions introduces incentives for firms to invest more in research and development in GHG reducing technologies. Absent a price on emissions, advances in GHG-reducing technologies must rely on “piggybacking” off cost-reducing advances that also reduce GHGs. For example, automobile firms have an incentive to invest in energy efficiency because consumers value fuel efficiency. These advances also reduce GHG emissions, but without pricing GHGs, firms and consumers have too little of an incentive to invest in energy efficiency. This suggests that rates of technological progress are likely to increase under a cap-and-trade program.

Issues Regional Cap-and-Trade Programs Must Address

Regional cap-and-trade programs, in order to achieve the necessary emissions reductions and protect the environment and the economy in a cost-effective and transparent manner, must address the following issues:

    (a) the stringency of the cap;
    (b) the sector coverage of the system;
    (c) the inclusion of all major heat-trapping gas emissions;
    (d) the auctioning of allowances;
    (e) the use of auction revenues for the public good;
    (f) the role of offsets;
    (g) the establishment of a strong institutional framework; and
    (h) the ability to link cap-and-trade programs.

The Stringency of the Cap: Stringently capping emissions, with firm near-term goals, is essential. The United States must reduce its global warming pollution emissions at least 80 percent below 2000 levels by 2050 to avoid some of the worst effects of global warming. Delay in taking action would require much sharper cuts later, making it much more difficult and costly to meet the necessary target. A near-term goal of a 15 percent to 20 percent reduction from current levels by 2020 is required.

The Sector Coverage of the System: The cap should cover all major sources of emissions, either directly or indirectly. These include electric utilities, transportation, and energy-intensive industries, which together comprise some 80 percent of U.S. global warming pollution, as well as fossil fuel emissions from the agriculture, commercial and residential sectors.

The Inclusion of All Major Heat-Trapping Gas Emissions: These include carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O), hydrofluorocarbons (HFCs), perfluorocarbons (PFCs) and sulfur hexafluoride (SF6).

The Auctioning of Allowances: An allowance auction would allow the market to set the price of carbon, and it would be the most efficient and equitable way of distributing allowances. Giving away too many allowances would distort the market and could result in windfall profits for polluters.

The opportunities for private-parties to buy and sell emissions allowances, and to purchase any allowances auctioned by the state, lie behind cap and trade’s potential to achieve emissions reductions at low cost to the overall economy. Emitters will generally consider their costs of reducing emissions to the level required by their current holdings of allowances, and compare this with the market price of allowances. For emitters with especially high abatement (emission-reduction) costs, the market price will be less than this cost. In this case, the emitter will benefit by purchasing additional allowances instead of taking on additional abatement cost. For emitters with especially low abatement costs, the market price will be greater than this cost. In this case, the emitter benefits by selling some of its allowances; although this obliges the emitter to reduce emissions even further, the proceeds from the sale will more than offset the additional abatement costs. Allowance trading thus results in more of the emissions reduction being undertaken by facilities that can do it most cheaply. Buyers and sellers both benefit, yet the trading leads to no change in overall emissions since it does not alter the number of allowances in circulation.

Rationales for Auctioning

Experience provides several rationales for the use of an auction for the initial distribution of emissions allowances.

Price Discovery: An auction will play a valuable role in identifying the market-clearing price in the early years of the program.

Transparency: One attraction of auctioning is that it can make the assignment of allowance value more transparent. Under other approaches for allocating emission allowances or other types of valuable licenses, administrative approaches can involve complicated formulas that obscure the identities of the true recipients of this value or the magnitude of the value being distributed. The assignment of value raised through an auction is likely to be more accessible to observers because it would involve a direct transfer of dollar value.

Easier Treatment of New Entrants: A system in which all compliance entities must obtain allowances through an auction also eliminates the need to adjust the allocation scheme to deal with sources entering and exiting the market. New entrants would see the same cost as their competitors when entering the market, and exiting entities no longer need to purchase allowances.

There are four general auction design choices that determine how the clearing price is determined and the auction outcome is achieved. These four choices are defined by two main features. One choice is between a single round (sealed bid) or multiple round (multi-round) auction wherein participants can revise their bids. Multi-round auctions are sometimes called clock auctions because the bid price moves up or down like the hands on a clock until supply equals demand. The second choice is whether bidders pay the amount they individually bid, called a “discriminating price” auction, or if all bidders pay the same “uniform price.”

One can find examples of each type of auction in practice. A uniform price, sealed bid auction is used in the Regional Greenhouse Gas Initiative cap-and-trade program that regulates CO2 emissions in ten northeastern states. Nearly 90% of the emissions allowances are distributed through an auction. A discriminating price, sealed bid auction is used for allocating a small portion of the allowances under the Acid Rain Program. A uniform price multi-round auction was used by the State of Virginia to auction its emissions allowances in the NOx Budget Trading Program in the eastern U.S. A discriminatory price multi-round auction is used by the Federal Communications Commission to distribute licenses for broadcast rights.

Among these types, the uniform price, sealed bid auction is the simplest design and the easiest to understand. It is easy to develop a bidding strategy for this design and the operations and outcome of the auction are transparent to participants and observers. It also conveys a sense of transparency about the overall operation of the market. This makes it an accessible auction institution for participants, non-experts and the public. These attributes can be expected to help build public trust in the allowance market. In the absence of other compelling arguments, the uniform price, sealed bid auction type seems a reasonable choice.

Other Features of the Auction

In addition to the two main choices that identify the way that the market clearing price is determined in the auction, there are a number of other subordinate features that should be considered, including:

    • Frequency of the auction (e.g. quarterly)
    • Allowance vintages to be auctioned (e.g. current year and/or future year vintages)
    • Use of a reserve price (a minimum price in the auction)
    • Auction platform (where the auction will occur and who will run it)
    • Eligibility rules and financial prequalification
    • Passive bid provisions for small entities so they can be guaranteed a small quantity at the market clearing price
    • Market monitoring and oversight (to ensure against auction manipulation)
    • Disclosure of beneficial interests by bidders
    • Limitations on acquisition by single parties
    • Information from the auction to be revealed to the public

The Use of Auction Revenues for the Public Good

Auction revenues may be used for the public good by allocating the allowance value to: (a) households as dividends; (b) financing investments and other public expenditures; and (c) administrative costs and the reduction of the budget deficits of states participating in the regional cap-and-trade program.

Dividends to the Public

The return of carbon permit auction revenues to the public in the form of equal per capita dividends, sometimes called a “cap-and-dividend” policy, transfers allowance value to households, leaving decisions on the final use of the money to the public.

Another potential use of allowance value is to provide the general public a “dividend” related to the public’s having granted firms the right to make use of the waste-disposal services of the atmosphere through their emissions. Support for this use of allowance value stems from the idea that the climate-regulating services of the atmosphere are a common property resource. If the general public is viewed as having ownership of these climate-regulating services, then it might seem appropriate that the allowance value that stems from allowing emitters to have access to these services should flow back to the general public.

This use of allowance value resembles using allowance value to compensate households for adverse impacts of climate policy. However, the basis for supplying allowance value as a dividend is different: in this case it is a payment for a service rendered rather than compensation for an adverse impact (such as higher consumer good prices).

In terms of simplicity, dividends are an exceptionally transparent use of allowance value; by transparency, we mean that the allocation of the allowance value is relatively easy to describe and thus easily comprehended by the general public. The federal American Clean Energy and Security Act proposes to disburse dividends via tax refunds to all U.S. nationals and legal residents. A dividend would also be similar to the Alaska Permanent Fund, which returns oil-extraction royalties to Alaska residents on a per-capita basis.

Financing Investments and Other Public Expenditures

Allowance value can be used to finance government expenditures of various kinds. It can be used to help industry make adjustments to adopt cleaner production processes or to support private efforts to invent new technologies that involve lower emissions. It can also be used to finance other types of investment, including investments in education and job training, or in various community development projects. It can be used to finance expenditures dedicated to planning to reduce regional emissions, to environmental remediation, and to biological carbon sequestration. Allowance value can be used to promote public efforts to overcome market barriers to the development of cost-effective new technologies.

A significant share of allowance value should be devoted toward financing of public and private investments. The investments to consider include those oriented toward achieving low-cost emissions reductions (both directly and through investments in cleantech R&D), adaptation to climate impacts, environmental remediation, improvements to disadvantaged communities, and job training.

There are three main justifications for employing allowance value to support these investments: (1) Because of market barriers and external benefits, there are some private-sector investments (e.g., in energy efficiency improvements) that would not be triggered by the price of emissions allowances and complementary policies, but that would nonetheless help achieve the regional cap-and-trade program goals in a cost-effective and fair way. (2) Job training, infrastructure improvements, adaptation and environmental remediation are public goods that generally require public-sector investments. (3) There are some beneficial local and state-level plans (e.g., improvements to land-use) that may not be successfully implemented if agencies are not sufficiently funded. Several state agencies are tasked with implementation of various components of a regional cap-and-trade program, and successful implementation will require adequate funding.

Administrative Costs

Despite the seemingly complex task of implementing a U.S. carbon market, administrative costs for RGGI are only 0.5 percent of the overall emissions allowance revenue. RGGI Inc., the administrative organization that manages implementation of the program, has accomplished what many claim to be impossible with a very lean staff of just five individuals – proving that better governance does not necessarily mean bigger government or more bureaucracy.

A hybrid program in which allowance value is used for dividends, financing investments and other public expenditures, administrative costs and budget deficit reduction is an attractive way both to achieve considerable cost-savings while accomplishing fairness goals in a targeted and transparent way.

An Example of the Use of Auction Revenues for the Public Good:

    • 60% of allowance value returned to households as dividends;
    • 25% of allowance value allocated to financing investments and other public expenditures; and
    • 15% of allowance value allocated to administrative costs and the reduction of the budget deficits of states participating in the regional cap-and-trade program.

The Role of Offsets

An offset is a measurable reduction, avoidance, or sequestration of GHG emissions from a source not covered by an emission reduction program. If a cap-and-trade program includes offsets, regulated entities have the opportunity to purchase the “emission credits” generated by carbon offset projects to help them meet their compliance obligations. In this way, offsets would complement the more traditional emissions trading that can occur between two covered sources. For example, a covered source (an entity in the power generation, chemicals, steel, and cement industries) can make reductions beyond its compliance obligations and then sell these reductions as credits to other covered sources.

The main concern with offset projects is whether or not they represent real emission reductions. For offsets to be credible, a ton of CO2-equivalent emissions from an offset project should equate to a ton reduced from a covered emission source, such as a smokestack or exhaust pipe. This objective presents challenges because many offsets are difficult to measure. If illegitimate offset credits flow into an emissions trading program, the program would fail to reduce GHG emissions. Another concern is whether the inclusion of offsets would send the appropriate price signal to encourage the development of long-term mitigation technologies.

Perhaps the primary concern regarding offsets is their integrity. To be credible, as noted above, an offset should equate to an emission reduction from a direct emission source, such as a smokestack or exhaust pipe. Offset integrity — whether or not the offsets represent real emission reductions — can be determined by analyzing six issues: additionality, supplementarity, measurement, double-counting, permanence, and leakage.

(1) Additionality

Additionality means that the offset project represents an activity that is beyond what would have occurred under a business-as-usual scenario. In other words, would the emission reductions or sequestration have happened anyway? Additionality is generally considered to be the most significant factor that determines the integrity of the offset.

(2) Supplementarity

Supplementarity refers to the idea that the role of offsets in an emission reduction program should be secondary to reduction efforts at regulated emission sources. The term comes from the text of the Kyoto Protocol, which states that emissions credits (or offsets) must be “supplemental to domestic actions for the purpose of meeting quantified emission limitations and reduction commitments … .”

(3) Measurement

Reliable GHG emissions data are a keystone component of any climate change program.

It is generally much simpler to measure and quantify an emission reduction from a direct source than from an offset project. Indeed, the more difficult measurement may be the main reason such reductions are not required by a control program. Regulated sources determine their compliance by comparing actual GHG emissions data against their allowed emissions. In contrast, project developers determine offset emission data by comparing the expected reduced, avoided, or sequestered GHG emissions against a projected, business-as-usual scenario (sometimes referred to as a counter-factual scenario).

To accomplish this task, offset project managers must establish an emissions baseline: an estimate of the “business-as-usual” scenario or the emissions that would have occurred without the project. Requiring third-party verification (as some proposals do) would potentially address this specific concern.

(4) Double-Counting

To be credible, when an offset is sold, it should be retired and not sold again or counted in other contexts.

(5) Permanence

With some offset projects there may be a concern that the emission offsets will be subsequently negated by human activity (e.g., change in land use) or a natural occurrence (e.g., forest fire, disease, or pestilence). This issue is most pertinent to biological sequestration projects, specifically forestry activities.

(6) Leakage

GHG emissions leakage generally refers to a situation in which an emissions decrease from a regulated (i.e., capped) source leads to an emissions increase from an unregulated source.

If allowed as part of an emissions reduction program, offsets have the potential to provide various benefits. The ability to generate offsets may:

    • provide an incentive for non-regulated sources to reduce, avoid, or sequester emissions (where these actions would not have occurred if not for the offset program);
    • expand emission mitigation opportunities, thus reducing compliance costs for regulated entities;
    • offer environmental co-benefits for certain projects; and
    • create new economic opportunities and incentivize parties to seek new methods of generating offsets.

The main concern with offset projects is whether or not they produce their stated emission reductions. A regional cap-and-trade program will resolve the concerns of integrity (e.g., additionality, supplementarity, measurement, double-counting, permanence, and leakage) more efficiently and transparently than a federal cap-and-trade program. The potential benefits provided by offsets in a regional cap-and-trade program would outweigh any potential harm.

The Establishment of a Strong Institutional Framework

A cap-and-trade program requires a strong institutional framework to function well. The regulatory authority will play a critical role in ensuring that the program achieves its emissions reduction role, and will have to work in close consultation with scientists, policymakers and the regulatory entity that will oversee the emissions trading market. Strict monitoring and enforcement of standards for offsets will be necessary, and a trustworthy fiduciary entity must oversee the disbursement of the auction revenues from the sale of allowances.

The regulatory authority specifies the total quantity of allowances to be distributed in given periods to participants in the program. Each allowance entitles the holder to emit a certain quantity of emissions of a given pollutant. In the case of a cap-and-trade program, an allowance entitles the holder to a given quantity (usually one ton) of greenhouse gases in carbon dioxide equivalents (CO2e). The number of issued allowances can decline over time; in this case overall emissions decline through time as well. The regulatory authority needs to distribute (put into circulation) the emissions allowances. There are two main mechanisms for this distribution: free allocation and auctioning. As discussed above, an allowance auction would allow the market to set the price of carbon, and would be the most efficient and equitable way of distributing allowances.

Finally, in all previous emissions allowance auctions in the U.S., a third-party vendor has successfully run auctions on behalf of federal or state agencies at low cost. This is a sound approach for a regional cap-and-trade program to consider. The regional cap-and-trade program could run a bidding process to select a vendor to manage the auction.

The Ability to Link Cap-and-Trade Programs

Linkage involves reciprocal agreements to accept allowances issued by another regional jurisdiction for compliance in one’s own. Linkage can reduce the overall cost of meeting an emissions target by increasing the breadth of reduction opportunities available.


Obviously, significant financial investment will be required to establish regional greenhouse gas cap-and-trade programs. In addition to proceeds from allowance auctions, much of the money could come from private sources, such as carbon-offset projects purchased under a regional cap-and-trade program.

“Public finance is important, but private sector investment will play a much bigger role, and how that’s mobilized is a key issue,” says Nobuo Tanaka, executive director of the International Energy Agency.

Ultimately, the decision of whether to invest in renewable energy will be made by investors taking a cold, hard look at economic realities.

TLC and Equity Capital

Transparency, longevity and certainty (“TLC”) drives investments, according to a policy “green paper” by DB Climate Change Advisors, a unit of Deutsche Bank. “There needs to be a transparent process that gives a reasonably certain rate of return over a long timeframe,” the report says. The right mix of TLC can produce job creation with energy security and climate protection at the most efficient cost, according to Deutsche Bank.

Arguably, hundreds of billions of investment dollars, if not trillions, from pension funds, private equity investors, sovereign wealth funds and hedge funds are waiting on the sidelines — capital that is ready to kick-start a shift to a low-carbon economy and create green jobs in the process, Deutsche Bank says. But uncertainty about the regulatory framework has prevented their full deployment, it adds.

“The most efficient way to scale up renewable energy sources is to get multiple investors involved, which requires TLC,” says Mark Fulton, global head of climate change investment research at Deutsche Bank.

Power-purchase agreements (PPAs) in the U.S. are contracts that set long-term prices for electricity. Creating a standard-offer PPA by bundling renewable energy credits at prices set to deliver appropriate returns to investors over a long time period would create a level playing field, according to Fulton.

“Everybody would know what they were getting,” he says. “But the process needs to include the private sector leveraging public finance, because governments do not have the scale to make the necessary investments.” If the policy mix is right, the private money will flow, he adds.

Getting the Price Right

Getting the price right will be key to achieving the scale-up of renewable energy necessary to achieve emission-reduction targets, the Deutsche Bank says. Failure to stimulate investor interest will lead to failure to achieve any target, it says. However, overly generous fixed incentives could prove politically difficult to sustain.

Given that a market-based system for pricing carbon had never been tried in the United States before 2008, starting the first phase with a generous allowance supply and a low price may be a prudent choice to avoid market volatility and gain the trust of market participants and the public. However, the low price of pollution allowances means less auction revenue for state clean energy and energy efficiency programs and reduced incentives for energy companies to shift away from dirty fuels. As the price of pollution goes up, it becomes increasingly profitable for companies to shift to cleaner sources of energy instead of buying allowances to pollute. This in turn drives demand for clean energy and energy efficiency equipment and attracts private investment in companies that develop these technologies.

A carbon price that is too low loses out on this demand-driving effect. The likely causes of the low price are an oversupply of allowances — the power sector is not required to reduce emissions until 2014, so they buy less pollution allowances — and reduced energy demand due to the recession.

Flexible Debt Capital

Cheap debt issuance alone, even if backed by the full faith and credit of the U.S. government, is unlikely to mobilize large sums of investment, the bank says. Providing flexible debt capital across a variety of tenures that conform to project-specific timeframes and certainty of capital availability are key, it says. “Providing these financing products would fill a large void in the U.S. energy sector, providing highly rated hedgeable instruments that could enable producers and financiers to dynamically adjust their capital at risk and market exposures by timeframe based on changes in fundamentals,” according to the DB Climate Change Advisors policy paper.


A federal cap-and-trade bill that satisfies the diverse economic, regional and ideological interests of Congress will be difficult, if not impossible, to achieve. However, as RGGI demonstrates, a regional greenhouse gas cap-and-trade program can generate revenues to fund energy efficiency.

Administrative costs for RGGI, with a very lean staff of just five individuals, are only 0.5 percent of the overall emissions allowance revenue — proving that better governance does not necessarily mean bigger government or more bureaucracy. Moreover, since September 2008, RGGI has raised $583 million for RGGI states in its quarterly auctions of permits with between 65 and 70 percent of cap-and-trade proceeds going back into the clean energy economy.

Regional cap-and-trade programs, in order to achieve the necessary emissions reductions and protect the environment and the economy in a cost-effective, transparent, long-term, and certain manner, must: (a) establish a uniform price, sealed bid auction of allowances; (b) ensure that the use of auction revenues are for the public good (by allocating the allowance value to: households as dividends; financing investments and other public expenditures; and administrative costs and the reduction of the budget deficits of states participating in the regional cap-and-trade program); (c) use offsets in a manner that will resolve the concerns of integrity (e.g., additionality, supplementarity, measurement, double-counting, permanence, and leakage) more efficiently and transparently than a federal cap-and-trade program; (d) establish a strong institutional framework; and (e) link with other U.S. regional cap-and-trade programs.

(Republished with permission of the Donovan Law Group)


Brian J. Donovan is an engineer and attorney with over 34 years of international business experience.