Analyzing carbon emissions trading: a potential cost efficient mechanism to reduce carbon emissions.

AuthorDonehower, Jonathan
  1. INTRODUCTION II. CLIMATE CHANGE AND THE NEED FOR INTERNATIONAL ACTION III. THE STRUCTURE, FRAMEWORK, AND ADOPTION OF EMISSIONS TRADING A. The Policy Behind the Flexible Mechanisms B. Carbon Emissions Trading 1. Policy Behind Emissions Trading 2. The Structure of the Kyoto Protocol GHG Emissions Trading Scheme 3. Requirements for an Effective Emissions Trading Scheme C. Kyoto Protocol's Project Based Mechanisms IV. THE EMERGENCE OF CARBON EMISSIONS TRADING A. European Union Emissions Trading Scheme B. Effectiveness of the EU ETS 1. Emissions Cap and Flexibility 2. Regulatory Certainty Over Time 3. Transparency and Enforcement 4. Conclusion C. Chicago Climate Exchange D. Effectiveness of CCX 1. Emissions Cap and Flexibility 2. Regulatory Certainty Over Time 3. Transparency and Enforcement 4. Conclusion E. Conclusion V. CONCLUSION I. INTRODUCTION

    The growing interest in emissions trading systems corresponds to a continued steady rise in greenhouse gas emissions that threatens the world with dramatic climate change. (1) Greenhouse gas (GHG) emissions work as "a blanket around the earth," likely increasing the earth's average temperature (2) over the next one hundred years between 1.1 and 6.4 degrees Celsius. (3) The temperature increase from climate change causes extreme weather patterns such as flooding, drought, and shifting ocean currents. (4) "Eleven of the last twelve years (1995-2006) rank among the 12 warmest years in the instrumental record of global surface temperature (since 1850). (5) The effects of climate change are already visible at the local level. For example, Europe faces dramatic cooling caused by climate change that slows the North Atlantic Drift, the ocean current that gives Europe its warm, mild weather. (6) In the Pacific Northwest, shifts in ocean temperature off the Oregon Coast, most likely caused by climate change, (7) created a hypoxic dead zone (8) for the fifth straight year. (9) Since 2002, when the phenomenon first appeared, the dead zone has quadrupled in size to 1235 square miles, (10) These examples are only two of many and demonstrate the international effect of climate change. Climate change is a global problem and remains unsolvable at an isolated, local level. One ton of carbon emitted in New York has the same climate change effect in Portland, Oregon, as one ton of carbon emitted in China. As a result, the fight to prevent or limit the effects of anthropogenic climate change requires international cooperation. Climate change is a global threat and therefore only international efforts can address local problems such as the hypoxic dead zone and the slowing of the North Atlantic Current.

    The United Nations Framework Convention on Climate Change (UNFCCC) (11) creates a possibility for global cooperation in fighting climate change and lays the framework for international efforts to reduce GHG emissions. The UNFCCC's goal is to stabilize "greenhouse gas concentrations in the atmosphere at a level that would prevent dangerous anthropogenic interference with the climate system." (12) This task was left to the Kyoto Protocol, which specifically calls for developed countries to reduce their emissions by five percent below 1990 levels during the commitment period 2008 to 2012. (13) The Kyoto Protocol recognizes the potentially high cost associated with reducing GHG emissions and, as a result, allows ratifying countries to use "flexible mechanisms," including emissions trading, (14) joint implementation, (15) clean development mechanism, (16) and joint-fulfillment, (17) in addition to domestic reduction efforts to limit compliance costs. Based on the realization that GHG emission reductions have the same effect regardless of geographic location, the flexible mechanisms allow participants to offset their own emissions by purchasing allowances from other participants. (18)

    Carbon emissions trading, one of the Kyoto Protocol's flexible mechanisms, presents a promising tool to limit global emissions of greenhouse gases that cause climate change. Questions still remain whether carbon markets provide a cost-efficient and environmentally effective method for reducing GHG emissions. Ideally, emissions trading reduces the cost of meeting emissions obligations by placing a monetary value on GHG emissions and using the flexibility of the market to allow participants to decide whether it is cheaper to reduce emissions or to purchase excess allowances from others. Emissions trading holds the promise to correct a market failure that allows "companies [to be] rewarded financially for maximizing externalities in order to minimize costs." (19) Currently, business decisions do not incorporate the true external cost of climate change because there is no incorporated production cost for the environmental effects of emitting GHG emissions into the commons. Sir Nicholas Stern, a former chief economist of the World Bank, recognizes this market problem and estimates that if climate change goes unabated, the total cost of climate change could top $5.5 trillion, or twenty percent of the world's economic output, approximately equal to the cost to the economy suffered during the Great Depression. (20) In contrast, "an investment of one percent [$350 billion] of total world economic output would suffice to avert the direst consequences of global warming." (21) Emissions trading promises to incorporate environmental externalities and to "enable capital markets to achieve their intended purpose--to consistently allocate capital to its highest and best use for the good of the people and planet." (22) If an emissions trading system adequately limits the supply of emissions allowance through a sufficient cap to prevent anthropogenic climate change, a carbon market will force participants to find cost-efficient ways to either reduce emissions or acquire reduction credits as cheaply as possible to meet their obligation.

    The implementation of emissions trading has been widely accepted by the international community as an important tool to reduce GHG emissions. The European Union and a group of private parties in the United States recently established two carbon markets, the European Union Emissions Trading Scheme (ETS) and the Chicago Climate Exchange (CCX). ETS is a mandatory cap and trade system while CCX is a voluntary program enforced through voluntary contractual obligations. (23) ETS grew dramatically and through the first nine months of 2006 had a market value of $19 billion. (24) CCX has a market value estimated at only $2.7 million in the first quarter of 2006. (25) The value of both markets is two fold. One, they provide a test ground for emissions trading to work out its kinks, and two, they provide participants with experience in trading carbon units and incorporating the cost of carbon into daily decision making before the Kyoto Protocol compliance period begins in 2008. (26) The early emissions trading systems developed effective market tools but have not forced emissions reductions that will have a significant environmental effect. For example, despite the growth of the ETS market, the ETS price of carbon failed to meet the threshold to convince companies to switch from coal to cleaner energy during the 2005 winter. (27) In order to switch from coal to natural gas, the clean spark spread must exceed the revenue from coal power to make the change cost effective. (28) A clean spark spread "represents the difference between the price of electricity at peak hours and the price of natural gas used to generate that electricity, corrected for the energy output of the gas-fired plant." (29) Neither ETS nor CCX have altered the "clean spark spread" in favor of cleaner sources of energy. For an emissions trading market to create environmentally effective emissions reduction it must cause market shifts to less polluting energy sources or cause emissions reduction changes in current production models. Both CCX and ETS have shown dramatic promise in creating an effective market framework that allows participants flexibility in complying with their emission reduction targets.

    A successful carbon market requires 1) a sufficient emissions cap, 2) ability to guarantee compliance, 3) flexibility, 4) regulatory certainty over time, and 5) transparency. (30) First, an emissions market requires a sufficient emissions cap to create market demand for allowances, maintain a carbon price, and to meet environmental targets. Second, without an ability to guarantee compliance there will be no assurance of the value of emissions credits or that reductions are occurring. Third, flexibility is required to allow companies to choose the cheapest reduction methods and therefore lower the total overall cost of reducing GHG emissions. Fourth, without regulatory certainty over at least a thirty-year period, companies are unable to incorporate the accurate costs of GHG emissions into the cost of future production. (31) And fifth, transparency is needed to foster public and private trust in the market. (32)

    The current carbon emissions trading markets do not fulfill all five of the requirements for an effective market, though the markets do show exciting promise. The growth of carbon emissions trading has demonstrated exciting growth and has a total market value estimated at $22 billion. (33) These markets have begun to teach companies how to incorporate the cost of carbon into business decisions. Despite the growth of carbon markets, GHG emissions reductions have not met the Kyoto Protocol goal of a five percent reduction below 1990 levels. (34) Even within the ETS, which has a mandatory cap, Portugal, Spain, Greece, and Ireland are expected to dramatically exceed their Kyoto Protocol emissions targets. (35) In order for the market to achieve its ultimate environmental goals, national governments must set sufficient long-term emissions caps to create demand and spur reductions. Both CCX and ETS created effective market...

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