Emissions Allowance

Cap and Trade Programs

Tradable emission allowances were first used under the United States’ Acid Rain Program, the world’s first cap and trade program. The program, which began in 1995, addresses sulfur dioxide emissions from utilities.¹  The success of this program helped paved the way for the development of cap and trade programs addressing green house gas emissions, the most notable of which are the European Union’s Emissions Trading Scheme (ETS)² and the Regional Greenhouse Gas Initiative (RGGI)³, which covers parts of the Northeastern part of the United States.

Under a cap and trade program, a regulating entity sets an emission target, or “cap,” for a specific pollution.  Each industry covered under the system is then allocated an individual cap on their emissions, which are accounted for through a system of emission allowances. One allowance usually equals one ton of the regulated pollutant. Under the Regional Green House Gas Initiative (RGGI), for example, the state of Connecticut has an overall emissions cap of 10,695,036 tons of CO2. The state is then responsible for allocating 10,695,036 emission allowances to the industries covered by the RGGI program in its state.⁴

Emission allowances can be bought, sold or traded by covered entities to help them meet their emission cap.  While each cap and trade programs has its own rules for trading allowances, the general concept works like this:  if a company emits 11,000 tons of a pollutant for which it is allocated 10,000 allowances, it must, in most circumstances, buy 1,000 allowances on the open market to cover its exceedance.  These allowances will usually come from companies that have cut their emissions below their cap.  The principle behind cap and trade is that it will create market incentives for companies to find the most cost effective strategies to reduce the covered emissions.

Allowances Represent Value

An emissions allowance represents a valuable commodity.  Governments create a significant source of wealth by allocating emission allowances and then allowing companies to buy and sell those allowances. For example, estimates put the value of emission allowances in a potential United States cap and trade program at tens of billions of dollars.⁵ How a government allocates these allowances will have significant economic and policy implications.

Distributing Emission Allowances

Governments may give away allowances, auction them, or use some combination of these two methods.   Giving away allowances is generally more politically acceptable to the regulated industries because it imposes less of a financial burden on them. Auctioning allowances, on the other hand, raises the cost of polluting, thereby providing a greater incentive for companies to reduce their emissions

The U.S. Acid Rain Program distributes allowances for free, using a formula to calculate how many allowances each facility will receive.⁶  States in the RGGI system auction the vast majority of their allowances, and use those proceeds to promote energy efficiency, mitigate ratepayer impacts, and develop innovative carbon emissions abatement technologies.⁷   The first two quarterly auctions were held in September and December 2008, and netted $44,071,285.⁸

ETS illustrates the pitfalls of both over allocating allowances and giving away too many allowances for free in a carbon cap and trade system. Currently in ETS, each member state decides how many allowances to allocate per trading period based upon criteria established by the European Commission.  The governments distribute almost all of these allowances for free to the installations covered by the program within their countries.  In the first trading period (2005-2007), and some would argue in the second trading period (2008-2012), the European members over allocated the number of allowances, creating a financial windfall for some companies, who were able to sell allowances to other companies without having to reduce their emissions, and undermining the goal of using the cap to lower overall emissions.⁹

In 2008, the European Commission introduced reforms to the EU-ETS to address concerns raised by the allocation of emission allowances in the first three years of the program.  Under these changes, the European Commission, not national governments, will begin allocated allowances in 2013. In the first trading period and second trading period, when member states allocated allowances, significant differences between the states emerged in how these allocations were done, and each state had strong incentives to favor its own industry.   In addition to this change, the European Union has agreed to significantly tighten its emissions cap, resulting in 21 percent reductions by 2020, and increase the amount of allowances auctioned from 4 percent in the second phase (2008-2013) to more than half in the third phase (2013-2020).⁹

Footnotes

¹United States Environmental Protection Agency, Acid Rain Program SO2 Allowances Fact Sheet  .In 2003, EPA also began to administer a NOx Budget Trading Program. NOx is a prime ingredient in the formation of ground-level ozone (smog), a pervasive air pollution problem in many areas of the United States.

²http://ec.europa.eu/environment/climat/emission/index_en.htm

³http://www.rggi.org

⁴Regional Greenhouse Gas Initiative, Memorandum of Understanding, December 20, 2005, Section 2(C).

⁵Knopp, Raymond J., Resources for the Future, Allowance Allocation, (May 2007), page 88; Pew Center on Global Climate Change, Introduction: Greenhouse Gas Emissions Allowance Allocation, (2008), page 7.

⁶See footnote 1.

⁷See footnote 4, Section 2(G).

⁸http://www.rggi.org/co2-auctions/results

⁹MEMO/08/796 Questions and Answers on the revised EU Emissions Trading System

⁹Id.