Existing cap-and-trade programs provide important lessons about the need for robust design features. A brief review of real-world experience will illustrate two of these lessons. First, a cap must be tight enough to achieve significant cuts in emissions. Second, the method regulators select for distributing emission allowances to firms is critical, and auctioning is gaining favor as the preferred approach.
Cap and Trade in Practice: The European Union's Trading Scheme
The European Union’s Emission Trading Scheme (EU ETS) is the first cap-and-trade program for reducing heat-trapping emissions, and is designed to help European nations meet their commitments to the Kyoto Protocol. This program includes 27 countries and all large industrial facilities, including those that generate electricity, refine petroleum, and produce iron, steel, cement, glass, and paper.
The first phase of the EU ETS—from 2005 to 2007—drew criticism for not achieving substantial cuts in emissions, and for giving firms windfall profits by distributing carbon allowances for free. These criticisms are valid. However, the EU viewed Phase 1 as a trial learning period. The extent to which Phase 2—which runs from 2008 to 2012—helps Europe fulfill its Kyoto commitments will be a better test of the program.
Phase 1 allowed countries to auction up to only 5 percent of allowances—and only Denmark chose to auction that amount. The result was billions of dollars in windfall profits for electricity producers. Phase 2 allows slightly more auctioning, which is expected to occur.
The rules for Phase 3—which extends from 2012 to 2020—were published in December 2008, and unfortunately they are not as ambitious as expected, given the EU’s stated commitment to tackling global warming. This phase targets a 20 percent reduction in emissions from 1990 levels by 2020; climate experts had hoped for 30 percent. Even this target is considerably watered down because of the large amount of offsets allowed from outside the capped region. Auctioning of allowances is still not likely to play a major role. This experience reinforces the fact that the United States would be much more likely to win stronger commitments from the EU and elsewhere if it fulfilled its responsibility to lead on climate policy.
The Northeast Regional Greenhouse Gas Initiative
The Regional Greenhouse Gas Initiative (RGGI) is a cap-and-trade program that covers a single sector—electricity generation—in 10 northeastern and mid-Atlantic states. The program aims to achieve a 10 percent reduction in emissions from power plants by 2018.
The program’s most notable aspect is that states unanimously chose auctioning to distribute the vast majority of emission allowances. Six of the ten states will auction nearly 100 percent of their allowances. The auctions of the other four states include fairly small portions of fixed-price sales or direct allocations.
The program's initial three-year compliance period begins in 2009, but the first multistate auctions occurred on September 25 and December 17, 2008. The first auction, which included allowances from only six states, raised $38.5 million, while the second raised $106.5 million. States and electric utilities will invest the vast majority of those funds in energy efficiency and renewable technologies, with an emphasis on reducing demand for fossil fuel–based electricity and saving consumers money.
The RGGI auction includes a reserve price, to ensure that CO2 emissions will always carry a minimum cost, and that the auctions will yield a minimum amount of revenue for these important programs. Some analysts fear that the states may have set the cap too high, because emissions have not grown at the rate expected when the cap was set in 2005. However, there is a possibility that the states could revisit the cap.
The Western Climate Initiative
The Western Climate Initiative (WCI)—which includes seven western states and four Canadian provinces—has established a regional target for reducing heat-trapping emissions of 15 percent below 2005 levels by 2020. WCI’s main focus is developing a regional cap-and-trade program. The WCI also requires participants to implement California’s Clean Car Standard, and recommends other policies and best practices that states and provinces can adopt to achieve regional goals for cutting emissions.
The first phase of WCI development culminated on September 23, 2008, with the release of its Design Recommendations. These sketch out a very broad cap-and-trade program that would cover 85–90 percent of all heat-trapping emissions from participating states and provinces. The only parts of the economy that would remain uncapped are agriculture, forestry, and waste management. However, some sectors, such as transportation fuels, would be brought in at the start of the second compliance period, in 2015.
California is the largest single entity in the WCI, and it has the most detailed action plan of any state in the nation. In 2006 the legislature passed, and Governor Schwarzenegger signed, a law to reduce emissions economywide. The California Air Resources Board has created a blueprint for achieving the required reductions. The plan includes a strong set of sector-specific policies forecast to provide about 80 percent of the needed reductions, as well as a broad cap-and-trade program linking to the WCI. The California and WCI cap-and-trade programs are scheduled to go into effect in 2012.
Midwestern Regional Greenhouse Gas Reduction Accord
Another nascent regional effort is occurring in the Midwest. On November 15, 2007, the governors of Illinois, Iowa, Kansas, Michigan, Minnesota, and Wisconsin, as well as the premier of the Canadian province of Manitoba, signed the Midwestern Regional Greenhouse Gas Reduction Accord. Participants agreed to establish regional targets for reducing global warming emissions, including a long-term target of 60–80 percent below today’s levels, and to develop a multisector cap-and-trade system to help meet the targets.
Participants will also establish a system for tracking global warming emissions, and implement other policies to help reduce them. The governors of Indiana, Ohio, and South Dakota joined the agreement as observers. The regional accord for reducing such emissions is the first in the Midwest.
The governors and premier assembled an Advisory Group of more than 40 stakeholders to advise them, and their final recommendations are due in May 2009. As now conceived, the cap would take effect January 1, 2012.