The Least-Cost Way to Control Climate Change

In December 1997 in Kyoto, Japan, representatives of 159 countries agreed to a protocol to limit the world’s emissions of greenhouse gases. Now comes the hard part: how to achieve the reductions. Emissions trading offers a golden opportunity for a company or country to comply with emissions limits at the lowest possible cost.

Trading allows a company or country that reduces emissions below its preset limit to trade its additional reduction to another company or country whose emissions exceed its limit. It gives companies the flexibility to choose which pollution reduction approach and technology to implement, allowing them to lessen emissions at the least cost. And by harnessing market forces, it leads to innovation and investment. The system encourages swift implementation of the most efficient reductions nationally and internationally; provides economic benefit to those that aggressively reduce emissions; and gives emitters an economically viable way to meet their limits, leading to worldwide efficiency in slowing global warming.

Benefits to the United States from emissions trading would most likely be achieved domestically. However, trading between developed nations and between developed and developing nations has much to offer. It can accelerate investment in developing countries. And it gives developed countries the flexible instruments they say they need to garner the political support necessary to agree to large emissions reductions. In a recent speech in Congress, Sen. Robert Byrd (D-W. Va.) stated that, “reducing projected emissions by a national figure of one-third does not seem plausible without a robust emissions-trading and joint-implementation framework.”

If effective trading systems are to be designed, tough political and technical issues will need to be addressed at the Conference of the Parties in Buenos Aires in November 1998-the next big meeting of the nations involved in the Kyoto Protocol. This is especially true for international trading, because different nations have significantly different approaches to reducing greenhouse gases and because many developing countries are opposed to the very notion of trading. However, if trading systems can be worked out, the United States and the world could meet emissions commitments at the lowest possible cost.

The challenge

The Kyoto Protocol requires developed countries to reduce greenhouse gas (GHG) emissions to an average of 5 percent below 1990 levels in the years from 2008 to 2012. The United States has agreed to cut emissions by 7 percent below its 1990 level. Russia and other emerging economies have somewhat lesser burdens. However, estimates indicate that at current growth rates, the United States would be almost 30 percent above its 1990 baseline for GHG emissions by 2010. Most emissions come from the combustion of fossil fuels. Carbon dioxide is responsible for 86 percent of U.S. emissions, methane for 10 percent, and other gases for 4 percent. Substantial reductions will be needed.

One strategy would be a tax on the carbon content of fuels, which determines the amount of GHGs emitted when a fuel is burned. Although this may be the most efficient way to reduce GHG emissions, it is politically unrealistic in the United States. Our domestic strategy is more likely to be a choice between a trading system linked with a cap on overall emissions and the more traditional approach of setting emission standards for each sector of the economy.

The strategy in other countries may be different. During the Kyoto debates, a sharp difference was evident between the United States, which favored a trading approach to achieving national emissions targets, and European nations, which are contemplating higher taxes as well as command-and-control strategies such as fuel-efficiency requirements for vehicles and mandated pollution controls for utilities and industry. Nonetheless, all countries can still benefit from international trading.

Why trading can work

An emissions trading system allows emitters with differing costs of pollution reduction to trade pollution allowances or credits among themselves. Through trading, a market price emerges that reflects the marginal costs of emissions reduction. If transaction costs are low, trading leads to overall efficiency in meeting pollution goals, because each source can decide whether it is cheaper to reduce its own emissions or acquire allowances from others.

Trading creates benefits by providing flexibility in technology choices both within and between firms. For example, consider an electric utility that burns coal in its boilers. To comply with its emissions limit, it could add costly scrubbers to its smokestacks or it could buy allowances to tide it over until it is ready to invest in much more efficient capital equipment. The latter option often results in lower or no long-term costs when savings from the new technology and avoidance of the costly quick fix are figured in. It also creates the potential for greater long-term pollution reductions. By not spending money on the quick fix, the utility has more capital to invest in more efficient future processes. This point is critical, because reductions beyond those prescribed in the Kyoto Protocol will be needed in the years after 2010 to stabilize global warming for the rest of the 21st century.

Some political and environmental groups oppose trading, equating it to selling rights to pollute. But this view fails to recognize the substantial differences in business processes and technologies, which may allow one source to reduce emissions much more cheaply than another. It also undervalues the importance of timing in investment decisions; the ability to buy a few years of time through trading may allow companies to install improved equipment or make more significant process changes. Trading leads to the firms with the lowest cost of compliance making the most reductions, creating the most cost-efficient system of meeting pollution goals.

Trading is also denigrated by those who say it can create emissions hot spots that result in local health problems. But GHGs have no local effects on human health or ecosystems; they are only problematic at their global concentration levels in the upper atmosphere.

Why a cap is needed

There are two prevailing emissions trading approaches: an emissions cap and allowance system and an open-market system. The cap-and-trade system establishes a hard cap on total emissions, say for a country, and allocates allowances to each emitter that represent its share of the total emissions. Sources could either emit precisely the amount of allowances they are issued, emit fewer tons and sell the difference or store (bank) it for future use, or purchase allowances in order to emit more than their initial allotment. Allowances are freely traded under a private system, much as a stock market operates. A great deal of up-front work must be done to establish baselines for the emitters and to put a trading process in place, but once that work is completed, trades can take place freely between emitters. No regulatory approval is needed. Environmental compliance is ensured because each emitter must have enough allowances to equal its emissions limit each year.

The beauty of the cap-and-trade system is an elegant separation of roles. The government exerts control in setting the cap and monitoring compliance, but decisions about compliance technology and investment choices are left to the private sector.

The best example of such a system in found in the U.S. Acid Rain Program. It has been remarkably effective. An analysis by the Government Accounting Office shows that this cap-and-trade system, created in 1990 to halve emissions of sulfur dioxide by utilities, cut costs to half of what was expected under the previous rate-based standard and well below industry and government estimates. What’s more, recent research at MIT indicates that a third of all utilities complied in 1995 at a profit. This happened because there were unforeseen cost savings in switching from high-cost scrubbers to burning low-sulfur coal, and because trading enabled a utility to transfer allowances between its own units, allowing it to use low-emitting plants to meet base loads and high-emitting plants only at peak demand periods.

The open-market trading system works differently. Generally, there is no cap. Regulators set limits for each GHG coming from each source of emissions-say, for carbon dioxide from the smokestacks of an electric utility. Therefore, whenever two emitters want to trade, they must get regulatory approval. Although the up-front work may be less than that required for a cap-and-trade system, the need for approval of each trade makes transaction costs high. Also, there is always uncertainty about whether a trade will be approved, and approvals can take weeks or months, all of which reduce the incentive to trade and create an inefficient system.

The most recent results from the U.S. Acid Rain Program show that transaction costs are about 1.5 percent of the value traded, which is about the same as those for trades in a stock market. Transaction costs for open-market trading are an order of magnitude or more higher. Not surprisingly, the results of open-market trading in several U.S. states to reduce emissions of carbon monoxide, nitrogen oxides, and volatile organic compounds have been generally disappointing.

An emissions cap-and-trade system would reduce GHGs within the United States at very low cost. Trading between developed countries and between developed and developing countries could help nations meet their Kyoto Protocol targets, too. Let’s consider what is needed for each system.

Trading at home

The protocol allows a country to use whatever means it wants to achieve its own limit, so there is no restriction on creating a good cap-and-trade system within the United States. The first step would be to allocate the U.S. allotment of carbon emissions among emitters. Emissions come from several major sectors: electricity generation contributes 35 percent; transportation, 31 percent; general industry, 21 percent; and residential and commercial sources, 11 percent. However, because large sources are responsible for most GHGs, the United States could capture between 60 and 98 percent of emissions by including only a few thousand companies in the system.

Possibly the biggest cap-and-trade question for the United States is whom to regulate. The most efficient system would be to impose limits on carbon fuel providers-the coal, oil, and gas industries. These fuels account for up to 98 percent of carbon emissions. Industry groups are concerned, however, that regulating fuel providers is tantamount to a quota on fossil fuels, although similar reductions in fossil fuels would be required by any GHG regulation.

The alternative is to impose limits on fuel consumers-utilities, manufacturers, automobiles, and residential and commercial establishments. This method is less efficient, covering 60 to 80 percent of emissions, because it cannot practically handle the thousands of small industrial or commercial firms, not to mention residences, and because it does not provide incentives to reduce vehicle miles traveled. These inefficiencies will lead to higher overall costs and less burden-sharing.

However, political considerations will be as important as technical ones in choosing whom to regulate, and a hybrid system is possible. The most likely hybrid would be direct regulation of electric utilities and industrial boilers, capturing most of the country’s combustion of coal and natural gas. A fuel-provider system would then be used to regulate sales of petroleum products and fossil fuels to residential and commercial markets. This may be politically expedient and could be almost as efficient as a pure fuel-provider model.

The design of the cap-and-trade program should follow the basic features of the U.S. Acid Rain Program. That program creates a gold standard with three key elements: a fixed emissions cap, free trading and banking of allowances, and strict monitoring and penalty provisions.

Several added benefits could be incorporated. First, the cost of continuous emissions monitoring could be reduced because emissions of carbon dioxide are very accurately measured by the carbon content of fuel. Second, the system could allow trading between gases. This could spur significant reductions of methane, which contributes 10 percent of the warming potential of U.S. emissions. A methane molecule has 21 times the warming potential of a carbon dioxide molecule, and certain sources of methane-landfills, coal mines, and natural gas extraction and transportation systems-could be included. Methane control can be low-cost or even profitable, because the captured methane can be sold; thus, trading between carbon dioxide and methane sources could be a cheap way to reduce the U.S. contribution to global warming.

A third design option would hinge on whether to allocate allowances to existing emitters for free or to auction them. Allocating allowances, as in the acid rain program, is the most politically expedient option, but burdens later entrants, who must buy allowances from others who have already received them. Auctioning allowances would make them available to all and could have a dual benefit if the monies are used to reduce employment taxes or spur investment.

The U.S. Acid Rain Program’s cap-and-trade system has cut the cost of sulfur dioxide compliance to $100 per ton of abated emissions, compared to initial industry estimates of $700 to $1,000 per ton and Environmental Protection Agency (EPA) estimates of $400 per ton. The same kind of cost reductions can be expected in a GHG system. The National Academy of Sciences has estimated that the United States could reduce 25 percent of its carbon emissions at a profit and 25 percent at very low or no cost, because of the hundreds of opportunities to achieve energy efficiency or switch fuels in our economy. Examples given by the Academy include switching from coal to natural gas in electricity generation, improving vehicle fuel economy, and creating energy-efficient buildings. The low net costs of GHG abatement would be further enhanced by the Clinton administration’s recent proposal to speed the development of efficient high-end technologies.

As the world’s largest emitter of GHGs, the United States should begin to implement a cap-and-trade system now. Market signals need to be sent right away to start our economy moving toward a less carbon-intensive development path. To prompt action, EPA should set an intermediate cap, perhaps for the year 2005, because the Kyoto Protocol requires countries to show some form of “significant progress” by that year.

Trading between developed countries

International emissions trading could contribute substantially to curbing many nations’ cost of compliance with the Kyoto Protocol. An assessment by the Clinton administration concluded that compliance costs could fall from $80 per ton of carbon to $10 to $20 per ton if full trading between all countries were allowed. A more realistic analysis done by the World Resources Institute examined 16 leading economic models and concluded that overall costs are much lower, but that international trading could still reduce the cost by around 1 percent of gross national product over a 20-year period.

Rules for trading between nations must begin to be drawn at the Conference of the Parties this November. However, there are key contentious issues, such as how to ensure the high credibility of trades through good compliance and monitoring systems and how to create a privately run system in which transactions can be made in minutes, not the months or even years required for government approval mechanisms. Whether transaction costs are high or low will probably determine the success of international trading.

Article 17 of the Kyoto Protocol authorizes emissions trading between countries listed in the protocol’s Annex B, which currently includes all industrialized countries. It is, however, short on details (it contains only three sentences). It will be up to the Conference of the Parties to define the rules, notably those for emissions reporting and verification and enforcement of violations penalties. It is critical that the Conference properly design rules that create a system that allows private trading with its low transaction costs. This may be difficult because of the lack of definition in the protocol and differing positions within the international community.

Key issues to be resolved include the following:

Trading by private entities. Article 17 makes no reference to it, but trading by private entities is fundamental. Requiring government approval for each trade creates such uncertainty, high transaction costs, and delays that the benefits of trading are substantially lost.

Monitoring and enforcement. High-quality monitoring and compliance systems are essential. At a minimum, this means accurate monitoring, credible government data collection and enforcement, and stiff penalties for noncompliance. In the United States, an early emissions trading system adopted to phase out leaded gasoline in the late 1980s experienced significant violations and enforcement actions until EPA tightened the rules. In the U.S. Acid Rain Program, high-quality monitoring, a public Allowance Tracking System, and steep penalties have led to 100 percent compliance-a remarkable achievement.

Compatibility of trading systems. Developed countries may adopt a wide variety of domestic strategies for achieving their GHG targets. Emissions trading would be facilitated if each were to adopt the cap-and-trade approach, but perhaps only the United States will do so. If other countries pursue other avenues, they could only participate in international trading through an open-market trading system, which involves substantial transaction costs. To ensure the least regulation and lowest cost for all, other countries should adopt the cap-and-trade model.

The “hot air” issue. The economic collapse of the former Soviet republics means that many central and eastern European countries are expected to be approximately 150 million tons below their GHG limits each year during the 2008-2012 commitment period. The protocol allows them to trade these “hot air” tons, even though they would never have been emitted. Trading for these tons could reduce other developed countries’ compliance obligations by an average of 3 percent, essentially raising the GHG cap. This issue muddies the waters because it mixes concerns about the overall cap with the issue of trading. Although trading should be allowed to function freely, it is unfortunate that the protocol allows the inclusion of these non-emissions.

The United States should also review two other trading-related provisions. Article 4 allows several developed countries to jointly fulfill their aggregate commitment to reduce GHG emissions. Although this umbrella approach is a potentially attractive vehicle for trading, its conditions are oriented toward the specific situation of the European Union. One major drawback is that the provision requires each country’s commitment to be established up front, which would restrain the operation of a more flexible market.

Article 6 authorizes a system of joint implementation among developed countries. Joint implementation differs from emissions trading because it requires that any emissions reduction done for trading be “additional to any that would otherwise occur.” This is a difficult case for any country to prove and requires even more oversight of each trade than the open-market approach. Such high transaction costs are likely to make this provision of little use, unless there is a failure to agree on good rules for regular emissions trading under Article 17.

Trading with developing countries

Trading between developed and developing countries has been hotly debated throughout the treaty process. For a developed country, the appeal is that investments made in developing countries, which are generally very energy-inefficient, can result in emissions reductions at very low cost, making allowances available. For a developing country, trading could be attractive because its sale of allowances could generate capital for projects that help it shift to a more prosperous but less carbon-intensive economy.

However, most developing countries, led by China and India, are opposed to trading. First, they simply distrust the motives of developed nations. Second, they rightly point out that the developed world has created the global warming problem and should therefore clean it up. Although legitimate, this second view ignores the many benefits that trading can bring to developing countries.

Many nongovernmental organizations (NGOs) are also wary of trading, claiming that the availability of allowances from developing countries will allow developed countries to avoid having to reduce their own emissions. This is unlikely, however. The United States, for example, will have to reduce its emissions by 37 percent by 2010 to reach its target. Developing countries that are willing to trade will simply not be able to accumulate enough tons to offset this large reduction. Indeed, trading with developing countries is likely to account for at most 10 to 20 percent of the reductions needed by a developed country.

Another major problem in trying to trade with developing countries lies in the weak emissions monitoring and compliance systems currently in place in many of them. Strengthening the basic institutional and judicial framework for environmental law may be necessary in many countries and could take considerable investment and many years. The protocol authorizes two possible ways for a developing country to participate in trading: emissions reduction projects under a provision called the Clean Development Mechanism (CDM) or regular emissions trading under Article 17. The choice depends on whether a developing country makes a specific emissions reduction commitment.

Without such a commitment, a developing country can trade only under the CDM, which is vaguely defined. Depending on decisions made at the Conference of the Parties, the CDM could be anything from a ponderous multilateral government organization whose bureaucracy would dilute any advantage of trading, to a certifying entity that creates a private system for approving trades. This second mechanism would be consistent with the kind of private trading system needed. Useful models for it may be found in the certifying mechanisms of the International Standards Organization or the Forest Stewardship Council.

Attention must be paid to reducing the high transaction costs of CDM trade, however. For a country’s project to qualify under the CDM, the emissions reduction must be “additional to what would have otherwise occurred.” Would a project to switch a utility from coal to natural gas combustion have been pursued anyway? Would a forest protected under a project have survived anyway? This is difficult to ascertain, as demonstrated by an existing pilot program for “activities implemented jointly,” approved by the first Conference of the Parties in 1995. The program addresses the “additionality” issue by requiring extensive review of each trade by the approving governments. This process relies on subjective prediction and can take on average one to two years, leading to very high transaction costs. Future improvements could include privatizing the verification system, standardizing predictive models, and perhaps discounting trades to adjust for uncertainties.

In addition to these difficulties, significant investment under the CDM is unlikely until rules for governing it are approved. This must await the first implementation meeting of the parties to the protocol, which cannot happen until the Kyoto Protocol has been ratified and the parties meet, which would be 2002 at the earliest.

Alternatively, Article 17 allows a developing country to participate fully in trading, with no requirement to show that reductions are additional, if it subscribes to an emissions reduction obligation that is adopted by the Conference of the Parties under Annex B. Because such a commitment for a developing country is likely to be generous, countries making a serious commitment to reductions, such as Costa Rica with its carbon-free energy goal, might well profit from trading.

One approach would be to set the commitment based on the growth baseline concept put forward by the Center for Clean Air Policy. This requires a commitment to reduce the carbon intensity of a country’s economy, which could allow for reasonable growth of emissions while setting firm benchmarks. In this approach, developing countries would not only benefit economically from emissions trading but would take on the kinds of solid commitments needed to achieve the goals of the convention and facilitate ratification of the protocol by the developed countries.

An effective cap-and-trade system implemented within the United States would allow this country to comply with the GHG reductions it has committed to in the Kyoto Protocol at low or no cost. Because the system is a market instrument, it can rapidly bring about the adaptation, innovation, and investment needed to reduce emissions.

International trading can contribute substantially to achieving cost reductions, particularly if a cap-and-trade model with private trading mechanisms can be built into the protocol. Although such a system is unlikely to be fully mapped out at the Buenos Aires meeting in November, the first critical steps must be taken there.