The concept of a cap-and-trade scheme was first introduced by the United States Environmental Protection Agency (US EPA) through the Clean Air Act Amendments of 1990 as a cost effective mechanism to regulate emissions of nitrogen oxides (NO-) and sulfur dioxide (SO2) in the power sector; the primary causes of acid rain7 -8] - The overwhelming success of the pollution control scheme led to
5) Leakage refers to the undue shift in production to countries with little or no regulation on GHG emissions.
6) Hot spots refer to areas that fall outside of emissions compliance countries where industry can shift production to avoid regulations on GHG emissions.
7) Acid rain refers to the deposition of precipitation containing acidifying particles and gases. The acid is derived from sulfur oxides (SOx) and nitrogen oxides (NOx) which enter the atmosphere from the combustion of coal and other fuels from industrial processes.
the adoption of emissions trading as one of the key flexible mechanisms of the Kyoto Protocol, conceived in 1997 as a means for countries to achieve their greenhouse gas reduction targets.
Emissions trading schemes operate by establishing an absolute emissions limit, usually done by a government or international authority, and issue emission allowances to industries covered under the scheme. This limit serves as a cap on emissions permitted under the framework during the compliance period. Following the establishment of a cap, emissions allowances are distributed to participating entities through free allocations, auctions, or a combination of both. In a cap-and-trade system for regulating CO 2 emissions, a quantity of allowances are surrendered at the end of each compliance period that are equivalent to the emissions for which the installation is responsible according to the governing authority. Each allowance generally refers to one tonne of carbon dioxide equivalent (CO2e). The distribution of allowances can be based on historical emissions, known as grandfathering,^ or can be output based and linked to a product of a given sector where benchmarking is used set emissions levels .
To prevent a negative economic burden to industries which are competitively disadvantaged by an absolute cap on emissions levels, the start-up process of emissions trading schemes generally relies heavily on free allowances and gradually incorporates auctioning of allowances by the governing body. In 2005, the launching of the European Union emissions trading scheme (EU ETS) took place under the guidelines of the Kyoto Protocol. The scheme relies heavily on the free allocation of emissions allowances through a national allocation plan (NAP2 2 during Phase I (2005-2007) and Phase II (2008-2012). During the compliance period, the EU ETS enables member states to trade allowances issued through the NAP to meet compliance obligations corresponding to national targets under the Kyoto Protocol.
Auctioning of emissions allowances, such as proposed under the US Climate Bill, generates revenue for the governing body to redistribute and lessen the economic burden on society resulting from pass-through cost to consumers. This is particularly attractive for governments to lessen taxes in certain areas which could otherwise curb or prevent economic growth. Auctioning of allowances also prevents some of the key criticisms surrounding a cap 2and2trade, namely where early entrants can achieve windfall profits10) through the sale of free allowances.
The cap - and - trade approach uses market efficiency by taking advantage of the least marginal abatement cost (MAC)11) to reduce the overall economic burden of
8) Grandfathering is method of allocating emissions allowances based on historic emissions levels.
9) A national allocation plan (NAP) defines basis on which free greenhouse gas emission allowances are allocated by national governments to individual installations covered by the emissions trading scheme.
10) Windfall profits refer to large profits that occur due to unforeseen circumstances in a market, such as unexpected demand or government regulation.
11) Marginal abatement cost (MAC) refers to the marginal cost of reducing one tonne of CO2 equivalent and is generally expressed in terms of€/tCO2e.
reducing emissions. Most notably, a cap-and-trade scheme places a value on CO2 which effectively drives innovation for technologies that reduce emissions. Entrants to the scheme which are capable of reducing emissions at a price lower than market value may generate a profit by selling excess allowance for surpassing their compliance obligation.
One of the fundamental advantages of a cap-and-trade scheme is the flexibility to use carbon offsets, which depending on the scheme, may include both domestic and international offsets. Domestic offsets are sourced from initiatives within the compliance country to reduce unregulated emissions, while international offsets are generated outside of the compliance country. Section 2.4 of this chapter further examines the role of international offsets and what mechanisms are currently available to develop and trade these offsets.
Emissions trading is often criticized by environmental non-governmental organizations (NGOs) and governments because it is viewed as a disincentive for 'own action'.'12) While this argument holds merit for some installations which have a high cost of abatement, supporters of a cap-and-trade dismiss the argument suggesting that installations will invest in their own reductions when they are more economical than the price of allowances in the market.
Further criticism attacks the unpredictable nature of market mechanisms, arguing that long-term price signals are needed to justify investment in low carbon technology. The EU ETS faced severe price volatility in the start-up Phase I where the price of European Union allowance (EUAs) fell to zero because of oversupply in the market. Market analysts attributed the price collapse of the Phase I EUA to a learning phase directed at gaining participation from installations and establishing baseline data for the following Phase II.
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