In the experience with emissions trading systems, two types of approaches to creating tradable emissions reductions are identified (e.g. Ellerman et al., 2000). A cap-and-trade system distributes allowances that must then be used by entities under the cap to cover their emissions. Trading is among these allowances. However they are originally distributed, entities may purchase more if they need them or sell extras they do not need, but they must hold allowances to match their emissions. The second type of system is a credit system. In a credit system, credits are earned by reducing emissions below an established baseline. Typically, entering the credit system is voluntary: there is a market for the credits and it is in the economic interest of an entity to produce credits at the going price if they can do so, but other entities may choose not to enter the credit system and so they are not required to make any reductions. A credit system is often an add-on to an allowance cap-and-trade system. The cap-and-trade system forces the entities under the cap to reduce emissions whether or not it is economically desirable, and thus allowances have a positive market price. Those entities outside the cap but allowed to produce credits can sell credits in the market if they want to. Since producing credits is voluntary, no entity covered under the credit system should bear net costs unless they have miscalculated their own cost of producing the credits. Those under the cap can be shown to gain from trading (as compared with trying to meet the allocation without trading), but in most cases they are bearing costs compared with not having the policy at all. Trading is beneficial because it reduces costs. Of course, a generous allowance allocation can mean that even under the cap there may be some entities that benefit from the policy compared to the case with no policy, but if the cap is binding, the entities under the cap on average bear a cost.
The Bush Intensity target is voluntary, and its main aspect is a credit system. At present there is not much of a market for these credits, but producing and registering credits may be worth it if entities anticipate that there will be a cap-and-trade system in the future. The McCain-Lieberman Bill was a cap-and-trade, but sinks were allowed in as credits. The language of the Kyoto Protocol is one that would allow sinks in as credits at least in terms of a country meeting its target. It is not clear that this would foreclose sinks or some amount of land area entering under a cap within a domestic system of a party under the Protocol, but whatever the result of that broader cap, it would have to be squared with the sinks language in the Protocol, making them credits against the national cap. As already noted, a problem with a credit system is the 'real reduction' problem. A baseline for emissions, the reference against which credits can be earned, is hard to establish. If very loose, many entities may have an interest in entering the credit market as sellers but many of the credits may be unrelated to real reductions. If very tight, few will have an incentive to sell credits. As a result, much effort must be expended to determine the baseline for each entity with potential credits. In contrast, if the national allowance target can be established, the integrity of the overall target is not compromised even if the allocation provides 'hot air' allowances to some participants.
Both spatial leakage (landowners not voluntarily entering the credit system) and temporal leakage (landowners selling credits this period with the sequestered carbon being emitted in later periods) are a problem with credit systems. A forest landowner, who forgoes harvesting to sequester carbon, reduces the supply of lumber. But the demand for lumber remains, and so other lumber suppliers produce more lumber, thereby offsetting most of the sequestered carbon by higher emissions from forests not in the credit system. Leakage will potentially occur anytime the policy is incomplete spatially or temporally. Cap-and-trade systems that are not geographically comprehensive also suffer leakage, and if a cap-and-trade system were only going to be in place for a few years, one might expect temporal leakage in such a system as well. A well-structured policy that covers all potential emitters and sinks across space and over time eliminates the problem of leakage. A credit system in which coverage is voluntary does not assure this, whereas a cap-and-trade system can be easily structured to do so.
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