Cap And Trade Fundamentals

GENEVA | HOUSTON | KANSAS CITY | LONDON | MIAMI | ORANGE COUNTY | SAN FRANCISCO | TAMPA | WASHINGTON, D.C.

CAP AND TRADE FUNDAMENTALSAn Introduction to Market-Based

Regulation of Greenhouse Gas Emissions

Presented by Kevin HaroffShook Hardy & Bacon LLP – San Francisco

CLE International 2008 California Climate Change Law Conference(UPDATE AND EXPANDED -September 2009)

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Overview

• What Is Cap And Trade• Who Cares• Does It Work• How Does It Work• Where’s The Catch• What’s Next• Questions/Discussion

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What is Cap and Trade?

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Cap and trade is a market-based policy tool for protecting human health and the environment by controlling large amounts of emissions from a group of sources.

U.S. Environmental Protection Agency (April 9, 2009)

http://www.epa.gov/captrade/basic-info.html

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Who Cares?

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I will implement a market-based cap-and-trade system to reduce carbon emissions by the amount scientists say is necessary: 80 percent below 1990 levels by 2050.

Democratic Presidential Candidate Barack Obama (August 30, 2008)

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To dramatically reduce carbon emissions, I will institute a new cap-and-trade system that over time will change the dynamic of our energy economy.

Republican Presidential Candidate John McCain (September 15, 2008)

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• American Clean Energy and Security Act of 2009– H.R. 2454 (Waxman

Markey) – Passed House on June

26, 2009– Sent to Senate

Legislative Calendar on July 7, 2009

• Senate Environment and Public Works Committee – Chaired by Barbara Boxer

(D-CA)

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Waxman Markey

• Amends the CAA to require EPA to promulgate regulations to cap and reduce GHG emissions from capped sources to – 97% of 2005 levels by 2012– 83% by 2020– 58% by 2030– 17% by 2050

• Requires EPA to establish a federal GHG registry• Requires EPA to establish specified emission allowances (annual

tonnage limits) for separate vintage years:1. Each of 2012‐20492. 2050 and thereafter

• Requires covered entities to demonstrate compliance through: (1)holding emission allowances, or (2) using offset credits.

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Does It Work?

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An Alternative Regulatory Strategy

• First proposed in 1980’s as alternative to traditional command and control regulations based on market-oriented economic principles

• In theory, cap and trade programs can– Be effective and administratively efficient– Reduce emissions quickly – Promote innovation– Work in concert with other regulatory approaches

• Projected to work best in situations where– Aggregate impact is principal concern– Costs differ across a range of options – Strong regulatory institutions and financial markets exist

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Precedent - U.S. Acid Rain Program

• Growing recognition during 1980’s of detrimental environmental impacts of acid deposition from the atmosphere (acid rain)– Caused when emissions of sulfur dioxide (SO2) and nitrogen

oxides (NOx) react with water, O2, and other atmospheric constituents

– Primary source – coal-fired electric power plants in eastern and midwestern states

• Title IV of 1990 Clean Air Act Amendments– Regulation of SO2 emissions in two phases§ Phase I (beginning in 1995 - affecting 110 mostly coal-fired

plants)§ Phase II (beginning in 2000 - tightened restrictions and new

limits on coal, oil and gas-fired facilities)

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U.S. Acid Rain Program - Results

Sulfur deposition and concentrations down 40% across the Eastern United States at lower than projected costs

Wet Sulfate DepositionAverage 1989 - 1991

Wet Sulfate DepositionAverage 2001 – 2003

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How Does It Work?

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Basic Elements of Cap and Trade Policy

• Government establishes a cap (caps) that limits total amount of emissions allowed in a given time period, e.g., each year.

• Government issues permits (allowances) giving “rights to emit” that can be traded like private property.

• As the total amount of capped emissions declines from year to year, demand for permits increases.

• Since supply is controlled by law, price of traded permits is a function of demand and substitution cost.

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An Analogy – The Game of Musical Chairs*

• Each chair represents a “right to emit” one metric ton of carbon (CO2) or carbon equivalents.

* From Holmes Hummel PhD(November 21, 2007)

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An Analogy – The Game of Musical Chairs

• At the start of the game, everyone who needs a chair has a chair(because there are no caps yet or because everyone has a permit).

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Musical Chairs – Year 1

• In the first year of the program, the initial cap goes into effect and the number of permits (chairs) is reduced.

• As a result, somebody doesn’t get a chair.

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Musical Chairs – Year 1

• Players have a choice:– Reduce emissions to eliminate need for a chair (by adding control

technologies or switching to less-carbon intensive production).

x

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Musical Chairs – Year 1

• Players have a choice:– Reduce emissions to eliminate need for a chair (by adding control

technologies or switching to less-carbon intensive production), OR– Pay money to buy a chair (permit) from someone else.

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Musical Chairs – Year 1

• Burden to reduce emissions falls on the party who sells his chair (permit).

x

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Musical Chairs – Year 1

• Burden to reduce emissions falls on the party who sells his chair (permit).

• Either way, total amount of carbon emissions is reduced.

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Using Market Incentives to Achieve Reduction Targets

• Emission allowances are traded in a carbon market that sets the price according to supply and demand.

• Since supply is fixed, market sets the price based on the marginal cost of emissions reductions (implementation of emission controlmeasures).

• Example:– Company A can reduce emissions by spending $1 per/MTC on emission

controls or alternative production technologies,– But Company B can only reduce emissions by spending $2/MTC on

control measures.– At a market price of $1.50 per emission credit, § Company A installs new technology, sells credit, and makes $.50

profit.§ B buys A’s credit and avoids the cost of more expensive controls.

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Using Market Incentives to Achieve Technological Innovation

• As the total number of available permits goes down, the price ofremaining permits goes up.

• As the cost of permits goes up, so does the cost of doing business for companies needing permits.

• Incentives are created to identify alternative technologies with lower carbon emissions and therefore lower total costs, such as green building technologies, solar and wind power, nuclear energy, alternative fuels.

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Musical Chairs – Year 2

• In the second year of the program, the initial cap is lowered and the number of available permits (chairs) is reduced even further.

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Musical Chairs – Year 2

• In the second year of the program, the initial cap is lowered and the number of available permits (chairs) is reduced even further.

• As a result, more and more players don’t get chairs.

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Musical Chairs – Years 3, 4 . . . .

• Fewer chairs means fewer total emissions.

x

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Musical Chairs – Years 3, 4 . . . .

• Fewer chairs means fewer total emissions. • And higher . . .

x

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Musical Chairs – Years 3, 4 . . . .

• Fewer chairs means fewer total emissions. • And higher . . .

. . . and higher prices for the chairs (permits) that remain.

x

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Musical Chairs – Years 3, 4 . . . .

Until the final objective (cap) is achieved.

x

xx xx

x x

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Musical Chairs – The End Game

• At the end of the day, the players remaining in the game are – Those who can afford to pay the most for emission credits.– Those who have the least flexibility in how they play the game.

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Where’s the Catch?

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Issues for Policy Makers

• Who is Covered?• How are allowances initially Allocated?• The problem of Offsets• The problem of Leakage• How much Market Freedom should be

allowed?

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Who is Covered

• Theoretically, any emitter of carbon or carbon equivalents can be covered.

• As a practical matter, most proposals only cover large emitters (and fossil fuel suppliers).

• Covered entities under Waxman Markey include: electricity sources, fuel producers and importers, industrial gas producers and importers, geological sequestration sites, industrial stationary sources, industrial fossil fuel‐fired combustion devices, natural gas local distribution companies and nitrogen trifluoride sources.

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Allocation – Auction v. Free Distribution

• Most economists advocate initial distribution of allowances by auction v. free distribution.– Protects against unfair competition,

since new players with innovative technologies cannot compete with existing players receiving allowances as a subsidy.

– Protects against windfall profits, since players receiving subsidized allowances can sell them at the same price as other players buying allowances on the market.

– Generates revenue that governments can use to mitigate negative impacts.

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Allocation – Free Distribution v. Auction

• Some parties advocate free distribution v. auction on equitable grounds.– Mitigates against loss of profits existing

players would have realized in the absence of cap and trade.

– Mitigates against impacts to consumersfrom players passing on costs of acquiring allowances in an auction.

• Optimal approach:– Mix of auction and free distribution to

accomplish multiple public policy goals and accommodate political realities.

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Allocation – Waxman Markey

• Most allowances initially are distributed “for the benefit of electricity, natural gas, and/or home heating oil and propane consumers,” i.e., to public utilities.

• Relatively few allowances to be sold at auction, with proceeds used for the benefit of low income consumers and for worker investment.

• Remaining allowances are distributed:– For supplemental emissions reductions from reduced deforestation;– To energy‐intensive, trade‐exposed industries;– For the deployment of carbon capture and sequestration technology;– To invest in energy efficiency and renewable energy;– To Clean Energy Innovation Centers;– To invest in the development and deployment of clean vehicles;– To domestic refiners;– For domestic and international adaptation;– For domestic wildlife and natural resource adaptation;– For international clean technology deployment.

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The Problem of Offsets

• Offsets are credits given for reductions in present or future emissions from sources not otherwise subject to cap and trade program requirements.– Sources outside covered industrial sectors,

e.g., agriculture and forestry projects.– Sources outside government jurisdiction,

e.g., Clean Development Mechanism (CDM) projects in other countries.

• Use of offsets is controversial because of difficulties in – Project validation.– Emissions quantification.– Monitoring and enforcement.

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Offsets under Waxman Markey

• Authorizes EPA to designate an international climate change program as a qualifying international program for purposes of international emission allowances provisions, if certain conditions are met.

• Establishes the Offsets Integrity Advisory Board and requires EPA, considering the Board's recommendations, to promulgate regulations establishing a program for the issuance of offset credits.

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The Problem of Leakage

• Leakage occurs when the cost of operating under a cap and trade regime exceeds the cost of relocating and operating outside the regime.

• Leakage undermines the efficacy of cap and trade in two ways:– Reduces the number of sources covered by the program,– Disrupts the price signal for emission credits to remaining

market participants.• Moral – national (or regional) cap and trade policy may be

ineffective in the absence of strong international agreements.

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Market Issues - Banking and Borrowing

• Banking allows market participants to defer using current allowances until a later period.– Banking reasonable when emissions have

a long residence time in the environment.– Allows holders to profit from later sales of

allowances at higher market prices.• Borrowing allows market participants to

“borrow” or use future allowances in the current period.– Creates risk that participants may not be

able to afford market prices later on.• Waxman Markey provides that allowances

may be traded, banked and borrowed (up to 15%).

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Market Issues – Regulation

• Emission credits will comprise an entirely new class of marketable securities.

• Waxman Markey would: – Require the Federal Energy Regulatory

Commission (FERC) to promulgate regulations for the establishment, operation, and oversight of markets for regulated allowances;

– Require EPA to establish an interagency working group on carbon market oversight;

– Amend the Commodity Exchange Act to provide for transactions in derivatives that involve energy commodities;

– Give the Commodity Futures Trading Commission (CFTC) jurisdiction over the establishment, operations, and oversight of markets for regulated allowance derivatives.

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What’s Next?

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What’s Next

• In Congress• Internationally• At the State and Regional Levels

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Questions/Discussion

GENEVA | HOUSTON | KANSAS CITY | LONDON | MIAMI | ORANGE COUNTY | SAN FRANCISCO | TAMPA | WASHINGTON, D.C.

CAP AND TRADE FUNDAMENTALS –An Introduction to Market-Based Regulation of Greenhouse Gas Emissions

Presented byKevin Haroff, Shook Hardy & Bacon LLP (San Francisco)