US Climate Change Policy-Learning from the European Union

While debate on the merits of scientific evidence of climate change and its potential costs and effects continues to persist in the United States (US), contentions that concerns are unwarranted appear to be waning as public support for a national climate change policy strengthens. In May of 2008 a poll commissioned by the non-partisan Presidential Climate Action Project and conducted by Harris Interactive found that 66 percent of Americans believed that the next President of the US should have a policy that addresses climate change. Public support for actions on climate change, the recent change in presidential administrations to one favorable of such measures, the increasing number of local and state climate change actions, and the increasing number of climate change-related bills proposed at the federal level all demonstrate the high likelihood that the US Congress will pass and implement a comprehensive climate change policy during the next few years (although the economic recession facing the US has made such major policy less likely). The majority of the bills proposed in the last US Congressional session (13 of 15) proposed some form of a cap and trade system for reducing GHG emissions while two bills proposed a tax on emissions [1]. This follows concerns over the political unattractiveness of a carbon tax despite assertions that a tax provides a stronger market mechanism to reduce GHG emissions.

The Future of US Climate Change Policy
As it appears that the US is likely to pass some form of federal carbon regulation in the coming years and this form of regulation is most likely to come in the form of a cap and trade system it is necessary to identify and assess the issues involved in designing an effective cap and trade system. Although the US has been ardently criticized, as the world’s greatest emitter of GHGs (although China has reportedly passed the US recently in terms of annual emissions), for its inaction on this matter its status as a laggard in establishing national climate change policy presents the opportunity to analyze the effectiveness and learn from the first major international attempt to regulate carbon dioxide (CO2) emissions (the most significant GHG) with a cap and trade model, the European Union’s Emissions Trading Scheme (ETS). While the ETS has received much acclaim for its efforts to tackle climate change, criticism abounds regarding its actual effectiveness in achieving emission reductions, its ability to keep costs manageable, and its ability to ensure the economic competitiveness of those affected. It is important for the US to address such concerns prior to designing such policy as it has been estimated that such a policy could entail costs estimated at 1-2 percent of national income [1].

Structure of European Union Emissions Trading Scheme
The ETS uses a cap-and-trade model similar to that used by the US to reduce sulfur dioxide emissions. Under the ETS national authorities for each EU-25 member state determine the number of allowances and distribution of allocations to each installation. The individual and collective “cap” placed on the number of allowances by each member state establishes a limit on emissions for each country and the entire regime. This cap intends to create a limited supply of allowances, allowing the market to generate a price for allowances that will lead to intended emission limits. Allowances can be traded by regulated entities with excess allowances for a given year or period to entities that fail to meet their emission limits through their own allowance allocation. Entities covered by the ETS can also use emission credits generated by emission-saving projects [2]. Therefore, market drivers for the choice of method for meeting emission goals include the cost of allowances, the cost of carbon credits, and the cost of failing to meet emission limitation or reduction requirements for a particular year.

Experience and Effectiveness of the EU ETS to Date
In order to assess the effectiveness of the ETS one must first identify its goals. Essentially, the ETS has two primary goals; to develop an effective carbon market and to abate emissions at capped amounts. Additionally, the intention of the warm-up phase (of which most current analysis is based) was to learn from both the successes and failures of the program and adapt policies to ensure future success. In this regard, it appears that Phase I has been useful for discovering program weaknesses particularly with regards to allocation changes that have been enacted for Phase II with National Action Plans (NAPs) providing fewer allowances [3]. While many critics point out the crashing of the trading price of carbon in 2007 as an indication of the failure of ETS this criticism fails to recognize that one of the primary purposes of Phase I was to determine the appropriate number of allowances to allocate. Only if member states failed to adjust allocation after such findings were made could one conclude failure.

Implications of the EU ETS for US Climate Change Policy
As the US designs its climate change policy it should draw heavily on the experiences of the ETS to avoid similar growing pains in developing effective climate policy. Lessons that can be learned from the ETS follow:

A “warm-up phase” can provide valuable insight for climate policies that deviate substantially from the EU ETS. If the US were to implement climate policies that deviate significantly from the EU ETS, particularly if a significant portion of allowances are auctioned or additional sectors such as transport are included in regulations the US should initiate a preliminary regulatory phase prior to the first commitment period. This would allow the US to exhibit a cautious initial approach and learn from its policies in a manner similar to that of the EU. If US climate policy aligns with that of the ETS such a preliminary phase may be unnecessary.

Emission abatement is heavily impacted by allocating allowances that accurately reflect emission limits. Several pressures led to the over-allocation of allowances by ETS member states [3]. By allowing member states to set their own allocation amounts and distribution, domestic pressures from industry and the public to lessen the negative impacts of climate policy has influenced allowance allocations. Although the European Commission is required to assess the NAPs of member states this has been inefficient overall in identifying allocation of allowances. A centralized approach to CO2 regulation should lead to greater ambitiousness and success in meeting emission limits [4].This demonstrates that the US should, at least initially, develop its domestic policies independent of an international climate regime and ensure integrity and transparency in its initial allocation of allowances through a delegated entity.

Accurate data on emissions is required to set an effective emissions cap and prevent over-allocation of allowances. ETS experienced high transaction costs and much delay by having a baseline emission cap set at 1990 levels because adequate data on emissions levels did not exist at that time [5]. It is widely agreed among researchers and experts that data availability limits allocation choices and partially contributed to the drop in ETS allowance prices to near zero [6]. It is essential for the US to set its baseline cap to a more recent year to avoid similar data limitations. For this reason, the baseline year of 2005 has been commonly used in proposed federal climate bills.

It is unclear if allowance pricing failures can be resolved through a partial or full auctioning of allowances. The initial failure of the ETS to price CO2 at levels sufficient to achieve emissions limits or reductions under a full allowance system suggests that some degree of auctioning could be necessary. This argument has been expressed by many ETS member states and has led to the concession in Phase II for member states to auction up to 10 percent of their allowances [5]. Some researchers have noted that downstream consumers should bear roughly the same energy costs under a cap with a 100 percent auction, 100 percent free allocation, or a tax on CO2 because the price of the allowance or tax represents the opportunity cost of emitting another unit of CO2 [1]. The primary disadvantage of auctioning is that it creates immediate substantial costs to regulated entities that could create economic turmoil. The primary advantage of auctioning is such immediate pricing signals should lead to more immediate actions to limit or reduce emissions. Additionally, free allocation can create and transfer new wealth to some participants while an auction can generate revenue that the federal government can use for purposes related to carbon reduction goals and to ensure industries or individuals are not unequally burdened by carbon regulation.

As this appears to be the most contentious issue among economists and policymakers in the US regarding a cap-and-trade carbon regulatory scheme such a decision should take a cautious approach [7]. While President Barrack Obama has shown support for a 100 percent auction system the impacts of such a system are unclear. The US should consider the initial experimentation of a partial auction system with the flexibility to adjust the number of allowances auctioned periodically.

The ETS provides clear evidence of impacts of carbon regulation on some sectors, but not all, particularly the transport sector. The ETS does not appear to have had significant negative effects on regulated industries. However, not all industries or sectors are covered. The EU’s decision not to include the transport sector in the ETS indicates the apprehension that is felt with regulating this industry. This indicates that inclusion of the transport sector US climate change policy will be similarly contentious and difficult to manage during the first stages of such policy. It is unclear what impacts CO2 regulation will have on this and other sectors not regulated by the ETS.

Transparent monitoring and verification is essential to successful carbon regulatory policy. As expected, independent verification of monitoring and compliance of regulated entities under the ETS has provided assurance that reported emissions are accurate and allows for accurate assessment of the effectiveness of the cap and trade system. The US should follow such a scheme.

A cap and trade program must cover a long enough time period to influence technology investment decisions. During the three-year preliminary phase of ETS little adoption of carbon-reducing technologies or less carbon-intensive power generation technologies was exhibited. It appears important for the US to set long term emission reduction goals to influence such investment decisions.

Linking nations in an emissions trading scheme causes inefficiencies and difficulties with emissions trading. This finding indicates that the US should develop a centralized approach to carbon regulation initially rather than linking with the EU-25 or other nations. Success has resulted from emissions reduction credit schemes when projects have been available, but this has not always been the case under the ETS. Price harmonization of carbon prices among countries provides an alternative to direct linkage by harmonizing marginal costs among countries with carbon regulatory schemes [8].

Conclusion
The EU ETS provides significant insight into the challenges faced in developing successful carbon policy. According to initial findings from the ETS it appears that ensuring optimal allocation of allowances is the primary determinant of the success of a CO2 cap and trade system in terms of effectively pricing carbon allowances and abating emissions. By adopting a centralized domestic approach, the US can overcome many of the difficulties felt by the EU’s multinational approach. By learning from the initial successes and failures of the ETS the US has the opportunity to avoid incurring high costs without achieving significant results.

References not hyperlinked above:

[1] Joseph E. Aldy and William A. Pizer, Resources For the Future, “Issues in Designing U.S. Climate Change Policy,” Discussion Paper, June 2008, RFF DP 08-20.

[2] European Union, “Combating Climate Change: The EU Leads the Way.” Europe on the Move Series, Luxemburg: Office for Official Publications of the European Communities, 2008, p. 12.

[3] Frank Convery, Christian De Perthuis, and Denny Ellerman, “The European Carbon Market in Action: Lessons From the First Trading Period. Interim Report.” MIT Center for Energy and Environmental Policy Research, March 2008.

[4] Jon Birger Skjaerseth and Jorgen Wettestad, EU Emissions Trading: Initiation, Decisions-Making and Implementation (Ashgate Publishing Company: 2008), p 188.

[5] A. Denny Ellerman and Barbara K. Buchner, “The European Union Emissions Trading Scheme: Origins, Allocation, and Early Results.” Review of Environmental Economics and Policy, vol. I, no. I (Winter 2007).

[6] A. Denny Ellerman, Barbara K. Buchner, and Carlos Carraro, Allocation in the European Emissions Trading Scheme: Rights, Rents and Fairness (Cambridge University Press: 2007), pp. 339-341

[7] T.H. Tietenberg, Emissions Trading: Principles and Practices, Second Edition, (Resources for the Future Press, Washington D.C.: 2006), 127.

[8] Joseph Kruger, Wallace E. Oates, and William A. Pizer, “Decentralization in the EU Emissions Trading Scheme and Lessons for Global Policy.” Review of Environmental Economics and Policy, vol. I, no. I (Winter 2007), p. 131.


Note: This blog post is a condensed summary of a research paper previously written by myself. If interested in the full paper feel free to email me at csmitty1983@yahoo.com.