ACCOUNTING FOR THE LINKING OF EMISSIONS TRADING SYSTEMS UNDER ARTICLE 6.2 OF THE PARIS AGREEMENT Discussion paper prepared for the International Carbon Action Partnership November 2018, Berlin, Germany Stockholm Environment Institute Lambert Schneider ko-Institut e.V. Johanna Cludius International Carbon Action Partnership Secretariat Stephanie La Hoz Theuer Acknowledgements This discussion paper was produced in the context of the ICAP Technical Dialogue on linking emissions trading systems. The authors would like to thank Claude Ct, Francis Bland-Plante and Jean-Yves Benoit from the Qubec Ministry of the Environment and the Fight against Climate Change; William Space from Massachusetts Department of Environmental Protection; and Laurence Mortier and Sophie Wenger from the Swiss Federal Office for the Environment for the valuable comments on an earlier version of this paper. Thanks also to Jason Gray from the Californian Air Resources Board; Alexander Handke and colleagues from the German Federal Ministry for the Environment, Nature Conservation and Nuclear Safety; and Stphane Legros and Thomas Duchaine from the Qubec Ministry of the Environment and the Fight against Climate Change for s that helped in the development of the study. The paper also benefitted from productive discussions during the ICAP Annual Meeting in September 2018 in New York. The authors also thank Constanze Haug, Johannes Ackva, Marissa Santikarn and William Acworth from the ICAP Secretariat, as well as Derik Broekhoff and Martin Cames for the valuable comments. The ICAP secretariat and the authors thank the government of the Netherlands for the financial support to prepare this paper. Cite as Schneider, L., Cludius, J., Green, Sterner, Helm, 2003. When linking ETSs internationally, allowances can flow across international borders. This, in turn, can change the level of emissions in the participating countries. As such, an important question arises as to whether and how linking affects the achievement of NDCs, and whether and how countries should account for such links under the Paris Agreement. Article 6.2 of the Paris Agreement establishes a framework that allows countries to engage in international carbon market mechanisms and to account for their use towards NDCs. International linking of ETSs is seen as one important application of Article 6.2. Indeed, several authors, countries and stakeholders have proposed that the net flow of allowances between linked ETSs could be accounted for as internationally transferred mitigation outcomes ITMOs under Article 6.2 of the Paris Agreement Howard, 2018; Mehling, Metcalf, Obergassel Schneider, Fssler, et al., 2017. The linking agreement between the EU and Switzerland European Union, 2017, for example, foresees that the net flows of allowances be accounted for in accordance with principles and rules approved under the United Nations Framework Convention on Climate Change UNFCCC. A key requirement for accounting for the linking of ETS under Article 6.2 of the Paris Agreement is that countries apply robust accounting to ensure, inter alia, the avoidance of double counting. If robust accounting is not applied, aggregated global GHG emissions could increase Schneider the paper identifies four possible approaches to quantify the shift in emissions and ACCOUNTING FOR THE LINKING OF EMISSIONS TRADING SYSTEMS UNDER ARTICLE 6.2 OF THE PARIS AGREEMENT 11 discusses their advantages and drawbacks section 3. The paper then identifies and discusses important implications for ulating NDCs and accounting under the Paris Agreement or towards jurisdictional goals. An important challenge is the inherent differences between the design of ETSs and the type of targets, policies and actions communicated in countries’ first NDCs. Whereas ETSs typically set a cap expressed as absolute GHG emissions over a continuous period of time, NDCs often establish mitigation targets for a single year and often include metrics other than GHG emissions. The paper discusses whether and how these differences can be reconciled in order to ensure robust accounting section 4. The findings of the paper can in both the ongoing negotiations on international guidance for Article 6.2, as well as the bilateral agreements between jurisdictions on how to account for ETS linking. The paper provides conclusions and recommendations that are relevant for policy-makers and experts involved in international negotiations and bilateral linking agreements section 5. This paper uses specific terminology and makes a number of assumptions. The term ‘allowances’ is used to refer to the compliance instruments that are allocated or auctioned to regulated entities under an ETS. The use of ‘countries’ is meant to encompass the EU with its 28 member states. When referring to ‘NDCs’, the paper also includes intended nationally determined contributions INDCs ted prior to the adoption of the Paris Agreement. Mitigation targets communicated in NDCs are referred to as ‘NDC targets’. Article 6.2 allows countries to use ITMOs to achieve NDC targets, but the nature and metrics of ITMOs are still unclear. It is here assumed that ITMOs are expressed as one metric tonne of CO2 equivalent tCO2e. When referring to linking of ETS, this includes both linking between two separate ETSs as well as allowance flows that occur within a single ETS but across countries or jurisdictions with separate NDCs or jurisdictional targets. This paper also focuses on ‘full linking’, in which allowances can flow unrestricted between the participating countries or jurisdictions, and does not consider other s of linking that restrict the transfer or use of allowances or indirect s of linking, such as the recognition of the same type of offset credits Burtraw, Palmer, Munnings, Weber, Mehling, Metcalf, Schneider, Lazarus, Lee, a decrease in emissions leads to an addition to actual emissions 100 60 5b Difference between the NDC target level and the adjusted actual emissions negative values denote that emissions are lower than the cap 0 0 ACCOUNTING FOR THE LINKING OF EMISSIONS TRADING SYSTEMS UNDER ARTICLE 6.2 OF THE PARIS AGREEMENT 16 3 Quantifying the shift in emissions from linking ETSs A prerequisite for accounting for the linking of ETSs is estimating the shift in emissions that occurs in each jurisdiction as a result of linking. Quantifying the shift in emissions that occurs as a result of linking is more complex than it may appear at first glance. A key challenge is that the actual shift in emissions cannot be empirically observed, as the situation of no linking is counter-factual once two systems are linked, it is impossible to determine the exact emissions levels in the jurisdictions in the absence of linking in order to compare them with the emissions levels observed under linking. Policy-makers from both jurisdictions therefore need to identify and agree on s to estimate – i.e. approximate – the shift in emissions. A second challenge is that emissions may not only shift from one jurisdiction to another but could also shift in time as a result of linking. As linking affects the price of allowances, it can affect when investments in GHG abatement are made. This could lead to a situation where the shift in emissions is not necessarily symmetrical between two jurisdictions in a specific period emissions could decrease more in one jurisdiction than they increase in the other, or vice versa. To address this, policy-makers could pursue two approaches they could either determine two different shifts in emissions for each jurisdiction for a specific period, or they could determine one equivalent shift in emissions that is likely to represent a fair picture of the two different shifts in the two jurisdictions. Furthermore, in estimating the shift in emissions, policy-makers may have an interest to identify approaches that give a fair representation of the likely actual shift. Underestimating the shift could disadvantage the importing jurisdiction because the emissions increase in the importing jurisdiction would be higher than the amount of ITMOs that the jurisdiction could account for. In Figure 1 in section 2.4 above, for example, country B would no longer achieve its NDC targets because the adjustment blue bar in Figure 1, line 3b in Table 1 would then be smaller than the increase in emissions due to linking. Similarly, overestimating the shift could disadvantage the exporting jurisdiction, because the emissions decrease in the exporting jurisdiction would be lower than the amount of ITMOs that the jurisdiction would account for in Figure 1, country A would no longer achieve its NDC targets because the adjustment blue bar in Figure 1, line 3b in Table 1 would then be larger than the decrease in emissions due to linking. In principle, two broad approaches could be pursued to estimate the shift in emissions. First, the emissions levels in the absence of linking could be estimated through economic modeling and compared to the observed emission levels under linking. The accuracy of this approach would strongly depend on how well the model would be able to reflect changing circumstances and the decisions of the participating entities. In practice, economic modeling could involve considerable uncertainties. The further this approach would be applied to the future, the more uncertain it may be. A second broad approach is using ination on allowances. In principle, the flow of an allowance from one jurisdiction to another implies that emissions may increase by one tCO2e in the importing jurisdiction while they are reduced by one tCO2e in the exporting jurisdiction. In practice, the implications are more complex, because allowances can flow back and forth between jurisdictions and regulated entities are typically allowed to hold and bank allowances between years. Moreover, ETSs can include price stability mechanisms and reserves such as floor and ceiling prices, quantity-based mechanisms that involve reserves, or new entrant reserves; allow for the use of credits from offsetting mechanisms; or include other elements that may affect where and when emissions are reduced. This has two important implications first, this means that the flow of an allowance from one jurisdiction to another may not necessary imply a shift in emissions. And second, this means that a snapshot of ination on allowances at one specific point in time, or over one calendar year, may not necessarily be a representative picture of the actual shift in emissions. ACCOUNTING FOR THE LINKING OF EMISSIONS TRADING SYSTEMS UNDER ARTICLE 6.2 OF THE PARIS AGREEMENT 17 This discussion paper focuses on how to estimate the shift in emissions with ination on allowances. In addition to avoiding complex modelling rcises, this has the advantage that ination on allowances is readily available to administrators. It also allows determining the shift in a transparent and reproducible manner. The paper explores four different approaches for using ination on allowances to estimate the shift in emissions. These approaches draw on ination from different stages of the life cycle of an allowance, including the number of allowances issued in a period e.g. a calendar year or ETS compliance period, the number of allowances held in holding accounts at a specific point in time e.g. at the end of a calendar year, the number of allowances transferred between holding accountings in a period, and/or the number of allowances surrendered for compliance purposes in a period see Figure 1. Figure 2 Life cycle of ETS allowances To illustrate the different approaches and their implications, Section 3.1 introduces a simple example of two jurisdictions that is used throughout the paper. Section 3.2 provides an overview of the four different approaches that could be pursued to estimate the shift in emissions. Sections 3.3 to 3.6 describe each of the approaches. Section 3.7 discusses in more detail the implications of specific ETS features such as allowance reserves, voluntary cancellations, and the use of offsets, among others. 3.1 Two-jurisdiction example of linked ETSs To illustrate the different approaches to estimate the shift in emissions from linking of ETSs, a simple example of a linking agreement between two hypothetical jurisdictions A and B is used. This example is purely hypothetical, and the values used in the example only serve to illustrate differences between the approaches. In this section, first the hypothetical situation of no linking is introduced. This is then compared to situation with linking. In the example, a number of simplifying assumptions are made; the implications if these assumptions do not hold are discussed in section 3.7. For simplicity, it is assumed here that both jurisdictions establish their ETSs at the same point in time and immediately establish a link. The example applies to the first year or any longer period starting from the first year of the ETSs. It is also assumed the ETSs have no price stability mechanisms, reserves nor allow offsets. The amount of surrendered allowances is assumed to correspond to the emissions of the regulated entities, and no allowances are cancelled, such as cancellation for voluntary climate offsetting or other purposes. Lastly, it is also assumed that the ETS caps are ambitious, i.e. they require the regulated entities to reduce emissions and do not include hot air. Figure 3 illustrates our two-jurisdiction example in the first period for the situation where a link between the two ETSs would not have been established. Jurisdiction A issues 135 million allowances in this period, whereas jurisdiction B issues 110 million allowances, making the latter a slightly smaller ETS. The regulated entities in jurisdiction A surrender 125 million allowances at the end of the period and keep 10 million allowances for future use. The regulated entities in jurisdiction B surrender 105 million allowances and keep 5 million allowances for future use. Combined emissions from both systems in this period are thus equal to 230 MtCO2e, and thus 15 MtCO2e lower than the aggregated cap of 245 MtCO2e. It is thus assumed that the regulated entities in both jurisdictions make use of the flexibility provided through banking. It is assumed that it is more cost-effective for them to reduce their emissions below the cap and to bank unused allowances to future years. This can be observed in many ETSs. ACCOUNTING FOR THE LINKING OF EMISSIONS TRADING SYSTEMS UNDER ARTICLE 6.2 OF THE PARIS AGREEMENT 18 Figure 3 Example of two ETSs without linking Figure 4 illustrates the same two-jurisdiction example in the same first period, but for the situation where the two jurisdictions link up their systems. The GHG abatement costs are assumed to differ between the two jurisdictions. Entities therefore engage in allowance transactions