Technical Note 7 | February 2014 Lessons Learned from Linking Emissions Trading Systems General Principles and Applications Public Disclosure AuthorizedPublic Disclosure AuthorizedPublic Disclosure AuthorizedPublic Disclosure Authorizedi This Technical Note the “report” was prepared for the PMR Secretariat by Erik Haites of Margaree Consultants Inc with guidance from the PMR Secretariat. This report was prepared for, and only for, The World Bank. Margaree Consultants does not accept or assume any liability or duty of care for any other purpose or to any other person to whom this report is shown or into whose hands it may come save where expressly agreed by prior consent in writing, or for any changes made to the report by the PMR Secretariat after submission. Comments and questions on this Note should be directed to the PMR Secretariat pmrsecretariatworldbank.org. For more ination on the Partnership for Market Readiness, please visit www.thepmr.org 1 LESSONS LEARNED FROM LINKING EMISSIONS TRADING SYSTEMS GENERAL PRINCIPLES AND APPLICATIONS CUTIVE SUMMARY In support of the Partnership for Market Readiness work on helping the emergence of Credible, Consistent, and Compatible market-based infrastructure across countries, this report reviews the lessons learned from linking greenhouse gas emissions trading systems. Two emissions trading systems ETS are linked if a participant in one system can use a compliance instrument allowance or credit issued by the administrator of either system for compliance. This report focuses on links that enable participants of both ETS to use compliance instruments from either system bilateral links. The linked systems can adopt common compliance instruments. Or each system can retain its own compliance instruments and accept those from either ETS for compliance, possibly subject to restrictions. Establishing a bilateral link between two ETS will cause the pre-link prices of the compliance instruments to converge. When a small system is linked with a large system, the price will tend to converge to the pre-link price in the large ETS. When two ETS of similar size are linked, the price will fall between their pre-link prices. A bilateral link will increase the compliance instrument price in one system and lower it in the other system from the pre-link levels. Restrictions on the use of compliance instruments from the linked ETS can limit price convergence. A bilateral link offers three potential benefits. First, it can make an ETS a viable policy option for a jurisdiction where an independent ETS would be infeasible for technical or cost reasons. Second, a bilateral link can reduce the total cost of achieving the combined emissions caps of the linked ETS. Third, a bilateral link can enhance the operation of the market for the compliance instruments. A bilateral link also involves some risks. First, a bilateral link changes the distribution of costs in each system. The sellers in the ETS with the lower pre-link price and the buyers in the ETS with the higher pre-link price benefit from the price convergence while other participants are made worse off. Second, a bilateral link, by changing the prices of the compliance instruments, can affect the competitiveness of firms that produce emissions-intensive goods or that rely on emissions-intensive s. Third, a bilateral link creates an incentive for each system to make smaller cap reductions over time. Fourth, a bilateral link to a system that issues credits for offsets that are not fully “additional” can increase total emissions. Finally, each administrator loses some control over the operation of its ETS as participants in both systems adjust their behavior to benefit from the least cost design features of each system. Establishment of a bilateral link is a voluntary decision on the part of each of the participating ETS. A decision to link requires  A political decision by each jurisdiction that the benefits exceed the risks and that the resulting changes to the balance of environmental benefits and distribution of costs will be acceptable;  Compatibility and consistency of the design features of the ETS to protect the environmental integrity of the linked systems and manage impacts on the distribution of costs within each system. This may require changes to the design of one or both systems; 2  Arrangements to maintain the compatibility and consistency of the design features of the linked ETS over time in the face of economic, technological and other developments; and  A legal agreement to implement the link. The political decision to link is influenced by the perceived environmental stringency of the partner ETS, relative compliance instrument prices and resulting cash flows, potential competitiveness impacts, possible legal issues, loss of control, and implications for international treaty compliance. Relatively few differences in the design features of an ETS present an insurmountable barrier to a bilateral link. Some design differences remain in most linked systems. This means a bilateral link will be easier for systems with similar designs. To maintain the compatibility and consistency of linked ETS over time requires, inter alia, a process for agreeing on revisions to the regulations of the linked systems, a mechanism to provide assurance of the environmental effectiveness of each of the linked systems, and a procedure for terminating the linking agreement. The two ETS being linked operate in different national or subnational jurisdictions. This affects the nature of the linking agreement. A binding international agreement, such as a treaty, is an option for national, but perhaps not for subnational, jurisdictions. Alternatively, the two jurisdictions can adopt reciprocal legislation in their respective jurisdictions supported by a non-binding agreement that outlines the commitments of the parties. Experience suggests that harmonization of designs is desirable even if not technically essential for a link. In the EU ETS, aspects such as the distribution of allowances and operation of the registry were initially left to member countries, but have since been centralized. The EU ETS also demonstrates that linking allows smaller countries, such as Cyprus, Iceland, Lichtenstein, and Malta to participate where it would otherwise not be feasible to use emissions trading as a policy option. The California-Qubec link also suggests that linking is easier if the system designs are similar. Implementing a link before a system is operational is easier because individual participants generally do not know how they will be affected by the link. The linking agreement commits the parties to collaborate on the harmonization and integration of regulatory provisions of their systems including trade of compliance instruments, joint auctions, a common registry and a common auction plat. Environmental stringency was an important political consideration for the linking decision. Although it is not expected to be implemented, the proposed Australia-EU link was interesting for the limit on the use of EUAs by Australian sources and the phased approach to implementing the link overall. Modification of the Australian price stabilization mechanism had been announced and issues for further negotiation had been identified, but the extent of the design harmonization that would have been agreed is not known. Specific guidance on ETS design features to facilitate bilateral links is not possible. The design features must be assessed in terms of their compatibility and consistency with those of a potential partner. The changes needed can only be identified through careful comparison of the features of the two ETS to be linked. 3 The strategy for implementing a bilateral link differs for an ETS that is still being designed and an ETS that is already operational. When an ETS is at the design stage, as is the case for the ETS being developed by Implementing Country Participants of the PMR, the options are to  Cooperate with other systems at a similar stage of development to cultivate a common design. The trust and mutual understanding established during the design process and the similarity of the final designs will facilitate a bilateral link.  Identify a desirable partner ETS and then develop a design compatible with that system. A high degree of harmonization will facilitate a link if the potential partner ETS is agreeable.  Work with other systems on technical design features such as monitoring, reporting and verification MRV provisions, the registry, auction design, and non-compliance penalties. Harmonization of such features will facilitate linking with other systems. When two operational ETS decide to establish a bilateral link, it is likely that some features of one or both systems will need to be modified to make them consistent and compatible. Implementation of these changes could be a condition for entry into force of the link. A political commitment by both jurisdictions to link helps drive the negotiations on modification of the design features. A bilateral link of two operational ETS can be implemented gradually. It can be preceded by mutual unilateral links, possibly at different times. A bilateral link with constraints on the use of imported compliance instruments can be implemented with an agreement to relax the constraints over time. A substantial price difference can be narrowed by implementing a common floor price that rises over time. When the floor price approaches the price in the higher price system, the bilateral link can be implemented. 4 TABLE OF CONTENTS CUTIVE SUMMARY 1 1. BACKGROUND . 5 2. TYPES OF LINKS AND BENEFITS AND RISKS OF LINKING 6 2.1 Types of Links 6 2.2 Price Impacts of Bilateral Linking . 7 2.3 Potential Benefits of Bilateral Linking . 8 2.4 Potential Risks of Bilateral Linking . 9 3. REQUIREMENTS FOR BILATERAL LINKING . 11 3.1 Background 11 3.2 Political Considerations that Affect the Establishment of a Bilateral Link . 12 3.3 Design Factors that Affect the Establishment of a Bilateral Link . 14 3.4 Sustaining a Bilateral Link over Time . 17 3.5 The Legal of the Bilateral Link 19 4. IMPLEMENTING A BILATERAL LINK 20 4.1 Requirements for a Bilateral Link 20 4.2 Lessons Learned from the Bilateral Linking Experience . 20 4.3 Designing an ETS to Facilitate Bilateral Linking 21 4.4 Bilateral Linking for Operational ETS 22 APPENDIX A . 23 A.1 The California-Qubec Link 23 A.2 The Announced Australia-EU ETS Link 24 REFERENCES . 26 5 1. BACKGROUND The Partnership for Market Readiness PMR is working towards defining common approaches to support the emergence of Credible, Consistent and Compatible market-based infrastructure across countries the “3Cs”. The PMR provides an opportunity for countries to work together to build common frameworks, including monitoring, reporting and verification MRV, registry and data management systems, which are credible, consistent and compatible. Such work aims to facilitate the recognition of the various emerging domestic market-based mechanisms and the fungibility of the carbon assets they generate to forge a common framework to prepare the integrated carbon market of the future. In support of work on the 3Cs, this report reviews the lessons learned from linking emissions trading systems ETS. Section 2 presents the types of links an ETS can establish and discusses the potential benefits and risks of linking. The requirements for a bilateral link between two ETS are summarized in Section 3. How to implement a bilateral link is discussed in Section 4. 6 2. TYPES OF LINKS AND BENEFITS AND RISKS OF LINKING This section categorizes ways in which emissions trading systems ETS can link and then outlines the main benefits and risks of linking. An ETS establishes an aggregate emissions cap for a defined set of participants. These participants must monitor and report their actual emissions and compliance instruments equal to their actual emissions at the end of each compliance period.1 The compliance instruments can be allowances issued by the ETS administrator or offset credits generated outside of the cap and accepted by the ETS administrator. Compliance instruments can be traded. An offset system, such as the Clean Development Mechanism CDM or Joint Implementation JI, issues credits for emission reductions or removals achieved by eligible actions in accordance with approved protocols. The protocols set out monitoring, reporting and verification requirements as well as the emission reduction/removal calculation. The participants in an offset system do not have an obligation to remit compliance instruments to cover their actual emissions, so the buyers for the credits issued by an offset system are outside the system. An ETS can have an offset component. The ETS administrator approves protocols for emission reductions or removals not covered by the emissions cap and issues credits for the verified reductions/removals achieved. These credits can be used by ETS participants for compliance. In addition to its own compliance instruments, an ETS administrator may allow participants to use allowances and/or credits from another ETS or offset system. That establishes a link as discussed in the next section. 2.1 Types of Links Two ETS are linked if a participant in one system can use a compliance instrument issued by the administrator of either system for compliance. In other words, the compliance instruments of the two systems are equivalent for compliance use Mehling and Haites, 2009. It is useful to distinguish  A unilateral link – one ETS accepts the compliance instruments of another ETS for compliance purposes, but NOT vice versa. System A accepts compliance instruments issued by system B, but system B does not accept compliance instruments issued by system A. A unilateral link often can be implemented without the explicit cooperation of the two systems being linked. Any link to an offset system is a unilateral link for the system that accepts the credits because the offset system participants never need compliance units from another system.  A bilateral link – each ETS accepts the compliance instruments of the other ETS for compliance purposes. System C accepts the compliance instruments issued by system D AND system D accepts 1 Allowances are issued by an ETS administrator free of charge or by auction. They permit the owner to emit a specified quantity – usually 1 metric ton 1 tonne of CO2 equivalent 1 tCO2-eq – of greenhouse gases. Offset credits are issued for emission reductions or removals at sources/sinks outside the scope of an ETS. Each system has a different name for its allowances and/or credits – EU allowances EUAs for the EU ETS and certified emission reductions CERs for the CDM, for example. The term “compliance instrument” covers all allowances and credits that can be used by participants for compliance. 7 the complianc