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Have the RGGI states repeated the mistakes of the European carbon trading system?

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"Have the RGGI states repeated the mistakes of the European carbon trading system?"

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[Another guest post by John Atcheson who has than 30 years in energy and the environment with government, private industry, and the nation's leading think tanks (see "Utility decoupling on steroids."]

rggi.jpgOn September 25th, the Regional Greenhouse Gas Initiative will hold its first auction. Six of the ten RGGI (pronounced Reggie) states will inaugurate the nation’s first mandatory GHG cap and trade program, designed to harness market forces in cutting GHG emissions. Some 12,565,387 CO2 allowances will be issued by Connecticut, Maine, Maryland, Massachusetts, Rhode Island, and Vermont in this round. Allowances purchased in RGGI auctions can be used for compliance in any RGGI state. A second auction will be held in December.

An important feature of RGGI is that the vast majority of allowances will be auctioned, rather than allocated for free, as was done with the Acid Rain trading scheme, and states will use the revenue generated from the auctions to invest in programs designed to stimulate energy efficiency and renewable energy.

Initially RGGI will cap emissions from 233 electricity plants at no more than 188 million short tons a year between January 1, 2009 and 2014. Thereafter, it will lower the cap by 2.5 percent a year, each year until 2018, for a total of 10 percent.

As with the European Union’s Emission Trading Scheme, RGGI’s initial allocation of credits is likely to exceed actual emissions, which will depress carbon prices and get trading off to a relatively slow start.

The target cap of 188 million tons was based on estimates made in 2004 and 2005, but recent data indicates that total emissions in RGGI states in 2009 — the first compliance year — will be lower. The New York Times reports that emissions fell to 164.5 million tons in 2006 (the last year with complete data), and estimates suggest that when data is finalized, 2007 emissions will come in at about 172.4 million tons.

Participants in the RGGI allocation process admit that politics played a role in the overestimate. Lobbying has been furious, as it was — and still is — in the EU’s ETS. In fact, The Guardian reports that even in round 2 of the ETS, over-allocation of credits is a serious problem.

With both Presidential candidates talking about a cap and trade program, it seems likely that there will be legislation passed within the next year or two containing a provision for one. By taking a look at what RGGI and the European Union have done right, and what they’ve done wrong, we can get some insight into how to structure such a Bill. We can also see how serious each candidate’s climate proposal is.

Let’s look at some of the things RGGI did well.

First, RGGI chose to auction nearly all allowances, meaning every ton of carbon will be priced.

Second, the RGGI states placed rigorous requirements for offsets, such as tree planting.

Third, by creating a consensus model rule the RGGI rule enabled credits to be traded across all 10 states, which increases the fungibility of the credits. Larger markets create more opportunities for trades and hence function more efficiently in terms of finding a price.

RGGI also built in flexibility — both with regard to target allocation caps and the potential sectors covered — so it can grow and adapt as more information becomes available and as experience is gained.

By far, the most important lesson is that the caps and allocations matter. Stringent caps will cut more carbon by inducing scarcity and thus, raising the price. The more an allowance is worth the more intense will be the pressure to game the system. If we learned one thing from the current meltdown in the financial sector it is that transparency and an active government role in regulating the terms of transactions are critical to any trading system. And carbon credits, it must be remembered, are a financial instrument, subject to the same abuses and failings as CDO’s credit default swaps and the other assorted sordid instruments of greed that are bringing us to our knees. Carbon can be a safe and low risk area for investments, done right. In fact, some are projecting that carbon trading will exceed a value of $1 trillion a year by 2020.

What does the EU ETS and RGGI experience tell us so far about the climate strategies of McCain and Obama?

Well, if you like the old uber-free market stuff that got us where we are today, offsets aplenty, with allocations handed out for free, and a vice president who thinks the jury is out on climate change, McCain’s your man, but you won’t cut much carbon. If you want a serious plan that respects climate science, that auctions allowances and uses the revenue from those auctions to help Americans transition to clean energy, and that puts strict limits on offsets, and that will actually cut carbon, then Obama is your man.

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4 Responses to Have the RGGI states repeated the mistakes of the European carbon trading system?

  1. Peter Wood says:

    It will be very interesting to see how RGGI develops. The issue of overallocation will be a little different to the EU ETS because as far as I understand, there is unlimited banking of permits, so the carbon price won’t completely collapse.

    This raises an interesting design question. Suppose X permits are auctioned, and Y permits are not exercised and are banked instead. Then in the following year do you auction X*0.975 permits (2.5% less than was first auctioned) or do you auction X*0.975 – Y permits? The former option means that over-allocation leads to depressed prices for longer; the latter option is much better if the purpose of the RGGI is to actually reduce emissions.

    An alternative way of setting the trajectory is by introducing a price floor. One option for introducing a price floor is by having the regulator buy back permits, but this has quite a few problems. A better way to maintain the price floor is by having firms pay an ‘extra fee’ per tonne CO2e when they exercise their permits (an ‘exercise price’). The carbon price is then equal to to the sum of the permit price and the exercise price. This approach has some of the advantages of a carbon tax, but maintains the cap of an emissions trading scheme.

  2. John Kelly says:

    If you take a look at NY specifically. the carbon cap is 62 million tons. In 2006 NY generators emitted 51 million tons. Another important trend is that electricity demand has been basically flat since 1990. Aggressive energy efficiency programs, greater focus on carbon by building owners, and a weakening economy could send NY’s carbon emissions below 45 million tons by 2015, rendering RGGI irrelevant as currently designed.

    What is most concerning to our company is that RGGI left the consumer out of the carbon initiative. Even though consumers stand ready to reduce signficant amounts of electricity consumption and associated carbon through energy efficiency, RGGI did not provide provisions for EE to retire carbon allowances. In NY, it is not out of the question for consumers to retire the equivelant of 10 million tons of carbon emissions annually through energy efficiency.

    Under RGGI it could take decades for the caps to catch up with the market.

  3. John Kelly says:

    If you take a look at NY specifically. the carbon cap is 62 million tons. In 2006 NY generators emitted 51 million tons. Another important trend is that electricity demand has been basically flat since 1990. Aggressive energy efficiency programs, greater focus on carbon by building owners, and a weakening economy could send NY’s carbon emissions below 45 million tons by 2015, rendering RGGI irrelevant as currently designed.

    What is most concerning to our company is that RGGI left the consumer out of the carbon initiative. Even though consumers stand ready to reduce significant amounts of electricity consumption and associated carbon through energy efficiency, RGGI did not provide provisions for EE to retire carbon allowances. In NY, it is not out of the question for consumers to retire the equivalent of 10 million tons of carbon emissions annually through energy efficiency.

    Under RGGI it could take decades for the caps to catch up with the market.

  4. shop says:

    Third, by creating a consensus model rule the RGGI rule enabled credits to be traded across all 10 states, which increases the fungibility of the credits. Larger markets create more opportunities for trades and hence function more efficiently in terms of finding a price.