One expert’s views on how to design a successful carbon trading scheme

As India contemplates the creation of a domestic emissions trading scheme, a number of things should be kept in mind. Mahua Acharya, MD & CEO, Convergence Energy Services Limited provides his views in an article on the Financial Express website.

 

Carbon Trading: New emission-markets for a new decade

As the world gets closer to the upcoming climate conference in Glasgow later this year, pressure is mounting on countries to restate their climate goals. Many want that countries revise their earlier commitments made at the time of the Paris Agreement, in December 2015, and do more to cut emissions.

India is likely going to be long on its climate commitment. Discussions at home have moved from how much renewable energy to inject into the grid to how big a limiting factor the grid is for injecting more. Discussions are also underway around the creation of new markets, premised on the assumption that nudging companies would inspire them to voluntarily seek to enhance their energy efficiency or GHG reduction targets and hence create demand for a market for energy efficiency certificates. If successful, this could become an important impetus to trigger the development of a domestic market for GHG reductions. Trading in energy certificates is, after all, not new. The Perform, Achieve, Trade scheme of the Bureau for Energy Efficiency provided enough experience and confidence during its time for policy makers, scheme operators, auditors and the companies themselves on whom the targets were applied.

Albeit preliminary, there are considerations around a domestic emissions trading scheme. As India contemplates the creation of a domestic emissions trading scheme, a number of things should be kept in mind—given the enormous precedence and experience there is to borrow from.

The first emissions trading scheme was in 1995. It addressed acid rain in California and reduced air pollution significantly. Compliance costs were less than half of those predicted by the US Environmental Protection Agency, and many times lower than those predicted by industry. Emissions trading for climate change has been going on since 2005, and today, there are at least 45 schemes across the world that put a price on carbon. The current carbon market is valued at USD 277 Bn and the average price of allowances in the European Union is Euro 35/ton. The design of trading programmes is critical to their success, as they will end up determining the transaction costs as well as the uncertainty and risk inherent in the trading system. There are plenty of learnings to use—from regulators, scheme operators, participants, auditors and financiers.

So, here are five design principles worth considering:

One, design for maximum reach. This means having to decide if the scheme is an allowance trading or a credit trading scheme, or both. Credit trading allows emissions reductions above and beyond business-as-usual to be certified as tradable. Allowance trading works by defining an aggregate emissions cap and authorizes tradable quantities of emissions under the cap. Generally speaking, schemes that have allowed both have been the most successful, though care ought to be taken to reduce the regulatory barriers to credit trading. Allowing opt-ins would be a good idea. This is a provision that allows otherwise uncovered sources to enter the program once their uncertainties have been resolved with the regulator. When the time is right, allow for international linkages. Permitting linkages with other international schemes will allow for the discovery of the lowest transaction costs, increase liquidity and options for participation. All this will eventually maximise the scope of scheme coverage, and provide other benefits—such as international markets, access to other forms of capital and so on. All these mechanisms will ultimately result in maximizing the total quantity of greenhouse gas emissions capped and reduced.

Two, design for flexibility. Since the carbon price can vary, costs to participants can be unknown. Allowing mechanisms such as banking of emissions reductions, or the use of offsets gives participants flexibility to decide which option to use. Banking of credits over a (regulated) period of time allows industries the flexibility to decide things like the price of acquisitions, timing of major investments, or their (degree of) competitiveness in the marketplace. Depending on the scheme, fungibility with other environmental commodities, such as energy efficiency certificates, can be used to meet compliance needs, at least to the extent it is not detrimental to environmental performance, i.e., it does not dilute the cap.

Three, keep it dynamic and in sync with the economy. Carbon credit prices in the EU emissions trading scheme fell from Euro 30 each to an all-time low of Euro 3 in 2013. Chief amongst the reasons that led to this drop was the economic recession that preceded it, and the subsequent drop in emissions—and hence a (reduced) need for allowances. It was not until 2015 that the EU introduced a corrective measure, and not until 2018 where appropriate revisions were made that allowed prices to come back up again. (This was done by adjusting the supply of allowances to be auctioned). Prices have since been on the rise—deliveries on March 29, 2021, closed at 42 euros.

Four, think long, think stable. One of the shortcomings of the Kyoto regime is that the commitment period was not long enough. By the time companies started to integrate the notion of a carbon price to their decision-making and discussions reached boardrooms, there were only a few years of the market left. For clean energy projects where gestation periods were long, the lack of a long enough runway triggered discussions around market continuity barely a few years after the scheme started. In contrast, the EU emissions trading scheme had/has compliance periods that progressively increased—giving companies enough certainty to plan, integrate and make investment decisions knowing regulators treated the carbon price seriously and the market was there to stay. Businesses need long time horizons to plan, make investments and decide corporate strategy. Institutions and policy makers need to design accordingly; the climate problem is long term issue, anyway.

And five, keep it simple and transparent. Historic evidence is clearly in favor of simple. The transaction costs associated with implementing and managing an emissions trading scheme rise with the number of rules, exceptions to rules and constraints. As transaction costs rise, the number of trades fall—and as the number of trades fall, the cost savings achieved by the program also decline. Deviations from simplicity should only be allowed when such deviations further climate goals.

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