Implementing Effective Emissions Trading Systems

Carbon pricing is a valuable instrument in the policy toolkit to help accelerate clean energy transitions. By providing a clear signal that GHG emissions entail a cost to society, carbon pricing can stimulate investments in low-carbon technological innovations, foster multilateral co-operation and create synergies between energy and climate policies. Carbon pricing instruments comprise carbon taxes and emissions trading systems. Carbon taxes consist of direct taxation on emissions. Emissions trading systems are market-based instruments that create incentives to reduce emissions where these are most cost-effective. In most trading systems, the government sets an emissions cap in one or more sectors, and the entities that are covered are allowed to trade emissions permits.

Emissions trading systems expose emitters to the external costs of emissions in the most flexible and least costly way. The design of such a system needs to take into account local contexts and regulations, as well as interlinkages with other policy priorities in each jurisdiction. This report analyses real-world experiences of the design and implementation of trading systems in different jurisdictions around the world. The analysis considers the diversity and complexity of the interlinkages of energy policies, energy targets and energy system structures, and it identifies key issues and common challenges that jurisdictions face when considering the establishment of a new trading system. In addition, common challenges in trading system design and implementation for the power and industry sectors are analysed. Key lessons and guiding questions for policy makers are provided to help with developing and implementing emission trading systems.

Carbon pricing initiatives are spreading throughout the world. Over 60 countries, cities, states and provinces have implemented or are planning to implement carbon pricing schemes, with a fairly balanced distribution between emissions trading systems and carbon taxes. When the trading system in China’s power sector starts operating, carbon pricing initiatives will cover 20% of global emissions. Jurisdictions in Asia and the Americas are now the driving forces for new carbon pricing initiatives.

In defining the role of a trading system, policy makers could reflect on what the system is designed for and expected to do. For example, an emissions trading system could be intended to drive emissions reductions as its principal role, or provide a backstop for other policies. In practice the system may function somewhat differently than intended, such as a means to raise revenue for investing in further emissions reductions projects or in sectors other than those covered by the system. Throughout the process of defining the role of an emissions trading system, policy makers could also reflect on other expected outcomes of the system, such as changing business practices or shifting investment decisions.

Primacy of trading systems in reducing emissions 

Jurisdictions have implemented emissions trading systems with varied ideas of the role they will play in reducing emissions reductions. In some cases, trading systems are seen as the principle means of achieving emissions reductions, in others as a backstop measure to ensure reductions in case other policies do not deliver. The effectiveness of an emissions trading system should be evaluated based on its objective. In the longer term, gradually increasing the stringency of a trading system’s cap would contribute more to emissions reductions.

Choosing the type of emissions cap

Policy makers can set the cap of an emissions trading system in different ways, and this choice affects the predictability of emissions reductions. The most common ways to set a cap are through an absolute emissions reduction target (or “mass-based” cap) or an emissions target set relative to output (“intensity-based” target). Mass-based caps provide certainty on emissions reduction performance. Intensity-based targets can increase absolute emissions under certain conditions, but they allow more flexibility in adjusting to changes in economic conditions.

The long-term perspective: Policy predictability

When designing an emissions trading system, policy makers may want to consider what role the system would play in the jurisdiction’s long-term strategy, as well as how to ensure long-term policy predictability for the emissions trading system. For the private sector, long-term policy predictability is important for guiding investment decisions as it enables management of carbon price expectations.

Guiding questions for policy makers on the role and function of a new emissions trading system:

• What is the intended role of the emissions trading system
• What is the emissions cap design most suited to the trading system’s role and function?
• How could the emissions trading system evolve to expand greenhouse gas and sectoral coverage, and strengthen incentives and emission cap stringency?
• What role will the trading system play in the jurisdiction’s long-term emissions reduction strategy?
• What is the best way to best ensure long-term policy predictability for the emissions trading system?

Carbon pricing policies are implemented alongside a wide mix of other policies that promote clean energy transitions, such as air pollution control, renewable energy deployment, energy conservation, economic restructuring, and energy sector and power market reforms. It is important to understand the interaction of an emissions trading system with these other policies because it can accelerate or hinder clean energy transitions. 

Emissions trading systems can be responsive

Mechanisms that promote both flexibility and certainty of a carbon price are fundamental to ensure that emissions trading systems can respond to unexpected or unintended impacts of domestic companion policies and other external factors, such as an economic crisis. Experiences from emissions trading system responses to the 2008 global financial crisis can enable us to understand market dynamics in the face of unexpected exogenous economic downturns. They can also help us to cope better with new crises, such as the global economic crisis induced by the Covid-19 pandemic in 2020. Policy makers can rely on several mechanisms to enhance the flexibility and certainty of the carbon price in an emissions trading system, which were not used during the 2008 crisis. Automatic triggers for such mechanisms further enhance predictability and minimise the need for discretion by policy makers.

Aligning emissions trading systems with national mitigation objectives

An emissions trading system is generally embedded within higher-level greenhouse gas mitigation objectives, including those expressed within each country’s nationally determined contribution (NDC) to the Paris Agreement on climate change and long-term mitigation strategies. Some jurisdictions have worked to align the emissions reductions trajectory and cap of their emissions trading system with these mitigation objectives, though in different ways. Setting the emissions trading systems cap with a top-down approach can help better align the trading system with the national mitigation objectives.

Guiding questions for policy makers on the interactions of emissions trading systems and other policies:

• How will the emissions trading system interact with other domestic companion policies?
• What mechanisms can be used to promote emissions trading system flexibility and certainty over time?
• What is the best way to align the emissions trading system with national mitigation objectives?

As a major source of emissions in most jurisdictions, the power sector is included in virtually all operating emissions trading systems around the world, as well as in jurisdictions that are developing or considering developing such systems. In theory, the cost of an emissions trading system allowances creates various levels of incentives for the power sector to reduce emissions, for example by investing in less carbon-intensive power supply, reducing electricity demand or changing the merit order of electricity dispatch in favour of low-carbon power supply.

In practice, however, power markets are often fully or partially regulated, and some power market structures can weaken the carbon pricing signal, reducing the emissions trading system’s effectiveness. This raises questions about the compatibility of trading systems with energy market regulation constraints. It is essential for the design of an emissions trading system to match local circumstances to generate the most effective carbon price signals. 

Adapting the design of emissions trading systems to power market structures

Several methods can be used to better reflect the system’s carbon price signal while taking into consideration existing power market regulations. These methods include consignment auctions, covering indirect emissions, consumption charges, climate-oriented dispatch rules, carbon investment boards and pricing committees. Further research and experience will improve understanding of the effectiveness of these options.

Guiding questions for policy makers on emissions trading systems and the power sector:

• How can the emissions trading system design align with the local power market structure?
• How can the carbon price be reflected in the capacity expansion planning, power plant dispatch decisions and end-use prices?
• In markets where electricity supply is liberalised but heat supply remains regulated, how should the carbon pricing be allocated to the electricity and heat output of co-generation plants?

How the industrial sector is included in an emissions trading systems needs careful consideration. Policy makers should estimate the potential greenhouse gas mitigation potential available in industry and more generally reflect on the role of industry as a functional sector for the wider decarbonisation of the economy. At the same time, it is important to estimate the potential economic impact that an emissions trading system would have on the various players in the industrial sector.

Competitiveness and carbon leakage concerns for industry

Introducing an emissions trading system in the industrial sector could in theory affect economic competitiveness, leading for example to lower investments in industry and job losses. It could also affect the economic competitiveness of internationally traded goods. Industrial production (and associated pollution) might also move to jurisdictions with less stringent environmental controls or emissions reductions requirements, a phenomenon known as “carbon leakage”. All current emissions trading systems address these concerns by including features aimed at reducing the extra costs imposed on some industries.

It is therefore important to have a transparent means of identifying industries with the highest risks of carbon leakage and competitiveness concerns, estimating the associated costs. Free allocation of allowances has been widely used by various emissions trading systems as a way to address competitiveness and carbon leakage concerns for the industrial sector. There exist different design methodologies to allow free allocation of allowances, which require varying degrees of inputs. The choice of the allocation method is important, as this would determine the amount of allowances that the industrial facility would receive and would impact its emissions trading system obligations. Gradually phasing down free allocation in favour of auctioning can help correct potential market distributional distortions, generate revenue, and increase the mitigation effectiveness of trading systems.

Guiding questions for policy makers on emissions trading systems and industry:

• How can competitiveness concerns and the risks of carbon leakage be accurately identified for different industries?
• How can allocation decisions balance near-term competitiveness concerns with ensuring cost efficiency and distributional equity over time?
• In which industries are there sufficient data to develop benchmarks? 

Carbon pricing is a valuable instrument in the policy toolkit to promote clean energy transitions, characterised by its versatility and flexibility. The design and application of carbon pricing mechanisms very much depends on local circumstances. Carbon pricing internalises societal costs of greenhouse gas emissions. If the carbon price is well reflected in relevant prices of goods and services, it can influence decisions in the short term (e.g. consumer behaviour, dispatch of cleaner power plants), medium term (e.g. decommissioning of high-carbon assets) and long term (e.g. investment in long-lived infrastructure). Confidence in rising future carbon prices can also be a strong driver for investment in clean energy technology research, development and deployment. A well-designed carbon price, therefore, operates through means that are difficult to replicate by any other single policy tool.

Carbon pricing systems are increasingly attractive for subnational, national and supranational jurisdictions as they do not dictate by how much individual entities reduce emissions; instead, they send economic signals to let emitters decide whether to change their business logic towards reducing emissions or continue emitting and pay the price. Carbon pricing can stimulate technological and market innovation. It can also be a significant source of public revenues. These could be used to fund or finance climate activities or supportive measures that can offset the cost burden on the most vulnerable consumers and firms. In addition, effective carbon pricing can transform private-sector business models by creating an incentive to integrate the price of carbon in operations and strategic decisions. The carbon price becomes a tool to identify potential risks and opportunities stemming from concerted policy action to mitigate climate change.

Carbon pricing instruments comprise carbon taxes and emissions trading systems. When optimally defined, both approaches have the same objective and impact. 1

More recently, hybrid systems with elements of carbon taxes and emissions trading have emerged as ways of best meeting national circumstances.

This paper focuses on emissions trading systems, which are market-based instruments that create incentives to reduce emissions where these are most cost-effective, allowing the market to find the cheapest way to meet the overall target. Policy makers can set a cap for an emissions trading system that would determine the maximum amount of greenhouse gases that can be emitted in the sectors covered by the trading system. The cap can be set in different ways, such as an absolute emissions reduction target (also called a “mass-based” cap) or a relative emissions reduction target (often called a “rate-based” or “intensity-based” cap; see section “Defining the role of an emissions trading system”). 

As of April 2020, there were 61 carbon pricing initiatives around the world already implemented or planned for implementation, including 31 ETS and 30 carbon tax initiatives. Carbon prices vary widely from scheme to scheme, from less than USD 1 per tonne of CO₂ equivalent (tCO₂-eq) to USD 127/tCO₂-eq (Sweden Carbon Tax). Carbon prices have increased in some regions in recent years, but only 5% of current carbon prices around the world are at levels consistent with emissions pathways that fulfil the Paris Agreement targets and less than 4% are at levels consistent with the emissions pathways of the IEA Sustainable Development Scenario.

Jurisdictions in Asia and the Americas are now the driving forces for the development of new carbon pricing initiatives. Eight new operational initiatives have been launched in the Americas in the past three years: carbon taxes or hybrid systems for Alberta, Chile, Colombia, Argentina and Canada at the federal level, and emissions trading systems in Mexico, Massachusetts and Washington State. In Asia, carbon pricing initiatives have been implemented or are scheduled for implementation in China, Indonesia, Japan, Kazakhstan, Korea, Philippines, Thailand, Singapore and Viet Nam, alongside various subnational jurisdictions. Implementing a carbon price initiative in these regions requires innovation in policy design because their economies are growing and restructuring rapidly, creating significant challenges for determining the emissions cap and price stabilisation (in the case of an emissions trading system) or the optimal price level (for a carbon tax).

As of April 2020, there were 23  emissions trading systems covering around 9% of global emissions:

• One supranational system: the European Union Emissions Trading System (EU ETS).
• Five national systems: in Kazakhstan, Korea, Mexico, New Zealand and Switzerland.
• Ten systems at regional, provincial or state level: in Alberta, California, Fujian, Guangdong, Hubei, Massachusetts, Nova Scotia, Quebec, the Regional Greenhouse Gas Initiative (RGGI) in the United States and the federal Output-Based Pricing System (OBPS) applied to certain provinces and territories in Canada.
• Seven systems at city level: in Beijing, Chongqing, Saitama, Shanghai, Shenzhen, Tianjin and Tokyo.

In addition, new emissions trading systems are being planned or considered by many jurisdictions around the world. Among these, the national emissions trading system of the People’s Republic of China (hereafter “China”), announced at the end of 2017, aims to start operation in 2020, becoming the world’s largest carbon market. However, the Covid-19 outbreak may delay the launch of China’s emissions trading system and affect other carbon pricing systems. A national emissions trading system will be launched in Germany in 2021, complementing the EU ETS and covering heating and transport fuels.

Carbon pricing instruments are often implemented within complex energy and climate policy landscapes that serve many policy objectives. If well designed and implemented, carbon pricing can bring environmental and social benefits and help governments and enterprises to find cost-effective emissions reduction methods. A price on carbon can affect operation costs, encourage stakeholders to lower emissions and spur technological innovation. In addition to reducing emissions, carbon pricing instruments can facilitate the achievement of complementary energy and environmental goals, such as conserving energy and reducing air pollution. For example, the emissions trading system pilot in Beijing and the carbon tax in Chile are also significantly reducing local air pollution.

Cross-border policy co-operation to implement or harmonise carbon pricing instruments in different jurisdictions is also possible. The EU ETS is the largest international regional carbon pricing initiative. It has gradually extended its geographic coverage over the years and currently operates in 31 countries. The European Commission promotes international co-operation beyond the boundaries of the EU ETS to link systems and build capacity. A linking agreement between the EU and Swiss emissions trading systems has been finalised. The European Commission has also established strong bilateral co-operation programmes with China and Korea on designing and implementing emissions trading systems.

In the United States, RGGI is the largest regional emissions trading system, operating in ten states. California, Québec and Ontario* established the first North American regional emissions trading system through the Western Climate Initiative. The multilateral process undertaken within the United Nations Framework Convention on Climate Change (UNFCCC) negotiations has provided considerable incentives for international carbon market development, initially through the Kyoto Protocol flexible mechanisms and more recently through Article 6 of the Paris Agreement, which is still under negotiation. Collaborative research on emissions trading systems as well as initiatives to link systems among government, the private sector and civil society are likely to increase.

The implementation of emissions trading systems in certain jurisdictions may also have supported the application of internal carbon pricing for corporate investment decisions. The private sector is increasingly using carbon pricing as an indicator to quantify the financial implications relating to energy transition risks, as part of their climate risk management strategies. In particular, the Task Force on Climate-related Financial Disclosures (TCFD) recommends that organisations provide their internal carbon prices as part of the metrics used to assess climate-related risks and opportunities, in line with their strategy and risk management processes. Private companies, organisations and investors are also using internal carbon pricing more and more as a planning tool to help identify revenue opportunities and risks, as an incentive to reduce costs through energy efficiency, and as guidance for capital investment decisions. The level, distribution, variation and trends of internal carbon prices could become key drivers for companies to change development plans, investment philosophies and climate governance.

*On 3 July 2018, the government of Ontario ended its climate plan, including its cap-and-trade pollution pricing system. The province of Nova Scotia joined in 2018 but is not yet linked to the Québec and California market. 

This report presents international experience in developing and implementing emissions trading systems, focusing on four key issues:

• Section 1 explains the importance of defining the role and function of an emissions trading system.
• Section 2 explores the interactions of emissions trading systems with wider energy transition policies and sets out strategies to manage these interactions.
• Section 3 outlines experiences on tailoring emissions trading systems to power market structures.
• Section 4 highlights the role of emissions trading systems in facilitating low-carbon transitions in industry.