A fundamental concept for policy makers in designing an emissions trading system is its role. The role concerns 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. For example, the system could end up functioning as a means to raise revenue for investing in further emissions reductions projects or in sectors other than those covered by the system. Defining the role offers a chance for policy makers to consider the expected outcomes of the system, such as changing business practices and shifting investment decisions.

In an ideal world, a carbon price would play the central – if not singular – role in driving cost-effective emissions reductions. However, in the real world the role of the carbon price is limited by three main factors. First, jurisdictions face constraints in implementing carbon prices at a level that would send a strong signal throughout the economy, including challenges associated with increasing final energy prices. Second, jurisdictions have multiple objectives that overlap and co-exist with emissions reductions within the energy transitions agenda, such as economic development (including growth of low-carbon sectors), energy access, air quality improvement, energy security and energy affordability. As a result of various constraints and objectives, governments develop packages of policies, of which carbon pricing may be only one (though important) element. A third limitation is that in the real world, market failures make it difficult for a carbon price signal to get through and play the role it is meant to.

In many jurisdictions, the role and function of the emissions trading system have also evolved. The function of a system can change as its design elements alter, such as changes in the cap stringency, carbon price levels, sectoral and gases coverage, and allowance allocation method.

For instance, in most trading systems a pilot phase generally precedes the actual trading of allowances. This helps to set up emissions measurement, reporting and verification systems, establish the allowances exchange platforms, simulate trading, and build capacity and buy-in of various stakeholders. Such a phase was used for example by the Korean emissions trading system: the explicit role of its first phase was to build knowledge and experience among stakeholders. In subsequent phases, its role focused on driving progressively more emissions reductions.

Jurisdictions implementing an emissions trading system have done so with varied conceptions of the role it will play in reducing emissions. In some cases, the system is seen as the principle means of achieving emissions reductions. In others, it is a backstop measure to ensure reductions in case other policies do not deliver.

The role and function of the EU ETS: Is meeting the emissions cap sufficient?

The EU ETS, launched in 2005, was initially designed as a primary means of meeting the European Union’s 2012 Kyoto Protocol target in a cost-efficient manner while minimising negative impacts on economic growth and employment. Subsequently, the European Union developed sequential emissions reductions targets for 2020 and 2030, with the trading system still intended to be a “cornerstone” for meeting these targets, as it covers approximately 45% of EU emissions. The EU ETS will also play a central role in the European Union’s long-term mitigation goal of reaching climate-neutrality by 2050.

The EU ETS has achieved its stated goal of meeting targeted emissions levels, with a reduction in emissions from fuel combustion in the power sector playing the biggest role. However, evidence suggests it has not been the primary driver of emissions reductions in the sectors that it covers, due to the over-allocation of allowances and resulting weak price signal (i.e. low allowance prices). Nevertheless, the allowance costs have been high enough to favour coal-to-gas switching in the power sector before 2011 and since 2016. The low allowance prices were caused by several factors, such as the unexpected low demand for allowances from emissions reduced by energy efficiency and renewable energy policies, the 2008-09 economic recession, and the oversupply of certified emissions reduction credits from the Clean Development Mechanism allowed in the emissions trading system to meet the Kyoto Protocol targets. Recent reforms aimed to address some of these challenges, such as making certified emissions reduction credits ineligible for use for compliance in the EU-ETS (see section “Managing interactions with wider energy transition policies”). Towards 2030, renewable energy and energy efficiency policies in EU member states may continue to contribute greatly to meeting the 2030 target for reducing emissions in sectors covered by the EU ETS.

Overall, views differ on the ultimate success of the EU ETS, depending on how its role is considered. The system achieved the objective of reaching the level of emissions reductions fixed by its emission cap. However, it is difficult to directly attribute the emissions reductions to the EU ETS alone, as other policies in each sector covered by the system may have contributed. However, policy makers considered that just meeting the emissions cap was insufficient; recent revision and reform of the system reveals the view that its role should also be to drive more fundamental changes in the economy, through both a stronger carbon price signal and use of revenue. Low allowances prices meant a weak price signal has failed to drive significant technology innovations and deeper emissions reductions. This experience underscores the importance of defining the primary objective of an emissions trading system: to achieve an emissions reductions level, to create a carbon price signal, to drive structural changes in the economy, or a combination of these.

The Canadian perspective: Federal carbon pricing as a backstop for provincial carbon pricing

Canada is a large country, with regionally diverse energy resources and levels of economic development, which has implemented a national carbon pricing policy. Canada is a decentralised federation, where provinces and territories have a high level of autonomy and responsibility in policy decisions, including those in relation to environment and energy. These subnational policies have an impact on the federal government’s ability to meet its national policy goals and commitments, including Canada’s nationally determined contribution to the Paris Agreement.

In its Greenhouse Gas Pollution Pricing Act, Canada’s federal government developed a backstop carbon pricing policy that prescribes a minimum carbon pricing benchmark (in terms of stringency and coverage), but allows subnational governments flexibility to determine the instrument (e.g. carbon tax or emissions trading system). Any jurisdiction not meeting the benchmark will follow the backstop policy, consisting of a carbon tax for the transportation and buildings sectors (referred to as the “fuel charge” component) and an output-based allocation system for electricity and industry. The backstop policy can also serve to supplement existing subnational policies that do not meet the benchmark.

The benchmark for subnational carbon pricing is defined as CAD 20/tCO_2-eq by 2019, rising to CAD 50/tCO_2-eq by 2022. In terms of coverage, the subnational carbon price has to cover all fuels with limited sectoral exemptions, such as on-farm fuel use. If the carbon price takes the form of an emissions trading system, it must define a cap at least as ambitious as Canada’s 2030 nationally determined contribution target and define annual and declining caps to meet the emissions reductions equivalent of the carbon price determined through modelling.

The implementation of the policies of the federal Greenhouse Gas Pollution Pricing Act are estimated to reduce 80-90 MtCO_2-eq by 2022 across all jurisdictions. Notably, this estimate includes the impact of provincial carbon pricing policies that existed before implementation of the federal policy but that may be modified to meet the benchmark. While carbon pricing is a critical element of Canada’s clean growth and climate plan, it is not designed to be the only policy measure in the plan to reduce greenhouse gas emissions, as this would require a very high carbon price. Complementary policies and measures, such as the Clean Fuel Standard, methane regulations and coal phase-out, are important to target emissions that are not covered by carbon pricing and can help make carbon pricing more effective.

A key strength of this approach is that it ensures a minimum carbon price benchmark across the country, while allowing subnational governments to design and manage their own carbon pricing policies. However, the primacy of the implemented carbon pricing system for reducing emissions may vary from province to province. Some provinces have backed away from previous carbon pricing systems or have not implemented these. In such cases, the federal government has applied the backstop system in whole, or for some regions, only the fuel charge or industry component. This effect was difficult to anticipate ex-ante but has shown that the backstop system has worked to ensure the intended emissions reductions. As of mid-2020, the backstop federal “fuel charge” tax applies in Alberta, Manitoba (which has plans for its own system), New Brunswick, Nunavut, Ontario, Saskatchewan and Yukon. The component of the federal pricing policy for industry and electricity production applies as of mid-2020 in Alberta, Manitoba, Nunavut, Ontario, Prince Edward Island, Saskatchewan and Yukon. In Ontario, Alberta and New Brunswick, previous provincial governments had conceived carbon pricing policies, but subsequently elected provincial governments scrapped or refused to implement them.

The Canadian example reflects a trade-off between regional goals and economic efficiency at the national level, and shows how the role and function of carbon pricing systems can vary from jurisdiction to jurisdiction at the subnational level as well as from country to country. Since most provinces are encouraged to develop their own carbon pricing systems rather than have the federal backstop applied, they will have the flexibility to tailor their policy design to the intended role of their carbon pricing system or to adopt the federal systems if it suits them.

California’s cap-and-trade: Backstop system alongside other mitigation policies

California’s cap-and-trade system is intended as a backstop to other policies that are expected to deliver the bulk of emissions reductions towards the state’s targets. The California Air Resources Board (CARB) estimates that in the period 2021-30 the cap-and-trade system and other key low-carbon policies can reduce emissions by 621 MtCO₂-eq. Of these, the cap-and-trade is expected to reduce 236 MtCO_2-eq and the other prescriptive mitigation policies the remaining 385 MtCO_2-eq. These other measures include the Renewables Portfolio Standard, energy efficiency measures, the Low Carbon Fuel Standard, vehicle emissions standards and measures to address short-lived climate pollutants.

However, these other mitigation policies could underperform relative to expectations. If this happens, the cap-and-trade system is designed as a backstop to ensure that the overall goal to reduce 621 MtCO_2-eq by 2030 is achieved, by filling the gap in the emissions reductions over and above what is achieved by the prescriptive measures. In light of this, a low initial carbon price in the cap-and-trade system was desirable from a political standpoint, to avoid political controversy and enhance the system’s long-term durability.1 Therefore, despite low allowance prices, the primary role of California’s cap-and-trade system is to maintain covered emissions below a cap representing a known level of emissions reductions that can be counted upon, should other policies fail to deliver.

The emissions cap of California’s system was set to decline by around 3% per year until 2020, then by 5% per year until 2030, and then until 2050 by a factor calculated by a formula set in the Cap-and-Trade Regulation.

The perspective of RGGI: delivering on policy goals other than reducing CO₂ emissions

RGGI was the first mandatory emissions trading system in the United States. As of April 2020, RGGI covers ten states in the Midwest and Northeastern United States: Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island and Vermont. The system’s composition has evolved over time, with New Jersey withdrawing in 2011 and re-joining in 2020. Virginia is set to join by the end of 2020 and Pennsylvania by 2022.

RGGI’s formal aim is to reduce CO₂ emissions from fossil fuel electric generating units. The initial 2009-13 cap was set above actual emissions, and despite downward revisions of the cap in 2014 by 45%, the system has had minimal impact as a direct driver of CO₂ emissions reductions. Other policy drivers and factors are likely to have had a greater impact. These include the introduction of state renewable portfolio standards, coal-to-gas switching due to market conditions, and overall declining electricity demand. The cap has not been significantly tightened up to this point, reflecting RGGI’s role in supporting overall power decarbonisation alongside other policies. RGGI may have driven emissions reductions indirectly, through revenue reinvestment in energy efficiency, renewable energy and other low-carbon projects.2 Evidence also suggests RGGI has influenced the revenues of power generators, favouring those using low-carbon sources. After 2020, the cap will decline linearly, resulting in a 30% reduction from 2020 to 2030.

Despite the limited CO₂ impact to date, RGGI has delivered on other important policy goals for the participating states, such as creating a stable source of revenue (through allowances auctions and price floors for allowances) and improving air quality. The economic gains resulting from reinvestment of auction revenues have been estimated at USD 1.4 billion between 2015 and 2017. The public health benefits of RGGI due to improved air quality were estimated at USD 5.7 billion between 2009 and 2014.

Policy makers can set the cap of an emissions trading system in different ways, and this choice affects the predictability of emissions reductions. One way to set a cap is through an absolute emissions reduction target (also called “mass-based” target). This cap would fix a maximum amount of emissions in the emissions trading system expressed in absolute form (e.g. in tCO_2-eq); only one variable (the quantity of emissions reductions) is concerned. Mass-based caps provide certainty on the emissions reductions performance of an emissions trading system, and are applied in the majority of existing systems, including California, the European Union, Korea, RGGI and the Tokyo Metropolitan Government.

Another possibility is to set an intensity cap, or a relative emissions reduction target (often called a “rate-based”, “output-based” or “intensity-based” target). This target is expressed in relative form, such as the emissions reductions per unit of output (e.g. tCO_2-eq/MWh). In this case, two or more variables are concerned, and the target is a level of emissions intensity that a given installation must remain below. With an intensity-based target, absolute emissions may rise. Intensity-based targets are selected where there is greater uncertainty about future levels of output and demand growth, which is the case in developing economies. They can allow installations to adjust more flexibly to changes in economic conditions. Intensity-based targets are therefore a means of applying an environmental constraint to economic activity in a flexible manner. Intensity-based systems currently exist in the Chinese emissions trading system pilots and the Canadian federal carbon pricing backstop policy (applied to large final emitters). China has also proposed an intensity-based target for its national emissions trading system.

Finally, policy makers can also choose not to set a cap if this facilitates system function. For instance, the New Zealand emissions trading scheme was designed without a domestic cap because it had full links to international carbon markets and was not intended to define a limit for domestic emissions (see also the section "Alignment of emissions trading systems with national mitigation"). The lack of a cap makes it hard to predict ex-ante the emissions reductions of the sectors covered by the system. However, not setting a cap accommodated one of the functions of the New Zealand emissions trading scheme, originally intended to provide flexibility to accommodate carbon sequestration from forestry activities and allow the use of international carbon credits from the Kyoto Protocol mechanisms. In 2019 New Zealand reformed its emissions trading scheme given its revised role: to support implementation of its nationally determined contribution under the Paris Agreement. As such, it has an absolute cap based on a provisional emissions budget for the 2021-25 period.

Another aspect that policy makers may want to consider when designing an emissions trading system is what role the system would play in the jurisdiction’s long-term strategy, and therefore how to ensure long-term predictability of the policies underlying the system. For the private sector, the long-term policy predictability of an emissions trading system is important for guiding investment decisions because it enables management of carbon price expectations (discussed in the section “Managing interactions with wider energy transitions policies”). This is particularly relevant for capital-intensive sectors with long-term assets, such as the energy and industrial sectors.

Long-term policy predictability in Korea’s emissions trading system

In Korea’s emissions trading system, long-term policy uncertainty was stated as a key factor contributing to low liquidity (i.e. a low level of trading) at the end of the first commitment period (2015-17). Companies had low visibility on emissions trading system details for the coming years. To address these concerns, long-term policy predictability is now ensured through two complementary plans. The first is a ten-year Master Plan, which establishes guiding principles and considers the emissions trading system within the context of other policies and in meeting longer-term emissions reduction targets. This provides clarity to market participants on the future long-term existence of the emissions trading system. The second is a five-year Allocation Plan, which outlines the details of the emissions trading system, including the cap and allocation method for each compliance period. This provides market participants with all necessary technical details at least six months before the start of the compliance period.

The EU ETS in the long-term mitigation strategy

The European Union clearly provided long-term certainty that the EU ETS will be central in EU climate governance, i.e., it will be a key element of the long-term mitigation strategy goal of reaching climate neutrality by 2050. The EU system also provides visibility on long-term emissions reductions pathways to mid-century, based on annual linear reduction factors that will lower the cap.

Furthermore, the EU system defines rules per compliance period; each period has been longer than the last, with Phase 3 lasting eight years and Phase 4 lasting ten years. These longer compliance periods have provided greater certainty to the private sector with regard to the system’s rules. The details of each compliance period were systematically released within good lead times ahead of the compliance period start. For instance, reforms for Phase 4, which begins in 2021, were agreed in 2018.

In addition, the EU ETS introduced some mechanisms, such as the Market Stability Reserve and other cancellation provisions for surplus allowances, to provide a reasonable supply-demand allowances balance and further long-term policy predictability.

• What is the intended role of the new emissions trading system? Is it to prioritise emissions reductions, to create a price signal, to enhance efficiency of economic decisions or to drive a shift in investment decisions?
• What is the most suited emissions cap design for the new emissions trading system considering its role? How important is it for the new emissions trading system to ensure predictability of emissions reductions over providing flexibility for economic outputs?
• How could the emissions trading system evolve with regard to expanding greenhouse gas and sectoral coverage, and strengthening incentives and emission cap stringency? For example, will the system evolve from being intensity-based to having an absolute emissions cap?
• What role will the emissions trading system play in the jurisdiction’s long-term mitigation strategy?
• What is the best way to ensure long-term policy predictability for the emissions trading system?