Linkage of Greenhouse Gas Emissions Trading Systems: Learning from Experience

ABSTRACT

The last ten years have seen the growth of linkages between many of the world's cap-and-trade systems for greenhouse gases (GHGs), both directly between systems, and indirectly via connections to credit systems such as the Clean Development Mechanism. If nations have tried to act in their own self-interest, this proliferation of linkages implies that for many nations, the expected benefits of linkage outweighed expected costs. In this paper, we draw on the past decade of experience with carbon markets to test a series of hypotheses about why systems have demonstrated this revealed preference for linking.

 Linkage is a multi-faceted policy decision that can be used by political jurisdictions to achieve a variety of objectives, and we find evidence that many economic, political, and strategic factors — ranging from geographic proximity to integrity of emissions reductions — influence the decision to link. We also identify some potentially important effects of linkage, such as loss of control over domestic carbon policies, which do not appear to have deterred real-world decisions to link.

These findings have implications for the future role that decentralized linkages may play in international climate policy architecture. The Kyoto Protocol has entered what is probably its final commitment period, covering only a small fraction of global GHG emissions. Under the Durban Platform for Enhanced Action, negotiators may now gravitate toward a hybrid system, combining top-down elements for establishing targets with bottom-up elements of pledge-and-review tied to national policies and actions. The incentives for linking these national policies are likely to continue to produce direct connections among regional, national, and sub-national cap-and-trade systems. The growing network of decentralized, direct linkages among these systems may turn out to be a key part of a future hybrid climate policy architecture.

Summary for Policymakers

Overview

During the last ten years, a number of countries and sub-national jurisdictions have started greenhouse-gas emissions trading systems (ETSs), and a number of others are in planning and preparation. There is increasing interest in linking these systems, both directly and indirectly via connections to emissions-reduction-credit (ERC) systems, the largest of which is the Clean Development Mechanism (CDM) under the Kyoto Protocol. This research reviews the evidence of the past decade and finds a number of economic, political, and strategic factors influencing policy decisions about whether or not to link. Because the number of proposed and existing linkages is too small to permit a statistical analysis, we qualitatively identify the determinants of policy decisions involving linkage.

Background

As of September 2013, there were international, regional, national, or sub-national ETSs operating or scheduled for launch in 36 countries. Of these, most had established or proposed at least one link with another ETS or ERC. These links fall into four general categories: one-way and two-way linkages between ETSs; one-way linkages between an ETS and an ERC; implicit linkages via national trading under the Kyoto Protocol; and various types of non-traditional linkage.

The current research has implications for the new international agreement to be concluded under the United Nations Framework Convention on Climate Change (UNFCCC) in late 2015. Negotiators working on that agreement favor a hybrid system, combining a bottom-up element of voluntary national policies and actions and a set of top-down elements, such as those related to monitoring progress toward emissions reduction. Some countries will surely choose market systems (ETSs) to reduce their domestic emissions and wish to link. Understanding why they might do so could help with the design and implementation of an effective international climate agreement.

Key Findings and Recommendations

1. The single most significant predictor of two systems linking is geographic proximity. Nearby countries may have similar environmental goals and economic conditions, a history of mutually beneficial engagement on environmental and other issues, or be a more palatable match for domestic audiences.
2. Among economic determinants of linkage, the increased cost-effectiveness that results from a larger pool of potential low-cost abatement opportunities appears foremost in policy decisions to link. Closely related benefits that can play a role in deciding to link are increased liquidity and reduced price volatility.
3. Supportive domestic political leadership is an important predictor of the adoption of an ETS and the decision to link. However, the decision to establish a link is not permanent, as recent delinking cases demonstrate; linkage requires sustained domestic political support. Conversely, domestic political opposition to cap and trade can reduce the chances that a government will decide to link.
4. Although the net social welfare gains from linkage (see (2) above) are an important factor driving linkage, not all regulated entities benefit equally. The relative political power of winners and losers could have strong impacts on governmental support for linking with another system.
5. Linkage decisions may be the result of strategic political behavior to build support for international climate action or the result of nations being coerced into linkage as a condition for receiving some other benefit.
6. Concern about the environmental integrity of allowances in other jurisdictions—especially of CDM and other offset credits—is a significant factor in the decision to link (or not to link). The global offset market has become much smaller in the last several years, making the possibility of achieving near-term cost savings through a system of indirect linkages more difficult.
7. Reduction in allowance prices (see (2) above) generates the cost savings of linkage. However, some jurisdictions may prefer higher prices to incentivize long-term investments in low-carbon infrastructure or in technological innovation.
8. Compatibility (or lack thereof) of ETS-design details and related legal frameworks can determine whether or not systems decide to link—or how much work is involved in doing so. In particular, differences in the ambition of ETSs and resulting price differences appear to be real barriers to linking.
9. Creating a link with another system can mean sacrificing some control over domestic carbon markets. Despite this, many nations and sub-national jurisdictions have chosen to establish links, suggesting that control is not a determinative factor in countries' linkage decisions, at least when partner nations have similar environmental objectives.

Conclusions

It appears that a variety of factors encourage linkage, given the revealed preference of governments over the past decade to link. Incentives for linking are likely to continue to produce direct connections among some regional, national, and sub-national ETSs—including as elements of voluntary actions under the 2015 UNFCCC agreement. Indeed, a growing but decentralized network of linkages among ETSs and ERCs may turn out to be a key part of a future hybrid climate policy architecture.

Matthew Ranson, Abt Associates, Inc.

Robert N. Stavins, Harvard Kennedy School