Linking Emissions Trading Schemes: an Economic Impact Assessment for Europe and Brazil

LINKING EMISSIONS TRADING SCHEMES: AN ECONOMIC IMPACT ASSESSMENT FOR EUROPE AND BRAZIL USING EPPA6 MODEL

Thais Diniz Oliveira[1]

Angelo Costa Gurgel[2]

Steve Tonry1

ABSTRACT:

Emissions Trading Schemes (ETS) are usually considered as a cost-effective method of achieving emissions abatement. Moreover, in order to provide a global signal for climate mitigation, linking of ETS has emerged as an important area for consideration. In practice, there are a limited number of operational ETS systems in the world, with the European Union Emissions Trading Scheme (EUETS) being the most established.This paper considers different scenarios for simulating a proposed Brazilian ETS (BRA ETS) and the establishment of a link with the EUETS by using a computable general equilibrium model, the EPPA6 as developed by MIT. We assume that some main design elements of the proposed BRA ETS are harmonised with the EUETS, such as emissions and sectoral coverage, as well as the cap nature. We also differentiate the level of stringency for the BRA ETS. The macroeconomic impacts of the national and linking scenarios are analysed in terms of GDP, welfare, sectoral emissions, total emissions and related carbon prices. Results indicate that linking the system would be preferable when Brazil adopts the Nationally Determined Contributions (NDC) targets.However, the potential benefits from linking the proposed BRA ETS are rather modest when one considers the complexity of implementation. It is suggested that this is as a consequence of the limited coverage of the proposed BRA ETS which represents a small relative share of total emissions in Brazil.As a result, the expected gains from linking are reduced. For the EUETS, linking to the proposed BRA ETS is not considered particularly advantageous.We finally conclude that further investigation of the proposed BRA ETS is required, particularly in the context of sectoral coverage and with respect to the NDC targets for Brazil and climate policies in other countries.

KEY WORDS:Linking, ETS, EPPA6, BRA ETS, EUETS

1. INTRODUCTION

In the climate policy arena, Emissions Trading Schemes (ETS)[3] have become a prominent alternative for mitigating emissions associated with economic production. Mostly implemented by developed countries, this mechanism is now also being considered by developing countries[4].

In the context of the Paris Agreement, provisions for carbon pricing are likely to become even more common in the post-2020 world. This is due to the fact that Article 6 allows for the use of international mechanisms to comply with NationallyDetermined Contributions (NDCs). As a consequence, the more interest in implementing carbon trading mechanisms the more linkages are expected to emerge among participants. Under a bottom-up policy architecture, this mechanism will be a fundamental element of the global climate change policy framework in the future (DODA; TASCHINI, 2016; EUROPEAN COMMISSION, 2015).

There are few examples of active linkages to date.One example is the recent California-Quebec link (the Western Climate Initiative, WCI). The Regional Greenhouse Gas Initiative (RGGI) in the northeast of the USA is also a combination of Emissions Trading Schemes from different jurisdictions that are linked together. Another effective linkage is the European Emissions Trading Scheme (EU ETS) since it is formed by a group of nations that has agreed to recogniseemissions permits mutually for common compliance. In addition to that, the EU ETS has just finished negotiating with Switzerland on linkage to the Swiss cap-and-trade scheme but the treaty has not entered into force yet.

Theoretical foundation for these empirical experiences are evidenced in the published literature. In general, it has highlighted opportunities and benefits from the use of market instruments for addressing climate change problems, particularly in relation to the linkage of carbon trading schemes.

Linkage is described as a multi-faceted policy decision that is envisaged to play an important role in future international climate policy architecture. The main argument for linking ETS systems is the overall emissions reductions across participating jurisdictions at a lower cost via interaction of regional carbon regulations. This ultimately may presumably lead to increased mitigation ambition and sustainable development.

This research provides an investigation into the economic impacts of linking the European Emissions Trading Scheme (EU ETS) - the largest and most consolidated scheme in the world - with an emerging non-EU scheme, a proposed Brazilian Emissions Trading Scheme (BRA ETS).

Severalstudieshave been carried out in order to evaluate linking with the EUETS, including the possibility of linking with non-EU schemes such as South Korea, China, Australia and California. This paper is conducted along the same lines but focuses on the Brazilian case. Among developing countries, Brazil has taken on a pioneering position when it comes to commitments to mitigate climate change. However, the movement towards the adoption of carbon pricing mechanisms is still at an incipient stage in Brazil. Discussions in this regard have increased significantly since the enactment of the National Plan for Climate Change Mitigation in 2009, which has considered economic instruments also as a means of achieving national targets by 2020.

In light of the Paris Agreement arrangements, Brazil should be encouraged to design a carbon trading scheme. Linking it to other systems would thereafter be an option. Under this perspective, we propose an economic evaluation of the feasibility and effectiveness of a linkage between the EU ETS and BRA ETS using the MIT CGE (Computational General Equilibrium) model, the EPPA6.

The study compares the impact from a national and linked perspective, highlighting differences with regard to relevant factors such as carbon price, stringency of targets, level of emissions, GDP and welfare. Simulations using the EPPA6 model show how the linkage would operate so that we can understand if a linkage policy would be the appropriate strategy for helping both jurisdictions to achieve a low carbon economy. For that purpose, section 2 discusses the literature on potential advantages and challenges of linking. Section 3 describes the modelling methodology and policy assumptions for the simulations. Section 4 exhibits the results and discusses the results. Finally, conclusions are highlighted in Section 5.

2. LITERATURE

The literature on the linkage of ETS schemes provides important insights associated with the regulatory, economic and environmental aspects of linking Emissions Trading Schemes. Mostly, the literature explores the advantages and disadvantages of linking cap-and-trade schemes, as referred to in publications by Flachslandet al. (2009), Jaffe andStavins (2007), Tuerket al.(2009),Haiteset al. (2001), Metcalf and Weisbach (2010), Stavins (2015),Bodanskyet al. (2015), PMR and ICAP (2016), Ranson and Stavins (2013), among others. In this section we briefly highlight some of the significant discussions on the theory of linking ETS systems.

2.1. Potential advantages and challenges

Linking ETS systems is considered to be a multifaceted political decision agreed by participants in order to achieve environmental, economic and political goals. It emerges in the form of agreements by separate policy systems in different political jurisdictions with the aim of maximising emission reduction efforts cost-effectively. For direct[5] linkage to occur, there must be recognition of emission allowances for the purposes of compliance with the local cap. A bilateral link enables full alignment of one or more ETS systems so that allowances are mutually recognised.

One of the expected outcomes from linkage is the reallocation of abatement effort between regulated entities which consider a wider range of available mitigation options. Kachiet al. (2015) highlight that efficiency gains from linking two ETS systems can be limited if abatement costs are similar since gain in efficiency depends on the heterogeneity of abatement alternatives. Therefore, the more diverse the market is, the more optionsfor emissions abatement with different associated costs.

For a greater economic efficiency gain from allowance trading, the difference between the pre-link allowance price and the linked one plays an important role. Literature points out that the larger the difference in equilibrium allowance prices, the greater the potential gain in economic efficiency (TUERK et al., 2009; PMR; ICAP, 2016).

An ETS where the emission price is higher before the linkage, benefits from the agreement once it tends to buy emission allowances from the other jurisdiction, reducing its price of compliance. As a consequence of linking up markets, there is a full convergence of allowance prices through trade.Linking ETS schemes potentially increases market liquidity[6] as it enlarges the market (RANSON; STAVINS, 2013). According to Jaffe et al. (2009) and Jotzo and Betz (2009), the largest economic benefit of a cap-and-trade scheme stems from the integration to other schemes.

In theory, to the extent to which liquidity increases, price stability in the systems also increases due to a reduction in price volatility caused by unexpected shocks. It ultimately contributes to the avoidance of market power and price manipulation from larger entities. Nevertheless, price volatility can be imported from other systems with the linkage (FLASCHSLAND; MARSCHINSKI; EDENHOFER, 2009).

An additional advantage of linkage isthe potential for reducing the risk of emissions leakage, that is, incentives for polluting activities to move to jurisdictions where regulation of the climate is less stringent, especially if the linking jurisdictions are also trade partners. In this sense, competitiveness concerns that might exist between the covered industries before the agreement may be alleviated with the linkage.

Linkage can result in reduced emission abatement effort in installations or jurisdictions which are then required to purchase allowances, whereas those installations or jurisdictions selling allowances see a reduction in emissions. Therefore, mitigation can be achieved in a cost-effective way to the extent that emissions are reduced where they are least expensive (ANGER, 2008).

However, there are some critics in the literature such as Bodanskiet al. (2014) and Stavins (2015) who point out that instead of achieving environmental effectiveness, linkage can undermine the environmental integrity of the combined system. For instance, if emissions flowing from one country to another and vice-versa are not properly accounted for, the linkage may result in double counting. Furthermore, some authors suggest that if jurisdictions design their own emission reduction targets in the linkage, allowance trading may even have a negative impact on the environment (e.g. if the cap is set too high)(HELM, 2003; CARBONEet al., 2009).

Aside from the aforementioned motives, there is also a strong political dimension associated with the linkage approach. The decision of linking upis itself a demonstration of commitment to global action on climate change.The European Union through the EU ETS offers a good example of leadership on the climate change policy arena. Based on the lessons from the EU ETS, many systems have been planned worldwide. The strategy of linking to existing or emerging systems also demonstrates Europe's ability to support global cooperation on climate change.

2.2. ETS Design Considerations for Linking

Harmonising the main features of both ETS signal a move towards a greater level of cooperation which is fundamental to achieve the goals across jurisdictions. However, it involves a significant effort from the systems to be linked for negotiating how to align the existing features. For example, the EU ETS and the Swiss ETS have now agreed to link up their systems after a long negotiation on the scope and coverage of the linkage, particularly regarding the inclusion of the aviation sector which was not previously included in the Swiss ETS.

There can also be administrative benefits from linking resulting from the sharing of knowledge regarding the design and operation of the system (STAVINS, 2015). For example, the Brazilian system here proposed would benefit from the linkage with the EUETS through the sharing of their practices in program administration especially because the Brazilian ETS has not been developed yet. Indeed, in this linkage it would be very likely that an alignment of features would simplify compliance and offer a reduced administrative cost for both jurisdictions.

Several factors determine the decision to link schemes such as geographic proximity, legal compatibility, potential distributional impacts and the respective ETS design elements.Rather than enhance environmental efficiency and effectiveness, differences in the design may impair the objectives of the scheme (STERK et al., 2006).Burtrawet al. (2013) and Kachiet al. (2015) discuss the differences in the design of schemes and which elements must be reconciled in order to link.

In relation to the scope[7] and coverage, differences do not seem to pose a technical barrier to linking nor does it affect the environmental effectiveness of the linkage. Diversifying and amplifying the scope and coverage may lead to a greater cost-efficiency of overall mitigation effort because the availability and also diversity of abatement options is enhanced (BURTRAW et al., 2013; STERK et al., 2006).

In fact, a completely equivalent sector in two independently-designed schemes is rather unlikely because countries have differing emissions profiles and have to choose accordingly which sources to include (BARON; BYGRAVE, 2002; METCALF; WEISBACH, 2010).Under such circumstances, even though the link generally is viewed as a facilitator for the economic sectors and general public to accept the climate policy, competitiveness and political support concerns would emerge.

Issues can be avoided or at least diminished if the alignment of the aforementioned elements are negotiated ex ante as usually supported by the literature on linkage(BURTRAW et al., 2013; LAZARUS et al., 2015). For Pizer and Yates (2015) the greatest obstacle regarding harmonisation in advance of the linking is to overcome the design differentials reflecting domestic preferences and reconcile both schemes.

Despite not necessarily implicating a negative environmental effect, differentials of scope and coverage may generate distributional impacts if the linkage occurs among heterogeneous systems (METCALF; WEISBACH, 2010). For instance, if the linkage is negotiated between a broader base ETS and a narrower one, the former may not be willing to link since the latter tends to present higher abatement costs and hence gains more from the linkage. In other words, linking systems that differ in the sectors or gases included may create winners and losers. This presumably might lead to a setback of the linkage process. For developing countries aiming to design an ETS and link it to existing developed-world programs, this aspect has to be carefully negotiated.

Conversely to the scope and coverage, the cap and its stringency present another potential barrier to linkage according to the literature. These design featuresreflect the environmental ambitionsand aggregate goals for any linked ETS system. Cap and stringency requirements will vary according to an economy's size, nature and level of development which aredifficult to coordinate when linking schemes from different jurisdictions. Green et al. (2014) and Burtrawet al. (2013) consider this to be the most prominent barrier to linkage which is relevant to the functioning of the markets and the political economy of the ETS.

Firstly, the methodology on which the cap is based on plays an important role in the environmental effectiveness of the agreement. If one cap is based on absolute emissions whereas the other is based on intensity, the policy objectives may be undermined. Hence, although it is not technically impossible it is complex and likely to generate adverse economic, distributional and environmental effects (KACHI et al., 2015). As a result, harmonising before the effective linkage is rather fundamental (DEHSt 2013, BURTRAWet al. 2013, TUERKet al. 2009).

In terms of stringency, the literature observes a relationship between trade of emissionsallowances and cap stringency. In general, along with environmental goals, an ETS is designed to obtain economic benefits. A country may choose its cap strategically in order to maximise potential gains from future trading (HELM, 2003).

This may occur because, as Zetterberg (2012) points out, allowances tend to flow from the less stringent (with lower marginal abatement cost) to the more stringent system, particularly if the pre-price gap is sufficiently large to begin with. Accordingly, with the lack of stringency harmonisation, linking may raise equity concerns and even prevent the linkage from materialising (GREEN et al., 2014). Therefore, to overcome those concerns Haites (2013) and Edenhoferet al. (2007) suggest linkage among schemes with comparable ambitions, climate policies and vision of medium and long-term emissions trends.

Others design features are regarded as critical for linking up ETS systems. Literature usually mentions price management (or cost-containment) andthe recognition of offsets[8]as the most problematic for the agreement (ZETTERBERG, 2012; KACHI et al. 2015; BURTRAW et al. 2013, STERK et al., 2009). These elements are designed to control the range of allowance prices. In addition to them, temporal flexibility through borrowing can also limit linking due to potential low environmental effectiveness when emissions allowances imports are unrestricted.

Price support and price containment measures (price ceiling and price floor) havealso been discussed in the literature due to their implications on both schemes. The price floor restricts the auction volume below a fixed price and the price ceiling sets a maximum allowance price. Once those measures exist in one ETS it propagates to the other. If before the linkage, price management measures differ among the schemes prices whenthe schemes are linked are also affected. In both cases, some issues may arise from the supply side of the allowances, essentially regarding allowance prices which can be difficult to align as they reflect the political objectives and priorities of the ETS programs (BURTRAW et al., 2013).

Offset provisions may also be critical to linkage and demand a degree of harmonisation (STERK et al., 2009; BURTRAW et al., 2013; ZETTERBERG, 2012). Linkage allows the existing offset credits in one ETS to be available in the linking partner ETS (at least indirectly). In this sense, the amount of offsets allowable for compliance purposes, the type of offset which is eligible, the stringency of standards and the potential for double counting summarises the main concerns outlined by Kachiet al. (2015). The EU ETS has so far permitted the use of offsets but it does not envisage the continuous use of this mechanism post 2020.