1 Breaking Up: It’s Not So hard To Do Exploring the Challenges and Opportunities for Establishing a North American Emissions Trading System Chicago November 15, 2007 Erik Haites

MARGAREE2 Why Break Up? The basic reason why the administrator of an emissions trading system linked to another trading system would sever the link is a difference of opinion over the perceived environmental integrity of the two systems, such as: Differences in adjustments to the respective caps The types of offset projects accepted The stringency of the protocols for offset projects Differences in enforcement standards Links by the second system to a third system Severing the link is likely to cause prices in the two systems to diverge

MARGAREE3 Issues Raised by Severance Severance requires: Rules relating to use/transfer of units of linked system that will no longer be accepted Mechanisms for implementing those rules Procedures for implementing those rules to minimize market uncertainty Discussed first for unilateral link, then a bilateral link

MARGAREE4 Unilateral Link A unilateral link means system B accepts units issued by system C for compliance, but system C does not accept system B units System B entities and administrator have accounts in system C registry To use system C units, a system B entity transfers them from its account in the system C registry to the system B administrator’s account in the same registry

MARGAREE5 Unilateral Link - Rule The C unit holdings of each B entity in the C registry at the time the system B administrator announces the end of the link can be determined System B administrator can allow use of those units for system B compliance for a specified time, e.g., the end of the next compliance period System B entities could use system C units for compliance or sell them to system C entities Sale might be the only option for some C units; C units for future compliance periods or C units owned by B entities with no compliance obligations (a B entity of C trader?)

MARGAREE6 Unilateral Link - Administration System B administrator requires system B entities transferring C units into its account for system B compliance to demonstrate the quantity owned on the announcement date from C registry statements At end of the transition, system B administrator closes its account in the C registry

MARGAREE7 Unilateral Link – Market Impact Can not prevent speculation of a break-up, but announcement should be handled like currency devaluation; no comment until the moment (after markets are closed) of the announcement with great care to prevent leaks CCX termination of acceptance of Phase 1 EUAs did not disrupt the CCX market

MARGAREE8 Bilateral Link A bilateral link means system D accepts (some) units issued by system E for compliance and system E accepts system D units for compliance Registries are linked by a transaction log; system D(E) entities can hold both D and E units in their system D(E) registry account To use E units, a system D entity transfers them from its account in the system D registry to the compliance account in the system D registry

MARGAREE9 Severing A Bilateral Link A bilateral link might be only partially severed: System D might terminate acceptance of some system E units – Phase 1 but not Phase 2 EU allowances, sink enhancement but not emission reduction offset credits, etc. System D might terminate acceptance of all system E units, but system E might continue to accept system D units – the bilateral link becomes a unilateral link

MARGAREE10 Bilateral Link - Rule The E(D) unit holdings of each D(E) entity in the D(E) registry at the time the system D(E) administrator announces the end of the link can be determined System D(E) administrator can allow use of those units for system D(E) compliance for a specified time, e.g., the end of the next compliance period System D(E) entities could use system E(D) units for compliance or sell them to system E(D) entities Sale might be the only option for some E(D) units; E(D) units for future compliance periods

MARGAREE11 Bilateral Link - Administration System D(E) administrator prohibits system D(E) entities from transferring E(D) units into the system D(E) registry after the announcement date The transaction log is used to prevent further transfers of E(D) units into the D(E) registry

MARGAREE12 Bilateral Link – Market Impact Can not prevent speculation of a break-up, but announcement should be handled like currency devaluation; no comment until the moment (after markets are closed) of the announcement with great care to prevent leaks

MARGAREE13 Conclusions Link could be severed if environmental risks become too large Entities that own units of the delinked system could be allowed to use holdings on date of announcement for compliance by a specified date They could also sell the units to entities in the delinked system; sale might be the only option for some units (e.g., units for future periods)

MARGAREE14 Conclusions Severing a link is easy administratively Announcement should be handled like a currency devaluation Erik Haites Margaree Consultants