Emission Caps and Flexibility Mechanisms A. Denny Ellerman Center for Energy and Environmental Policy Research Massachusetts Institute of Technology Regional Greenhouse Gas Initiative Boston, Massachusetts May 20, 2004

A. Denny Ellerman Page 2 TOPICS The Essentials of Emission Caps Within-system Flexibility Off-system Flexibility –Mutual recognition –System extension –Off-system credits Concluding Points

A. Denny Ellerman Page 3 Essentials of an Emissions Cap Decision on an emissions cap and allocation of equivalent rights to emit (allowances) Monitoring and reporting of emissions Periodic reconciliation of emissions and allowances –Surrender of allowances –Penalties for non-compliance

A. Denny Ellerman Page 4 Redefining Compliance A very simple compliance requirement –One ton  One allowance –Plus monitoring and reporting No specific instruction to abate for any source Strict accountability and complete flexibility –A “no excuse” system Only issue is allowance availability and cost

A. Denny Ellerman Page 5 Within-system Flexibility The sine qua non: No review of trades –But trades are tracked or recorded Spatial flexibility within a compliance period is always accepted Temporal flexibility (banking/borrowing) between periods is less so –No reason to prohibit banking –Ditto for borrowing, but more problematic

A. Denny Ellerman Page 6 More on Borrowing Remember system is enforced, now and in the future –Using more now means fewer later Cannot allow infinite borrowing –Limit to x years forward Or, apply discount to future vintage allowances surrendered in current reconciliation Objective is reducing price volatility

A. Denny Ellerman Page 7 Off-system Flexibility No environmental reason (for GHGs) to limit abatement to within-system sources Only requirement is that off-system “rights” be as good as within-system allowances –Or, that they be “real” or “additional” Implies effective extension of system to off- system sources

A. Denny Ellerman Page 8 Mutual Recognition Option Some other equivalent system exists Both may recognize similarity and allow trading (as with any commodity) Main criterion is “integrity” of other system Note, however, that any trading inevitably –“Loosens” one cap and –“Tightens” the other cap

A. Denny Ellerman Page 9 System Extension Option Off-system source is brought within the system –Baseline is established and allowances issued –Emissions are monitored and reported –Emissions and allowances are reconciled Easy to see for within-jurisdiction opt-in sources –Example: US SO 2 emissions trading Cap is “loosened,” but scope is extended

A. Denny Ellerman Page 10 Off-system Credit Option “Real” abatement is credited and traded Recognition of “credit” implies –Definition of a baseline for off-system source –Monitoring of emissions and implicit reconciliation to determine quantity of credits Only difference is system allowances not issued and required to be surrendered for emissions –Recognize only the “surplus” allowances

A. Denny Ellerman Page 11 Problems with Off-system Credits “Anyway tons:” Adverse selection and information assymmetry are unavoidable problems –The same problem is faced (and solved) in within-system allocation –Various ways to minimize problem (e.g., no in- and-out opt-ins) Transaction costs are likely to be high Can be delegated: CDM or other certifying agency

A. Denny Ellerman Page 12 How to Treat Off-system Credits The Wrong Approach: Arbitrary limits –Assumes off-system credits are worthless or not equivalent –Pointless loosening of the cap The Right Approach: Open but tough –Problems of off-system credits can be solved –“The customer is always right” Always an extension of the system

A. Denny Ellerman Page 13 Off-system Flexibility in Perspective Initial caps are unlikely to be very demanding –This implies relatively low prices Low prices do not encourage extensive off- system reliance (unless they are free!) –Transaction costs of open but tough system will limit reliance on off-system credits No more “loosening” of cap than in recognizing another system with a lower price

A. Denny Ellerman Page 14 Concluding Points Flexibility is the way to success and low cost Flexibility is possible only with strictly enforced binding caps All provisions for off-system flexibility must involve the application of within-system standards RGGI will be successful only if it sets an example and induces others to follow by adoption of simple, practical, and effective rules