1. Emissions Trading: Background, Prior Programs and Implications for a U.S. Carbon Cap-and-Trade Program David Harrison, Jr., Ph.D. ALI-ABA Course on Clean Air: Law, Policy and Practice Washington, D.C. January 17, 2007

2. 1 NERA Economic Consulting 22 Offices Worldwide: 500 Economists, Over 600 Total Staff Sydney Tokyo Sao Paulo Chicago Denver San Francisco Los Angeles Boston New York City Philadelphia Washington, DC White Plains (HQ) Detroit Ithaca Madrid Rome Frankfurt London Brussels Paris Melbourne Shanghai

3. 2 NERA’s Environment Practice  NERA’s global environmental practice assists companies and governments in evaluating the effects of environmental policies  Wide-ranging experience in emissions trading and climate change programs –Acid rain trading, RECLAIM, NO x Budget/NO x SIP Call, state RPS –Regional Greenhouse Gas Initiative (RGGI) –California AB32 –Congressional carbon initiatives  Extensively involved in the development of the European Union Emissions Trading Scheme (EU ETS) for greenhouse gases –European Commission prior and ongoing work on initial allowance allocation –UK government development of National Allocation Plan –Evaluation of effects on electricity prices

4. 3 Agenda  What is cap-and-trade and what programs have been put in place?  What effects of trading programs do we care about?  What effects are common to most/all trading programs?  What are “obvious” elements that matter?  What are “less obvious” elements that matter?  What lessons does experience provide on the evolution of a U.S. greenhouse gas trading program?

5. 4 What is Emissions Trading?  Flexibility to find and to choose the lowest cost means for reducing emissions  Allows plants to transfer emission reductions from relatively high cost plants to lower cost plants (“trade”)  Works only when costs differ among plants  Assumes requirement to reduce emissions (“cap”) and effective enforcement

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8. 7 Non-CO 2 Emissions Trading Programs  Early EPA Emissions Trading Programs  Lead-in-Gasoline Trading  Acid Rain Trading Program (SO 2 )  RECLAIM (NO x and SO 2 )  Mobile Source ABT Programs  Northeastern NO x Budget Program

9. 8 European CO 2 Cap-and-Trade Program  European Union Emissions Trading Scheme (EU ETS) –All 25 EU Member States, with over 11,000 installations representing about 40 percent of EU CO 2 emissions –“Pilot” Phase I (2005-2007) and Phase II (2008-12) targets based upon National Allocation Plans (NAPs) of individual Member States  “Downstream” covering CO 2 emissions from five sectors: –(1) Electricity and heat generation; (2) Petroleum refining; (3) Ferrous metals industry; (4) Cement, glass, and brick industry; and (5) Pulp, paper, and board industry –Likely to be expanded to other sectors (e.g., aviation) and other GHGs  “Laboratory” for well-structured CO 2 cap-and-trade program

10. 9 EU ETS Overview of National Allocation Plans (NAPs) BAU BSA / “Kyoto Target” Non-Covered Sectors Government Purchases Covered Sectors ETS Facility Individual Sectors ETS Facility Individual Sectors ETS Facility Individual Sectors

11. 10 EU ETS CO 2 Prices Source: PointCarbon

12. 11 Movements in EU CO 2 Price  High allowance prices in 2005 surprising to most –Despite un-ambitious cap (0-4% below BAU) –Few projected prices over €10/tCO 2 before the program began –High oil/gas prices and other potential causes (low hydro, sellers waiting, strategic behavior for Phase 2) but much to be explained –Contrast to SO 2, where actual prices lower than expected (used by some to measure “success” of trading)  Phase I price collapse and strong Phase II in 2006/2007 –Several major countries’ reported 2005 emissions lower than allocation –Limited information on historical and projected emissions –Collapse of Phase I prices indicates no remaining scarcity in market –EC intervention to reduce Phase II cap has kept prices higher, but significant uncertainty remains about future developments

13. 12 Similar Volatility in U.S. NO x Market  Will EU Phase II CO 2 prices look like these?

14. 13 Linkages Between CO 2 Price and Electricity Prices  Electricity price rise with CO 2 price rise led to concerns for “windfall profits”  Fall in CO 2 price coincided with fall in UK electricity prices Source: PointCarbon

15. 14 Significance of EU ETS Thus far  In Europe –EU ETS a major “learning experience” for EC and Member States –CO 2 prices and electricity prices – future uncertainties/volatilities and importance of electricity liberalization suggest actions premature –“Got peoples’ attention” – process for post-2012 NAPs (both caps and allocations) complicated in light of international interest –“Jury still out” on extent of emissions reductions during pilot phase  U.S. and Rest of the World –Shows continent-wide carbon trading regime can be set up –Global support for emissions trading, putting spotlight on CDM –Implications for potential U.S. cap-and-trade program

16. 15 Effects We Care About for U.S. Cap-and-Trade Program for CO 2 1.Overall performance of the trading program –Cost savings and incentives for innovation –Environmental (emissions) cap/targets –Workability of the program 2.Distributional impacts of the program –Trading participants (sectors, firms) –Others (e.g., electricity users, fuel producers, taxpayers)

17. 16 Effects Common to Most/All U.S. CO 2 Cap-and-Trade Proposals  Common features –Shift from legal-engineering to market-based approach –Basic architecture of a cap-and-trade program –Potential for cost savings relative to “command-and-control” approach  Implications of common features –Actual cost savings depend on program design –Other major differences are stringency of targets (i.e., cap) and distributional impacts

18. 17 Some “Obvious” Design Elements That Matter  Coverage (sectors, sources)  “Upstream” versus “downstream”  Stringency of cap (relative to BAU)  “Safety valve” to constrain price  Ability to use “credits” as substitute for allowances  Allocation elements (auction vs. free, metric, years)  “Banking” (and “borrowing”) provisions

19. 18 Some “Less obvious” Design Elements That Matter  “New entrant” reserve and other “updating” features –Can affect price-cost pass-through and distributional impacts (as well as cost-saving potential)  Interactions with other programs –RPS (“green certificates” in Europe) affect electricity price impacts  Linking of programs –Linking “imports” features of other program (e.g., “safety valve”)  Electricity regulatory treatment –Affects electricity price effects (and can affect overall cost-savings)  Details of auctioned/allocated elements –Hybrid versions/trajectories over time/”recycling” of revenues

20. 19 NERA Carbon Financial Impacts Model to Clarify “What is at Stake” in Design Choices NERA Carbon Financial Impacts Model CO 2 Program  Regulation (Cap, Tax) and Stringency  Point(s) of Regulation  Allowance Allocation / Tax Exemptions  Modeling Assumptions Characteristics of Company Facilities  Production  Fuel and Electricity Inputs  Fuel and Process CO 2 Emissions Market Impacts of Program  CO 2 Emissions and Allowance Prices  Fuel Prices  Electricity Prices  Product Prices  Changes in Costs –CO 2 Costs –Increases in Energy Costs  Changes in Revenues –Product Revenues –CO 2 Allowance Allocation  Change in Net Revenues (Revenues – Costs ) The NERA Carbon Financial Impacts Model combines data on company facilities and on the CO 2 program using NEMS market modeling and other information to provide estimates of changes in company/sector costs and revenues

21. 20 Looking Ahead: Lessons/Implications from U.S. and European Experience 1.“Substance” lessons/implications –Cost savings are substantial from trading (vs. “command-and-control”) –Cap-and-trade approach better than “credit” trading 2.“Process” lessons/implications –Allocation process contentious but doable –Importance to both stakeholders and government officials of “clarifying what is at stake” –Program design not “once and for all” set of decisions

22. Contact © Copyright 2006 NERA Economic Consulting All rights reserved. Dr. David Harrison, Jr. Senior Vice President Boston +1 617 621 2612 David.Harrison@nera.com