The Fight Against Global Warming: Another Way States Can Rein in Greenhouse Gas Emissions

The U.N. Intergovernmental Panel on Climate Change (IPCC), which shared this year's Nobel Peace Prize with Al Gore, recently released a report detailing the negative environmental changes that will result from climate change, including higher temperatures leading to increased deaths from more severe heat waves, increased incidence of infectious diseases, and severe damage to ecosystems. The IPCC report warned that there were only eight years left to act to prevent the worst effects of global warming. 

However, it turns out that the IPCC may have been too optimistic.
Carbon dioxide, the most common greenhouse gas, is accumulating much faster in the atmosphere than predicted, according to the most recent estimates. Carbon dioxide emissions sharply increased for the fourth year in a row in 2006.

The simple fact is that carbon emissions need to be reduced and they need to be reduced now, a sentiment echoed in a recent CNN poll that found 66% of people polled think that the U.S. should do what it can to fight climate change. 

This Dispatch will highlight one key tool states can use to decrease emissions: cap and trade systems, where the total emissions allowed in a state or region are capped and industrial plants are required to buy emission credits when they exceed their allocated emission limits. We've highlighted other ways states can fight climate change and cap and trade is another example. We'll begins with an overview of the idea behind cap and trade systems and how it is currently being used, then discuss how states can move towards better models of cap-and-trade, including auctioning off credits to polluters to raise revenue for energy efficiency programs and to reduce taxes for consumers.

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Current Cap-and-Trade Plans in the States

The idea behind cap and trade is simple: the system sets a cap on the total amount of emissions allowed for an industry or area. "Emissions allowances" are distributed amongst the industry or area totaling the agreed upon cap on emissions, basically an "allowed emissions" credits. These credits can then be traded in the market, giving an economic incentive to reduced emissions.

For example, a company that emits carbon dioxide is assigned a limit on emissions and a target for emissions reductions. If they are able to cut their emissions below their targets, the company retains extra credits which they can sell to others who exceed their targets. Those that exceed their emissions allowance have to buy allowances from other companies or pay high fines. The system allows businesses to choose the most cost-effective way to deal with their emissions, either through efficiency measures or by buying available credits.

The idea of cap and trade is not new in the U.S. Under the 1990 Clean Air Act, a cap and trade system was implemented for sulfur dioxide emissions as a way to combat acid rain. The market cost for sulfur dioxide allowances was much lower than expected and in the 1990s, the program achieved 100% compliance in reducing sulfur dioxide emissions. The long-term costs of the program were also far below early projections. Cap and trade has also been successful in decreasing NOx emissions.

The Regional Greenhouse Gas Initiative (RGGI): The first mandatory cap and trade program for carbon dioxide emissions at the state level is the Regional Greenhouse Gas Initiative (RGGI). Currently, RGGI focuses only on decreasing carbon dioxide emissions from power plants, but may expand to include other greenhouse gas emissions. Earlier this year, Maryland joined Connecticut, Delaware, Maine, New Hampshire, New Jersey, New York and Vermont as a participating member of the initiative. California is also exploring ways to join RGGI and the District of Columbia, Massachusetts, Pennsylvania and Rhode Island are observers in the process.

Beginning in 2009, carbon dioxide emissions from power plants in the region of participating states would be capped at 121 million tons annually. This amount will remain the same until 2015. Starting in 2015, the states will then begin to reduce their emissions incrementally over a four-year period to reach a 10% reduction by 2019. Compared to the emissions increases that would occur without the program, RGGI will result in a reduction of approximately 35% by 2020.

Once the program is implemented, states will issue an allowance, or permit, for each ton of carbon dioxide emissions allowed by the cap. Each operating plant will be required to have adequate allowances to cover its reported emissions. The plants can then buy or sell allowances, depending on their emissions, but an individual plant's emissions cannot exceed the amount of its allowances. In other words, if a plant cannot lower its emissions to the designated level, it must buy allowances from a plant that is under its allowance limit. Plants that decrease their emissions below their alloted allowances can make money by selling off their extra allowances to a plant that has exceeded their allowances.

The RGGI states will allot at least 25% of a state's allowances to a strategic energy or consumer benefit purpose, such as energy efficiency, new clean energy technologies, or rate-payer rebates. These allowances could also be purchased by a power plant for its own uses with the funds generated from the sales to be used for beneficial energy programs. 

The RGGI program also allows power plants to use "offsets" -- greenhouse gas emissions reduction projects from outside the electricity sector -- for up to 3.3% of their overall emissions. Under the model regulations and the Memorandum of Understanding signed by the participating states, these offset credits may come from anywhere in the U.S. 

Western State Governors' Action:  Earlier this year, governors from Washington, Oregon, California, Arizona, and New Mexico signed the Western Regional Climate Action Initiative, requiring the five states to:

  • Set an overall regional greenhouse gas (GHG) reduction goal by August 26, 2007
  • Design a regional market based multi-sector program to achieve GHG reductions by August 26, 2008
  • Establish a multi-state registry to track GHG emissions and credit companies for reductions

It should be noted that the Western State Governors' action does not necessarily require implementation of a program by August 2008. One concern is that because Nevada did not sign onto the initiative, California would lose business to the relatively low-regulation neighbor state. 

Chicago Climate Exchange: The Chicago Climate Exchange (CCX) began trading allowance credits in 2003 and is the only emissions reduction and trading system for all six greenhouse gases. CCX members make voluntary, but legally binding, commitments to meet annual GHG reduction targets. Those who have surplus allowance can sell or save their allowances. Those that emit above their targets can reach compliance by purchasing CCX Carbon Financial Instrument contracts, or allowances, equivalent to 100 metric tons of carbon dioxide. CCX has nearly 300 members participating in their program. Several counties and cities participate in the Chicago Climate Exchange program, including King County, WA; Miami-Dade County, FL; Sacramento County, CA; Aspen, CO; Berkeley, CA; Boulder, CO; Chicago, IL; Oakland, CA; and Portland, OR -- each of which made a binding commitment to reduce their emissions.

Individual State Plans: Several states have adopted their own schemes to do their part. Illinois, for example, adopted an Emissions Reduction Market System to reduce Volatile Organic Compound emissions to help decrease ozone emissions. In the first year of the program, emissions were reduced 48% below their alloted emissions. "The Emissions Reduction Market System has consistently exceeded expectations and goals and continues to be an effective tool in improving air quality in the Chicago region," said Illinois EPA Director Renee Cipriano. In addition to exploring a regional system, California and Oregon are exploring individual state-wide cap and trade system.

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Lessons from Europe's Cap-and-Trade Experience

In implementing state cap-and-trade plans, we can learn from the experience of the European Union's Emission Trading Scheme (ETS), which is the largest multi-country, multi-sector greenhouse gas emissions trading scheme world-wide. The EU's cap and trade system started in the 25 EU member states on January 1, 2005 to help member states meet their Kyoto Protocol obligations for greenhouse gas reductions. As a result:

  • Companies in Europe established carbon dioxide budgets and management systems for the first time.  
  • A whole new business sector emerged as a result of the carbon market, including carbon traders, carbon finance specialists, carbon management specialists, and carbon auditors and verifiers. 
  • More importantly, because carbon dioxide now has a price, companies are investing resources in identifying cost-effective ways to reduce their emissions.

The program is run in two phases. Phase 1 running through the end of this year was intended as a trial period to work out the kinks in the system with Phase 2 running from 2008-2012. Now that the first phase is coming to an end, reviews of the scheme have found it to be successful overall in reducing carbon dioxide emissions. However, governments did issue too many allowances, flooding the carbon markets and causing the price of allowances to plunge. Because governments simply gave away allowances to existing polluters, the result was a carbon market that was not as competitive as it should have been.

The EU is working to rectify this mistake as they enter into Phase 2 of the scheme. The European experience highlights several lessons to be learned. First, allocation rules should be as simple and transparent as possible to keep administrative costs down. Second, governments should avoid setting overly generous caps for polluters.

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Auctioning Emissions Versus Giving Existing Polluters a Free Ride

The biggest lesson from the European experience is the importance of auctioning credits to raise revenue that can be devoted either to energy efficiency plans or to strengthen non-polluting parts of the economy, rather than simply giving allowances away. 

As a recent Congressional Budget Office report indicated, giving away allowances is less efficient and creates windfall profits for existing polluters:

For example, one study estimated that a 23 percent cut in CO2 emissions could cost the economy nearly twice as much if allowances were given away than if they were sold and the revenues used to cut taxes...[G]iving away allowances could yield windfall profits for the producers that received them by effectively transferring income from consumers to firms' owners and shareholders.

Revenue from auctions of carbon dioxide emissions could be used to both fund other energy efficiency programs and reduce taxes for working families, thereby off-setting any higher energy prices due to emission limits. A wide-range of economists from both the left and the right have emphasized the efficiency gains from auctioning credits. One of the most prominent advocates of auctioning off emission credits is N. Gregory Mankiw, the Chairman of President Bush's Council of Economic Advisers from 2003 to 2005, who argues for making sure that polluters pay for the costs of their pollution, what economists call a Pigovian tax. As Mankiw wrote recently criticizing cap-and-trade plans that do not auction off allowances:

Why should an electric utility, for example, be given a valuable resource simply because it has for years polluted the environment? That does not strike me as equitable. A new firm entering the market should not have to pay for something that an incumbent gets for free...Cap-and-trade systems [waste] the opportunity to use the tax revenue to reduce distortionary taxes on labor and capital.

If the pollution rights are auctioned off rather than handed out, then cap-and-trade systems are almost identical to Pigovian taxes, including all the desirable efficiency properties.

U.S. PIRG this summer released a report, Cleaner, Cheaper, Smarter, that also emphasized the gains from auctioning pollution allowances. The push for requiring such auctions is backed by a wide range of organizations, from the Sierra Club to the Consumer Federation of America to Public Citizen. 

Several states, including New York, Massachusetts, Maine and Vermont, have committed to auctioning 100% of their pollution allowances under the RGGI system, and other states appear likely to do so as well. At the national level, Presidential candidates John Edwards and Barak Obama have both called for auctioning off some or all emission credits in their proposals for national cap-and-trade systems. 

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Other Tools to Strengthen Cap-and-Trade Goals

Revenues from auctioning emission credits can help fund other energy efficiency programs, which is important since preliminary modeling indicates that such programs are key to cap-and-trade successes. A recent study found that doubling the current level of energy efficiency spending would have many favorable effects on the cap and trade system, including reducing electricity load growth, future electricity prices, carbon emissions, carbon emission prices and total energy bills. This is not a difficult or onerous proposition, however, as thirteen states already have an Energy Efficiency Resource Standard (EERS), a market-based mechanism to encourage energy efficiency. Texas, for instance, requires electric utilities to offset 20% of load growth through energy efficiency.

Along with exploring cap-and-trade markets, Oregon and Washington have actively implemented direct regulatory programs to reduce greenhouse gas emissions. Oregon ultimately passed a commitment to decrease emissions by 75% by 2050 with either a statewide or regional cap and trade program to help reach the target. Washington passed a target of reducing statewide emissions to 50% below 1990 levels by 2050.

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Inevitably, there will be some increase in energy prices when a cap and trade system is implemented because the use of fossil fuels, the main creator of greenhouse gases, will be restricted. However, the cost of not decreasing carbon dioxide emissions will be much greater. The damage due to climate change effects of famine, rising sea levels, storms, and other environmental damage is estimated at $9.6 trillion. The Union of Concerned Scientists projects that greenhouse gas emissions must be cut by at least 80% by 2050 to have even a 50-50 chance of avoiding the worst consequences of global warming. An effective cap and trade system, combined with revenue-raising auction of pollution allowances, is a key way to ensure that these goals are met.

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