In the early days of the development of the EU Emissions Trading System (EU-ETS) a number of industry groups, particularly in the energy intensive sector (e.g. cement, metals) put forward an alternative design known as “baseline-and-credit”. This was widely discussed and strongly advocated by some, but never gained traction with the EU Commission and was ultimately rejected as a viable way forward.
Baseline-and-credit is fundamentally different to cap-and-trade, in that no cap exists within the system. Rather, individual facilities are assigned a benchmark CO2 per unit of production (or it could be against some other specific production related metric) and must either buy credits in the market if the facility is short for the compliance period or are awarded credits by the government if the facility exceeds the benchmark. Offset project credits may also form part of the mix as they often do in traditional cap-and-trade approaches.
Since then, baseline-and-credit has been applied in a limited way in Alberta, Canada and did actually run for a few years in the United Kingdom in some sectors. Otherwise, the focus has been on cap-and-trade. But baseline-and-credit keeps rearing its head and has done so again in Australia very recently as the debate over the CPRS (Carbon Pollution Reduction Scheme) continues.
This then raises the question, yet again, as to whether such an approach can be the basis of a workable emissions trading system. Whilst baseline-and-credit seems to have all the components necessary for a viable market, (i.e. a tradable unit, supply, demand), the reality of trying to build such a system is very different. A number of obstacles present themselves:
- Of primary importance is that there is no overall cap on emissions. This is what really drives demand and creates the necessary scarcity to see a price develop. Whilst individual facilities may have a benchmark target, actual emissions from the system remain unknown until the level of production is known. If production is high, total emissions from the covered sector may even rise, even though the intention of the government is to drive emissions down. This means that delivering a specific environmental outcome cannot be guaranteed.
- A linked issue to the lack of a cap is that the government probably has one, perhaps in the form of a pledged reduction target for the nation as a whole. If production is high and emissions rise, the government will be forced to rachet down the benchmark, creating uncertainty for the scheme participants. Alternatively, the performance risk for the nation as a whole could rest with the government, which might then have to step in and buy international allowances to meet a cap such as that pledged under the Kyoto Protocol.
- The approach is built on the assumption that benchmarks are available and easy to establish. Whilst this may be true for some sectors, it is far from true for others. Chemicals is a good example, where one site may be comprised of many different processes and as such unlike any other single chemicals site. A related issue comes from attempting to find equality between sectors – i.e. how do I know that my benchmark for the cement sector is equivalent in difficulty to achieve as my benchmark for the steel sector?
- The world is progressing towards absolute numbers and developed countries are taking the lead in this respect. This means that national obligations must all eventually be in the form of absolute numbers and developed countries today are now targeting between 15 and 20% reductions in absolute emissions by 2020 from 2005. As discussed above, governments would rather not have to manage compliance, so they will cascade the obligation down into the economy as much as possible. This means that many nations will use cap-and-trade and will seek to link these with other cap-and-trade systems to increase flexibility and lower overall compliance costs. But a baseline-and-credit system cannot fully link with a cap-and-trade system given that one has an overall cap and the other doesn’t. The UK tried to link two such systems some years back and had to implement a complex gateway. Whilst the baseline-and-credit system can always buy from the cap-and-trade system, the reverse is not the case. A supply of credits from a baseline-and-credit system that has overall emissions rising due to increased production may undermine the environmental objective of the cap-and-trade system it is linked to (hence the UK gateway).
- A cap-and-trade system works its way progressively along the abatement curve, always implementing the next best reduction opportunity. This may be an efficiency measure, a CCS project or possibly a reduction in demand for a given product as a cheaper alternative (lower carbon footprint) is found. By contrast, the baseline-and-credit system may distort this progression along the abatement curve, driving up the overall cost of compliance for the economy as a whole. Whilst the system favours production and encourages efficiency measures, the hard truth may be that the most effective way to reduce emissions is through demand destruction and replacement of certain products and not through improved efficiency of existing production capacity.
- Lastly and perhaps most importantly, a trading system must deliver a liquid market. The ensures efficient price discovery, sufficient depth to execute large trades and the development of a forward curve – all important criteria to support investment. But the development of a liquid carbon market is hampered by the very design of baseline-and-credit. This has been seen in practice in systems that have come and gone, where trade was negligible and the price feeble at best. Up front allocation of allowances delivers a tradable commodity into the market early on, allowing future prices to develop – a critical component of overall trade in the energy sector. By contrast, baseline-and-credit delays crediting until after the event, which limits future trade. Many companies will simply not even entertain the notion of trading something they don’t yet have.
Cap-and-trade is the proven performer. It has delivered successfully in the US Acid Rain Program and has created a robust and growing carbon market in the EU. We need to create more systems of this design if we want to reduce emissions at lowest overall cost to the economy and have any chance of a global market in the years to come.
Sorry for the rant, this is an important topic to share and your points bring up a lot of priorities we need to address before this proposal gets a ‘first pass for plight’…
Very true statement: “We need to create more systems of this design if we want to reduce emissions at lowest overall cost to the economy and have any chance of a global market in the years to come.”
Yet the ‘Acid Rain Program’ is a much different beast and the ‘carbon market in the EU’ is a blueprint of failure when the world was not in a fiscal collapse or peak energy period.
David, I know you believe and know as much as I do that we have very little time (in bureaucracy years) to become energy independent and reduce the destructive manmade influence on our environment and its inhabitants.
But, for four decades we have failed biblically at this.
In the ‘grand scheme of things’ we can not fail this time. Four decades ago we always had ‘x’ amount of oil, coal, uranium and other finite resources to fall back on when our next ‘scheme failed’.
Remember energy independent (or insert fav program name here) by 2000?
It is not that ‘Cap-and-trade’ is a horrible idea or option, just the way we are ‘proposing doing it’ make even energy tax programs look ‘promising’
Facts are that the proposed Cap-and-trade will do very little to reduce global energy consumption or help the environment resulting in “slightly less new renewable energy generation capacity by the year 2020 than if the U.S. continued on a business-as-usual path with no emissions caps”*. And inarguably “U.S. action alone will not impact CO2 levels”
NOTE: non-OECD countries do not have the efficiencies, regulations, funding or incentive to join and now the are the largest (and growing) CO2 and global emission generators exceeding ALL OECD countries. Not to mention the massive energy demand gap this program is not filling. JUST the U.S. needs 119QBTu by 2030… how much do the others need or get?
‘I get it’ in understanding that continuing with the ‘do nothing until better ideas come along’ has failed and makes most state that ‘Cap-and-trade’ is better than nothing.
But, with the Trillions in global economies at stake this time in the hardest fiscal state many have seen… it has to be right this time.
I am just asking you and all energy experts not to compromise the ‘good idea and intentions’ of this kind of program and ask the same to collaborate and produce a written dialogue of better options to submit to the house before we make another biblical mistake in the fall.
Most environmental and energy experts who oppose and supportive this system see the obvious problems and ‘hope’ the market will join or work with them to succeed in the long run and have other nations buy into the scheme. Most knowing that non-OECD never will and never could under this plan.
After working with chemical industry leaders for two decades I do believe we can work together with the environmental and energy groups to develop a vastly better proposal for our government that continue to make America the worlds energy and environmental leader that brings historic prosperity and independence to all nations through these efforts
Thank you for openly sharing yours and shells thoughts on this blog, it is not easy to publicly make statements and go against the crowd to make the right choices… but nothing worthwhile in this world ever is easy.
P.S. Oh please do not get me started on CCS options… I really enjoy reading your blog.
* EPA acknowledged and by published at house.gov
Thanks for your comment, but it’s not clear to me from this what you think should be done instead. I can’t agree with your view that the EU approach is a failure – it has barely had time to get going. Don’t forget cap-and-trade is a 40 year policy instrument – it isn’t going to deliver anything very noticable in 2-3 years.
Thank you for your points. It is true that I should not be the judge of ‘failure’ as it has many levels. History will.
And my rant did deviated a little from the message…
‘create international trade & industrial collaborative group to draft a better program’. A program so strong all nations would want to voluntarily join due to the massive savings in resources and increases in trade and GDP’s.
If 40 years of policy has not reduced energy dependency, emissions or finite resource depletion what makes us think that continuing with this model will.
In 2-3 or 20-30 years the current policy will have little to no impact on global resources or reductions and has the ‘potential’ of the opposite.
I am thrilled that we are this closed to making program to reduce environmental impact and energy use. But the U.S. program falls very short of this.
ALL nations need to be in the program and policy for any ‘real progress’ in reductions. Otherwise this is just a ‘plight for profit and power’.
I strongly believe (and am calling for) international trade and industrial groups to collaborate on a open draft policy that includes all nations of influence (and affected).
The strong positive points and obstacles in your post are valid and many will not be addressed in current policy.
It is critical we address them.
This is debated everywhere on the internet and news being talked to death… I chimed in on yours as I felt Shell, as a world renewable and energy leader, could open this idea to bring a international collaborative group together before we waste any good intentions or momentum of current ideals.
We are at a pivotal point to bring progress and prosperity or enter a decade decline and volatility.
Thanks again David for bringing attention to the important points in this policy and entertaining my rant on your blog.
Your work and patience is appreciated.