Swedish Carbon Tax Program

In Sweden, carbon is taxed both directly on each emitted unit of CO₂ and indirectly (and imperfectly) via an energy tax on fossil fuels that is not based on their carbon content. The carbon tax was introduced in Sweden in 1991 as a complement to the existing system of energy taxes, and the existing taxes were simultaneously reduced by 50 percent.

When the European Union Emissions Trading Scheme (EU ETS) was introduced in 2005, some sectors were covered both by the carbon tax and by the EU ETS. Most emissions from the transport sector and from households were excluded from the EU ETS, but were covered by other taxes. To avoid double regulation, the government decided to exempt the industries covered by the EU ETS from the carbon tax. Hence, all sectors are now covered by a carbon price, but it varies greatly across firms and sectors, with some activities being fully exempted. Although it is covered by the EU ETS, electricity production faces neither energy nor carbon taxes, but a special electricity consumption tax is levied on households.

This mixed system has been effective in reducing emissions. According to the Swedish Ministry of the Environment, Swedish greenhouse gas (GHG) emissions fell by almost 17 percent during the period from 1990–2009, mainly through fuel substitution. The share of renewable energy has increased from 34 percent in 1991 to 44 percent in 2007 and is among the highest in Organization for Economic Cooperation and Development (OECD) countries. Electricity is now almost CO₂ free with hydroelectricity and nuclear power accounting for more than 90 percent of electricity generation.

The carbon tax is considered to have caused emission reductions mainly in the residential sector (largely by promoting district heating, which is more efficient than localized heating) and has diminished the historic trend of increasing emissions in transport. Experts believe that the carbon tax’s impact on industry is probably small due to the many exemptions granted.

British Columbia Carbon Tax Program

Implemented in 2008, the carbon tax in British Columbia, Canada, is imposed on each tonne of CO₂ equivalent (CO₂-e) emissions from the combustion of each fuel. In this case, CO₂-e is the amount of CO₂, methane, and nitrous oxide (N₂O) released into the atmosphere. The non-CO₂ emission levels are adjusted to a CO₂ equivalent basis using global warming factors. Fuel for commercial aviation as well as for cargo and cruise ships is exempted. This program covers an estimated 77 percent of total GHG emissions in British Columbia.

Administratively, the carbon tax is applied and collected at the wholesale level in essentially the same way that the province collects its motor fuel taxes, a strategy that makes administration easier. The tax is ultimately passed forward to consumers.

All revenue generated by this revenue-neutral carbon tax is returned to Canadians residing in British Columbia through tax cuts. The first two personal income tax bracket rates were reduced by 5 percent on January 1, 2008. To attempt to protect low-income households, the Low Income Climate Action Tax Credit program provides adult residents with lump sum tax credits that are reduced by 2 percent of net family income over specified income thresholds.

European Union Emissions Trading Scheme

Launched in 2005, the EU ETS is the largest emissions trading system in the world. The EU ETS now operates in 30 countries (the 27 EU member states plus Iceland, Liechtenstein, and Norway). It covers CO₂ emissions from installations such as power stations, combustion plants, oil refineries, and iron and steel works, as well as factories making cement, glass, lime, bricks, ceramics, pulp, paper, and board. Between them, the installations currently in the scheme account for almost half of the EU’s CO₂ emissions and 40 percent of its total GHGs.

The EU ETS established a cap on the total amount of certain GHGs that can be emitted by liable entities. Within this cap, companies receive emission allowances, which they can sell to or buy from one another as needed. The number of allowances is reduced over time so that total emissions fall. By 2020, emissions are targeted to be 21 percent lower than those of 2005.

While the scheme currently covers only CO₂ emissions, the scope of the ETS will soon be extended to include other sectors and other GHGs such as N₂O and perfluorocarbons. Pending the outcome from legal challenges, airlines are expected to join the scheme in 2012. Expansion to the petrochemicals, ammonia, and aluminum industries and to additional gases is expected in 2013. In 2013, the scheme will also begin to auction off allowances, with the ultimate goal being to attain full auctioning by 2027.

Regional Greenhouse Gas Initiative

In 2009, ten states—Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island, and Vermont—launched the first market-based regulatory program to reduce GHG emissions in the United States. Through the Regional Greenhouse Gas Initiative (RGGI), each participating state caps CO₂ emissions from power plants, auctions CO₂ emission allowances subject to a price floor, and invests the proceeds in strategic energy programs that may further reduce emissions.

In retrospect, this program imposed a rather weak cap, but expectations about tighter caps in the future, coupled with very favorable natural gas prices that made a rapid transition to lower carbon fuels cost-effective, apparently led to dramatic declines in emissions. By the end of 2010, the second year of the program, emissions were 27.1 percent lower than the cap and 25.6 percent lower than the year the program was announced (2005). While the recession played some role in this decline, economic analysis suggests that the main source of the reductions was fuel substitution, promoted by lower natural gas prices. During the period 2005–10, electricity generation from residual fuel oil fell 95 percent, generation from coal decreased 30 percent, and natural gas generation increased by 35 percent.

RGGI states allocate a large proportion of the money specifically to promote energy efficiency (e.g., weatherizing buildings and incentivizing investments in new technologies offering much more energy-efficient lighting). Analysis has found that energy efficiency is now the most cost-effective tool for reducing GHG emissions in this region in the near term.

The politics of using the money for energy efficiency is illustrated by noting what happened to public support for the program in the states within the RGGI that (in direct contradiction to program intensions) diverted money that was originally targeted at energy efficiency to the general treasury for deficit reduction. New York took $90 million during the fall of 2010, roughly half of its fund; New Jersey zeroed out its fund, taking all $65 million; and New Hampshire, a much smaller state, took $3.1 million. Since diverting the funds undermined a major source of political support for these programs, diversion triggered a withdrawal from RGGI by New Jersey. An attempt to withdraw by the New Hampshire legislature was only thwarted when the governor vetoed the legislation.

RGGI has a price floor (approximately $2 per tonne), which is indexed to remove the effects of inflation, and (due to the surplus of allowances created by the large emissions reductions relative to the cap) that floor has been binding. In fact, the floor has played a major role in the region because revenue from the auctions is an important source of funding for the popular energy efficiency programs. Without that floor, a considerable amount of funding would have been lost, thereby creating a source of instability in the regional energy efficiency market.

Australian Hybrid System

The Australian plan envisions a two-stage transition from a carbon tax to an emissions trading market:

• In the first stage, lasting from July 1, 2012, until June 30, 2015, emitters will face a fixed price for each tonne of CO₂ emitted. The price will start at $A23 (US$23.81) per tonne and will rise at 2.5 percent per annum in real terms.

• On July 1, 2015, the fixed carbon price regime will transition to a fully flexible price regime with the price determined by the emissions trading market.

While half of a source’s compliance obligation must be met through the use of domestic permits or credits, after the commencement of the flexible price period, offsets from credible international carbon markets and emissions trading schemes may be used to fulfill the remaining obligation.

A price ceiling and floor will apply for the first 3 years of the flexible price period. The price ceiling will be set at $A20 (US$20.70) above the expected international price and will rise by 5 percent in real terms each year. The price floor will be $A15 (US$15.53), rising annually by 4 percent in real terms.

While coverage under the emissions trading market will be quite broad, it will not be universal. Four of the GHGs covered by the Kyoto Protocol—CO₂, methane, NO_x, and perfluorocarbons (in this case from aluminum smelting)—will be covered. Transport fuels will be excluded, but an equivalent carbon price will be applied to domestic aviation, domestic shipping, rail transport, and nontransport use of fuels. No carbon price will apply to household transport fuels, light vehicle business transport, or off-road fuel use by the agriculture, forestry, and fishing industries. Agricultural emissions will also be exempted.

Of the potential revenue derived from 2011–15, more than 50 percent will be used to reduce the cost burden on households. Assistance will be delivered through the tax and transfer system. To reduce the regressivity of the burden, the government will also target the assistance to low- and middle-income individuals by more than tripling the statutory tax-free threshold for personal income taxes.

Some revenue has also been specifically targeted to facilitate the transition for highly impacted firms. An Energy Security Fund will oversee two main initiatives: (1) payments for the closure of around 2,000 megawatts of coalfired generation capacity by 2020 and (2) transitional assistance to highly emissions-intensive, coal-fired power stations in the form of a limited free allocation of Australian carbon permits and cash until 2016/17, estimated to be worth $A5.5 billion.

Other initiatives that use revenue generated by the program will focus on job promotion and promoting both renewable energy and energy efficiency.

Instrument Choice

Older public discourse frequently framed the instrument choice as deciding whether carbon taxes were superior to emissions trading or vice versa. In practice, it is now more common to frame the issue in terms of how they can best be combined.

For example, these two instruments can be used sequentially, where one instrument is used initially until a transition to the second instrument is completed. Some evidence, which we will discuss, suggests that emissions trading markets take a while to mature. To make sure that these early markets do not produce volatile or unstable prices, it is possible to start with a tax regime that produces known, stable prices until such time as participants become sufficiently familiar with abatement choices and their costs that an emissions market can take over. Australia’s plan to impose a carbon tax to take effect in mid-2012, for example, is expected to pave the way for a transition to a carbon trading system where prices would be determined by the market by mid-2015.

These instruments can also effectively be used at the same time but applied to different sectors. It is not a coincidence that emissions trading systems, such as the EU ETS and RGGI, target larger sources, while taxes have been typically targeted on more diffuse sources such as residential or transport emissions. In the Australian emissions trading plan, for example, sources not covered by the cap will be controlled by an equivalent carbon price. Similarly in Sweden, household and transport emissions are controlled largely via taxation and large enterprise emissions are controlled via the EU ETS. This can be perfectly consistent with optimality as long as the resulting prices in the two systems are, in fact, equivalent

Finally, the two instruments can be combined to form a hybrid instrument. One well-known example, the use of a price collar with emissions trading, is mentioned in Chapter 1, and we also discuss it more in the section in this chapter on price volatility.

Scope of Coverage: Gases and Sources

Gases. The Kyoto Protocol envisions that all six named GHGs could be simultaneously controlled with a carbon pricing program by translating all six of them into a CO₂-e.¹ In practice, this is accomplished using their relative Global Warming Potentials (GWPs), which are defined as the cumulative radiative forcing effects of a unit mass of gas relative to CO₂ over a specified time horizon (commonly 100 years). In an inclusive system, it is this CO₂-e that forms the basis for either the tradable commodity or the tax base.

Including multiple gases can reduce the cost of reaching a specific concentration target by quite a bit. The disadvantages include not only that the GWP approach does not produce a perfect equivalency (residency time in the atmosphere varies considerably among the different gases, for example), but also the fact that some of these gases may be more difficult to monitor.

In practice, for administrative ease, most programs currently focus on CO₂ emissions from fossil fuel consumption. This can be a viable transition strategy since it is not difficult to add additional gases as the monitoring capacity matures. Both RGGI and the Swedish Carbon Tax, for example, have a CO₂-only focus. However one jurisdiction, the Bay Area Air Quality Management District in San Francisco, California, does tax CO₂-e (all gases), and Australia plans to cover four of the six Kyoto GHGs.

Historically, some regulatory targets other than CO₂ have also been adopted. For example, Boulder, Colorado, taxes only electricity use. A number of European countries also tax energy (Btus) and/or electricity consumption.²

While a uniform tax on energy does promote energy conservation, it fails to promote switching among fuels with different emissions per unit of energy.

Sources. From the point of view of minimizing cost, more universal coverage of sources (like gases) is also better. Yet no existing program involves universal control. As noted above, the EU ETS covers only certain categories of large emitters, although expansion to other sectors is in process. RGGI covers only one sector (large power generators).

Aside from including some sectors and not others, source size commonly affects coverage. For most programs, even in covered sectors, only facilities over a specified size threshold usually incur pricing obligations.

Expanding the original scope of coverage has occurred as a result of broadening the concept of where the carbon pricing can be applied. In general terms, emissions can not only be controlled directly (via “downstream” targeting), but also indirectly (via “upstream” targeting), or even via a hybrid involving some combination of the two.

A downstream point of regulation would focus control on the point of use, where GHGs are emitted into the atmosphere. An upstream system imposes the taxes or allowance requirements on the point of extraction, production, import, processing, or distribution of substances, which, when used or combusted, would generate GHGs.

The downstream approach is probably the most common in practice. For example, in the Bay Area Air Quality Management District, the fees are applied directly to the emitting facilities, and in RGGI, it is the emitting generators (and not the fuel suppliers) that are required to submit allowances. In Australia, the carbon pricing mechanism will apply directly to several hundred of their biggest polluters.

Like so many other design choices, the point of regulation should not be considered simply as a binary choice. Hybrids involving upstream control of some sources and downstream control of others have proved to be popular options and are becoming more common. For example, the British Columbia carbon tax is generally applied and collected upstream, except for the fee on natural gas, which is collected at the retail level. Overlaps (double taxation) are commonly avoided either by rebates or granting within-category exemptions to those facing the possibility of double taxation.

Temporal Flexibility

Emissions trading systems offer more temporal flexibility by allowing banking, borrowing, and advance auctions. Banking means holding an allowance for use beyond its designated year. Borrowing means using an allowance before its designated date. Advance auctions sell allowances that can be used after some future date, commonly 6 or 7 years hence.

The economic case for allowing this temporal flexibility is based upon the additional options it allows sources in timing their abatement investments, which lower compliance costs. The optimal time to install new abatement equipment or to change the production process can vary widely across firms. Factors such as the age of the equipment that is being replaced and the number of available technological options for additional control clearly matter.

Price considerations also argue for temporal flexibility. Forcing firms to adopt new technologies at exactly the same time concentrates demand at a single point in time (as opposed to spreading it out). Concentrated demand would raise prices for the equipment as well as for the other complementary resources (such as skilled labor) necessary for its installation.

Banking also has been shown to reduce the damage caused by price volatility. Storing permits for unanticipated outcomes (such as an unexpectedly high production level, which triggers higher than expected emissions) can reduce the future uncertainty considerably. Because stored permits can be used to achieve compliance during tight times, they provide a safety margin against unexpected contingencies.

The existence of a banking system, where allowances can be stored for future use, may also contribute to the political durability of the policy. Enacting a well-designed carbon pricing policy will not be sufficient if it cannot be maintained when public attention wanes and the policy faces the threat of being undermined or distorted by special interest politics. Even just the credible threat of dismantlement can have a strong negative effect on investment incentives.

History suggests that reforms are sustainable when the major participants have an interest in their continuation and, in general, when policy preservation incentives are aligned in a way that is self-reinforcing. Those holding banked allowances (as well as entities involved in and profiting from the infrastructure of the carbon market, such as brokerage houses, registries, etc.) are likely to insist on preserving a stable market.

In recognition of these substantial advantages, banking is widely used in emissions trading programs. Borrowing, on the other hand, has experienced more limited use, in part due to a fear that firms that borrow heavily could become enforcement problems later. The Australian ETS plans to allow limited borrowing of permits such that, in any particular compliance year, a covered source can surrender permits from the following vintage year to discharge up to 5 percent of its obligation. So far, the fact that borrowing has been limited has not seemed to raise costs in any significant way.

Advance auctions are now more common, but little analysis of their impact has made it into the literature.

Using Revenue from Taxes or Auctions

Carbon taxes and auctioned allowances not only provide incentives for reducing emissions, but they raise revenue as well. The distribution of the revenue from auctioned allowances or carbon taxes can, in principle, enhance policy efficiency, reduce the regressivity of the distribution of the financial burden, and/or improve the political feasibility and stability of the program, but those benefits depend upon what is done with the revenue. Operating programs provide experience with a wide variety of choices, which can be helpful in seeing whether experience matches expectations.

Containing the Burden on Target Groups. It is not uncommon for nations setting up carbon pricing programs to have to deal with powerful political concerns about their possible economic impacts, especially on energy-intensive businesses. These concerns have resulted in several design strategies that use potential or actual revenue to contain possible cost increases faced by these businesses, including exemptions, preferential tax rates, or gifted allowances.

Exemptions are a common strategy for targeted burden containment (especially in European tax systems). Types of exemptions include (1) exempting all emissions from sources that emit fewer emissions than some established threshold (a strategy followed by most programs), (2) exempting emissions from sources that are covered by another policy to prevent double taxation (also common), (3) exempting emissions from sources deemed unacceptably vulnerable to cost increases, and (4) exempting emissions where international legal issues introduce special implementation barriers. While the first two types of listed exemptions may not normally raise significant cost-effectiveness issues, exemptions of the third and fourth types can. Because facilities that receive exemptions face no controls on GHGs from that instrument, their incentive to reduce emissions is eliminated. Furthermore, when the instruments are designed to reach specific quantitative targets, the other facilities must pick up the slack created by exemptions, which raises compliance costs for the program as a whole.

Preferential tax rates are even more common. In Norway, for example, the pulp and paper industry, fishmeal industry, domestic aviation, and domestic shipping of goods pay reduced rates. In Sweden, manufacturing, agriculture, cogeneration plants, forestry, and aquaculture face lower rates.

Another possibility (with mixed results) for reducing the cost burden on vulnerable firms, issuing rebates, is illustrated by the Swedish Nitrogen Charge System (Box 8.1).

Gifting can occur in either a tax system or an ETS. With a tax system, it involves taxing only emissions above the gifted threshold, a strategy found in some European effluent charge systems. Alternatively, in emissions trading, some proportion of the allowances in a cap-and-trade system can be gifted (given free of charge) to favored sectors. Either approach eliminates the financial burden associated with paying for gifted emissions, but in contrast to an exemption, it does not relieve the sector of its obligation to control GHGs.

The EU ETS and California, at least initially, gifted some or all of the allowances to parties based upon some specified eligibility criteria. In the European Union, free allowances are allocated based on product-specific benchmarks for each relevant product. The starting point for the benchmarks is the average of the 10 percent most-efficient installations, in terms of GHGs, in a sector. In California, utilities will apparently receive 90 percent of 2008 electricity sector emissions for free in preparation for the start of the GHG trading scheme on January 1, 2013.

From an efficiency point of view, basing the amount of gifted allocation simply on historical emissions is an inferior basis for allocation since it can end up rewarding sources that have the poorest historical track record (notice how the EU ETS system circumvents this problem). Furthermore, if this method is known in advance, it can even discourage early reduction actions, lest such reductions lower the emitter’s subsequent gifted allocation.

The experience in the EU ETS has enriched our understanding of the dynamics of gifted systems. Empirical evidence has demonstrated that in deregulated electricity markets—mainly Germany, the Nordic countries, the United Kingdom, and the Netherlands—a significant share of the value of the gifted allowances in the marketplace was passed through to consumers in the form of higher prices. Since the allowances were gifted, the benefiting firms earned “windfall profits.”

Generally, this experience with gifted allocations suggests that they are sometimes necessary for political reasons, but as we will describe, marginal increases in gifting also reduce or eliminate some very beneficial other possibilities for using that revenue. Furthermore, the evidence suggests that the revenue necessary to fully protect sectors that are truly vulnerable is a minor fraction of the total that would be derived from a revenue-raising approach, since most of the burden of carbon pricing is ultimately passed forward to households in higher energy prices.

In recognition of their large and rising opportunity cost, gifting of allowances is being used less as experience with carbon pricing grows. Even in systems granting gifted allowances, the proportion of gifted allowances is usually diminished over time. For example, the EU ETS aims to auction off 20 percent of all EU allowances in 2013, with subsequent gradual increases aiming at auctioning off 70 percent by 2020. The ultimate goal is to attain full auctioning by 2027. In RGGI, gifting already plays a very small role. Approximately 86 percent of CO₂ allowances are offered at auction, and roughly only 4 percent of CO₂ allowances are offered for sale at a fixed price.

Using Revenue to Lower Other Taxes. Considerable variability can be found in the revenue-use choices made by different countries as they have sought to enhance policy efficiency and to reduce inequity. The energy and carbon taxation schemes in several EU member states have been guided by the environmental tax reform. This reform of national tax systems seeks to shift the tax burden from conventional sources, such as labor and capital, to alternative sources such as environmental pollution or natural resource use. As discussed more fully in Chapter 2, using revenue to reduce taxes on items that distort the broader economy considerably reduces the overall costs of the policy. At the same time, this revenue recycling can reduce, at least to some degree (depending on the choice of which distortionary taxes to reduce), the regressivity of the distributional burden of the costs.

The burden of a carbon pricing program is estimated to be regressive, particularly for nontransport emissions in industrialized counties, in the absence of any redistribution of the revenues, because lower-income households use a larger proportion of their earnings to purchase energy-intensive products (gas and electricity being the most important). Gifted allowances intensify this regressivity because the gains accrue to stockholders, who on balance tend to have higher incomes than wage earners.

Countries have made rather different choices in how they have chosen to recycle revenue. Sweden and Finland have mainly recycled revenue by lowering income taxes. On the other hand, Denmark and the United Kingdom have predominantly used revenues to lower employers’ social security contributions. British Columbia, Canada, has principally used the revenue to lower personal, corporate, and small business income taxes.

Recognizing that some efficiency-enhancing strategies, such as lowering corporate taxes, do little to diminish regressiveness, some programs target some proportion of the funds specifically to reduce the cost burdens on households, particularly low-income households. In the Australian plan, more than 50 percent of the revenue will be used to reduce the cost burden on households. Cash assistance will be delivered through the tax and transfer system. Assistance will be targeted to low- and middle-income individuals by more than tripling the statutory tax-free threshold. The tax cuts, increases in pensions, and cash transfers have been designed to at least offset any expected average price impact from the carbon price on low-income households. Middle-income households will be eligible for assistance that is expected to meet their average price impact.

Promoting Renewable Energy and Energy Efficiency. Other programs use the revenue to promote renewable energy and energy efficiency. Under a carbon tax, this strategy reduces emissions further, while under an ETS, it may instead lower allowance prices depending on whether these emissions reductions are covered by the cap. In Denmark, although about 60 percent is returned to industry, some 40 percent of tax revenue is used for environmental subsidies. Quebec, Canada, deposits its carbon tax revenue into a “green fund,” which supports measures offering “the largest projected reduction in, or avoidance of, GHGs” (Sumner, Bird, and Dobos, 2011, p. 934).

As we have noted, RGGI tends to concentrate its revenue on promoting energy efficiency. These investments not only tend to have a higher cost-effectiveness than renewable resource investments in those states, but by lowering demand, they have even lowered electricity prices (thereby reducing the regressive impact of the policy). These incentivized investments in energy efficiency have also raised the competitiveness of several large industrial facilities and have increased the political support for (and stability of) these programs in the process.

Wise use of the revenue from auctioned allowances or carbon taxes has, in practice, enhanced policy efficiency, reduced the regressivity of the distribution of the financial burden, and/or improved the political feasibility and sustainability of the program. In this case (at least at the macro level), reality is increasingly matching expectations.

Achieving multiple objectives implies making multiple choices on how to use the revenue. Fortunately, the revenue stream seems large enough to allow governments to make headway on all these fronts.

General Cost Containment: The Role for Offsets

Exemptions, differential prices, gifting, and rebates all attempt to reduce the burden for certain targeted sources. Allowing offsets is a common means for reducing the cost on all participants by expanding the supply of reduction possibilities to sources not otherwise covered by the carbon pricing program.

Offsets allow emissions reductions for sources not covered by the cap or not included in the base of a GHG tax to be credited against the cap or tax base by the acquiring party. Offsets or offset tax credits perform four roles in pricing GHGs: (1) by increasing the number of reduction opportunities, they lower the cost of compliance;³ (2) lowering the compliance cost increases the likelihood of enacting the program; (3) they extend the reach of the program by providing economic incentives for reducing sources that are not covered by the tax or cap;⁴ and (4) because offset credits separate the source of financing of the reduction from the source that provides the reduction, it secures some reductions (in developing countries or low-income projects, for example) that for affordability reasons might otherwise be precluded (Box 8.2).

While offset credits can be a permanent component of a carbon pricing program, they may also be used as a transition strategy. For example, as long as countries remain outside the cap, offset credits may represent the best opportunity to secure emission reductions in those countries. Once all countries fall under a pricing regimen, this specific form of offset would become unnecessary.

The challenge for an effective offset program is to ensure that all three of the primary requirements (the reductions should be not only quantifiable, but also enforceable and additional) are met. One barrier involves the tension over the trade-off between transactions costs and offset validity—ensuring valid offsets is not cheap. Other criticisms involve not only the types of projects being certified (an alleged overemphasis on non-CO₂ gases) and the skewed regional distribution of clean development mechanism (CDM) activity (with Brazil, China, India, and the Republic of Korea creating more than 60 percent of generated credits), but also the amount of subsidy being granted (with incremental costs of reduction of these non-CO₂ gases being well under the price received for a credit) and the adverse incentives created for host countries to pursue reduction on their own (developing counties may well hesitate to undertake projects on their own as long as they can get someone else to pay for them through an offset mechanism such as the CDM).

Motivated by concerns over the validity of offsets, most programs now consider ways to limit their use. One historical method has been to restrict the use of offsets (either domestic or foreign or both) to some stipulated percentage of the total required allowances. In RGGI, for example, CO₂ offset allowances may be used to satisfy only 3.3 percent of a source’s total compliance obligation during a control period, although this may be expanded to 5 percent and ultimately 10 percent if certain CO₂ allowance price thresholds are reached. In 2011, Germany announced that it would not allow any offsets to be used to pursue its reduction goals. Similarly, California is seen by observers as being highly unlikely to allow CDM-certified emissions reductions to be used in its emissions trading scheme when it kicks off in 2013. California’s position on these CDM offsets contrasts sharply with that of Australia, which apparently plans to rely heavily on the purchase of offsets to hold costs down. Until 2020, Australian sources can use offsets to meet up to 50 percent of their annual liability.

The disadvantage of this quantitative limit approach is that it not only raises compliance costs, but it also fails to distinguish between high-quality and low-quality offsets. Both are treated with the same broad brush.

Newer approaches make these kinds of quality distinctions. Countries could, for example, establish eligibility criteria to identify certain offset types that it deems as acceptable (and therefore treated as fungible with allowances), while not allowing others where the reductions are more speculative and/or the monitoring is less reliable. For example, in 2011, Australia announced that it would not accept HFC 23, or N₂O, offsets from the CDM program.

An alternative approach, being discussed especially with respect to forestry offsets, is to discount the offset (for example, giving certified credit for only 50 percent of the expected reduction) to provide a margin of safety against the uncertainty in the magnitude of the ultimate reductions from this offset project. Discounting can specifically address such concerns as permanence, additionality, and leakage.

Price Volatility

A tax system fixes prices, and in the absence of any administrative intervention to change those prices, price volatility is not an issue. That is not the case with cap-and-trade systems either in principle or practice.

Experience validates the concern that emissions trading can be plagued by volatile prices. The EU ETS, the Regional Clean Air Incentives Market (RECLAIM), and the U.S. Sulfur Allowance Program have all experienced events where prices became quite volatile.

• In the case of the EU ETS, it was attributable to two correctable design mistakes—inadequate public knowledge of actual emissions relative to the cap and a failure to allow allowances in the first phase to be banked for use in the second phase.

• In the case of RECLAIM, it was due to an unanticipated rise in the demand for allowances resulting from an unexpected shortage of important low- or nonpolluting electricity-generating sources (natural gas and hydro from out of state) at precisely at the same time that the program was reaching the “crossover” point, where actual emissions would be expected to exceed allocations unless emission reduction controls were installed at facilities.

• In the U.S. Sulfur-Emissions Trading Program, prices became volatile in the 2004–05 and 2008–09 periods. In the first period, a large rise in allowance prices was triggered by a rapid rise in natural gas prices due in part to Hurricane Katrina, while in the second period, volatility was introduced by two U.S. Circuit Court rulings dealing with a related program (the Clean Air Interstate Rule) to control sulfur.

One potentially appealing, but as yet untested in practice, approach to lower the degree of possible price volatility couples a “price collar,” consisting of a safety valve price ceiling and an allowance reserve, with a price floor. Establishing a safety valve ceiling would allow sources to purchase additional allowances at a predetermined price set sufficiently high to make it unlikely to have any effect unless allowance prices exhibited unexpected spikes.⁵ To prevent these purchases from breaking the cap, they would come from an allowance reserve that was established from allowances set aside for this purpose from earlier years, an expansion in the availability of domestic or international offsets, or perhaps from allowances borrowed from future allocations. An allowance reserve has been included in the California program set to begin in 2012 and was part of the Waxman-Markey bill that passed the U.S. House of Representatives but failed to become law.

Australia has proposed a price floor that would apply for the first 3 years of the flexible price period (as we previously discussed). The price floor has two roles: (1) By recognizing that low carbon prices diminish or eliminate incentives to invest in new low carbon forms of energy, it tries to assure investors that prices will fall no lower than the floor, and (2) it provides some price protection for the revenue stream from auctioned allowances. As described above, RGGI also has a price floor, and it has, in fact, constrained prices.

Australia’s new climate policy also introduces another innovation targeted at reducing price volatility that can arise in immature markets. During the fixed-price period, sources covered by the program will be able to purchase allowances from the government at a fixed price. Any allowances purchased at the fixed price must be surrendered and cannot be traded or banked for future use. Subsequently, prices would be determined by supply and demand as the carbon pricing system transitions from the fixed-price regime to an emissions trading market.

Policy Evolution via Adaptive Management

One of the initial fears about market-based systems was that they would be excessively rigid (resistant to change), particularly in the light of the need to provide adequate security to investors. Policy rigidity was seen as possibly preventing the system from responding to better information.

Rigidity was certainly not the result with the process set in motion to control ozone-depleting gases under the Montreal Protocol. Not long after the original caps were set, better scientific information confirmed that they were insufficient to achieve the desired results. Soon after this discovery, the cap was made more stringent; the existence of specific caps did not preclude an ability to adjust their stringency to changing conditions in that setting.

Yet system modification, if not done carefully, does have the potential to undermine the incentives that provide the foundation for the system. The stable and predictable prices established by a tax system provide a form of market security investors depend upon when making long-lived energy investments. Similarly cap-and-trade systems depend on allowance holders having secure ownership rights to the allowances. When a new understanding of climate science makes adjustments in the tax rates or the caps necessary, that security can be jeopardized. Can the desire to constantly incorporate change be made compatible with the desire to preserve sufficient security for investors?

While careful design cannot eliminate the tension between flexibility and security, it can reduce it by implementing an adaptive management system coupled with flexible policy instruments. Adaptive management goes beyond trial and error in the sense that it designs initial programs at least in part to learn about the magnitudes and effects of responses so that knowledge from those experiments can be used to improve subsequent programs. This is especially important in a scientifically complex system (such as climate change) that will involve many combinations of policies with equally complex patterns of interaction.

Adaptive management involves two possible pathways—active and passive.⁶ Passive adaptive management involves the establishment in advance of triggering thresholds and prescribed rules for changing key parameters once any specified threshold is exceeded, while active adaptive management specifies in advance the deliberative process by which the need for change will be identified and the necessary modifications implemented.

The virtue of passive adaptive management strategies is that they do not depend on future political action; the prespecified action follows directly from the prespecified triggering event. The disadvantage is that not all circumstances that affect the optimal choice may be known in advance. Passive strategies are typically less tailored, but they are also less susceptible to political manipulation.

One of the simplest passive strategies, and one that has already been adopted in some tax programs, is to index the tax rate or the level of a price floor or ceiling to a specified rate of inflation index. In this case, measured inflation is the triggering event, and the resulting action is to increase the prevailing price or tax rate to account for the amount of measured inflation. Without this strategy, the real tax rate or price would become weaker and weaker over time. Conversely, under an ETS, the quantity of allowances might be reduced at a fixed annual rate over time.

Experience also provides a guide for how change should not be implemented. In one such case in the early days of the first U.S. program, called at the time the Emissions Trading Program, it became clear that additional emissions reductions were needed. Some states simply confiscated all banked credits.

While this had virtue in that it provided quick, easy reductions, it proved disastrous in the long term because it destroyed any future incentive to create those credits. Since banked credits are a significant source of temporal flexibility for those required to comply with the law, this turned out to be not only short-sighted, but also quite cost-ineffective.

The takeaway lesson from this specific experience is clear—authorized levels of emissions for banked allowances and offsets in general should not be affected by a change in the cap. Government should not confiscate banked credits or offsets just because they are handy and not currently in use.

Active adaptive management involves specifying a specific and transparent process for dealing with the evolution of the system over time. The advantage of this pathway is that it can take into consideration all of the circumstances that prevail at the time the change would be needed, while the disadvantage is that discretion allows politics to distort or prevent effective change.

Implementing an active adaptation strategy would involve specifying trigger points (possibly just future dates, but potentially contingencies such as falling below specified horizons for meeting deadlines) for initiating any investigation of the need for modification. Reviews of the appropriateness of the previously specified cap or tax schedule should be conducted on a periodic, announced schedule. The process and criteria for deciding whether the caps or tax rates need to be modified (and, if so, how large a change might be needed) should be made transparent to interested parties in advance.

Some small steps toward this approach can be found in the plan announced by the Commonwealth of Australia. This plan will announce the first 5 years of caps by 2014. For the sixth and subsequent years, the pollution cap will be extended by 1 year every year to maintain 5 years of known caps at any given time. The government has set out in advance the considerations that will be used to set future caps, including such aspects as progress in meeting emissions targets and the social and economic impacts of various choices. A specific independent body, the Climate Change Authority, will be established by legislation to advise on key aspects of the carbon pricing mechanism, not only with respect to the caps, but also on such aspects as the chosen values for the price ceiling and price floors (as we have discussed). The level of the international price will be examined closer to the point of transition to a flexible price to ensure that the price ceiling still reflects the specified margin above its expected level.

The details of climate change policy will necessarily change over time. Markets can accommodate those changes providing the changes are neither arbitrary nor capricious. Establishing a transparent, adaptive management plan can go a long way to facilitating the necessary evolution without unreasonably jeopardizing the incentives upon which the system depends.

Transparency and Accountability

One lesson that emerges quite forcefully from the operational experience with pricing mechanisms is the importance of price and emissions transparency. Not only can this reduce the likelihood of fraud, but also it can enhance market effectiveness. One of the successful features of the U.S. Sulfur Allowance Program—the zero revenue auction—had the effect of reducing the uncertainty associated with trading and facilitated negotiations about price and quantity by making prices public (see Box 8.3). Furthermore, the availability of both organized exchanges (where buyers and sellers could meet) and knowledgeable brokers lowered the transactions costs for those seeking trades.

Other forms of transparency are also important. Transparency promotes accountability and facilitates programmatic refinement over time. Independent evaluations are an important component of ex post evaluation, and therefore it is important to provide data access so outside objective reviewers can perform those evaluations. To facilitate these evaluations, it is necessary to provide access not only to the details of the program, but also to various performance measures such as emissions levels for all covered sources.

Most of the programs covered by this review do not meet this standard of transparency. Many of the websites (at least the versions in English) about the programs contain little more than a series of press releases. An early partial exception was the U.S. Sulfur Allowance Program, which provided sufficient access to data from two major external ex post reviews of that program.

The RGGI website also lists all the covered sources, their annual individual emissions for a number of years both before and after implementation, and the results of each auction for each participating state and for the program as a whole. The site also contains not only the documents that describe the details of the program, but also evaluations by a consulting firm hired specifically to do a public accounting of whether any evidence of market power has emerged.

The revised ETS Directive adopted in 2009 provides for the centralization of the EU ETS operations into a single EU registry. This Union Registry will be operated by the commission and will replace all EU ETS registries currently hosted in the member states in 2012.

The widespread use of the Internet has made the current possibilities for sharing information historically unprecedented. It is now possible to make very large datasets available to the public at very low cost. The existence of these technological possibilities means that ex post evaluations can no longer be prevented simply because information dissemination is too expensive. Resolving the tension between providing public access to the data and adequately protecting proprietary information is the largest remaining challenge.

Cost Savings

Two types of studies have conventionally been used to assess cost savings and air quality impacts—ex ante analyses based on computer simulations, and ex post analyses, which examine the actual implementation experience.

A substantial majority, though not all, of the large number of ex ante studies of programs involving pollutants other than carbon have found traditional regulatory limits on emissions to be a significantly more expensive way to reduce emissions than the least-cost allocation of the control responsibility. These studies demonstrate that a change from more traditional regulatory measures to more cost-effective market-based measures such as emissions trading or pollution taxes could potentially either achieve similar reductions at a much lower cost or could achieve much larger reductions at a similar cost to more traditional policies based upon source-specific limits.

The evidence also suggests that these two instruments typically produce more emissions reduction per unit expenditure than do other types of existing policies such as renewable resource or biofuel subsidies.

The one exception to this robust finding of significant cost savings arises when the amount of additional reduction is so stringent that the control authority has no choice but to reduce emissions close to the limits established by technological feasibility. In that case, the immediate potential cost savings from moving to market-based approaches are typically very small; however, over time, as new technologies are encouraged and introduced by the market-based approaches, those savings can rise considerably.

Although the number of detailed, completed ex post studies is small, the few existing studies typically find that cost savings from moving to these market-based measures are considerable, but less than would have been achieved if the final outcome were fully cost-effective. In other words, while both taxes and emissions trading are fully cost-effective in principle, in practice, they fall somewhat short of that ideal in part because actual designs, fashioned in the crucible of politics, deviate from the dictates of optimality.

Although political manipulation can distort both tax and emissions trading outcomes, emissions trading has a unique potential exposure to price manipulation arising from the presence of market power. Should it materialize, market manipulation could reduce the cost savings.

Two rather distinct types of market power are possible in emissions trading. The first arises when a price-setting source or a collusive coalition of sources seeks to manipulate the price of allowances in order to reduce their financial burden from pollution control. The second stems from the desire of one predatory source or a collusive coalition of sources to leverage market power in either the allowance market or the output market (or both) for increasing profits across both markets. Generally, market power concerns arise only in situations where participants or coalitions of participants control a significant proportion of the market.

Implementation experience with the use of emissions trading has uncovered only one example of market power and that flowed directly from a design flaw.⁷ The paucity of cases involving market power is perhaps not surprising since these concerns diminish with large markets and most carbon markets have a large number of participants. However, if emissions trading expands to settings where the market is fragmented and hence limited to a relatively few participants, this could change.

Emission Reductions

While the evidence in general is that implementing these market-based programs reduces emissions (sometimes substantially), that evidence is on less solid ground than the evidence on costs. Almost all of the emissions evidence is based upon what happened to emissions following the introduction of the program relative to what they had been prior to the program (as opposed to comparing them to a counterfactual baseline defined in terms of what would have happened otherwise).

Using emissions patterns before and after implementation is problematic in at least two important senses. First, a historic baseline can be a highly inaccurate benchmark. Suppose, for example, in the absence of the program, the emissions level would have increased dramatically over time. In that case, a program that stabilizes emissions would inappropriately be judged to have accomplished nothing, since emissions would not have declined relative to the year of introduction. In fact, however, it would have achieved substantial reduction relative to what would have happened otherwise. Second, with the exception of the U.S. Sulfur Allowance Program and the U.S. Lead Phase-Out Program (where the evidence is compelling), the degree to which credit for these reductions can be attributed to the market-based mechanisms (as opposed to exogenous factors or complementary policies) is limited.⁸

With that cautionary note in mind, in general, emissions in the noncarbon pollution pricing programs have fallen substantially following the introduction of these market-based mechanisms. (For example, emissions from covered sources have fallen 67 percent in the sulfur allowance program, and lead emissions from gasoline were eliminated.)

Emission reductions following the time of introduction are also the norm for carbon pricing programs, although the reductions in general tend to be more modest. The reductions are typically in the high single digits for the carbon tax, with one country, Norway, actually reporting an increase. Collectively, the EU ETS reported “reduced annual emission per covered installation” by 8 percent from 2005 to 2010 (Hedegaard, 2011).

Not all sources of GHGs end up being regulated, of course, and that raises the specter of leakage. Leakage can occur when pressure on the regulated source to reduce emissions from one location results in a diversion of emissions to unregulated, or less regulated, sources. Common channels for this diversion involves firms moving their polluting factories to countries with lower environmental standards or consumers increasing their reliance on imported products from countries with unregulated sources. For example, states falling under RGGI could potentially import (presumably cheaper) electricity from neighboring states that are not covered by RGGI. In these cases where some emissions are diverted to unregulated areas, the net emissions reduction effects of the program (reductions from the regulated sources minus the offsetting increases from the less regulated sources) could be smaller than the more apparent gross effects.

Generally, to date, the evidence suggests that carbon leakage effects have been rather small (typically less than 10 percent).

Market Transformation

Although hard evidence on the point is scarce, a substantial amount of anecdotal evidence suggests that pricing pollution can change the way environmental risk is treated within polluting firms. In the absence of pollution pricing, environmental management was commonly relegated to the tail end of the decision-making process. Specifically, the environmental risk manager was not involved in the most fundamental decisions about product design, production processes, selection of inputs, and so on. Rather, she or he was simply confronted with the decisions already made and told to take whatever precautions were necessary to ensure compliance. This particular organizational assignment of responsibilities inhibited the exploitation of one potentially important avenue of risk reduction—pollution prevention.

Carbon pricing tends not only to move emissions reduction objectives earlier in the decision process, but it also tends to get corporate financial officers involved in environmental risk management. Furthermore, as the costs of compliance rise in general, environmental costs trigger more scrutiny and consideration. Over time, reducing environmental risk can become an important component of the bottom line. Given its anecdotal nature, the evidence on the extent of organizational changes that might be initiated by pricing pollution should be treated more as a hypothesis to be tested than a firm result, but its potential importance is large.

The existing experience also provides some evidence on the behavior of markets. While economic theory treats markets as if they emerge spontaneously and universally as needed, in practice, in unfamiliar markets such as these, the participants frequently require some experience with the program before they fully understand (and behave effectively) in the market. Both regulators and environmental managers of emission sources have apparently experienced considerable “learning by doing” effects in response to pricing pollutants with the result that markets tend to operate much more smoothly after they have been in existence for some time.

Technological Innovation and Diffusion

The literature contains some empirical support for the theoretical expectation that the implementation of market-based mechanisms would induce both emission-reducing innovation and the adoption of new emission-reducing technologies. While the gains in innovation from emissions trading programs have not always been as large as expected, most studies do find a statistically significant response. Furthermore, with respect to the international transfer of mitigation technologies, some evidence also suggests that the CDM, one component of emissions trading, has been a channel for hastening transboundary diffusion, although some observers question the quantitative importance of this channel in practice.

Some case studies also suggest that environmental taxes have made a difference in introducing innovative strategies.

• Norway’s carbon tax, for example, has also apparently promoted carbon sequestration, one form of technological innovation.

• The Swedish Nitrogen Charge apparently promoted both innovation (improvement of best practices) and diffusion (the spread of the new technologies to other firms). Specifically, researchers found that not only did the best plants make rapid progress in emission reductions, but also the other plants caught up to such a high degree that they ultimately ended up lowering their emission intensities even more than the best plants.

• During the 1990s, as the demand for biofuels increased in Sweden, in part due to the energy and carbon taxing system, several new wood-handling technologies were introduced.

The finding that market-based instruments hasten innovation and diffusion is not, however, a universal finding. In some circumstances, pollution pricing may incentivize the exploitation of low-cost existing strategies (such as switching to lower carbon fuels) rather than stimulating the adoption of new technologies, thereby delaying their commercialization relative to other policies such as renewable portfolio standards. In these cases with carbon pricing, the stimulus to more fundamental innovation takes place over a longer time frame, once the existing cheaper opportunities are exhausted.

For more information on some of the carbon pricing programs discussed in this chapter, see the following:

For a discussion of the evidence on cost savings from emissions pricing programs over regulatory alternatives, see the following:

For evidence on the impact of emissions pricing on technological development, see the following:

For more on general carbon taxes and environmental tax reforms, see the following: