us cap-and-trade program: options for compliance

8/9/2019 US Cap-and-Trade Program: Options for Compliance

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Carbon Market Analyst

A US Cap-and-Trade Program: Options or Compliance

TO THE POINT CONTENT

UPCOMING REPORTS

POINT CARBON RESEARCH All rights reserved 2009 Point Carbon

RESEARCH

North America

2 Executive summary

2 Introduction

2 Sizing up the gap

6 Compliance options10 Market implications

12 Conclusion

13 Contacts

Assessing the Impact o the Reces-sion on US GHG Emissions

A Post-2012 Global Climate Change

Agreement What Role or International Forestry

and REDD credits

The Emission-to-Cap in the cap and trade program proposedby Rep. Waxman would be 205 million tons in 2012, growing to1.4 billion tons by 2020.

This gap could be cut in hal i complementary policiespromoting clean energy and energy efciency standards arealso passed. The long term impact o the economic recessioncoupled with ambitious policies could create a long market or

the rst compliance period.

In 2012, the domestic osets supply will be too scarce to fllin the gap. Certied Emission Reductions (CERs) could helpmeet the gap, placing US acilities in competition against other

international buyers.

In 2016, because o the limited domestic oset supply, some

uel switching may be needed, rapidly pushing prices up.

To remedy high prices, we anticipate the development o anew international oset programs, where sectoral and REDDcredits could play a much larger role.

In 2020, a large reliance on uel switching would bring pricesup over $50 a ton. These high prices would render economicallyattractive most other compliance options, including purchases

o international allowances and a wide range o internal

abatement measures

April 2, 2009


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Carbon Market Analyst North America

2 All rights reserved 2009 Point Carbon

CMA April 2, 2009

This report provides an overview o compliance options

under a US cap-and-trade program using the discussiondrat proposed by Rep. Waxman on March 31st, 2009.

We rst estimate the size o the emission-to-cap (E-t-C),

or the dierence between projected US greenhouse gas

emissions and the cap this is the amount by which

covered entities collectively will have to reduce their

emissions to comply with the carbon limits. We estimate

this gap at 205 million tons in 2012, growing to 1.4 bn

tons in 2020, i business-as-usual projections ollow the

path orecasted by the Energy Inormation Agency.

The bill includes a wide array o complementary

policies to reduce emissions, notably a renewable

electricity standard, an energy eciency standard, and

improvements to uel economy and carbon-intensity otransportation uels. These policies could cut the E-t-C in

hal, reducing the gap to 87 million tons in 2012, a mere

1.2 percent o the total cap. Coupled with the eect o

the economic recession, the program could start long in

the rst compliance period (2012-2013). We orecast the

2020 gap at roughly 760 million tons, 15 percent o the

cap that year.

We then investigate the main compliance options or

lling this gap: osets and internal emission reductions.

The bill authorizes 2 bn oset credits or compliance,

evenly split between domestic and international osets.

Domestic osets will likely constitute the least expensivecompliance option, but with a pipeline currently below

20 million tons per year, we oresee a shortage o these

credits.

International osets are also unlikely to ll in their quotas,

although we orecast a potential supply o Certied

Emission Reductions (CERs) o over 700 million tons

globally in 2015. US acilities would have to compete

with European emitters and Kyoto countries or these

credits. Other orms o international osets could be

developed, notably sector-based credits and Reduced

Emissions rom Deorestation and orest Degradation

(REDD) credits and help make up the shortall.

In terms o internal abatement, uel switching has the

largest potential aside rom energy eciency. The

cost o uel switching can rise rapidly depending on uel

prices. A high price o carbon would trigger a negativeeedback loop and incentivize other internal abatement

measures, such as industrial energy eciency,

improvement to chemical processes, etc. This would

bring prices back down to a level where uel switching is

the most economical available option.

High carbon prices would also create an incentive to

link with other carbon markets, such as the European

or the Australian emission trading systems. LInkages

with other markets would not necessarily bring prices

down but could help dampen price volatility.

Executive summary

IntroductionThe prospects or a carbon market in

the US are looking better by the day.

Lawmakers in Congress are actively

discussing a climate bill, and hopes

are high that cap-and-trade legislation

may be passed by the end o the

year.

This issue o Carbon Market Analyst

North America looks at complianceoptions under a US cap-and-trade

program. We rst estimate the size

o the emission-to-cap (E-t-C), or

the dierence between projected

emissions under a business-as-usual

(BAU) scenario and the cap, and then

investigate the main compliance

options to close this gap: osets and

internal emission reductions.

This report provides an analysis o

supply and demand dynamics under

a US cap-and-trade program and sets

up the conceptual ramework or

price ormation in a uture US carbon

market.

We provide snapshots o three

milestone years during the rst

decade o the program - 2012,

2016 and 2020 - and discuss which

compliance option is likely to be

preerred in each o these years.

We look at the carbon price range

involved and implications or the

carbon market, assuming no major

technological breakthrough occurs in

this time rame.

Sizing up the gapUnder a compliance program,

demand or emission reductions is

derived rom the gap between the

emission cap established by the

government and actual emissionsrom covered sources.

Setting the cap

In the White House budget proposal

released February 27, President

Obama stated his reduction targets

14 percent below 2005 levels by

2020; 83 percent below 2005 levels

Hopes are high thatcap-and-trade leg-islation will pass by

the end o the year


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CMA April 2, 2009

by 2050. More recently, on March

31st, Representative Waxman (D-

CA) and Markey (D-MA) released adiscussion drat setting even more

ambitious medium-term targets

starting in 2012 at 3 percent below

2005 levels, declining to 20 percent

below 2005 levels by 2020 and 80

percent below 2005 levels by 2020

(see Figure 1 and Table 1). While

these targets may change in the nal

climate bill, we take them as the

best available indication o the depth

o the cuts to be expected and use

them in this analysis.

We also use the scope proposed

in the Waxman discussion drat, an

economy-wide coverage o all sectors

except or waste and agriculture.

Some sectors are phased into the

program over the rst years, creating

steps in the curves representing the

cap and the emissions rom coveredsectors in Figure 1.

The sector phase in provision means

only 68.2 percent o US emissions

are covered in 2012-2013, but this

number increases to 75.7 percent in

2014-2016 when industrial acilities

are phased in, to eventually reach

its maximum at 84.5 percent in 2016

as the requirement extends to local

distribution companies. The scope

remains at 84.5 percent o total

emissions through the rest o the

program.

Business as usual emissions

We use with the business as usual

(BAU) emissions projections, which

illustrate the path US greenhouse gas

emissions levels are expected to take

given existing environmental policies

and regulations. The projections are

based on the US Energy Inormation

Agencys (EIA) Annual Energy

Outlook released in December 2008.

BAU emissions or the US as a whole

are projected to increase rom 7,294

million tons (mt) in 2012 to 7,380 mt

in 2020, a 1.2 percent growth.

These projections account or

the new Corporate Average Fuel

Economy (CAFE) and the renewable

uel standard passed in theDecember 2007 Energy bill. They

also include the reductions rom

existing state renewable portolio

standards. In Figure 1 we chart total

US emissions (top dotted line) and

emissions rom covered sources only

(solid line) against the cap.

Emission-to-Cap

As shown in Table 1, we nd that in

2012, covered sources will have an

estimated annual emission-to-cap(E-t-C) shortall o approximately

205 MmtCO2e, or 4.1 percent o

BAU projections, total

US emissions

BAU projections,

covered sectors Cap

Emission-to-Cap

(EtC)

2012 7 294 4 975 4 770 205

2013 7 301 4 979 4 666 313

2014 7 273 5 506 5 058 448

2015 7 282 5 513 4 942 571

2016 7 307 6 175 5 391 784

2017 7 336 6 199 5 261 938

2018 7 364 6 223 5 132 1 091

2019 7 378 6 235 5 002 1 233

2020 7 380 6 236 4 873 1 363

2030 7 894 6 671 3 533 3 138

Table 1: E-t-C in the Waxman-Markey drat proposal

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

2012

2014

2016

2018

2020

2022

2024

2026

2028

2030

Million

tonsCO2e

Business-as-usual projections, total US emissions

Business-as-usual emissions from covered sectors

Waxman reduction targets from covered sectors

Figure 1: Emission-to-Cap in the Waxman-Markey proposal

Waxman sets ambi-tious medium andlong term emission

reduction targets


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CMA April 2, 2009

speed at which the economy will

recover rom the current recession is

unknown.

We do not attempt to capture thispotential recession eect on US

emission levels but consider possible

that emissions would be lower than

projected during the rst years o

the program. This would reduce the

gap between emissions and the cap

even urther. The eects on long term

emissions, however, would probably

be negligible.

Proposed Policies

In addition to the eects o the

economic slowdown, US GHGemissions, and thereore the E-t-C,

could look dramatically dierent i

some urther energy command-and-

control measures are passed ahead

o or in conjunction with legislation

establishing a cap-and-trade

program. Such regulations are under

discussion and would have a large

eect on long term GHG emission

their estimated BAU emissions.

This gap is anticipated to increase

to approximately 571 million tons by2015 and up to nearly 1.4 billion tons

by 2020. The shortall in 2020 is then

22 percent o BAU emissions rom

covered sectors.

Lower Emissions?Actual emissions will likely be lower

than even the most recent EIA

orecasts because o recently-passed

policies, proposed policies, and the

impact o the economic recession.

Enacted Policies

The Obama administration has

passed important policies and large

investment programs in the past

two months, notably the American

Recovery and Reinvestment Act,

better known as the stimulus bill, and

the proposed 2010 ederal budget.

Both packages contain signicant

investments in clean energy and

energy eciency, and could by one

groups estimate reduce business-

as-usual emissions by 61 million tons

annually rom 2012 onwards (see

Textbox 2).

Furthermore, the Annual Energy

Outlook projections, dated December

2008, likely do not ully account or

the deepening economic downturn

and its lasting eect on greenhouse

gas (GHG) emission levels. Analyses

o the recessions eect on Europes

emissions have estimated close to

six percent reduction in emissions

rom 2007 to 2008, partially due to

decreased industrial output rom

energy-intensive sectors such as

cement and pulp and paper. The

levels in the US. Two sectors are the

most likely targets or broad-reaching

regulations: the power sector and

the transportation sector. New

climate-oriented regulations in bothsectors would evoke large amounts

o emission reduction.

Power sector

A national renewable electricity

standard (RES), mandating that a

minimum percentage o electricity be

generated rom renewable energy, is

under discussion in Congress and

could be passed as early as this

summer. A proposal introduced by

Sen. Bingaman (D-NM) early 2009

would require that 20 percent oelectricity sold in the US come rom

renewable sources by 2025. A similar

bill proposed by Rep. Markey aims

or 25 percent renewables by 2025.

This provision was included in the

Waxman-Markey drat and would

reduce emissions by an estimated

57 mt in 2012, growing to 279 mt by

2020 (see Textbox 2).

Many studies show the potential savings rom energy eciency most recently,McKinseys report Reducing US Greenhouse Gas Emissions: How Much at WhatCost? announced close to one billion tons o GHG emissions could be reducedrom energy eciency measures alone, at a cost o zero or less (negative cost, i.e.a net saving). I this is true, why do we even need energy eciency standards?

Economically, energy eciency appears to be an obvious investment, yet the shitstoward better-insulated buildings and ultra low-energy appliances are not occurringon the massive scale that their economic protability would suggest. Three typeso hurdles typically get in the way o eciency improvements according to energyeciency experts Arthur Roseneld and Paul Stern. First, structural issues, like thetenant/landlord dilemma, prevent useul investments rom taking place becausethe decision-makers and the beneciaries are disconnected. Second, the economicprotability o eciency investments is not always as clear cut as economic theorywould imply. Discount rates (the time-value o money) and interest rates aced by

individuals can be signicantly higher than those used by economists in calculatingthe worth o energy eciency investments. Finally, individuals and companies donot always behave rationally in the economic sense and may elect to keep pricierincandescent light bulbs because they preer the quality and color o the light to thato cost-savings compact fuorescent lights.

Because economic rationality is oten not enough to trigger these energy eciencyinvestments, standards and public action are needed to overcome structural andnancial hurdles. Cap-and trade can also trigger some energy eciency investments,but only i carbon prices are high enough to make a large dierence on the energybill.

Textbox 1: Energy efciency: the answer to it all?

BAU projections donot ully account orthe deepening eco-

nomic downturn


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CMA April 2, 2009

Energy eciency standards are

also being discussed in Congress.

The Save American Energy Act,introduced by Rep. Markey (D-MA)

and Sen. Schumer (D-NY) establishes

a ederal energy eciency resource

standard, requiring utilities to

reduce electricity demand by 15

percent and natural gas demand by

10 percent by 2020. This mandate

could lower emissions by 39 mt in

2015, increasing to 262 million tons

by 2020 according to the ACEEE (see

Textbox 2). Other measures included

in the drat bill promote appliance

eciency standards, improved

building eciency standards, etc.and would also reduce emissions.

Transportation sector

President Obama lists two key

measures or the transportation sector

in his energy agenda: increasing uel

eciency standards and passing alow-carbon uel standard (LCFS). As

a Senator, Barack Obama supported

the Fuel Economy Reorm Act, which

proposed a our per cent per year uel

economy improvement beginning in

2009 or passenger cars and 2012 or

light trucks. The proposed LCFS set

targets o uel carbon-intensity at 10

percent below 2005 levels by 2020.

The National Commission on Energy

Policy has estimated the combined

eect o both proposals at 550 million

tons worth o reductions by 2020.

The Waxman-Markey bill contains an

LCFS provision that only takes eect

when the Renewable Fuel Standard

ends, in 2022, and mandates the

EPA to harmonize uel eciency

standards building on Caliornias

tailpipe emission standards (the

Pavley bill), but does not set

specic targets.

E-t-C Stimulus RES Energy Efciency New E-t-C

2012 205 61 57 0 87

2013 313 61 52 5 195

2014 448 61 104 18 265

2015 571 61 103 39 368

2016 784 61 156 58 508

2017 938 61 151 88 638

2018 1,091 61 220 117 693

2019 1,233 61 210 214 747

2020 1,363 61 279 262 761

Table 2: Eect o mandated emission reductions on E-t-C

All numbers in million metric tons o CO2e

Smaller gap long market?

We account or the emission

reduction potential o the big ticket

items in the Waxman-Markey bill and

estimate the size o the new gap in

the short and medium-term, up to

year 2020. Hence we exclude the

eects o transportation policies,

as the main measures are either

unspecied or only take eect ater

Compliance period Annual E-t-C

2012-2013 141

2014-2015 316

2016-2017 573

2018-2019 720

2020 761

Table 3 -E-t-C by compliance periodThe E-t-C could behalved by comple-mentary energy pro-

visions in the climate bill

Reduction orecasts or the stimulus bills are drawn rom an analysis commissionedby Greenpeace in January 2009. Consultancy ICF evaluated sixteen energy,environment, transportation and technology provisions included in the initialEconomic Stimulus Package and quantied the expected emission reductions romeach o them.

The emission reductions rom renewable electricity standards are detailed in aPoint Carbon report dated February 23, 2009: Greenhouse Gas Reductions romRenewable Electricity Standards.

For energy eciency, we used the American Council or an Energy EciencyEconomy (ACEEE) report: Laying the Foundation or Implementing a Federal Energy

Eciency Resource Standard, published March 18, 2009.

Our estimate or transportation is based on a memo dated June 2007 by the NationalCommission on Energy Policy and the International Council or Clean Transportation.The study quanties reductions rom a low carbon uel standard (LCFS) and the FuelEconomy Reorm Act and nds the combined measures would yield 550 milliontons by 2020. This orecast is likely overestimated because it does not account orthe Energy bill passed later that year and uses the 2007 AEO BAU orecast.

Point Carbon does not support or promote any o the policies studied, nor does itassociate with the policy positions rom the authors o these studies.

Textbox 2: Sources or Emission Reduction Estimates


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CMA April 2, 2009

2023. As shown in Table 2 and Figure

2, the new E-t-C is roughly halved by

the complementary policies, leavingonly hal the initial gap to be reduced

by market orces.

Another way to look at these numbers

is by compliance period (Table 3). The

Waxman-Markey bill establishes two-

year compliance periods, allowing

companies to borrow and bank rom

one year to the other within the two-

year periods. By smoothing out the

dierences created by the phase-in

provision, compliance periods provide

a clearer picture o the reduced but

growing gap over the rst nine yearso the program.

Because the E-t-C constitutes such

a small percentage (2-5 percent) o

the total cap rom 2012 to 2014, it

is possible that the program could

actually be over-allocated in its earlyyears. Should the impact o the

recession be lasting on emission

levels, and should the transportation

provisions yield early reductions, US

emissions could be lower by a ew

hundred million tons, potentially

making the system long. This over-

allocation would be unlikely to last

because o the steeply declining cap

and thereore would not threaten the

long-term integrity o the program.

Conversely, the orecasts could

be overestimating the expected

reductions rom the policies by

using an outdated baseline, or

because o overlap between the

policies - making the sum less than

the parts. In this case the gap would

be larger and a larger role let to

markets.

Compliance OptionsWe now turn to compliance options:

ways to ll the gap between actual

emissions and the cap, under a price-

driven, market-based mechanism.

Companies regulated under a cap-

and-trade program typically ace

three main compliance options:

reduce their own emissions

(internal abatement);

purchase allowances;

buy oset credits.

Economic theory warrants that

companies will opt or the least cost

option rst, moving up the marginal

abatement cost curve until their

emissions match their allowances.

In other words, a company will only

attempt to reduce its emissions

i it anticipates that doing so willcost less than buying osets or

allowances. I the market unctions

without distortions, allowance prices

should refect the marginal cost o

abatement.

We take a closer look at the

compliance options most likely to

be on the margin: osets and uel

switching. For each we oer, to the

extent possible, a volume and price

assessment.

Buying osets: the cheap wayout?

Osets are emission reduction

credits rom project-based activitiesthat can be used to meet compliance

as a supplement or alternative to

reducing ones own emissions. The

use o osets is usually subject to

a quantitative limit, or quota, known

as supplementarity. The Waxman-

Markey bill sets a very large ceiling

or osets o up to 2 bn tons annually,

evenly split between domestic and

international osets.

The total amount o osets allowed

into the system is roughly 1.5 bn tons

per year rom 2012 to 2015, then 1.7bn rom 2016 to 2020, amounting

to 30% o the cap in average. The

drat bill also suggests a 20 percent

discount rate or oset credits,

calling or 1.25 oset credits to claim

one ton o CO2e (one allowance).

Domestic osets

The oset market is developing ast

Figure 2: Whats let to markets?

4,000

4,500

5,000

5,500

6,000

6,500

2012

2013

2014

2015

2016

2017

2018

2019

2020

MilliontonsCO2e

Remaininggap

RES Energy Efficiency StimulusThe Waxman-Markeybill sets a generousceiling o up to 2 bn

tons or osets


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CMA April 2, 2009

in the US, largely in anticipation o

a regulated market. Point Carbons

oset database Carbon Project

Manager North America lists mostoset projects in the US and Canada.

The current pipeline o projects is

about 20 mt annually in 2012.

Not all oset credits currently traded

on the voluntary markets would

qualiy under a compliance program,

however. Restrictions on project

types and quality would likely weed

out a signicant number o projects,

rom which oset credits are currently

generated. Projects in capped sectors

(such as energy eciency) would not

qualiy as osets anymore but asinternal abatement.

The Waxman-Markey bill does not

establish an exhaustive list o eligible

project types. We use elements

rom previous cap-and-trade bills to

distinguish between projects likely

to make the cut or not, and conclude

that ve oset type categories are

Figure 3: US carbon oset pipeline with likely eligibility

0

5

10

15

20

25

y2000 y2001 y2002 y2003 y2004 y2005 y2006 y2007 y2008 y2009 y2010 y2011 y2012

0

5000000

100

00000

15000000

20000000

25000000

Fuel Switching

Energy Efficiency

Renewable Energy

Industrial Processes

Geosequestration

Biosequestration

Forestry

Soil Sequestration

Fugitive Emissions/CMM

Agricultural Waste

Landfill Gas

Likely-EligibleMilliontonsCO2e

most likely to qualiy under a ederal

compliance program: agricultural

waste, orestry, ugitive emissions

(coal mine methane), landll gas

and soil sequestration. (See our

previous report, US Osets: Outlook

or Supply and Demand, published

January 22, 2009, or more details).

As illustrated in Figure 3, only about

hal o the projected volume would

qualiy i screening out the non-

eligible projects, bringing the supply

to about 10 mt in 2012.

Could US osets ever come close

to lling the E-t-C gap? It is highly

unlikely, i not impossible. Even

though we anticipate investment in

osets to rise sharply as the beginning

o the cap-and-trade program nears,

the increase in available credits is

unlikely to get even near the limit. US

oset supply will be constrained by

sheer physical limitations - there are

only so many sites (landlls, arms,

and elds) that could potentially

qualiy and host oset projects. I

osets are discounted at a ratio o

5 to 4 as suggested in the Waxman

bill, the amount o credits would be

even less adequate. The suggested 1

billion ton limit on domestic osets in

the bill hence sets a theoretical limit

on demand, but the real limitation

will be on the supply side.

The role o domestic osets will bedetermined by how they compare

nancially to other compliance

options. Current average over-the-

counter oset prices vary rom $4.00

to $9.00 a ton depending on project

types and certications, and CCAR

utures (Dec12 delivery) trade at

roughly $7.00 a ton on the Chicago

Climate Futures Exchange.

It is highly unlikely

US osets could evercome close to lling

the E-t-C gap


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CMA April 2, 2009

International osets

In addition to domestic osets,international osets are also likely

to qualiy as a compliance option in

the US. Again, the Waxman-Markey

bill allows up to one billion tons in

international osets or compliance.

The dynamics or international

credits are much more complex, as

US emitters will be competing with

entities covered by the EU Emission

Trading Scheme and parties to the

Kyoto protocol or those reduction

credits.

The current international oset

system is the Clean Development

Mechanism (CDM) and Joint

Implementation (JI) under the Kyoto

Protocol. Point Carbons database

Carbon Project Manager anticipates

that around 1,850m Certied

Emission Reductions (CERs, credits

rom CDM projects) and Emission

Reduction Units (ERUs, credits

EUAs (Europe)AEUs

(Australia)

2012 15 ($19) A$21.75($14.50)

2015 48 ($63) A$23.25($15.50)

2020 48 ($63) Not available

Table 4 - International allowances

2012 prices are uture prices traded onthe exchange (2011/12 or Australia)Point Carbon orecast or Phrase 3 EUETS prices and traded 2012/13 uturesor the Australian CPRS

rom JI projects), will be issued by

2012. Ater 2012, the orecast is

much more uncertain (see Textbox3), as the uture o the CDM will

be renegotiated in Copenhagen in

December 2009. However, given

Point Carbons main policy scenario

or post-2012, CER volumes could

increase to 715 mt in 2015, beore

down to 75 mt in 2020 (see our CMA

The Future of the CDM: Supply

Forecast to 2022, November 26,

2008).

Prices will play a determining

actor in the nal use o CERs.

Secondary CERs (Dec12 delivery)are orecasted by Point Carbon at

21 ($28) and usually track European

Union Allowances (EUAs) at a

discount. I EUA prices are higher

than a US allowance price, the use o

international osets will be secure in

Europe - but i EUA prices are close

to US prices, US emitters could have

a shot at securing some o these

credits.

International negotiations are

increasingly ocusing on two new

types o international credits:reduced and avoided deorestation

(REDD) projects and sectoral credits

(see Textbox 3). The Waxman-Markey

bill signals a strong interest in both

credit types by allowing their use or

compliance. Sectoral credits are still

at an early design stage but enjoy

strong political support on both sides

o the Atlantic (see Textbox 2 and our

Analyst Update: ECs sector crediting

proposal, rom March 19, 2009).

REDD also enjoy political support but

ace with major challenges related

to accounting, monitoring, and

enorcement. We have no indication

o volume or prices or either o these

mechanisms, but we expect they will

play a large role in compliance post-

2012.

The uture o the CDM will be renegotiated in Copenhagen in December 2009, in an attempt to address concerns about thequality o projects, the countries where they are located, and eorts to redene eligible project types. An important source osupply uncertainty stems rom the discussion on project types and reorming the approval process. Stricter approval criteriacould lead to a dwindling o the supply, possibly matched by tough import limits by the EU ETS in Phase 3.

Another source o uncertainty comes rom the act that countries currently hosting most o the CDM projects China, India,

Mexico, South Korea, etc. might take on mandatory targets ater 2012 in a successor agreement to Kyoto, which wouldend the supply o oset credits coming rom those countries. The emissions reduced by CDM projects taking place in thosecountries would then count toward the respective countrys achievement o its emission reduction obligation. This expectationthat more countries will take on legally binding reduction commitments post-2012 explains the dramatic all in supply between2015 and 2020.

CERs could be replaced by sectoral credits, a proposed mechanism based on a no-lose target or a set o industrial installationsin advanced developing countries. Under this proposal, the group o installations, ideally covering a whole industrial sector,would have an emission target below its business-as-usual emissions. I it reduces emissions below the target, it will be givencredits equal to the dierence between the target and actual emissions. But there would be no penalty i the targets are notmet. The mechanism is anticipated to generate larger volumes o reduction credits than the CDM.

Textbox 3: Wither the Clean Development Mechanism?

Sectoral credits enjoystrong political sup-port on both sides o

the Atlantic


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CMA April 2, 2009

International allowances

The Waxman bill also permitsemitters to use allowances rom

other emission trading programs

or compliance. Until recently, this

would have applied to the EU ETS

exclusively, but the implementation

o a carbon pollution reduction

scheme by 2010 in Australia, as

well as the expectation that other

countries (New Zealand, South

Korea) may ollow suit, opens up new

possibilities.

Volumes are potentially large, since

the entire pool o allowances rom the

other trading programs could be used

or compliance. The Waxman-Markey

bill does not set any limitation on the

use o international allowances or

compliance, so that the limitation is

more likely to come rom prices.

At current prices, European Union

Allowances (EUAs) and Australian

Emission Units (AEUs) could

constitute an attractive compliance

option. Figure 4 plots prices or EUA

utures (Dec 12 delivery). However,

Point Carbon anticipates prices will

increase in the EU ETS, as the cap

or its next compliance phase (Phase

3, 2013-2020) is very strict. We

orecast prices at 42 in 2013 and

48 on average over the whole phase

(assuming no linkage with the US).

To conclude domestic osets will

not ll much o the gap as they are in

short supply. US osets are currently

the least cost option but this might

change i we see the same trend

as in the CDM market. CERs are

priced based on their value in use

(i.e. as substitutes or EUAs) and not

based on marginal production costs.

US osets would then track US

allowance prices at a discount.

The role o international osets is

more uncertain. The CDM may not

be the right vehicle or the long term

supply o credits to the US market. I

an agreement is ound in Copenhagen

on sectoral credits and / or on REDD,

these would likely constitute the bulk

o the credit fow into the US.

International allowances could play

a large role i the various emission

trading programs establish linkages

allowing ree trade rom one program

to the other.

Internal Abatement

We now consider ways to reduce

emissions or large compliance

players, internal abatement.

As the import limits o osets and

international allowances are de acto

almost unlimited, the split between

oset credits and internal abatement

as compliance option will mainly

depend on prices.

Emitters have many emission

reduction options, including

Our analysis o the role o international allowances assumes that US emitters couldpurchase allowances rom Europe or Australia, but that the reverse is not true. In thelong term, however, one could oresee increasingly integrated global markets whereallowances would be reely traded rom one compliance program to another. TheEuropean Commission suggested in a recent Communication that it ambitioned tosee an OECD-wide market - including all major industrialized countries by 2015.

I there are no restrictions on the use o allowances in other markets, this wouldlead to a global, unique carbon price. In practice, countries are likely to set a limit,or quota, on how many oreign allowances can be used or compliance creatingdierent subsets o prices.

Even i direct trading o allowances is not allowed, international osets couldindirectly link dierent programs, as emitters in each country would be competingor the same credits. Hence policy developments abroad could play a role in price

ormation and market dynamics in the US in the medium to long term.

Textbox 4: Towards a global market?

Figure 4: EUA uture prices

0

5

10

15

20

25

30

35

40

Jan-08

Feb-08

Mar-08

Apr-0

8

May-08

Jun-08

Jul-0

8

Aug-08

Sep-08

Oct-0

8

Nov-08

Dec-08

Jan-09

Feb-09

Mar-09

Price/tCO2e

EUA 2012

The limitation on the

use o internationalallowances will come

rom prices


10/13



CMA April 2, 2009

improvement o industrial processes,

reducing methane leaks in pipelines

and rening, limiting the use o high

global warming potential (GWP)

gases fuorocarbon gases, etc. We

ocus on uel switching exclusively

because it is more likely to deliverlarge numbers o emission reductions

and thus be on the margin.

Fuel switching

Large reductions can come rom the

power sector: as the price o carbon

penalizes more carbon-intensive

uels (coal, petroleum) than natural

gas or carbon-ree generation, the

economics start working in avor o

the less carbon-intensive uels (see

our report The Power o Carbon, June

2008 or a detailed analysis o this

issue).

The amount o reductions at any

given carbon price varies with the

relative price o the uels. Point

Carbon created a simplied model

to evaluate the amount o reductions

associated with uel switching rom

coal to gas by applying a carbon price

to the electric generation feet by

region. Switching varies by region,

but the model assumes that price

would trigger the switch regardless

o any technical impediments.

Figures 5a and 5b show emissions

reductions rom uel switching in

$5 increments. Figure 5a uses spot

uel prices rom March 2009 ($4.35

natural gas, $49 coal, $63 SO2, $625

Nox) while Figure 5b plots the uel

switching curve using uture prices

or December 2012 delivery, as o

March 24, 2009 ($7.45 natural gas,$67 coal, $35 SO2, $650 Nox.)

The gures illustrate the extreme

sensitivity o uel switching to actual

uel prices. A carbon price o $10 a

ton yields over 120 mt o reductions

in GHG emissions in one case, and

a mere 10 mt in the other. I natural

gas is relatively more expensive than

coal, it takes a higher carbon price

to make the switch economical on

power markets.

Fuel switching has a potential or large

volumes o emission reductions.

However, i coal prices are low, the

carbon price needed to realize this

potential can climb very rapidly, as

seen in Figure 5b. I uel switching is

expensive and is setting prices on the

carbon market, it will provide a strong

signal or emitters to look into other

internal abatement measures. These

abatement measures would create

a negative eedback loop that would

eventually pull back down prices,

to the point where uel switching

is more economical than any other

abatement strategy.

Market Implications

Price ormation

Prices on the carbon market are set,

like those o other commodities,

by the intersection o supply and

demand. Figure 6 represents a

conceptual marginal abatement cost

curve. In this example, we assume

US Fuel switching curvefuel spot prices

$0

$10

$20

$30

$40

$50

0 50 100 150 200 250 300 350

Million tons CO2e

U

SDp

ertonofCO2e

Figure 5: Fuel switching curve in the US, spot and 2012 uture prices

We use NYMEX spot and 2012 uture uel prices as o March 24, 2009

US Fuel switching curve

future fuel prices (2012 delivery)

$0

$10

$20

$30

$40

$50

0 50 100 150 200 250

Million tons CO2e

U

SDp

ertonofCO2e

Reductions rom uel

switching are ex-tremely sensitive to

uel prices


11/13



CMA April 2, 2009

domestic osets are the lowest

cost compliance option, ollowed by

international osets. Fuel switching

(internal abatement) comes next,with international allowances at the

higher end o the range.

The demand intersects the marginal

abatement curve at 205 million

tons (the 2012 E-t-C without

complementary policies), calling

or some amount o uel switching

and bringing prices to around $30

a ton. Should energy eciency and

renewable electricity standards be

adopted, the demand curve would be

lower, and would intersect the MAC

curve at 87 million tons. Internationalosets would be on the margin, no

uel switching would be needed, and

prices would be below $15 a ton.

Conversely, as the size o the E-t-C

gap grows over time, the demand

curve will shit to the right because

emitters will need more allowances

to cover a greater shortall. This will

push prices up the uel switching

curve i no other type o reduction

takes place. As discussed above, the

MAC curve is itsel subject to change

as oset supply and uel prices

change over time.

We now tie the pieces together and

discuss likely compliance strategies

or selected compliance periods in

the rst decade o the cap-and-tradeprogram.

2012-2013 Few reductionsneeded

The rst compliance period would

require about 140 million tons o

reductions each year. US osets

will not suce to meet the gap.

CERs would constitute the next

most attractive compliance option.

I prices on the EU ETS have not

recovered, EUAs could also be part o

the compliance mix and would bring

prices on the US market to about

$20 a ton. I emissions and pricesrecover in Europe by 2012, prices in

the US would likely be set by CERs

and could thereore track EUAs at a

discount. This would constitute the

rst hint o market linkages.

It is also possible that the scheme

would be somewhat over-allocated i

the recession has an enduring eect

or i energy eciency investments

deliver their theoretical emission

reduction potential. The program

would not be compromised i

it started with a brie period o

over-allocation, provided that over-

allocation is small: participants would

likely bank allowances or later years,

when the caps get tighter. This would

prevent prices rom crashing to

zero. The bank would create a small

cushion to help buer volatility rom

uel prices or unoreseen exogenous

events.

I the eect o complementary

policies is lower than expected,

market participants will have

to procure more osets and

international allowances or turn to

internal abatement.

2016-2018 A wide array oabatement strategies

By the time the third compliance

period rolls in, the gap will have

grown to over 550 million tons:

this strong demand or allowances

calls or a wide array o reduction

strategies. All available US osets

will be tapped and the demand or

international osets will increase.

The gap could still potentially be met

through international osets, possibly

including the new credit types romsectoral and orestry programs.

I the competition or international

osets was such that osets could

only cover hal the gap, 250 million

tons o reductions would be needed.

Such volume o uel switching would

call or very high prices, up to $85 a

ton. Hence other compliance options

would likely come into the mix

Figure 6: Conceptual MAC curve

$0

$10

$20

$30

$40

$50

$60

0 100 200 300 400 500 600

Million tons CO2e

USD

pertonofCO2e

Volume

Price

Fuel switching

US Offsets

Intl Offsets

Intl Allowances

Demand curve

Marginal Abatement

cost curve (supply)

Demand goes up

as EtC grows

US emitters will haveto compete withother countries or

the international credits


12/13



CMA April 2, 2009

other internal abatement measures.

International allowances, even priced

at 50 a ton, could remain attractive.

Figure 7 shows the wide array o

compliance options that will be

necessary to meet the gap in the

medium term.

2020: The breaking point?In 2020, with a gap close to 800

million tons, we would approach the

point where meeting the gap under

current technological constraints

becomes very costly unless the

supply o international credits is

sustained and aordable.

High carbon prices could also raise

the interest in creating linkages

with a large number o countries.

The larger market could help

dampen the volatility derived rom

uel prices and would theoreticallyenable all participating countries to

take advantage o the lowest cost

reductions through the market.

This is especially true i countries

like South Korea or Mexico set up

their own trading program, where

reduction costs could be lower than

in Europe or in the US.

Figure 7: Meeting the E-t-C

5200

5400

5600

5800

6000

6200

6400

BAU Stimulus RES EnEf Remaining

emissions

Dom.

offsets

Int'l

Offsets

Fuel

switching

Cap

What to expect post-2020

Our analysis was ocused on the

short to medium term as it allowed

us to project the impact o policies

currently under discussion and to

assume no major technological

breakthrough would occur. But with

a rapidly declining cap, change within

the system will quickly become verycostly, providing a strong incentive

or technologies in the development

stage today like carbon capture and

storage or electric cars. Osets

play a key role in helping keeping

prices down while this transition

takes place, since investments in

cleaner power plants and new energy

systems take time. Whereas osets

provide a temporary x and a useul

cost-containment mechanism, they

do not substitute or necessary long

term changes.

ConclusionAll signals indicate that the new

administration and Congress are

serious about their commitment

to lower GHG emissions. The

dominant strategy involves a mix o

command-and-control and market-

based mechanisms. The regulatory

provisions energy eciency and

clean energy standards or the power

and transportation sectors have thecapacity to evoke large reductions

at a airly low cost, especially or

energy eciency measures. These

provisions are not only crucial or the

US to meet its target; they will also

lower signicantly the price o carbon

on the traded market.

US osets are unlikely to play a

large role as a cost-containment

mechanism because their supply

is very constrained. An increase

in investment will help increase

the available volumes, but the keylimitation is physical rather than

nancial.

The degree to which the internal

abatement option o uel switching

is deployed largely depends on the

level o reductions achieved by the

other options. Some amount o

switching will occur, but the carbon

cost at which uel switching becomes

economical is very volatile and does

not provide the clear, predictable price

signal needed to redirect investments

towards clean technology in the longterm.

These limitations put the spotlight on

international osets and allowances,

where larger amounts o emission

reductions could come rom

developing countries at lower costs.

But uncertainties related to the

upcoming international negotiations

still cloud orecasts both or volumes

and prices. The experience with

the CDM shows, however, that

maintaining high standards and

submitting projects to a stringent

evaluation process raises prices

even or initially low-cost projects.

International allowances and linkages

with other emission trading system

could also help temper prices in the

medium term. The outcome o the

Copenhagen negotiations will thus

have signicant implications or the

US carbon market.


13/13

Ofces

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CMA April 2, 2009

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us cap-and-trade program: options for compliance

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