Linking The Emissions Trading Systems in EU and California

Linking the Emissions Trading Systems in EU and California
Lars Zetterberg
With political will, the current barriers to linking the EU ETS and the emerging California scheme could probably be solved.
FORES Study 2012:6
2012 FORES Linking the Emissions Trading Systems in EU and California Lars Zetterberg First print, first edition FORES, Bellmansgatan 10, SE-118 20 Stockholm, SWEDEN +46 (0)8-452 26 60 brev@fores.se www.fores.se Print: Sjuhradsbygdens Tryckeri AB, Bors 2012 Paper: Scandia 2000 (cover), Edixion Offset ISBN: 978-91-979505-8-9
FORES is thankful to the Jan Wallander och Tom Hedelius reserach foundation for providing funding to print this publication.
IVL Swedish Environmental Research Institute is an independent, non-profit research institute, owned by a foundation jointly established by the Swedish Government and Swedish industry. IVL undertakes applied research and contract assignments for an ecologically, economically, and socially sustainable growth within business and society at large. The institute employs around 200 experts, which makes IVL a leading institute for applied environmental research and consultancy services
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fores study 2012:6

Lars Zetterberg
FORES, 2012
About FORES
FORESForum for Reforms, Entrepreneurship and Sustainabilityis a think tank that seeks to renew the debate in Sweden with a belief in entrepreneurship and opportunities for people to shape their own lives. Environment and the market economy, migration, entrepreneurship and civil society, integrity, gender equality, global democratisation and modernisation of welfarethese are some of the issues on which we focus. FORES is an open and independent forum for civil society, academics and policy makers throughout Sweden and Europe. Together with people in Sweden and abroad, we will find solutions to better meet the challenges that globalisation and climate change brings. We function as a link between the civil society, entrepreneurs, policymakers and serious research. FORES produces research papers and books, and organises seminars and debates. Visit our webpage www.fores.se
Table of Contents
About the Authors_ ________________________________________________ xi Acknowledgements_ ______________________________________________ xi _ About the Study___________________________________________________ xiii Foreword__________________________________________________________ xv Sammanfattning p svenska_____________________________________xix
Executive summary_ _______________________________________________ 1 _ Chapter 1. Introduction____________________________________________ 11 Chapter 2. Implications of linking_________________________________17 Chapter 3. Analysis of linking EU ETS with the emerging California ETS_ _______________________________________ 29 Chapter 4. Conclusions__________________________________________ 41 Chapter 5. Comments____________________________________________ 45 References________________________________________________________ 49
About the Authors

Lars Zetterberg is a researcher at the IVL Swedish Environmental Research institute. He has a doctoral degree from the university of Gothenburg where his dissertation had a focus on bioenergy, emissions trading and international climate policy. In his research, Zetterberg in particular focuses on design of emissions trading systems, the role of bioenergy in the climate policy and different paths towards a low carbon society. He has published a large number of peer reviewed articles and research articles and is a member of the FORES expert group on emissions trading.
Acknowledgements
The author would like to thank the Mistra foundation through the research program Mistra Indigo and the research foundation FORES for financial support. I would like to thank Peringe Grennfelt, Daniel Engstrm Stenson, Marcus Carson, Peter Zapfel, Paige Weber and Gernot Wagner for thorough reading and Dallas Burtraw, James Nachbaur, Daniel Radov, and Adam Diamant for valuable guidance.
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About the Study

Several countries and regions are following the example of
Europe and are establishing carbon emissions trading systems. One of the more promising developments is the one in California where a cap-and-trade-market is set to be operational in 2013. This paper explores the possibility of linking the EU ETS with the California ETS by focusing on specific design features of the two systems. In theory, both systems would benefit from linking, as it would lower the costs to reduce emissions, and both the EU and California are overall positive to linking their ETS with other systems. There are, however, still technical difficulties in linking these two systems, not least the different views on which off-setting mechanism to allow. EU ETS allows credits from the UN CDM system and does not allow for off-setting through forest credits, while the situations in the California ETS is the reverse. However, the study concludes that if the political will to link is there, it could overcome the technical obstacles
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Foreword
This study concerns one of the most interesting issues in
climate policy, linking emission markets to create a global price on carbon emissions. At a time when the UN sponsored global climate negotiations have repeatedly failed to come to a major agreement on emission reductions it has become evident that other alternatives have to be explored. At least, around and waiting for that agreement will not be sufficient. FORES has in its work looked for other ways of connecting countries and regions in the fight against climate change. Maybe most promising are the developments of emission trading systems emerging around the globe. In China, California, Australia, South Korea and many other places policy makers consider on emissions through carbon trading as way to reduce emissions. Often they look to Europe for guidance. Despite its shortcomings the European Unions EU ETS is by far the biggest and most successful emission trading system up to date. Establishing markets is in itself an important step. However, it might be just a first step into something even greater the linking of carbon markets and creation of a global price on carbon emissions. Not too many years ago, such a linking of emission trading systems was discussed in academia as a theoretical exercise. The idea that the few existing carbon markets would link up with carbon markets that did not yet exist, eventually creating a global price on carbon, seemed idealistic bordering on the nave. Today it is not as far-fetched anymore. FORES has in a previous publication discussed the
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developments of carbon markets in China, where pilot markets are to be introduced in seven provinces aiming at initiating a national system in 2015. Although the project is ambitious and promising, linking with other markets seem to be some way down the road. In this study, Lars Zetterberg, a researcher at IVL Swedish Environmental Institute, looks into a market that will soon be operative, and where the foundations for linking are already in place, namely the Californian emission trading system that is to start in the beginning of 2013. The basics of the US climate policy are well known. Washington is polarized, cap-and-trade has almost become a four-letter word and the hopes for an ambitious climate initiative on the federal level are slim. When looking for a silver lining, observers have instead turned to developments at state level, not least in California. California, the worlds eight largest economy with yearly emissions that roughly equals the total emissions of Poland, has previously been a frontrunner when it comes to environmental policies. From 2015, 85% of these emissions, will be regulated by a cap-and-trade-system. Should this turn out be successful in reducing carbon emissions in a cost efficient way, other US states will probably follow. Lars Zetterberg concludes that there are technical obstacles to linking, such as which off-sets are allowed, the Californian price ceiling and a problem of funds moving from the more to the less ambitious system (as has been addressed by FORES publication Bretton Woods for the Climate). But if there is political commitment from both parties, it should be possible to overcome these barriers. How strong these commitments are is addressed by the comments on the study.
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A few days before this report was sent to print, the European Commission and the Australian government declared that they are initiating a process with the intention to fully link their markets in 2018. With these developments, the idea of a ton carbon dioxide costing as much in Melbourne as in San Francisco and Stockholm is no more nave than 192 states agreeing on a burden sharing principle for reduced emissions. FORES would like to thank IVL Swedish Environmental Research Institute for making it possible for Lars Zetterberg to write this study. We are also thankful to Andrew Light from the Centre for American Progress and Andrei Marcu from the Centre for European Policy Studies for their comments found in the back of this publication. Martin dahl, director FORES
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Sammanfattning p svenska
Sedan 2005 har det europeiska systemet fr handel med
utslppsrtter EU ETS varit en av grundstenarna i EU:s klimatpolitik. Flera lnder och regioner har fljt det europeiska exemplet och etablerat, eller deklarerat en vilja att introducera, utslppsmarknader. Att flera lnder fljer efter skapar mjlighet fr EU att uppn ett uttalat ml att lnka samman sitt handelssystem med andra system fr att skapa strre utslppsmarknader som lngsiktigt skulle kunna innebra att kostnaden fr att slppa ut ett ton koldioxid blir detsamma i stora delar av vrlden. EU har under en tid framfrallt visat ett intresse fr att lnka samman sin utslppsmarknad med en amerikansk dito. I USA har politisk opposition i kongressen grusat ambitionen att etablera en federal utslppsmarknad. Men p delstatsniv r utslppshandel fortfarande p dagordningen. I nordstra USA lanserades 2009 the Regional Greenhouse Gas Initiative som inkluderar 10 stater. I den vstra delen av USA antog Kalifornien 2011 en lag om att infra ett cap-and-trade system, som trder ikraft den 1 januari, 2013. Med tanke p den kaliforniska ekonomins storlek och delstatens utslpp har denna utveckling attraherat ett srskilt intresse frn EU. 2011 mtte EU:s klimatkommissionr Connie Hedegaard Kaliforniens guvernr Jerry Brown och de bekrftade d planer p att lnka samman EU:s utslppshandel med Kaliforniens. Syftet med denna rapport r att utforska mjligheterna att lnka samman EU ETS med Kalifornien ETS genom att specifikt fokusera p hur de tv systemen r uppbyggda. I denna rapport diskuteras en mjlig lnkning i tv delar, den frsta fokuserar p de allmnna
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konsekvenserna av lnkning, den andra analyserar srskilt lnkningen av EU ETS med det framvxande Kalifornien ETS.
Konsekvenser av lnkning
Att lnka samman tv system innebr att utslppsrtterna i ett system ven kommer att vara till salu fr aktrer i det andra systemet. Att lnka samman tv existerande utslppshandelsystem kar i praktiken marknadens omfattning och fler utslppsminskningar ryms i systemet. I ett scenario dr kostnaden fr en utslppsrtt skiljer sig t i de olika systemen, kommer skillnaderna att jmnas ut och priset fr att slppa ut ett ton koldioxid kommer att bli detsamma i de tv lnkade marknaderna. En lnkning kan ske genom en direkt lnkning mellan de bda utslppsmarknaderna. En annan mjlighet r en s kallat indirekt lnkning dr tv separata system konkurrerar om samma offsetkrediter, allts utslppsrtter i ett tredje system, exempelvis i en av FN:s flexibla mekanismer. Denna rapport behandlar i huvudsak en direkt lnkning. Enligt ekonomisk teori finns det flera frdelar med att lnka samman utslppshandelsystem. Att lnka ett system med ambitisa ml och pfljande hga kostnader med ett system med mindre ambitisa ml och lgre kostnader leder till kad effektivitet och lgre totala kostnader fr att n gemensamma utslppsminskningsml. I grunden skapar transaktionen, dr tillgngar flyttas frn hgkostnadssystemet i utbyte mot fler utslppsrtter frn lgkostnadssystemet, en win-win situation dr de gemensamma utslppsminskningarna genomfrs till lgre kostnad. En kad likviditet p marknaden och lgre transaktionskostnader r tillsammans med frbttrat politiskt samarbete och
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en mjlighet att rtta till potentiell snedvridning av konkurrensen genom jmstllda koldioxidpriser andra frdelar. Att lnka marknader medfr ocks risker. I en situation dr tv marknader med avvikande ambitioner lnkas kommer stora summor frflyttas frn den ambitisa marknaden till den mindre ambitisa marknaden. Detta kan skapa ett incitament fr marknadsreglerare att stta ett mindre ambitis utslppstak n annars. Dessutom kan konkreta politiska frdelar ssom fortsatt samarbete och en starkare transatlantisk lnkning f ge vika fr en rdsla att frlora kontroll ver systemet.
Kompatibilitet en nyckel till framgngsrik lnkning

Designkompatibilitet r viktigt fr en framgngsrik lnkning. De tv systemen behver inte ndvndigtvis vara fullt kompatibla, men det finns tre aspekter dr skillnader kan orsaka srskilda problem: utslppstak och prisskillnad, erknnande av offsets, samt prisreglering.
Utslppstak och prisskillnad
Priset pverkas framfr allt av hur mnga utslppsrtter som finns tillgngliga i systemet. Ju strre prisskillnad p utslppsrtter, desto strre kommer vinsten att vara nr tv system lnkas samman. Men en betydande prisskillnad kan leda till en ovilja hos aktrer i hgkostnadssystemet att betala fr utslppsminskningar i lgkostnadssystemet. Detta kan skapa en politisk barrir som kan bli problematisk att bryta ner.
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Faktaruta: EU och Kaliforniens utslppsmarknader.

EU ETS
Tak. antal utslppsrtter (miljoner ton CO2-ekvivalenter Tcker andel av total utslpp (procent) Minskningsml 1900 (2013)
California
340 (2015)
40%
85%
-21% till 2020 jmfrt med 2005
-9% till 2020 jmfrt med 2005 (0% jmfrt med 1990 rs niv)
Erknnande av offset-krediter
Det r viktigt att de bda systemen har en verenskommelse om gemensamma regler fr offsets. Om tv system lnkas samman pverkar offset-krediter som anvnds i ett system ven det andra systemet, ven de inte tillts i det andra systemet. Detta eftersom utslppsrtter och krediter r utbytbara. Om exempelvis skogskrediter frn utvecklingslnder fr anvndas fr att uppn mlen i det ena systemet frigrs systemets vanliga utslppsrtter som kan anvndas av kpare i det andra systemet. Drmed anvnder kparen indirekt offset-krediter som inte tillts och det politiska beslutet att ej tillta visa krediter kringgs.
Prisreglering
Fundamentet bakom utslppsmarknader r att utslppstaket reglerar mngden utslpp och att priset sedan bestms p marknaden utifrn tillgng och efterfrgan. Till skillnad frn en koldioxidskatt dr reglerarna stter priset men de framtida utslppsniverna r oskra. I vissa fall har oro ver oskerheten kring priset lett till att reglerare infr en priskontrollmekanism i
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utslppshandelsystemet, till exempel ett pristak. Nr marknader lnkas samman kan skillnader i priskontrollmekanismer utgra ett betydande hinder. Anta ett scenario dr det ena systemet infr ett pristak men inte det andra. Pristaket i det frsta systemet blir d tillgngligt fr det andra systemet oavsett om det finns ett motsvarande pristak i det andra systemet eller inte. Dessutom skulle det totala antalet utslppsrtter ka, vilket pverkar utslppen i bda systemen.
En analys av potentiell lnkning mellan EU ETS och det framvxande Kalifornien ETS
Vid en diskussion av mjligheterna att lnka samman utslppsmarknaderna i EU och Kalifornien r fljande aspekter srskilt viktiga att beakta:
Syn p lnkning
EU ser grna ett framtida samarbete med andra stater och regioner, en ambition som tydliggjordes nr Kommissionen i augusti 2012 tillknnagav att man inlett en process fr att lnka EU ETS med Australiens ETS. Lnkning ses frn EU:s sida som ett stt att fra fram unionens klimatagenda och snka priserna. I Kalifornien, andra sidan, rder en viss tveksamhet om det europeiska och det kaliforniska systemen r kompatibla. Dremot r arbetet lngt gnget gllande en lnkning med Quebec svl som delstaterna i det som kallas Western Climate Initiative. Bde EU och Kalifornien r i allmnhet positiva till att lnka med andra utslppshandelssystem.
Niv p utslppsml
Om utslppsmlen skiljer sig vsentligt mellan EU och Kalifornien kan en lnkning innebra betydande frndringar i priset p utslppsrtter ( jmfrt med att inte lnka) och drmed kommer ocks betydande summor pengar fras ver frn det system med det mer ambitisa mlet till det med mindre ambitisa ml. I procent rknat r EU:s ml mer ambitist, men vid en jmfrelse mellan tv ml br ven faktorer som befolkningstillvxt, ekonomisk tillvxt och tillgngliga minskningstgrder beaktas. Trots EU:s mer ambitisa ml r det mjligt att priserna i de bda systemen kommer att landa p samma niver, beroende p att kostnaderna fr att minska utslppen antagligen r hgre i Kalifornien. Utslppsrttspriserna fr 2020 uppskattas ligga mellan 17 och 37 USD fr EU ETS och mellan 15 och 75 USD fr Kalifornien. Utifrn dessa siffror r det svrt att dra ngra slutsatser om vilket system som kommer hgst priser under perioden 2013-2020. Drfr r det ocks svrt att avgra vilket system som kommer att vara nettokpare av utslppsrtter.
Erknnande av offsets
EU och Kalifornien tillter olika typer av offsets. I EU ETS fr man inte tillgodorkna sig skogskrediter som offsets, men dremot utslppsrtter frn FN:s CDM. I Kalifornien r situationen den omvnda. Dr tillts skogskrediter, men inte CDM-krediter. Detta anses vara ett betydande hinder i arbetet med att lnka samman de tv systemen. Med tanke p att en lnkning kan bli verklighet om ngra r kommer utvecklingen av en framtida CDM och mjliga nya marknadsmekanismer inom UNFCCC-strukturen vara viktig att flja.
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Prisreglering
I Kaliforniens system finns en reserv av utslppsrtter som utgr ett stt att skapa ett pristak. Om priset nr $40 grs utslppsrtter frn reserven tillgngliga p marknaden fr att driva ner priset. Detta skulle kunna utgra ett hinder fr en lnkning eftersom EU ETS-direktivet enbart tillter utslppsrtter frn system med absoluta utslppstak. Det kommer emellertid finnas ett begrnsat antal utslppsrtter som kan anvndas om priset slr genom taket. Reserven med utslppsrtter utgr de-facto ett utslppstak, vilket underlttar fr en lnkning med EU ETS.
Tckning av sektorer och distribution av utslppsrtter
Skillnader i vilka sektorer som ingr och frdelningen av utslppsrtter torde inte utgra ngot strre hinder fr lnkning. Bda systemen tcker en relativ stor andel av utslppen och liknande sektorer (ven om Kaliforniens system innefattar utslpp frn transporter). I bda systemen delas ett minskande antal utslppsrtter ut gratis samtidigt som andelen utslppsrtter som sljs p auktioner kar ver tid.
Slutsatser
Det finns betydande tekniska hinder fr att lnka utslppsmarknaderna i Kalifornien och Europa. Dessa borde emellertid vara mjliga att lsa om det finns tillrcklig politisk vilja att genomfra lnkningen. Bde EU och Kalifornien r generellt positiva till att lnka sin ETS med andra system. Teoretiskt skulle bda systemen dra nytta av en lnkning eftersom den leder till lgre kostnader. Dessutom skulle ett gemensamt arbete att minska
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utslppen belysa behovet av att minska vxthusgasutslppen svl som att etablera en starkare politiskt lnk mellan de tv systemen. En framgngsrik lnkning vore ett vlkommet framsteg i en tid dr effekterna av klimatfrndringar blir alltmer synliga fr varje frlorad mjlighet.
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Executive Summary
The European emissions trading system EU ETS has since
its inception in 2005 been one of the cornerstones of the unions climate policy. As of today, several countries and regions have followed the European example and established, or declared their intentions to initiate, carbon markets. Along with this development comes the possibility to achieve another aim of the European climate policy to link up its emission trading system with other systems in order to create larger carbon markets which could in the long run mean that the cost of emitting a ton of carbon dioxide will be the same in large parts of the world. In particular, the EU has shown an interest in creating transatlantic carbon markets. In the US, the ambition of establishing carbon markets on a federal level has been stalled by political opposition in Congress and the chances of a federal cap-and-trade system are slim. But on a state level carbon markets are still on the agenda. In the North-Eastern US, the Regional Greenhouse Gas Initiative was launched in 2009, involving 10 states. In the western part of the US, California adopted, in 2011, a cap-and-trade system that will be enter into force from January 1, 2013. Given the size of the Californian Economy and its emissions, these developments have attracted particular interest from the EU and in 2011 the EU commissioner on Climate Action, Connie
1
Linking_the_Emissions_Trading_Systems_in_EU_and_California
Hedegaard, met with Californias governor Jerry Brown and confirmed plans to link the EU emission trading system (EU ETS) with Californias emerging carbon market. The aim of this paper is to explore the possibility of linking EU ETS with the California ETS by focusing on specific design features of the two systems. This paper approaches the prospect of linking from two different angles, the first considers the general implications of linking, the second aims to analyse in the case of linking the EU ETS with the emerging California ETS.
Implications of linking
Linking two emissions trading systems means, in short, that emission allowances in one system will be also be up for sale for actors in another system. Linking two existing emissions trading system expands the scope of the market, and enables emission reductions in both systems. In a situation where the costs of an allowance differ between the systems, a linking will result in a levelling of these differences and the price to emit a ton of greenhouse gas will be the same in the two linked markets. A linkage can be done in a direct way, whereby one emission trade system is directly linked with another. Another possibility is a so-called indirect linkage, where two separate systems compete over the same off-set credits. This report focuses on a direct linkage. According to economic theory, the benefits from linking emissions trading systems are several. Linking two systems with differences in ambition (in terms of emission reductions) and subsequent emission reduction costs will lead to increased efficiency and lower total costs for reaching collective emission reduction
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Executive_Summary
targets. At its essence, a transaction between the two systems where the high-cost systems pays the low costs system for emissions reductions in the form of allowances creates a win-win situation where the total costs are reduced. Further benefits include increased liquidity and lower transactions costs, political cooperation as well as eliminating any potential competitive distortions as linking of carbon markets may equalize carbon prices. Linking emission markets also comes with its risks. In a situation where two markets with very different ambition links up, large funds will be transferred from the ambitious market to the less ambitious market, which may create an incentive for the market regulators to have a laxer cap than they would otherwise strive for. Moreover, tangible political benefits such as further cooperation and a stronger transatlantic linkage could be overshadowed by a fear of losing political control and lead to a compromising of original targets.
Compatibility a key to successful linking

Compatibility of design features is crucial to a successful linkage. The two systems do not necessarily have to be fully compatible, however there are a some features which may constitute a barrier to linking if they diverge: relative stringency of targets, recognition of off-sets and price management.
Relative stringency of targets
The number of allowances available is what primarily affects the price in an emissions trading system. The greater the allowance prices of the two systems differ, the greater the economic gain will be when linking the two systems. However a substantial price
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Fact box: European and Californian carbon markets the basics

EU ETS
Cap, number of allowances (million ton CO2-equiv.) Coverage of Emissions (percent) Reduction targets 1900 (2013)
California
340 (2015)
40%
85%
-21% to 2020 compared to 2005
-9% compared to 2005 (0% compared to 1990 levels)
difference could lead to significant change in allowance price and substantial flow of funds from one system to the other. This could create a political barrier, which could be problematic to overcome.
Recognition of off-sets
In the case of offsets, it is important that the two systems agree on a joint scheme. If two trading systems are linked, an off-set credit in one system would have an impact on the second system, even if that system restricts its use. This because allowances and credits are interchangeable. If for instance forest credits from developing countries are used for compliance in one system it will free up regular domestic allowances that buyers in the second system will use, thereby indirectly using the offset credits restricted. This way the political decision in the second system to restrict the use of certain off-sets has been bypassed.
Executive Summary
Price management
The foundation behind emission markets is that an emission cap is set to regulate the quantity of emission, and that the price of allowances will then be decided on the market due to the logics of supply and demand. This is opposed to a carbon tax, where regulators set the price, while the emissions volume is uncertain. In some cases, concern about price uncertainty has led regulators to introduce price control mechanism in the emission trading systems. When linking markets, differences in price control mechanisms in two systems could constitute a considerable barrier. Consider a scenario where one of the systems introduces a price ceiling by adding extra allowances to the market. The price ceiling in the first system would become available in the other system regardless if the other system acknowledges this price-ceiling or not. Not only would emissions increase in both systems as a result of the extra allowances, if the price is too low the development of new carbon efficient technologies will be delayed.
Analysis of linking EU ETS with the emerging California ETS

When considering the prospects of creating a common ETS for the EU and California, it is important to have the following aspects in mind:
General positioning on linking
The EU is keen to cooperate with other states and countries, not least shown in their declaration to initiate a process to link up with the Australian ETS, as it would push their climate change
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agenda and lower costs. California, on the other hand, has doubts concerning the compatibility between the two jurisdictions and is considering Quebec as well as the Western Climate Initiative as more likely as primary candidates for linking. However, it seems likely that in the longer run, there is an interest from both parties to link up with each other.
If the ambition of the targets of EU and California differ significantly, linking may lead to substantial changes in allowance price (compared to not linking) and a net flow of funds from the system with the more ambitious target to the system with less ambitious target. In terms of percentage the EU reduction is more ambitious, but when comparing targets one need also to consider aspects such as population growth, economic growth and available abatement options, which all have an impact on allowance prices. Even if the EU has more stringent targets vis--vis California in terms of reduction percentage, the prices of the two systems may more or less overlap due to the higher costs of reducing emissions in California. Estimated allowance prices for 2020 lie between USD 17-37 in the EU and between USD 15-75 in California. Based on these figures, it is difficult to conclude which system will have the highest allowance price over the period 2013- 2020 and therefore be the net buyer of allowances.
The EU and California acknowledge different off-sets. California relies on forest credits, which the EU does not recognise. In
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Executive Summary
contrast, the EU uses CDM, which are not acknowledged by California. This is considered to be a major obstacle in joining together the two systems. Given that a linkage is a few years down the road, the developments of a future CDM and possible new market mechanisms within the UNFCCC-structure will be important to follow also in the sense that it might effect the possibilities of linking.
Price management
The Californian uses a reserve of allowances system as a price ceiling mechanism. If the allowance price reaches $40 a number of allowances are made available to the market, which drives the prices down. This could be an obstacle to a linkage with Europe since the EU ETS according to its directive only recognizes allowances from systems with absolute caps. However, in California there will only be a limited number of allowances available if the allowance price reaches the price ceiling levels. This price ceiling reserve works like a de-facto cap on emissions, which would facilitate linking with the EU ETS.
Sector coverage and Distribution of allowances
The two last criteria should not pose much of a barrier to create a linkage. Both jurisdictions have similar sector coverage and distribution of allowances, each having a long-term plan of phasing out free allocation of allowances.
Overall findings
Although there are considerable technical difficulties in linking these two systems, a political willingness towards linkage could overcome most of the obstacles. Both the EU and California are overall positive to linking their ETS with other systems. In theory, both systems would benefit from linking, as it would lower costs and overall emissions. Moreover, a concerted effort to reduce emissions would push the climate change agenda forward and highlight the need to reduce GHG emissions as well as establishing a closer political connection between the two jurisdictions. An effort desperately needed in times where the effects of climate change become more tangible for every opportunity that goes by.
Chapter 1
Introduction
In the absence of an international agreement on climate
change, significant efforts are being initiated today, on a regional, national and sub-national basis. These initiatives could be connected from the bottom-up to form a regime with growing global coverage. In this respect, the creation and linkage of carbon markets is considered key. Carbon markets are seen as a cost effective way to reduce GHG emissions. In addition, carbon markets can provide finance for mitigation and adaptation actions and provide support for technology deployment and innovation (CEPS 2012). The EU emissions trading system (EU ETS), in operation since 2005 and covering about 6% of global CO2 emissions, is by far the worlds largest emissions trading system. The EU emission trading system was launched with the purpose of reaching the EU reduction target according to the Kyoto protocol in a costeffective way and is now regarded by the EU as the main policy instrument to reach the 20% reduction target by the year 2020 (European Commission 2008a and 2011). The EU ETS applies to the 27 EU member states and Norway, Iceland and Lichtenstein. It covers some 11500 participating installations in the energy and
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industrial sectors which are collectively responsible for almost half of EU emissions of CO2 and 40% of its total greenhouse gas emissions (European Commission, 2009). The EU ETS also provides demand and finance for emissions reductions in developing countries by supporting the Clean Development Mechanism (CDM). Together with the CDM, the EU ETS forms the basis for the most important global carbon market. The EU is working towards creating a global carbon market, with a vision of having an OECD-wide market in operation by 2015. A stepping stone in this direction would be the establishment of a transatlantic carbon market by linking the EU ETS with emerging carbon markets in the US. Although the US has been unwilling to join the EU in the efforts to develop a global Kyoto style carbon market, there have been several proposals for a US federal emission trading system (Sterk et al 2009). However, climate policy in the USA has taken another direction. After the congress in July 2010 failed to pass comprehensive climate legislation, the prospects for establishing a nationwide emission trading system suffered a serious setback. Following the midterm elections in 2010, there has been a shift in power from Democrats to Republicans generally unenthusiastic about cap-and-trade. Together with the financial crisis, this change in the US political landscape has led to decreased opportunities for a national climate policy and the support for emissions trading has vanished. Although the prospects of a federal emissions trading system seem far away, regional initiatives are emerging. This has been made possible due to the election outcomes on the North East and West coasts (Mehling et al 2011). Beginning in 2009, the Regional Greenhouse Gas Initiative (RGGI) sets a modest but binding cap on power plants in 9 Northeastern US states.
12
Introduction
In the other part of the United States, California will launch a state wide cap and trade program in 2013. The California initiative builds on targets set in the Global Warming Solutions Act from 2006 to reduce GHG emissions statewide to 1990 levels, about 432 million metric tons CO2-equivalents (MtCO2e) by 2020 corresponding to a reduction of roughly 80 MtCO2e below forecast business-as-usual levels (LAO 2012). The lions share of these reductions is expected to be achieved by a number of regulatory standards and measures, including motor vehicle standards and renewable portfolio standards for power production. The residual reductions are left to the cap-and-trade program (Zetterberg et al 2012). Beginning in 2013, this ETS will first cover power production and energy intensive industry. From 2015 the system will expand its scope to cover approximately 340 MtCO2e or 85% of the state emissions by including distributors of transportation fuels, natural gas and other fuels (LAO 2012). This progress on US state level has helped to keep the EU vision of a transatlantic carbon market alive. In April 2011 EU:s commissioner on Climate Action, Connie Hedegaard, met with Californias governor Jerry Brown and confirmed plans to link the EU emission trading system with Californias emerging carbon market (Guardian 2011). However, given the differences in the two systems regarding cost management, use of external off-sets and other design features, it is unclear whether the emerging carbon markets in California will be sufficiently compatible to allow a transatlantic link to the ETS already in place in the EU. The objective of this paper is to investigate the prospects of linking the EU ETS with the California ETS with regard to relevant design features of the two systems. Chapter 2 presents
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implications of linking two emission trading systems in general, while chapter 3 analyses the specific case of linking the EU ETS with the California emission trading system. Finally chapter 4 presents conclusions and recommendations for facilitating linkage.
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Chapter 2
Linking an emission trading system can in a general sense be
seen as expanding the scope and coverage of the emission trading system in order to achieve efficiency gains. This can for instance be done by including new countries, sectors and gases or import emission reduction credits (off-sets). An emission trading system can also link with another emission trading system directly in the sense that allowances from both systems are interchangeable and acknowledged by both jurisdictions for compliance. Linking can also be indirect, if two separated cap-and-trade programs accept and compete over the same offset credits. In this report, the analysis is limited to direct linking of two emission trading systems. In particular the European and Californian carbon markets. Economic theory suggests that linking two carbon markets will increase efficiency and lower the total costs for reaching the collective emission reduction target, since more reduction options are available in the larger system (Sterk and Kruger 2009). Linking is also expected to increase liquidity and lower transaction costs. By equalizing carbon prices in the two markets, linking also addresses the issue of competitive distortions. Furthermore, linking signals international collaboration and a commitment to
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long-term climate policy and multilateralism. This may in turn provide larger predictability for investors in carbon intensive industries (Flachsland et al 2009).
Economic implications of linking

The economic benefits of linking two systems is graphically illustrated in figures 1, showing two separated emission trading systems, and figure 2, showing the effects of linking these two systems. Figure 1 shows the situation before linking. System 1 has a more ambitious reduction target and is referred to as the High cost system, while System 2 has a less ambitious reduction target and is referred to as the Low cost system. The sloping line illustrates
Figure 1. Two separated emission trading system with different allowance price.
System 1. High cost

Price Marginal abatement cost
System 2. Low cost

Price
p1
Total abatement cost
p2
cap1
Emissions
cap2
Emissions
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the Marginal Abatement Costs (MAC) as a function of emissions. We assume that when the ETS is introduced emissions are at the level where the MAC-curve crosses the x-axis, where the marginal abatement cost is zero. When emissions are capped, firms will need to reduce emissions down to the level of the cap. As emissions are reduced the marginal cost for abatement will increase. When emissions are reduced to the level of the cap, the price of allowances will equal the marginal cost for abatement. The total cost for reaching the emissions target is illustrated by the red triangle in the figure. A system with a more stringent cap (system 1) will have a higher allowance price and higher costs than a system with less ambitious cap (system 2).
Figure 2. The effects of linking two emission trading system with different allowance price.
System 1. High cost

Price
System 2. Low cost

Price
allowances p1 pLink p1 funds
cap
eLink
Emissions
eLink
cap
Emissions
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Figure 2 shows the effects of linking the two emission trading systems in figure 1. System 2 with a lower allowance price will perform additional emission reductions and sell the surplus allowances to system 1. This continues until allowance prices are equalized in the two systems at the new price level pLink. In system 1 emissions increase from the cap level to a new level, eLink. In system 2 emissions decrease from the cap level to a new level, eLink. The high cost system pays the low cost system in return for allowances, while the total emissions in the two systems are unchanged. The cost savings in system 1 will be the reduction of abatement costs minus the costs for acquired allowances, illustrated by the blue triangle. The net revenues in system 2 will be the value of sold allowances minus the additional costs of abatement, illustrated by the yellow triangle. This graphical illustration shows that both systems benefit from linking and that the total costs are reduced by the sum of the yellow and blue triangles. Estimates show that the total cost savings from creating a global carbon market with trade across all countries and sectors as opposed to non-trade can be as high as 50 percent or more (Flachsland et al 2009). Although both systems, on aggregate, are better off from linking than before, there may be individual participants that are worse off from linking. For instance, sellers of allowances prior to linking may become buyers after linking (EPRI 2006). In addition to the cost savings and effects on allowance price, there are other economic implications of linking. Linking carbon markets from different regions may equalize carbon prices and thereby reduce competitive distortions between the regions. With the creation of a larger carbon market, with more players and allowances, linking is likely to reduce transaction costs and
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increase market liquidity. Price variations and shocks within one system can be absorbed and cushioned within a larger overall market. Thus, linking may enhance price stability which improves certainty for investors. On the downside, from a single systems point of view, volatility from the other system might be imported (Flachsland et al 2009). There are concerns that linking could introduce a perverse incentive for allowance sellers to relax their cap in order to sell more allowances, and as a result increase their revenues.
Political implications of linking

In addition to the strict economic implications from linking, there are also political consequences from linking. Although this paper mainly focuses on the technical implications of linking, a few points on political implications are worth mentioning. According to Flachsland et al (2009), linking signals political collaboration which may enhance further cooperation between parties and provide an example to follow. In fact, the authors argue that this is the most tangible benefit of a transatlantic linkage. Secondly, as mentioned previously, linking can equalize carbon prices and address the issue of competitive distortions, an effect that also holds a political dimension. Linking can facilitate the acceptance of climate policy among business actors and the general public. The relevance of this point is manifested in what the business community calls leveling the playing field by harmonizing carbon prices globally within a sector. Third, linking is a way for one party to signal approval towards other systems. Conversely, a linking offer could be declined despite the efficiency gains, if the potential
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partners efforts are perceived to be unacceptably low. The authors take the example of linking the EU ETS with the US RGGI system. Even though cost savings would be expected, the EU would most likely be reluctant to link to a system that would sell hot air allowances to the EU ETS. A problem of linking two systems with different political objectives may be the loss of control and compromising of the original policy priorities in each system. By linking, the scope for regulatory interventions of the single system is reduced.
Implications of differences in design features

Linking will generally lead to mixing of design features (Tuerk et al 2009). Linking does not require all design features to be identical, however differences in certain design features may undermine the original objectives of the system and thereby constitute a barrier to linking. In this respect, the following design features are regarded as critical (Sterk and Kruger 2009, Mehling et al 2011): Relative stringency of targets Recognition of off-sets Price management, also referred to as cost containment

As shown in figure 2, linking will raise the allowance price in the low cost system while reducing allowance price in the high
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cost system. On aggregate, money will flow from the high price system to the low price system. This effect can result in significant political pressure, especially if the price gap is large to begin with. Constituents in the high cost system may be very reluctant to pay for emissions reductions in the low cost system. On the other hand, if allowance prices are very similar in the two systems, there will be little economic gain in linking. In fact, the greater the difference in pre-link allowance prices, the greater benefit from linking will be. Paradoxically, the difference in abatement costs, reflected in allowance price, is an important economic motive for linking two emission trading systems, but may also constitute a significant political barrier.
Recognition of off sets

A second barrier to linking may be what off-sets are allowed in the two systems. Sterk and Kruger (2009) and Mehling et al (2011) note that if two trading systems are linked, an off-set credit in one system would have an impact on the second system, even if that system restricts its use, as shown in figure 3. This is because allowances and credits are interchangeable. If a particular kind of credit, for instance forest credits from developing countries are recognized in one system but not in the second, the forest credits could be used for domestic compliance purposes in the first system. This would free up regular domestic allowances in the first system that could be sold to the second system. It would be impossible for the second system to know the origin of the allowances. The combined system would therefore be using forest credits. This way the political decision in the second system to restrict the use of certain off-sets has been bypassed.
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Figure 3. Off-sets available in one system are after linking available in the second system even if that system restricts its use
California ETS
EU ETS
Forest credits
CDM
Price management mechanisms

The third design feature that may be a barrier to linking is the existence of price management mechanisms, also called cost containment mechanisms. Emission trading is a so called quantity based market mechanism. By defining an emissions cap, there is certainty about how high the emissions will be, but uncertainty about the price on allowances. In contrast a price based policy like a carbon tax provides certainty about the carbon price, but uncertainty about what the level of emissions will be. Before emission trading was introduced, The EU investigated the possibility to implement a carbon tax. However, since this turned out to be politically impossible, they changed strategy and pursued the concept of emissions trading instead (Wrke et al 2012). In addition, since the EU has committed to reduce emissions by 20% by the year 2020, emission trading is regarded as an attractive policy instrument since it can
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provide certainty in reaching this objective. The uncertainty of allowance price associated with emission trading has led to concerns by both EU and US regulators. In the US, different emission trading scheme proposals have involved different types of cost containment provisions, including off-sets and borrowing provisions. However, the option for cost containment that has been most commonly discussed is some sort of price ceiling, also referred to as price caps. This is due to the economic down turn and concerns about international competitiveness. The function of a price ceiling is illustrated in figure 4. If the allowance price reaches a pre-determined level, pceiling extra allowances are provided by the regulator at a fixed price. As long as the allowance price is below the price ceiling, the scheme functions like a quantity based policy with certainty of total emissions, but not price. If the price ceiling is reached, the system turns into a price based policy (like a carbon tax). As additional allowances are injected
Figure 4. Schematic description of how a price ceiling functions

Price
p p
ceiling
Emissions cap eceiling
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into the market, emissions increase. This provides certainty about the maximum carbon price, but not the emissions volume. Price ceilings have important implications on linking. Mehling et al (2011) and EPRI (2006) show that if this type of provisions are available in one system, they will become available in the other system after linking too, regardless if the other system acknowledges them or not. This mechanism is described in figure 5. Assume that system 2 has a price ceiling that has been activated, i.e. allowance price has increased to the price ceiling level, which has triggered the release of extra allowances until the marginal abatement costs correspond to the price ceiling. After linking the participants in system 1 (without a price ceiling) will be able to buy allowances from system 2 at the price ceiling level. Emissions will
Figure 5. Linking an emission trading system without a price ceiling with another system with a price ceiling
System 1 without price ceiling

Price
System 2 with price ceiling

Price
p1
p2 p
ceiling
p ceiling cap e
ceiling
Emissions cap eceiling
Emissions
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also increase in system 1 until marginal costs of abatement equals the price ceiling level. As shown by the graphics, emissions could increase considerably in system 1. This example illustrates one possible case, when the price ceiling is activated both before and after linking. Other cases include: The price ceiling is not activated before nor after linking The price ceiling is activated only after linking The price ceiling is activated before linking, but not after These alternative cases are described in EPRI (2006). The EU commission has also been concerned about carbon price, but now discussions mainly focus on a too low allowance price. A too low price will result in a delay in the development of necessary carbon efficient technologies. In the first phase of the EU ETS, allowance price was volatile and reached 34 per ton before plummeting to almost zero (Wrke et al 2012). Following the revision of the directive, starting in phase two (2008-2012) limited price management has been provided by off-sets provisions, limited borrowing and adjusting the cap. In phase two, allowance price has been relatively stable around 15, but since the end of 2011 allowance price has fallen to a level below 7 (May 2012). This recent development has opened for new EU discussions of increasing carbon price through cap adjustments.
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Chapter 3
In this chapter we analyze the prospects for linking EU ETS
with a Californian scheme with regard to the following aspects: General position on linking Relative stringency of targets Recognition of off-sets Price management Sector coverage Distribution of allowances
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Fact box: European and Californian carbon markets the basics

EU ETS
Cap, number of allowances (million ton CO2-equiv.) Coverage of Emissions (percent) Reduction targets 1900 (2013)
California
340 (2015)
40%
85%
-21% to 2020 compared to 2005
-9% compared to 2005 (0% compared to 1990 levels)
EUs and Californias position on linking

The EU sees its emission trading system as an important building block for the development of a global network of emission trading systems.1By linking other national or regional cap-and-trade emissions trading systems to the EU ETS a bigger market can be created, thus potentially lowering the aggregate cost of reducing greenhouse gas emissions, increasing liquidity and reducing price volatility. The EU points out that it is keen to work with the US to build a transatlantic carbon market which can act as the engine of a concerted international push to combat climate change. While the original Directive only allowed for linking the EU ETS with other countries that have ratified the Kyoto Protocol, the new rules (EC 2008b) allow for linking with any country or administrative entity (such as a state or group of states under a federal system). A requirement for linking is that the other country establishes
1. In late August 2012, when this report where about to be finalized, the European Commission and the government of Australia declared their intention to link their respective carbon markets not later than 2018.
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a compatible mandatory cap-and-trade system whose design elements would not undermine the environmental integrity of the EU ETS, meaning that there must be an absolute cap on emissions. When developing the cap-and-trade regulation, the California Air Resources Board indicated that linking with other jurisdictions cap-and-trade programs is interesting as it could serve to contain aggregate program costs by providing more opportunities for low cost emission reductions. However, legal questions have been raised regarding Californias ability to enter into an agreement with a province of another country. In addition to legal concerns, California points out that it is important that covered entities in both jurisdictions are harmonized and subject to equally stringent rules for compliance. Otherwise, unintended adverse economic impacts may result. For instance, off-set protocols should be harmonized. Moreover, the California Air Resources Board raises concerns that if the linked jurisdiction has a more stringent target than California, this may lead to a scarcity of allowances which may increase overall allowance prices and increase compliance costs for Californias covered entities (LAO 2012). Regarding potential candidates for linking, California specifically mentions the Western Climate Initiative (WCI) a consortium of Western US states, Canadian provinces and Mexican states. While many of the WCI members have either postponed or are further behind the regulatory development process, Quebec is seen by the Air Resources Board as being on track to link with California. Consequently, in May 2012 the California Air Resources Board announced plans to link with Quebec (CARB 2012). Linking with EU ETS is not explicitly mentioned.
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Significant differences in the stringency of targets may lead to large differences in pre-link prices in the two systems. If this is the case of EU and California, linking may lead to significant changes in allowance price (compared to not linking) and a significant net flow of funds from one system to the other. In the EU, the target is to reduce GHG emissions by 20% in 2020 as compared to 2005. The EU leaders also offered to strengthen the EUs emissions reduction target to -30%, on condition that other major emitting countries in the developed and developing world commit to do their fair share under a global climate agreement (EC 2012a). For sectors participating in the EU ETS, the target is currently 21% below 2005 year levels by the year 2020, while other sectors, mainly transports and housing have a lower reduction target. The reason for this differentiation is that the trading sectors are estimated to have cheaper mitigation options available. Californias target is that emissions in 2020 shall be at the same level as in 1990. Comparing these targets is not just a matter of percentages, but need to consider several other aspects such population growth, economic growth and available abatement options. Allowance price can be used as proxy for describing the stringency of the policy since it reflects the costs incurred by the policy. In the EU, from April to December 2011, allowances were sold at US$9 - US$23. EU allowance futures for the year 2020 have been sold at US$17 - US$37 during the same period (co2prices 2012). For California, futures for 2013, 2014 and 2015 were in May 2012 sold at US$15, US$15.75 and US$16.75 respectively (GreenTex 2012). For the year 2020, according to California Air Resources Board, allowance price is estimated to lie between US$15 and US$75 (LAO
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2012). Based on these figures, it is difficult to conclude which system will have the highest allowance price over the period 20132020 and therefore be the net buyer of allowances. Variations in price over time may lead to trade in both directions.
In the EU ETS, the overall use of credits is limited to 50% of the EU-wide reductions over the period 2008-2020. In practice, this means that existing operators will be able to use credits up to a maximum of 11% of their allocation during the period 20082012. The EU only recognizes offsets produced under the Kyoto Protocols Joint Implementation (JI) mechanism (covering projects carried out in countries with an emissions reduction target under the Protocol) or Clean Development Mechanism (CDM) (for projects undertaken in developing countries) (EC 2012b). For the third phase of EU ETS, beginning in 2013, the use of CDM-credits is restricted so that any credits used for compliance need to be either from projects registered before the end of 2012 or from projects in so called least developing countries. Unused CDM-credits from the period of 2008-2012 may be carried over to phase III, but will have to be swapped for EU allowances before 2015. In addition, EU has from 2013 also banned the use of CDMcredits from projects destroying HFC-gases. Any future decision on the use of offsets from flexible mechanisms is closely linked to developments in the UNFCCC-negotiations, both in regards to CDM and a possible new market mechanism. In the California emission trading system, the regulation allows no more than 8 % of a covered entitys compliance obligation to
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be met with off-set credits, while the remainder must be met with allowances. As of January 2012, only off-set projects in the US were allowed and only from the following four areas: forestry, urban forestry, dairy methane digesters and prevention of the release of ozone-depleting substances (LAO 2012). As noted previously, when two systems are linked, off-sets that are recognized in one system will become available in the other. If off-sets from one system are not allowed in the other, these off-sets will still have an indirect impact on the other system, since allowances and off-sets are interchangeable. When it comes to recognition of off-sets, Europe and California are currently far apart. While the EU only allows CDM projects, these Kyoto Protocol project based off-sets are regarded with a high degree of skepticism in some US quarters (Sterk and Kruger, 2009). Moreover, the EU does not recognize the use of forest off-sets, due to questions about monitoring and reporting, but also due to uncertainties about the permanence of these reductions (EC 2008b).
Price management
The price management features mostly discussed in emission trading schemes include off-sets, borrowing and banking provisions and price ceilings. The recognition of off-sets has been previously discussed. The EU ETS did not allow banking between phase 1 (2005-2007) and phase 2 (2008-2012), but banking will be possible between phase 2 and phase 3 (2013-2020). The EU ETS also allows for limited borrowing between years. In February allowances are issued for the current year and in April allowances for the previous year need to be surrendered. This means that
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allowances corresponding to two years allocation are available at the time of compliance. This opportunity will be reduced as free allocation is phased out. In the EU, a new provision will apply as of 2013 in case of excessive price fluctuations in the allowance market. If, for more than six consecutive months, the allowance price is more than three times the average price of allowances during the two preceding years, the Commission may (after a meeting with the Member States) either allow Member States to auction a part of future quantities, or allow them to auction up to 25% of the remaining allowances in the new entrant reserve (EC 2012a). This provision is similar to a price ceiling, but with a limit for how many allowances can be used. The economic recession in combination with new EU policies to increase energy efficiency and use of renewables has led to a collapse in EU allowance price (Grubb 2012). This has fueled discussions of how to increase allowance price in order to create better incentives for emissions reductions. One of the options involves a tightening of the overall EU emissions targets 2020 from -20% to -30% compared to 2005 levels. The EU commission also considers setting aside a number of allowances (Reuters 2012). Another short term option being addressed involves reviewing the auctioning profile. This measure would not affect the total amount of allowances being auctioned in 2013 to 2020, but rather addresses the schedule when these allowances are auctioned (Businessweek 2012). California will allow for limited banking of allowances, with a basic holding limit of 2.5% of the number of allowances issued by the regulator (auctioned and free allocation). California has also
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adopted a price ceiling mechanism. An allowance set-aside will be sold at US$40, US$45 and US$50 per ton CO2e. These prices are valid for 2013 and will grow at 5% per year plus inflation. The total amount of allowances that can be released through the price ceiling mechanism is limited to an allowance reserve corresponding to 4% of the total allowance volume. This design functions as a hybrid of a price and quantity system, since total emissions are limited, while there is some certainty of allowance price. An important feature of this hybrid system is that the allowance reserve limits the amount of allowances that can be sold at the price ceiling. If this reserve is exhausted, there is no longer certainty of price. However, the California Air Resources Board estimates that the reserve is sufficient to contain the allowance price while holding the total emissions within a prescribed cap. California will also adopt a price floor on allowances, corresponding to US$10 per ton CO2e (LAO 2012). According to the EU directive, article 25, EU only recognizes allowances from emission trading systems with absolute caps (EC 2009). In general, systems with price ceilings would therefore not be compatible with the EU since emissions may increase and the environmental integrity of the system would be reduced. As California adopts a price ceiling, linking with EU could be problematic. However, in California there will only be a limited number of allowances available if allowance price reaches the price ceiling levels. This price ceiling reserve works like a de-facto cap on emissions, which would facilitate linking with the EU ETS. Moreover, as described previously in this section, the EU will apply a similar provision, releasing extra allowances from a reserve in the case of excessive price increase.
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Sector coverage
The California system will, at its start in 2013, have very similar sector coverage including power production and carbon intensive industries as the EU ETS. However, from 2015 California will also include transport fuels. The inclusion of transports in the California system is likely to increase the allowance price in California (Holmgren et al 2006), but since the California system is significantly smaller than EU ETS, the impact on allowance price from including California transports in a linked EU-California system will be reduced. There are differences regarding which entity is obliged to surrender allowances for compliance.
Distribution of allowances
In the EU ETS phases 1 and 2 allowances were to a large extent allocated free of charge and based on historic emissions, a method often referred to as grandfathering. In phase 3, from 2013 and onwards, the main principle for allocation will be auction. However, an exception from this rule will be made for carbon intensive industries exposed to international competition. In practice, full auctioning will only be applied in the electricity sector. For other sectors, a transitional free allocation based on EU-wide sector specific benchmarks will be used. At least 50% of allowances will be auctioned in 2013, with a target of reaching 70% in 2020. In California, the long term aim is to use auctions for the distribution of allowances. Initially, most allowances will be distributed for free. Industrial sources will receive most allowances from the
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start in order to reduce the competitive disadvantage and avoid relocation outside California so called carbon leakage. Electric utilities will receive allowances on behalf of their retail customers in order to reduce the burden on electricity users. Auctioning will then gradually be phased-in and during the period 2012-2020, with 100% being allocated for free in the first compliance period 20132014, 50% being auctioned in compliance period 2015-2017, and 70% being auctioned in 2018-2020 (World Bank 2012). Differences in allocation may have impacts on the compliance costs for the participating entities but should not affect competitiveness unless allocations are updated in ways that distort product prices (Jaffe and Stavins 2008).
Table 1. Comparison of EU ETS and California ETS regarding critical design features and what implications this may have on linking
Design feature
General position on linking
EU ETS
California ETS
Implications on linking
Both parties positive to creating a larger carbon market through off-sets and linking. However, in the short term California appears to have moved its attention away from EU.
Positive since costs are lowered. Vision of creating transatlantic and later on a global carbon market. EU commissioner Hedegaard has met with California governor Brown to discuss linking.
Positive in order to lower total costs. Requirement that both systems apply equally stringent compliance rules. Has announced plans to link with Quebec.
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Design feature
Stringency of targets
EU ETS
California ETS
Implications on linking
Both parties appear to have comparable stringent caps on emissions. Its difficult to predict if funds will flow from EU to California or vice versa. Differences in which offsets are recognized will be a major obstacle to linking since off-sets in one system will become indirectly available in the other. Future developments in international negotiations on flexible mechanism will be critical.
Allowances for the year 2020 are sold at US$17 US$37
Allowance price for the year 2020 is estimated to lie between US$15 and US$75
EU relies on credits from the Clean development Mechanism (CDM) and does not recognize forest credits.
California allows the use of (domestic) forest credits and does not acknowledge off-sets from CDM
Price management
Use of off-sets, limited banking and adjustments of the scheduling for allowances release. EU only recognize allowances from emission trading systems with absolute caps Electricity and heat production, refineries, metal and mineral production, forestry
Use of off-sets and limited banking. A price cap which is limited to a prescribed allowance reserve.
The price cap in California should not pose a major problem for the EU since it is limited in volume.
Sector coverage
Similar coverage as EU plus transport fuels.
The inclusion of transport fuels in California may drive California allowance price up. But since EU ETS is much larger than the California ETS the price impact on the linked system from including California transports will be reduced. Should not pose a major problem for linking
Distribution of allowances
Up until 2012, most allowances have been distributed for free. From 2013 free allocation will be phased out and replaced by auction
Initially in 2013, allowances will be distributed for free, but the long term aim is to use auctions.
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Chapter 4
Conclusions
Both California and the EU are generally positive to linking
their cap-and-trade systems to other carbon markets, either through off-sets or direct linking. The EU specifically mentions the creation of a transatlantic carbon market, by linking to the emerging systems in Northern America. This vision received further traction when EU commissioner Hedegaard met with California Governor Brown in 2011 to discuss linking between the emission trading systems in EU and California. Since then California has announced plans to link with Quebec, and Europe declared that it will link up with Australia. This could either be viewed as evidence that there is a political appetite for linking and that Europe and California could link at a later stage, or that both parties have found other partners considered to be more suitable for linking. In addition, a possible obstacle to linking may be the differences in which type of off-sets that are acknowledged. California allows the use of forest credits and does not acknowledge off-sets from the Clean Development Mechanism (CDM). In contrast, EU relies on CDM credits, and does not recognize forest credits. Therefore, the ongoing negotiations on a new market mechanism may have an important impact on the future of offsets in the two systems.
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There exist other differences in design features of the two systems, but these are probably less challenging to resolve: California will adopt a price ceiling. In contrast, the EU only allows linkage with systems that have absolute caps on emissions and therefore see price caps as a major complication to linking. However, the California price cap is limited to a prescribed number of allowances. This should, from an EU perspective, facilitate linkage. Both parties signal concerns that linking will lead to losing control of allowance price. Paradoxically, the difference in abatement costs, reflected in allowance price, is an important economic motive for linking two emission trading systems, but may also constitute a significant political barrier. Legal questions have been raised regarding Californias ability to enter into an agreement with another country. Flow of funds from EU to California or vice versa may be a political complication although it is difficult to predict which system will be the net buyer of allowances. The inclusion of transport fuels in California could lead to an increase in allowance. In summary, given the recent Californian plans to link with Quebec and European plans to link with Australia, and due to
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Conclusions
different views on off-sets, linking the EU ETS with the emerging California scheme is not likely, at least not in the short term. There is however, some common ground that are of interest for further consideration. Both parties are positive to creating a larger carbon market through off-set markets and linking. Both parties appear to have compatible levels of ambition with comparably stringent caps on emissions. Although California has adopted a price cap, its use is limited to an allowance reserve and would probably from an EU perspective not create an insurmountable problem. Regarding allocation rules, both systems aim at using auction in the long term. Finally, both systems provide mechanisms for overview and adjustment of the rules, which could help the calibration of critical features like off-sets, price management mechanisms and legislative differences. With political will, the current barriers to linking the EU ETS and the emerging California scheme could probably be solved.
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Chapter 5
Comments
Comment by Marcu Andrei

Andrei Marcu, senior advisor, Centre for European Policy Studies
The EU has been a leader in creating carbon markets and its
efforts have been largely responsible for the fact that a cap and trade system is one of the options many jurisdictions around the word are examining. Lessons learned from the EU ETS have played an important role in the design of emissions trading around the world, including California. One of the important planks have been that the EU ETS is the start of a global GHG emissions trading system that will create a global price for carbon and play a key role in mitigation efforts. This has not changed, but circumstances around the world since early 2000s have changed and many lessons have been learned on how ETS behave. That can be transposed also to a linking discussion. The EU ETS, being large and relatively well developed, in spite of no having yet matured, was seen as playing the role of a docking station with most other ETS as takers of the EU ETS features. In addition, the initial discussions were also taking place in
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a world in which, while the Kyoto Protocol was seen as a shaky proposition, was nevertheless still seen as an ideal model for a global climate change agreement to underpin a framework for linking ETS around the word. The AAUs were providing the global currency. The linking of EU ETS with a California ETS continues to be high on a political agenda, but the immediate practicality of it seems to be questionable. It is clear that politically, those favourable to markets in California and the EU would warmly welcome such as development, as it would further underpin the feasibility and desirability of trading as one of the tools in the toolbox to combat climate change. The EUAustralia link is the best example of the priority that this gets in the EU. In linking, there are technical issues that cannot be different, and that are essential for linking. In this category one could include MRV to ensure that a ton is a ton and provide the environmental credibility that an ETS needs in order to have the societal license to operate. Others are related to registries, etc. Clearly these are elements that the two jurisdictions in cause would negotiate and there is little doubt that an agreement would be reachable. The second set of conditions touch upon what would matters that would have economic implications, as they would affect price level and competitiveness. In this category we can include matters such level of ambition, offsets allowed, price management mechanisms, etc. These are matters that require political decisions. Negotiations would be hard if either side draws lines in the sand. These negotiations may be long, but my belief is that a way
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Comments
could be found after long and protracted discussions. One issue that also needs to be considered is that of the current contracts that many entities have entered into regarding purchases and sales of offsets, and how they would play in case rules are changed for compliance use in the EU ETS. There is a third category that is not doable right now and that has to do with political and regulatory matters, including accounting, as well as the global systems that the two jurisdictions belong to. I think this is a barrier that will be more difficult to cross. California Quebec is a link that seems to go ahead in spite of possible questions regarding the ability of California to enter into international agreements. It seems that California legislation has been written carefully to ensure that this does not become a barrier. At the same time, the Quebec link is much lower profile that a EU link, and the implications very different. Under the current system any units that trade in the EU ETS can be used for EU compliance with its international obligation under KP. It is not conceivable that units allowed for import and compliance in EU ETS could not be used for EUs international agreements that would make EUs compliance much harder. California, and its Federal jurisdiction, are not part of any international accounting system and may or may not be post 2020. However, until then, there is the issue of compliance with Cancun commitments and KP2 commitments, and at this time these accounting systems do not talk or recognize California units. Australia is currently under KP and has signalled it desire to use KP units in its ETS, which may indicate a desire to continue as part of a KP system. In addition the ability of California to import KP units such as
47
CERS makes a link also very challenging. There is no link between the California and CDM registries, ITL, etc. Finally, a challenge that I regard as most significant. The US seems to see the ETS as a way to decrease costs to its industry, and minimize the price of carbon. The EU sees the ETS as an instrument for driving change, and has been going through difficult internal discussions to find ways to insure that the price in the ETS provides incentives for transformation. Are systems with different views of the world and objectives linkable until these differences are addressed?
48
Comments
Comment by Andrew Light

Senior Fellow and Director of International Climate Policy, Center for American Progress & Director, Center for Global Ethics, George Mason University.
This is an important report at an important turning point in
trans-Atlantic relations. California, the U.S.s largest state and the worlds ninth largest economy, is moving into territory our nation as a whole has not yet managed: Creation of an economy-wide carbon pricing mechanism. If the EU ETS and the California ETS could be linked, this could speed up the creation of a global carbon market by decades by lowering the cost of reducing greenhouse gas emissions and reducing price volatility in these markets. But a compelling argument is needed to encourage policy makers to make this jump forward. Zetterberg has provided just the kind of clear and concise analysis we need to move this effort along. If the EU and California connect their carbon markets, others will follow. It would be an essential step toward long-term stabilization of emissions and provide a needed boost to the global clean energy economy.
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References
Businessweek (2012) www.businessweek.com/news/201204-24/eu-says-carbon-auctions-review-won-t-reduceamount-of-permits CARB (2012). California Air Resources Board Press release 12-18, 9 May 2012. ARB PIO: (916) 322-2990. Contact Dave Clegern, dclegern@arb.ca.gov CO2 prices (2012). www.co2prices.eu, accessed 4 May 2012. EPRI (2006). Interactions of Cost-Containment Measures and Linking of Greenhouse Gas Emissions Cap-and-Trade Programs. Report 1013315. Electric Power Research Institute. 3420 Hillview Avenue, Palo Alto, California 94304-1338. www.epri.com European Commission (2008a). 20 20 by 2020 Europes climate change opportunity. Communication from the commission to the European parliament, the council, the European economic and social committee and the committee of the regions. 23.1.2008 COM (2008) 30 Final. European Commission (2008b). MEMO/08/35, Brussels, 23 January 2008. Questions and Answers on the Commissions proposal to revise the EU Emissions Trading System. European Commission (2009). Directive 2009/29/EC of the European Union and of the Council of 23 April 2009 amending Directive 2003/87/EC so as to improve and extend the greenhouse gas emission allowance trading scheme of the community.
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European Commission (2011). Fact sheet Climate Change. March 2011. European Commission (2012a) http://ec.europa.eu/clima/ policies/package/index_en.htm, accessed 4 May 2012. European Commission ( 2012b) http://ec.europa.eu/clima/ policies/ets/faq_en.htm, accessed 23 April 2012. Flachsland, C., R. Marschinski, O. Edenhofer (2009). To link or not to link: Benefits and disadvantages of linking capand-trade systems. Climate Policy 9 (4) 358-372. Fujiwara, N. and Georgiev, A. (2012). The EU Emissions Trading Scheme as a driver for Future Carbon Markets. Centre for European Policy Studies, Place du Congrs 1, B-1000 Brussels, Belgium. ISBN-978-94-6138-169-9. Greentex (2012). http://www.thegreenx.com/products/cca/ market-data.html, accessed 3 May 2012. Grubb, M., (2012). Strengthening the EU ETS Creating a platform for EU energy sector investment. Climate Strategies. www.climatestrategies.org/research/our-reports/category/60/343.html. accessed 23 May 2012. Guardian (2011). http://www.guardian.co.uk/environment/2011/apr/07/eu-emissions-trading-california, accessed 4 May 2012 Holmgren, K., hman, M., Belhaj, M., Gode, J., Srnholm, E., Zetterberg, L. (2006), Greenhouse gas emissions trading for the transport sector. IVL report B-1703. www.ivl.se
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IPCC (2007). Summary for Policy makers. In: Climate Change 2007: The Physical Science Base. Contribution of Working group I to the Fourth Assessment Report of the Intergovernmental Climate Panel on Climate Change. Solomon, S., Qin, D., Manning, M., Chen, Z., Marquis, M., Averyt, K.B., Tignor, M. and Miller, H.L. (eds.). Cambridge University Press, Cambridge, United Kingdom and New York, NY, USA. Jaffe, J., Stavins, R.N. (2007). Linking Tradable Permit Systems for Greenhouse Gas Emissions: Opportunities, Implications and Challenges, IETA. LAO (2012). Evaluating the Policy Trade-Offs in ARBs Capand-Trade Program, Legislative Analysts Office, www.lao. ca.gov. Mehling, M., Tuerk, A., Sterk, A. (2011). Prospects for a Transatlantic Carbon Market What next after the US Midterm elections? Climate Strategies. www.climatestrategies.org. Reuters (2012). www.reuters.com/article/2012/04/19/ environment-carbon-eu-idUSL6E8FJC2820120419 Sterk, W. and J. Kruger (2009). Establishing a transatlantic carbon market, Climate Policy 4, pp. 389401. Sterk, W., Mehling, M., Tuerk, A. (2009) Prospects of linking EU and US Emission Trading Schemes: Comparing the Western Climate Initiative, the Waxman-Markey and the Lieberman-Warner Proposals. Climate Strategies. www. climatestrategies.org.
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Several countries and regions are following the example of
Europe and are establishing carbon emissions trading systems. One of the more promising developments is the one in California where a cap-and-trade-market is set to be operational in 2013. This paper explores the possibility of linking the EU ETS with the California ETS by focusing on specific design features of the two systems. In theory, both systems would benefit from linking, as it would lower the costs of reducing emissions, and both the EU and California are overall positive to linking their ETS with other systems. There are, however, still technical difficulties in linking these two systems, not least the different views on which off-setting mechanism to allow. EU ETS allows credits from the UN CDM system and does not allow for off-setting through forest credits, while the situations in the California ETS is the reverse. However, the study concludes that if the political will to link is there, it could overcome the technical obstacles

Linking The Emissions Trading Systems in EU and California

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