Carbon Market Analyst

North America
RESEARCH

A US Cap-and-Trade Program: Options for Compliance
April 2, 2009

TO THE POINT
The Emission-to-Cap in the cap and trade program proposed by Rep. Waxman would be 205 million tons in 2012, growing to 1.4 billion tons by 2020. This gap could be cut in half if complementary policies

CONTENT
2 2 2 6 10 12 13
Executive summary Introduction Sizing up the gap Compliance options Market implications Conclusion Contacts

promoting clean energy and energy efficiency standards are also passed. The long term impact of the economic recession
coupled with ambitious policies could create a long market for the first compliance period.

In 2012, the domestic offsets supply will be too scarce to fill in the gap. Certified Emission Reductions (CERs) could help meet the gap, placing US facilities in competition against other international buyers. In 2016, because of the limited domestic offset supply, some fuel switching may be needed, rapidly pushing prices up. To remedy high prices, we anticipate the development of a new international offset programs, where sectoral and REDD credits could play a much larger role. In 2020, a large reliance on fuel switching would bring prices up over $50 a ton. These high prices would render economically attractive most other compliance options, including purchases of international allowances and a wide range of internal abatement measures

UPCOMING REPORTS
• • • Assessing the Impact of the Recession on US GHG Emissions A Post-2012 Global Climate Change Agreement What Role for International Forestry and REDD credits

POINT CARBON RESEARCH

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Carbon Market Analyst North America

CMA April 2, 2009

Executive summary
This report provides an overview of compliance options under a US cap-and-trade program using the discussion draft proposed by Rep. Waxman on March 31st, 2009. We first estimate the size of the emission-to-cap (E-t-C), or the difference 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, if ‘business-as-usual’ projections follow the path forecasted by the Energy Information Agency. The bill includes a wide array of complementary policies to reduce emissions, notably a renewable electricity standard, an energy efficiency standard, and improvements to fuel economy and carbon-intensity of transportation fuels. These policies could cut the E-t-C in half, reducing the gap to 87 million tons in 2012, a mere 1.2 percent of the total cap. Coupled with the effect of the economic recession, the program could start long in the first compliance period (2012-2013). We forecast the 2020 gap at roughly 760 million tons, 15 percent of the cap that year. We then investigate the main compliance options for filling this gap: offsets and internal emission reductions. The bill authorizes 2 bn offset credits for compliance, evenly split between domestic and international offsets. Domestic offsets will likely constitute the least expensive compliance option, but with a pipeline currently below 20 million tons per year, we foresee a shortage of these credits. International offsets are also unlikely to fill in their quotas, although we forecast a potential supply of Certified Emission Reductions (CERs) of over 700 million tons globally in 2015. US facilities would have to compete with European emitters and Kyoto countries for these credits. Other forms of international offsets could be developed, notably sector-based credits and Reduced Emissions from Deforestation and forest Degradation (REDD) credits and help make up the shortfall. In terms of internal abatement, fuel switching has the largest potential – aside from energy efficiency. The cost of fuel switching can rise rapidly depending on fuel prices. A high price of carbon would trigger a negative feedback loop and incentivize other internal abatement measures, such as industrial energy efficiency, improvement to chemical processes, etc. This would bring prices back down to a level where fuel 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.

Introduction
The prospects for 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 of the year. This issue of Carbon Market Analyst North America looks at compliance options under a US cap-and-trade program. We first estimate the size of the emission-to-cap (E-t-C), or the difference between projected emissions under a business-as-usual (BAU) scenario and the cap, and then investigate the main compliance options to close this gap: offsets and internal emission reductions.

This report provides an analysis of supply and demand dynamics under a US cap-and-trade program and sets up the conceptual framework for price formation in a future US carbon market.

carbon market, assuming no major technological breakthrough occurs in this time frame.

Sizing up the gap
Under a compliance program, demand for emission reductions is derived from the gap between the emission cap established by the government and actual emissions from covered sources.

Hopes are high that cap-and-trade legislation will pass by the end of the year
We provide snapshots of three milestone years during the first decade of the program - 2012, 2016 and 2020 - and discuss which compliance option is likely to be preferred in each of these years. We look at the carbon price range involved and implications for the

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

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by 2050. More recently, on March 31st, Representative Waxman (DCA) and Markey (D-MA) released a discussion draft 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 final climate bill, we take them as the best available indication of the depth of the cuts to be expected and use them in this analysis.

Table 1: E-t-C in the Waxman-Markey draft proposal
BAU projections, total US emissions 2012 2013 2014 2015 2016 2017 2018 2019 2020 2030
7 294 7 301 7 273 7 282 7 307 7 336 7 364 7 378 7 380 7 894

BAU projections, covered sectors
4 975 4 979 5 506 5 513 6 175 6 199 6 223 6 235 6 236 6 671

Cap
4 770 4 666 5 058 4 942 5 391 5 261 5 132 5 002 4 873 3 533

Emission-to-Cap (EtC)
205 313 448 571 784 938 1 091 1 233 1 363 3 138

Waxman sets ambitious medium and long term emission reduction targets
We also use the scope proposed in the Waxman discussion draft, an economy-wide coverage of all sectors except for waste and agriculture. Some sectors are phased into the program over the first years, creating steps in the curves representing the cap and the emissions from covered sectors in Figure 1. The sector phase in provision means only 68.2 percent of US emissions are covered in 2012-2013, but this number increases to 75.7 percent in 2014-2016 when industrial facilities 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 of total emissions through the rest of the program.

Agency’s (EIA) Annual Energy Outlook released in December 2008. BAU emissions for the US as a whole are projected to increase from 7 ,294 million tons (mt) in 2012 to 7 ,380 mt in 2020, a 1.2 percent growth. These projections account for the new Corporate Average Fuel Economy (CAFE) and the renewable fuel standard passed in the December 2007 Energy bill. They also include the reductions from

existing state renewable portfolio standards. In Figure 1 we chart total US emissions (top dotted line) and emissions from covered sources only (solid line) against the cap.

Emission-to-Cap
As shown in Table 1, we find that in 2012, covered sources will have an estimated annual emission-to-cap (E-t-C) shortfall of approximately 205 MmtCO2e, or 4.1 percent of

Figure 1: Emission-to-Cap in the Waxman-Markey proposal
9,000 8,000 7,000

Million tons CO2e

6,000 5,000 4,000 3,000 2,000 1,000 -

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 Information

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20 12 20 14 20 16 20 18 20 20 20 22 20 24 20 26 20 28 20 30
Business-as-usual projections, total US emissions Business-as-usual emissions from covered sectors Waxman reduction targets from covered sectors

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their estimated BAU emissions. This gap is anticipated to increase to approximately 571 million tons by 2015 and up to nearly 1.4 billion tons by 2020. The shortfall in 2020 is then 22 percent of BAU emissions from covered sectors.

Textbox 1: Energy efficiency: the answer to it all?
Many studies show the potential savings from energy efficiency – most recently, McKinsey’s report “Reducing US Greenhouse Gas Emissions: How Much at What Cost?” announced close to one billion tons of GHG emissions could be reduced from energy efficiency measures alone, at a cost of zero or less (negative cost, i.e. a net saving). If this is true, why do we even need energy efficiency standards? Economically, energy efficiency appears to be an obvious investment, yet the shifts toward better-insulated buildings and ultra low-energy appliances are not occurring on the massive scale that their economic profitability would suggest. Three types of hurdles typically get in the way of efficiency improvements according to energy efficiency experts Arthur Rosenfeld and Paul Stern. First, structural issues, like the tenant/landlord dilemma, prevent useful investments from taking place because the decision-makers and the beneficiaries are disconnected. Second, the economic profitability of efficiency investments is not always as clear cut as economic theory would imply. Discount rates (the time-value of money) and interest rates faced by individuals can be significantly higher than those used by economists in calculating the worth of energy efficiency investments. Finally, individuals and companies do not always behave rationally in the economic sense and may elect to keep pricier incandescent light bulbs because they prefer the quality and color of the light to that of cost-savings compact fluorescent lights. Because economic rationality is often not enough to trigger these energy efficiency investments, standards and public action are needed to overcome structural and financial hurdles. Cap-and trade can also trigger some energy efficiency investments, but only if carbon prices are high enough to make a large difference on the energy bill.

Lower Emissions?
Actual emissions will likely be lower than even the most recent EIA forecasts because of recently-passed policies, proposed policies, and the impact of 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 federal budget. Both packages contain significant investments in clean energy and energy efficiency, and could by one group’s estimate reduce businessas-usual emissions by 61 million tons annually from 2012 onwards (see Textbox 2).

speed at which the economy will recover from the current recession is unknown. We do not attempt to capture this potential “recession effect” on US emission levels but consider possible that emissions would be lower than projected during the first years of the program. This would reduce the gap between emissions and the cap even further. The effects on long term emissions, however, would probably be negligible.

levels in the US. Two sectors are the most likely targets for broad-reaching regulations: the power sector and the transportation sector. New climate-oriented regulations in both sectors would evoke large amounts of emission reduction.

BAU projections do not fully account for the deepening economic downturn
Furthermore, the Annual Energy Outlook projections, dated December 2008, likely do not fully account for the deepening economic downturn and its lasting effect on greenhouse gas (GHG) emission levels. Analyses of the recession’s effect on Europe’s emissions have estimated close to six percent reduction in emissions from 2007 to 2008, partially due to decreased industrial output from energy-intensive sectors such as cement and pulp and paper. The

Power sector
A national renewable electricity standard (RES), mandating that a minimum percentage of electricity be generated from 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 of electricity sold in the US come from renewable sources by 2025. A similar bill proposed by Rep. Markey aims for 25 percent renewables by 2025. This provision was included in the Waxman-Markey draft and would reduce emissions by an estimated 57 mt in 2012, growing to 279 mt by 2020 (see Textbox 2).

Proposed Policies
In addition to the effects of the economic slowdown, US GHG emissions, and therefore the E-t-C, could look dramatically different if some further energy command-andcontrol measures are passed ahead of or in conjunction with legislation establishing a cap-and-trade program. Such regulations are under discussion and would have a large effect on long term GHG emission

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Energy efficiency 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 federal energy efficiency 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 draft bill promote appliance efficiency standards, improved building efficiency standards, etc. and would also reduce emissions.

Table 2: Effect of mandated emission reductions on E-t-C
All numbers in million metric tons of CO2e E-t-C 2012 2013 2014 2015 2016 2017 2018 2019 2020 205 313 448 571 784 938 1,091 1,233 1,363 Stimulus 61 61 61 61 61 61 61 61 61 RES 57 52 104 103 156 151 220 210 279 Energy Efficiency 0 5 18 39 58 88 117 214 262 New E-t-C 87 195 265 368 508 638 693 747 761

The E-t-C could be halved by complementary energy provisions in the climate bill
Transportation sector
President Obama lists two key measures for the transportation sector in his energy agenda: increasing fuel efficiency standards and passing a low-carbon fuel standard (LCFS). As a Senator, Barack Obama supported the Fuel Economy Reform Act, which proposed a four per cent per year fuel economy improvement beginning in 2009 for passenger cars and 2012 for light trucks. The proposed LCFS set targets of fuel carbon-intensity at 10 percent below 2005 levels by 2020. The National Commission on Energy Policy has estimated the combined effect of both proposals at 550 million tons worth of reductions by 2020. The Waxman-Markey bill contains an LCFS provision that only takes effect when the Renewable Fuel Standard ends, in 2022, and mandates the EPA to harmonize fuel efficiency standards building on California’s tailpipe emission standards (the “Pavley bill”), but does not set specific targets.

Smaller gap – long market?
We account for the emission reduction potential of the ‘big ticket’ items in the Waxman-Markey bill and estimate the size of the new gap in the short and medium-term, up to year 2020. Hence we exclude the effects of transportation policies, as the main measures are either unspecified or only take effect after

Table 3 -E-t-C by compliance period
Compliance period 2012-2013 2014-2015 2016-2017 2018-2019 2020 Annual E-t-C
141 316 573 720 761

Textbox 2: Sources for Emission Reduction Estimates
Reduction forecasts for the stimulus bills are drawn from an analysis commissioned by Greenpeace in January 2009. Consultancy ICF evaluated sixteen energy, environment, transportation and technology provisions included in the initial Economic Stimulus Package and quantified the expected emission reductions from each of them. The emission reductions from renewable electricity standards are detailed in a Point Carbon report dated February 23, 2009: Greenhouse Gas Reductions from Renewable Electricity Standards. For energy efficiency, we used the American Council for an Energy Efficiency Economy (ACEEE) report: Laying the Foundation for Implementing a Federal Energy Efficiency Resource Standard, published March 18, 2009. Our estimate for transportation is based on a memo dated June 2007 by the National Commission on Energy Policy and the International Council for Clean Transportation. The study quantifies reductions from a low carbon fuel standard (LCFS) and the Fuel Economy Reform Act and finds the combined measures would yield 550 million tons by 2020. This forecast is likely overestimated because it does not account for the Energy bill passed later that year and uses the 2007 AEO BAU forecast. Point Carbon does not support or promote any of the policies studied, nor does it associate with the policy positions from the authors of these studies.

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2023. As shown in Table 2 and Figure 2, the new E-t-C is roughly halved by the complementary policies, leaving only half the initial gap to be reduced by market forces. Another way to look at these numbers is by compliance period (Table 3). The Waxman-Markey bill establishes twoyear compliance periods, allowing companies to borrow and bank from one year to the other within the twoyear periods. By smoothing out the differences created by the phase-in provision, compliance periods provide a clearer picture of the reduced but growing gap over the first nine years of the program.

Figure 2: What’s left to markets?

6,500 6,000
Million tons CO2e

5,500 5,000 4,500 4,000

Remaining gap

The Waxman-Markey bill sets a generous ceiling of up to 2 bn tons for offsets
Because the E-t-C constitutes such a small percentage (2-5 percent) of the total cap from 2012 to 2014, it is possible that the program could actually be over-allocated in its early years. Should the impact of the recession be lasting on emission levels, and should the transportation provisions yield early reductions, US emissions could be lower by a few hundred million tons, potentially making the system long. This overallocation would be unlikely to last because of the steeply declining cap and therefore would not threaten the long-term integrity of the program. Conversely, the forecasts could be overestimating the expected reductions from the policies – by using an outdated baseline, or because of overlap between the policies - making the sum less than the parts. In this case the gap would be larger and a larger role left to markets.

12 013 014 015 016 017 018 019 020 20 2 2 2 2 2012 2 2013 22014 2 20152 2016 2017 2018 2019 2020
RES Energy Efficiency Stimulus

Compliance Options
We now turn to compliance options: ways to fill the gap between actual emissions and the cap, under a pricedriven, market-based mechanism. Companies regulated under a capand-trade program typically face three main compliance options: • reduce their own emissions (‘internal abatement’); • purchase allowances; • buy offset credits. Economic theory warrants that companies will opt for the least cost option first, 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 if it anticipates that doing so will cost less than buying offsets or allowances. If the market functions without distortions, allowance prices should reflect the marginal cost of abatement. We take a closer look at the compliance options most likely to be on the margin: offsets and fuel

switching. For each we offer, to the extent possible, a volume and price assessment.

Buying offsets: the cheap way out?
Offsets are emission reduction credits from project-based activities that can be used to meet compliance as a supplement or alternative to reducing one’s own emissions. The use of offsets is usually subject to a quantitative limit, or quota, known as ‘supplementarity.’ The WaxmanMarkey bill sets a very large ceiling for offsets of up to 2 bn tons annually, evenly split between domestic and international offsets. The total amount of offsets allowed into the system is roughly 1.5 bn tons per year from 2012 to 2015, then 1.7 bn from 2016 to 2020, amounting to 30% of the cap in average. The draft bill also suggests a 20 percent discount rate for offset credits, calling for 1.25 offset credits to claim one ton of CO2e (one allowance).

Domestic offsets
The offset market is developing fast

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CMA April 2, 2009

Figure 3: US carbon offset pipeline with likely eligibility
25000000

25

Fuel Switching Energy Efficiency Renewable Energy Industrial Processes Geosequestration Biosequestration Forestry

20000000

20

Million tons CO2e

15000000

15

Soil Sequestration Fugitive Emissions/CMM Agricultural Waste Landfill Gas Likely-Eligible

10000000

10

5000000

5

0 y2000

0

y2001

y2002

y2003

y2004

y2005

y2006

y2007

y2008

y2009

y2010

y2011

y2012

in the US, largely in anticipation of a regulated market. Point Carbon’s offset database Carbon Project Manager North America lists most offset projects in the US and Canada. The current pipeline of projects is about 20 mt annually in 2012. Not all offset credits currently traded on the voluntary markets would qualify under a compliance program, however. Restrictions on project types and quality would likely weed out a significant number of projects, from which offset credits are currently generated. Projects in capped sectors (such as energy efficiency) would not qualify as ‘offsets’ anymore but as internal abatement. The Waxman-Markey bill does not establish an exhaustive list of eligible project types. We use elements from previous cap-and-trade bills to distinguish between projects likely to make the cut or not, and conclude that five offset type categories are

most likely to qualify under a federal compliance program: agricultural waste, forestry, fugitive emissions (coal mine methane), landfill gas and soil sequestration. (See our previous report, US Offsets: Outlook for Supply and Demand, published January 22, 2009, for more details). As illustrated in Figure 3, only about half of the projected volume would qualify if screening out the noneligible projects, bringing the supply to about 10 mt in 2012.

It is highly unlikely US offsets could ever come close to filling the E-t-C gap
Could US offsets ever come close to filling the E-t-C gap? It is highly unlikely, if not impossible. Even though we anticipate investment in offsets to rise sharply as the beginning

of the cap-and-trade program nears, the increase in available credits is unlikely to get even near the limit. US offset supply will be constrained by sheer physical limitations - there are only so many sites (landfills, farms, and fields) that could potentially qualify and host offset projects. If offsets are discounted at a ratio of 5 to 4 as suggested in the Waxman bill, the amount of credits would be even less adequate. The suggested 1 billion ton limit on domestic offsets in the bill hence sets a theoretical limit on demand, but the real limitation will be on the supply side. The role of domestic offsets will be determined by how they compare financially to other compliance options. Current average over-thecounter offset prices vary from $4.00 to $9.00 a ton depending on project types and certifications, and CCAR futures (Dec12 delivery) trade at roughly $7 .00 a ton on the Chicago Climate Futures Exchange.

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International offsets
In addition to domestic offsets, international offsets are also likely to qualify as a compliance option in the US. Again, the Waxman-Markey bill allows up to one billion tons in international offsets for compliance. The dynamics for 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 for those reduction credits.

from JI projects), will be issued by 2012. After 2012, the forecast is much more uncertain (see Textbox 3), as the future of the CDM will be renegotiated in Copenhagen in December 2009. However, given Point Carbon’s main policy scenario for post-2012, CER volumes could increase to 715 mt in 2015, before 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 factor in the final use of CERs. Secondary CERs (Dec12 delivery) are forecasted by Point Carbon at €21 ($28) and usually track European Union Allowances (EUAs) at a discount. If EUA prices are higher than a US allowance price, the use of international offsets will be secure in Europe - but if EUA prices are close to US prices, US emitters could have a shot at securing some of these credits. International negotiations are increasingly focusing on two new types of international credits: reduced and avoided deforestation (REDD) projects and ‘sectoral credits’ (see Textbox 3). The Waxman-Markey bill signals a strong interest in both

Table 4 - International allowances

2012 prices are future prices traded on the exchange (2011/12 for Australia) Point Carbon forecast for Phrase 3 EU ETS prices and traded 2012/13 futures for the Australian CPRS EUAs (Europe) 2012 2015 2020
15€ ($19) 48€ ($63) 48€ ($63)

AEUs (Australia)
A$21.75 ($14.50) A$23.25 ($15.50) Not available

Sectoral credits enjoy strong political support on both sides of the Atlantic
The current international offset system is the Clean Development Mechanism (CDM) and Joint Implementation (JI) under the Kyoto Protocol. Point Carbon’s database Carbon Project Manager anticipates that around 1,850m Certified Emission Reductions (CERs, credits from CDM projects) and Emission Reduction Units (ERUs, credits

credit types by allowing their use for compliance. Sectoral credits are still at an early design stage but enjoy strong political support on both sides of the Atlantic (see Textbox 2 and our Analyst Update: EC’s sector crediting proposal, from March 19, 2009). REDD also enjoy political support but face with major challenges related to accounting, monitoring, and enforcement. We have no indication of volume or prices for either of these mechanisms, but we expect they will play a large role in compliance post2012.

Textbox 3: Wither the Clean Development Mechanism?
The future of the CDM will be renegotiated in Copenhagen in December 2009, in an attempt to address concerns about the quality of projects, the countries where they are located, and efforts to redefine eligible project types. An important source of supply uncertainty stems from the discussion on project types and reforming the approval process. Stricter approval criteria could lead to a dwindling of the supply, possibly matched by tough import limits by the EU ETS in Phase 3. Another source of uncertainty comes from the fact that countries currently hosting most of the CDM projects – China, India, Mexico, South Korea, etc. – might take on mandatory targets after 2012 in a successor agreement to Kyoto, which would end the supply of offset credits coming from those countries. The emissions reduced by CDM projects taking place in those countries would then count toward the respective country’s achievement of its emission reduction obligation. This expectation that more countries will take on legally binding reduction commitments post-2012 explains the dramatic fall in supply between 2015 and 2020. CERs could be replaced by sectoral credits, a proposed mechanism based on a no-lose target for a set of industrial installations in advanced developing countries. Under this proposal, the group of installations, ideally covering a whole industrial sector, would have an emission target below its business-as-usual emissions. If it reduces emissions below the target, it will be given credits equal to the difference between the target and actual emissions. But there would be no penalty if the targets are not met. The mechanism is anticipated to generate larger volumes of reduction credits than the CDM.

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International allowances
The Waxman bill also permits emitters to use allowances from other emission trading programs for compliance. Until recently, this would have applied to the EU ETS exclusively, but the implementation of a “carbon pollution reduction scheme” by 2010 in Australia, as well as the expectation that other countries (New Zealand, South Korea) may follow suit, opens up new possibilities.

Textbox 4: Towards a global market?
Our analysis of the role of international allowances assumes that US emitters could purchase allowances from Europe or Australia, but that the reverse is not true. In the long term, however, one could foresee increasingly integrated global markets where allowances would be freely traded from one compliance program to another. The European Commission suggested in a recent Communication that it ambitioned to see an OECD-wide market - including all major industrialized countries – by 2015. If there are no restrictions on the use of allowances in other markets, this would lead to a global, unique carbon price. In practice, countries are likely to set a limit, or quota, on how many ‘foreign’ allowances can be used for compliance – creating different subsets of prices. Even if direct trading of allowances is not allowed, international offsets could indirectly link different programs, as emitters in each country would be competing for the same credits. Hence policy developments abroad could play a role in price formation and market dynamics in the US in the medium to long term.

The limitation on the use of international allowances will come from prices
Volumes are potentially large, since the entire pool of allowances from the other trading programs could be used for compliance. The Waxman-Markey bill does not set any limitation on the use of international allowances for compliance, so that the limitation is more likely to come from prices. At current prices, European Union Allowances (EUAs) and Australian Emission Units (AEUs) could constitute an attractive compliance option. Figure 4 plots prices for EUA futures (Dec 12 delivery). However, Point Carbon anticipates prices will increase in the EU ETS, as the cap for its next compliance phase (Phase 3, 2013-2020) is very strict. We forecast prices at €42 in 2013 and €48 on average over the whole phase (assuming no linkage with the US). To conclude – domestic offsets will not fill much of the gap as they are in short supply. US offsets are currently the least cost option but this might change if we see the same trend as in the CDM market. CERs are priced based on their value in use (i.e. as substitutes for EUAs) and not based on marginal production costs. US offsets would then track US allowance prices at a discount.

The role of international offsets is more uncertain. The CDM may not be the right vehicle for the long term supply of credits to the US market. If an agreement is found in Copenhagen on sectoral credits and / or on REDD, these would likely constitute the bulk of the credit flow into the US. International allowances could play a large role if the various emission trading programs establish linkages allowing free trade from one program to the other.

Internal Abatement
We now consider ways to reduce emissions for large compliance players, ‘internal abatement’. As the import limits of offsets and international allowances are de facto almost unlimited, the split between offset credits and internal abatement as compliance option will mainly depend on prices. Emitters have many reduction options, emission including

Figure 4: EUA future prices
40 35 30
Price €/tCO2e

EUA 2012

25 20 15 10 5 0
8 08 08 08 08 08 08 08 08 08 08 08 09 09 09 -0 trr- y- n- ulb- rgv- cnpa Ju an Feb Ma Ap J Au Se Oc No De Ja Fe Ma J M

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Figure 5: Fuel switching curve in the US, spot and 2012 future prices
We use NYMEX spot and 2012 future fuel prices as of March 24, 2009

$50

US Fuel switching curve fuel spot prices
$50

US Fuel switching curve future fuel prices (2012 delivery)

$40
USD per ton of CO2e
USD per ton of CO2e

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$0 0 50 100 150 200 250 300 350 Million tons CO2e

$0 0 50 100 150 200 250 Million tons CO2e

improvement of industrial processes, reducing methane leaks in pipelines and refining, limiting the use of high “global warming potential” (GWP) gases – fluorocarbon gases, etc. We focus on fuel switching exclusively because it is more likely to deliver large numbers of emission reductions and thus be on the margin.

region. Switching varies by region, but the model assumes that price would trigger the switch regardless of any technical impediments.

to make the switch economical on power markets. Fuel switching has a potential for large volumes of emission reductions. However, if coal prices are low, the carbon price needed to realize this potential can climb very rapidly, as seen in Figure 5b. If fuel switching is expensive and is setting prices on the carbon market, it will provide a strong signal for emitters to look into other internal abatement measures. These abatement measures would create a negative feedback loop that would eventually pull back down prices, to the point where fuel switching is more economical than any other abatement strategy.

Fuel switching
Large reductions can come from the power sector: as the price of carbon penalizes more carbon-intensive fuels (coal, petroleum) than natural gas or carbon-free generation, the economics start working in favor of the less carbon-intensive fuels (see our report The Power of Carbon, June 2008 for a detailed analysis of this issue). The amount of reductions at any given carbon price varies with the relative price of the fuels. Point Carbon created a simplified model to evaluate the amount of reductions associated with fuel switching from coal to gas by applying a carbon price to the electric generation fleet by

Reductions from fuel switching are extremely sensitive to fuel prices
Figures 5a and 5b show emissions reductions from fuel switching in $5 increments. Figure 5a uses spot fuel prices from March 2009 ($4.35 natural gas, $49 coal, $63 SO2, $625 Nox) while Figure 5b plots the fuel switching curve using future prices for December 2012 delivery, as of March 24, 2009 ($7 .45 natural gas, $67 coal, $35 SO2, $650 Nox.) The figures illustrate the extreme sensitivity of fuel switching to actual fuel prices. A carbon price of $10 a ton yields over 120 mt of reductions in GHG emissions in one case, and a mere 10 mt in the other. If natural gas is relatively more expensive than coal, it takes a higher carbon price

Market Implications
Price formation
Prices on the carbon market are set, like those of other commodities, by the intersection of supply and demand. Figure 6 represents a conceptual marginal abatement cost curve. In this example, we assume

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domestic offsets are the lowest cost compliance option, followed by international offsets. Fuel switching (internal abatement) comes next, with international allowances at the higher end of the range. The demand intersects the marginal abatement curve at 205 million tons (the 2012 E-t-C without complementary policies), calling for some amount of fuel switching and bringing prices to around $30 a ton. Should energy efficiency and renewable electricity standards be adopted, the demand curve would be lower, and would intersect the MAC curve at 87 million tons. International offsets would be on the margin, no fuel switching would be needed, and prices would be below $15 a ton. Conversely, as the size of the E-t-C gap grows over time, the demand curve will shift to the right because

CMA April 2, 2009

Figure 6: Conceptual MAC curve

Price
$60 $50
USD per ton of CO2e
Demand goes up as EtC grows Int’l Allowances

Marginal Abatement cost curve (supply)

$40 $30 $20 $10 $0 0 100 200 300 400 500 Million tons CO2e
Int’l Offsets US Offsets Demand curve Fuel switching

600 Volume

US emitters will have to compete with other countries for the international credits
emitters will need more allowances to cover a greater shortfall. This will push prices up the fuel switching curve if no other type of reduction takes place. As discussed above, the MAC curve is itself subject to change as offset supply and fuel prices change over time. We now tie the pieces together and discuss likely compliance strategies for selected compliance periods in the first decade of the cap-and-trade program.

CERs would constitute the next most attractive compliance option. If prices on the EU ETS have not recovered, EUAs could also be part of the compliance mix and would bring prices on the US market to about $20 a ton. If emissions and prices recover in Europe by 2012, prices in the US would likely be set by CERs and could therefore track EUAs at a discount. This would constitute the first hint of market linkages. It is also possible that the scheme would be somewhat over-allocated if the recession has an enduring effect or if energy efficiency investments deliver their theoretical emission reduction potential. The program would not be compromised if it started with a brief period of over-allocation, provided that overallocation is small: participants would likely bank allowances for later years, when the caps get tighter. This would prevent prices from crashing to zero. The bank would create a small cushion to help buffer volatility from fuel prices or unforeseen exogenous events.

If the effect of complementary policies is lower than expected, market participants will have to procure more offsets and international allowances or turn to internal abatement.

2016-2018 – A wide array of abatement strategies
By the time the third compliance period rolls in, the gap will have grown to over 550 million tons: this strong demand for allowances calls for a wide array of reduction strategies. All available US offsets will be tapped and the demand for international offsets will increase. The gap could still potentially be met through international offsets, possibly including the new credit types from sectoral and forestry programs. If the competition for international offsets was such that offsets could only cover half the gap, 250 million tons of reductions would be needed. Such volume of fuel switching would call for very high prices, up to $85 a ton. Hence other compliance options would likely come into the mix –

2012-2013 – Few reductions needed
The first compliance period would require about 140 million tons of reductions each year. US offsets will not suffice to meet the gap.

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Carbon Market Analyst North America

CMA April 2, 2009

Figure 7: Meeting the E-t-C
6400 6200 6000 5800 5600 5400 5200 BAU Stimulus RES EnEf Remaining Dom. emissions offsets Int'l Fuel Offsets switching Cap

provisions – energy efficiency and clean energy standards for the power and transportation sectors – have the capacity to evoke large reductions at a fairly low cost, especially for energy efficiency measures. These provisions are not only crucial for the US to meet its target; they will also lower significantly the price of carbon on the traded market. US offsets 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 key limitation is physical rather than financial. The degree to which the internal abatement option of fuel switching is deployed largely depends on the level of reductions achieved by the other options. Some amount of switching will occur, but the carbon cost at which fuel switching becomes economical is very volatile and does not provide the clear, predictable price signal needed to redirect investments towards clean technology in the long term. These limitations put the spotlight on international offsets and allowances, where larger amounts of emission reductions could come from developing countries at lower costs. But uncertainties related to the upcoming international negotiations still cloud forecasts both for 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 for initially low-cost projects. International allowances and linkages with other emission trading system could also help temper prices in the medium term. The outcome of the Copenhagen negotiations will thus have significant implications for the US carbon market.

other internal abatement measures. International allowances, even priced at €50 a ton, could remain attractive. Figure 7 shows the wide array of compliance options that will be necessary to meet the gap in the medium term.

What to expect post-2020
Our analysis was focused on the short to medium term as it allowed us to project the impact of 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 very costly, providing a strong incentive for technologies in the development stage today like carbon capture and storage or electric cars. Offsets 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 offsets provide a temporary fix and a useful cost-containment mechanism, they do not substitute for necessary long term changes.

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 of international credits is sustained and affordable. High carbon prices could also raise the interest in creating linkages with a large number of countries. The larger market could help dampen the volatility derived from fuel prices and would theoretically enable all participating countries to take advantage of the lowest cost reductions through the market. This is especially true if 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.

Conclusion
All signals indicate that the new administration and Congress are serious about their commitment to lower GHG emissions. The dominant strategy involves a mix of command-and-control and marketbased mechanisms. The regulatory

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Copyright © 2009, by Point Carbon. All rights reserved. No portion of this publication may be photocopied, reproduced, scanned into an electronic retrieval system, copied to a database, retransmitted, forwarded or otherwise redistributed without prior written authorization from Point Carbon. See Point Carbon’s “Terms and Conditions” at www.pointcarbon.com The data provided in this report were prepared by Point Carbon’s Trading Analytics and Research division. Publications of Point Carbon’s Trading Analytics and Research division are provided for information purposes only. Prices are indicative and Point Carbon does not offer to buy or sell or solicit offers to buy or sell any financial instrument or offer recommendations to purchase, hold or sell any commodity or make any other investment decision. Other than disclosures relating to Point Carbon, the information contained in this publication has been obtained from sources that Point Carbon believes to be reliable, but no representation or warranty, express or implied, is made as to the accuracy or completeness of this information. The opinions and views expressed in this publication are those of Point Carbon and are subject to change without notice, and Point Carbon has no obligation to update either the opinions or the information contained in this publication. Point Carbon’s Trading Analytics and Research division receives compensation for its reports. Point Carbon’s Trading Analytics and Research division reports are published on a subscription basis and are not issued at the request of any client of Point Carbon.

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