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Designing an Effective Emissions Trading Scheme:
Lessons Learned from the European Union,
United States and Global Implications
Abstract:
The European Unions Emissions Trading Scheme is the largestmultinational Emissions Trading Scheme in the world, yet it is still inearly stages and policy makers have much to learn from itsshortcomings. This literature review surveys the various design issuesthat have confronted the nascent scheme and the underlying causes of these issues. Specifically, a larger ascending auction would reducecosts and long-horizon banking and a safety cap will increase marketstability and clarify price signals. An analysis of 2005 EU verifiedemissions data concludes that overallocation definitely occurred, andtraces its cause primarily to the decentralized national structure of thetrading scheme. Decentralization generally contributes to inefficiency,as it increases costs between trading and non-trading sectors, reducesincentives to use design features like auctioning and offsets, andprecludes hybrid systems with upstream regulation. What do theselessons learned tell us about the prospects of a United States orglobal trading scheme? Offsets and linkages to other schemes willincrease efficiency in the United States and globally, but its not clear
what role decentralization will play. A hybrid system that relies onregional schemes but also manages upstream regulation may help tomitigate inefficiency in the US. While the implications for globalarchitecture are less clear, the same design issues will remainrelevant.
Chris Bennett
Stanford University
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For Roosevelt Review 2008 Submission
Section 1: Context of the European Union Emissions Trading Scheme
More than ten years after the Kyoto Protocol was signed in 1997 and several years
after it was signed into force in 2005, policy makers and citizens alike may be
disappointed to find a lack of worldwide consensus on climate change under the United
Nations Framework Convention on Climate Change. The lack of participation of the
developing world and the United States may eclipse what may be the greatest single
achievement of Kyoto, the establishment of a price on carbon throughout the European
Union. Under the auspices of Kyoto each individual country in the EU has national
objectives for emissions reductions relative to 1990 levels; after a two-year learning
phase, the first commitment period for compliance takes place from 2008-2012. 1
The European Emissions Trading Scheme is the worlds single largest
multinational emissions trading scheme. After most European Union countries had
ratified Kyoto by 2004, the new EU ETS scheme was initially developed as a pillar of EU
Climate Policy in order to maximize reductions over the first commitment period by
allowing for international trading of emission permits within the EU. The first learning
phase was implemented in January 2005 and continued until December 2007. More than
12,000 installations throughout the EU were allocated under the plan in five key sectors,
including power generation and the mineral industry. 2 This original implementation
1 Mullis and Karas, 132 Greenwald, 4
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covered around 40% of total carbon dioxide emissions in the European Union; member
states were allowed to design national distribution schemes in keeping with their Kyoto
commitments. Firms can trade nationally allocated carbon permits internationally,
privately through a broker, or on the open market. 3 The prior existence of the UK
Emissions Trading Scheme was a useful model for the initial launch in 2005, although for
the first couple of months transactions were limited in scope and the initial commodity
price on carbon was extremely variable. Despite the difficulties, the program was
enormously successful in almost immediately establishing a price on carbon and
obtaining almost 100% compliance throughout member states. Since then, the schemehas expanded slightly to include new members of the EU. In many reports, the original
15 EU members of the trading scheme are denoted as the EU15, and the newer EU
members now participating as the EU8; the total pool of member states is denoted as
EU23. 4
The learning period phase involved only very slight auctioning, at 5% of the
excess permits, and banking was allowed within the periods but not between them. 5
Borrowing was not allowed. Offsets (whether via Clean Development Mechanisms or
Joint Implementation) applied as comparable permits by proxy in Phase I, yet their use
was not formally included under the EU Linking Directive. The majority of data on the
status of initial reductions and targets was published as verified 2005 emissions data
relative to business as usual in the spring of 2006. Initial estimations showed that on the
whole, most countries had achieved marginal if any emissions reduction from Business-
as-Usual, leading to a sharp drop in commodity prices and a lack of scarcity through the
3 Ellerman4 Ellerman and Buchner5 Greenwald
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rest of the Learning Phase.
From January of this year until 2012, Phase II will greatly expand the scope of the
scheme, both in number of sectors and participating member states. Aviation sectors will
be included, several non-EU member states will join, and the structure of the scheme will
become more rigorous. Offsets will be more flexibly applied and national allocation plans
will become far more aggressive and centralized in order to generate compliance with
Kyoto targets by inducing scarcity and assuring that targets fall far below business as
usual. Auctioning, banking, and borrowing will play more central roles.
The purpose of this paper is to closely analyze the various policy components
referenced in overview in order to determine what truly worked and what did not.
Although Phase II recommendations have already occurred and many of the components
that will be explored in this paper are slated to be improved, its the authors hope that a
comprehensive literature review will offer a more subtle exploration of emissions trading
scheme design that will apply not just to future EU but to the United States and other
large multistate trading systems. The next section of this paper will closely analyze the
data and synthesize economic research in five key policy design areas: auctioning, long
horizons and banking, a safety valve, over-allocation, and decentralization.
Section 2: Select Design Issues
1. Auctioning
A key part of understanding implementation in the European Union system is that
in the Learning Phase, distribution of permits was done almost entirely for free, as
national allocation systems gave permits to the corporations that needed them. The
vehicle of allocation was directly planned and implemented, rather than adjusted by the
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market. Less than 5% of the excess permits were initially auctioned on the market, or
purchased by the firms as their demand for them dictated. Moreover, this was carried out
in a system known as grandfathering, in which permits are given to those firms who have
established themselves as reliable polluters over the years prior to the implementation of
the program. 6 The reasons an auction was not implemented initially were extensive: lack
of trust in the economics of the model, lack of coordination between EU member states,
and the decentralized nature of the allocation system. However, this topic bears a
discussion once again, since in the Phase II auctions will only compose 10% of the total
number of allocated permits in the first cycle, and the amount of auctioning is undefinedafter that. 7
The economic literature is almost unequivocal in the fact that an auctioning of
permits is more economically efficient for corporations and more efficient in correctly
matching allocation patterns to market demand. The auctioning debate is often framed as
that of policymakers trying to increase results pitted against companies who will be
disadvantaged by a system that no longer provides them permits for free through the
grandfathering system. In The Effect of Allowance Allocation on the Cost of Carbon
Emissions Trading, Dallas Burtraw and Karen Palmer conduct analysis on the economic
efficiency of grandfathered (GF), auctioned (AU), and generation performance standard
(GPS) systems using past information from electricity systems. Using sensitivity analysis
and estimates of producer and consumer surplus, the authors compare the average social
cost as well as cost of adjustment to various allocation schemes. Their conclusion is
dramatic and displayed visually in Figure 1. While grandfathered and performance
standards raise costs substantially because of inflexibility, auctioned allocation systems
6 Burtraw and Palmer7 Hepburn and Grupp
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are approximately one half the economic costs of the other options. 8 In addition, this
huge savings holds up under a wide range of targets as well as a large number of different
competitive scenarios. This makes sense; while grandfathered schemes may represent
past polluters as more needing of permits when they may have reduced costs of emissions
in the interim, an auctioned system will adjust to the real demands of firms.
Figure 1: The Decreased Social Cost of Auctioned Allocation 9
If the savings in social cost are clear, the question remains how an auctioning
system should be designed to maximize economic efficiency and how this analysis
applies to the EU ETS. In Auctioning of EU ETS Phase II Allowances: How and Why?
a team of authors explore how an auctioning system should be expanded from the
currently planned one and what the potential implications would be in the EU system.
They conclude that auctioning may offer a long-term price signal to investors, assist in
system transparency, and act as a price cushioning mechanism, and is likely to have
negligible implications for competitiveness .10 As far as the amount of auctioning, they
argue that the 10% limit will somewhat dampen price volatility, but that larger amounts
will enhance that effect greatly without any real negative implications.
8 Burtraw and Palmer, 289 Burtraw and Palmer, 4810 Hepburn and Grubb, 3
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However, the question remains of how exactly the auctioning process would
happen. Peter Crampton provides a lucid glimpse into how these systems would operate
in his analysis of the merits of the sealed (uniform-price) bidding auction as opposed to
an ascending clock or bid auction. Crampton first establishes criteria of a successful
auction system: it must create efficient prices, promote transparency, simplicity, and
neutrality. 11 Crampton criticizes the currently recommend concealed bidding auction,
which in this case is relevant to the design of the new RGGI auction in New England but
which is being considered for the EU auction as well. The concealed bid auction happens
in which firms submit their desired price before hand, and a clearing price is established based on firm decisions. Those bids above the clearing price are winners, while the half
of the demand below that are losing bids and do not receive anything. Crampton argues
that this system is inefficient since it requires firms to estimate the demand of other firms
ahead of time, and when they do this incorrectly they will lose out even if they actually
needed to purchase permits. 12 This system is portrayed graphically in Figure 2.
Figure 2: A Concealed Bid Auction
The better option is an ascending clock auction, portrayed in Figure 3. The
auction is dynamic, and occurs as the price rises gradually until there is no excess
demand. In this round-based auction system, the auctioneer announces each round the
11 Crampton 412 Crampton 6
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excess demand from the round before and the start and end or round price. 13 The idea is
that firms will be able to much more accurately predict overall carbon market demand,
allowing them to make more informed economic decisions about the number of permits
they need to sell or buy and defraying cost.
Figure 3: An Ascending Auction
A final consideration is that of revenue raising and sharing. In the debate between
a carbon tax or emissions trading scheme, it is often stated that revenue raising is
immediate and dramatic in a carbon tax system, while an emissions trading scheme,
while more market friendly, does not provide any such funds. Auction revenues may be
used for this purpose and therefore defray some of the costs of such a program and
provide funds for further linkages and offsets. One idea proposed by many is that auction
revenue can be used to promote greater system linkage to other Kyoto countries by way
of Clean Development Mechanisms and Joint Implementation. This would occur as the
European Commission would use the funds to purchase CDM approved permits to
increase the share of international permits as opposed to EU credits (ERUs). The move
towards increasing offsets would increase international efficiency.
2. Long Horizons and Banking
The current EU system is characterized by repeated, sequential trading. One can
argue this was politically necessary in implementing the initial status of the Learning
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Phase; however, most economists argue this is a major defect in the system that will
destroy price signals and reduce investor confidence and activity, and complicate issues
relevant to entrants and closures in the market.
Denny Ellerman argues in EU Trading: Origins, Allocation, and Early Results
that the current short-term horizons are confusing the price formation in the market and
hurting the way in which firms respond to the market. The national committee updates
firm permit caps frequently, as they are solely responsible for assigning and creating the
national distribution pattern for allocation (largely under the grandfathered system). 14
Even if the caps do not alter, the overall horizon was only two years for the Learning
Phase and only 4 years for the next, so there is an assumption of instability. These
fluctuations create a lack of market consistency that has a ripple effect throughout the
liquid markets and subsequently affects investor behavior.
This problem is exacerbated by the problem of entrants and closures in the
market. Under the current entrants and closures provisions, allowances are essentially
given to new entrants for free, while any firm that shuts down forfeits allowance
assignments. 15 This effectively shortcuts market mechanisms in which said firms would
have to buy and sell their permits, respectively. In a Ten Year Rule to guide the
Allocation of EU emission allowances, Ahman and Burtraw argue for the creation of a
set of procedures to deal with this provision and therefore increase the consistency and
length of these caps. Under their formulation, industries will receive allocations equal to
their emissions from 10 years earlier, and then be required to obtain the rest of their
permits on the market. 16 This mechanism, depicted in Figure 3, would not only serve as a
14 Ellerman, 415 Ellerman, 2016 Ahman and Burtraw, 10
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way of maintaining the consistency of caps, but also may be viewed as a forward-looking
way of assigning longer horizons. Cap levels will symmetrically be set at a baseline at the
current date and set for future allocation 10 years later. This will clarify price signals and
confidence in the market. 17 Although Phase II will only have an effective horizon of four
years, this may serve as a formulation for future periods. The major downside of this
approach is uncertainty, since future allocations are difficult to estimate. These longer
horizons should be used to implement more banking and borrowing. Banking should be
allowed in between phases to equalize demand and supply, and borrowing should be
allowed without evidence of abuse in the Learning Phase. This would allow firms toapply future allowances against their current ones rather than miss their commitments.
Figure 4: A Ten Year Rule for LongHorizons
3. Safety Valve
The idea of a safety valve has been a part of discussions on emissions trading
design for years, and so this section will only cover the concept cursorily. As the Market
Advisory Committee explains, a safety valve is simply a ceiling price on emission
permits; this limits the cost of a cap and trade program and provides useful price
certainty. 18 The safety valve is portrayed graphically in Figure 5. When emissions
allowances reach a certain quantity (A) that raises their value to the trigger price, the
price can no longer raise above Pt, and the program administration can then sell
17 Ahman and Butraw, 1218 Market Advisory Committee, 67
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additional permits at the ceiling level.
Figure 5: A Safety Valve
Safety valves offer increased flexibility that helps to allay some of the greatest
weaknesses of the emissions trading scheme, which is why it is so often included in so-
called hybrid schemes. While it often argued that a safety valve reduces the certaintythat total emissions will stay under the overall cap, the valve can be designed in such a
way as to link to offsets that will make up for the excess permits, depicted as the linking
limit C in Figure 5. The main advantage of safety valve is not structural but in the liquid
market, however; the safety valve insures that investors and firms do not get off to a
rocky start when the program starts and when new information hugely changes the
market. A safety valve may have prevented some of the huge price fluctuations in the EU
market such as the price spike in early 2005 and the massive price drop in late in 2007.
Although no safety valve is planned for Phase II, presumably because the market is
considered to be stable already, it seems a mistake not to prepare for a huge price spike at
the beginning of the more scarce distribution of permits over the next four years. Safety
valves will be an important part of any successful future market.
4. Over-Allocation
Besides auctioning, accurate allocation was the greatest issue to arise during the
Learning Phase and will greatly influence the structure of the Phase II of the Emissions
Trading System. Overallocation is distributing too many permits to too many firms so
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that scarcity in the allowance market is not actually created, and overall emissions
reductions are not any less than business as usual even when firms and countries meet
their targets. In May 2006, analysis on the 2005 data revealed that on the whole
emissions had not been reduced below that of business as usual and that countries did not
plan to reallocate; knowledge of overallocation lead to a massive drop in market price
that continued through the end of the Learning Phase. In order to understand exactly
where and why over allocation occurred requires a close analysis by country and sector,
which A. Denny Ellerman and Barbara Buchner compile in Over-allocation or
Abatement? a preliminary analysis based on the 2005 verified emissions data.
They argue that the real question of over-allocation or abatement is more subtle
than whether or not total emissions is less than or more than their baselines; skimming
over country emission totals ignores the inter-country trade in the permits they bought
and sold, as well as the banking and borrowing that occurred. Some countries that went
over their targets very well could be borrowing against future allowances or have sold
most of their permits to save for abatement. 19 In order to get to the bottom of this, they
analyze whether individual industries and countries are short, or their emissions are
below their allowances, or long, in that their emissions are greater than their allowances.
19 Buchner and Ellerman, 5
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Figure 6: Country Allocation v. Emissions
As Figure 6 depicts, there is a huge variance in emission reduction between
member states. Although some countries like Italy and the United Kingdom achieved
very substantial reductions close to or below their emissions, other countries such as
Poland and Germany were far beyond their allowances. Without diving into the country
specifics, this reflects a lot of whether these countries were net buyers or sellers on the
market; countries like UK were net buyers, while countries like Germany were selling
allowances. A rift between the EU15 and EU8 also exists. Whereas emissions reduction
relative to the baseline was only around -2% in the EU15, in the EU8 it was around
-8%. 20 This implies that a majority of new entrants to the scheme were buying permits on
the market and therefore were more able to meet their allowance, while many EU 15
countries were selling theirs and perhaps borrowing against future allowances. Finally, a
sectoral approach reveals a stark difference between power and heat sectors, which were
substantially short, and all other sectors, which were long. 21 This reflects that almost all
of the compliance demand was placed on this one sector during the Learning Phase,
while other sectors more easily got off the hook.
20 Buchner and Ellerman, 1521 Buchner and Ellerman, 9
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Figure 7: Estimating Over-allocation v. Abatement
The question of allocation or abatement comes down to a question of magnitude,
and Ellerman and Buchner attempt to answer it fully by analyzing the counterfactual and
seeing how BAU emissions compare to adjusted baselines. As displayed in Figure 7
above, with adjustment of baseline emissions, overall reduction does exist, but only
slightly with the EU23 at around -.4% reduction; this small reduction makes it clear that
over-allocation did occur .22 How much of the margin was due to overallocation and how
much was due to abatement? They estimate abatement was around 50 million tons of
carbon dioxide, while overallocation accounts for around 100 million; this makes it clear
that overallocation not only occurred, but also was extremely significant in the Learning
Stage. 23
5. Decentralization
Structurally, the most important characteristic of the EU Emissions Trading
Scheme under Phase I was the decentralization of the scheme. There were three primary
stakeholders in the process of the decentralized structure: The European Commission,
which set basic guidelines for structure and participation of the system, the Member
States, which singlehandedly designed and implemented their National Allocation Plans
to achieve their Kyoto target, and the individual firms which complied. 24 The hierarchy of
22 Buchner and Ellerman, 2223 Buchner and Ellerman, 2524 Kruger, Pizer, Oates, 2
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stakeholders is demonstrated in Figure 8, where the Kyoto Target (1) is structured by the
Commission, States implements the Emissions Trading Scheme itself (2) and then sectors
and firms are regulated (3,4). The jurisdiction of Member States included deciding the
national cap, allocation, verification, and structural decisions about banking and
auctioning. 25
Figure 8: Decentralization of EU ETS
In Decentralization in the EU Emissions Trading Scheme and Lessons for Global
Policy, Joseph Kruger, Wallace Oates, and William Pizer argue that the decentralized
structure of the EU ETS is the common denominator in explaining many of the results
and failures experienced in the Learning Phase. They focus on the basic implications that
such a structure has on supply and demand decisions, and the way this explains many
features of the system, including over-allocation, downstream and upstream regulation,
and difficulties with implementations of offsets, banking, and auctioning.
A unifying cause of many of these effects is the huge costs between trading and
non-trading sectors brought about by a decentralized structure. Since it is difficult for any
Member State to predict the overall price on allowances since they only set their own,
there is a huge level of uncertainty on the market price. 26 This makes it difficult to set
allowances so as to minimize the actual effort and emissions of the various sectors, which
25 Kruger, Pizer, Oates, 226 Kruger, Pizer, Oates, 7
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leads to inefficiency and larger costs. This basic increase in compliance costs is portrayed
graphically in Figure 9, which plots the uncertain market price against the nations sector
based allocation factor.
Figure 9: Costs Between Trading and Non-Trading Sectors
Increasing compliance costs reduces overall abatement since Member States tend
to inaccurately allocate sector allowances based on uncertainty. An additional reason for
overallocation is the lack of good available data on individual firms and sectors, and the
fact that Member States are solely responsible for collecting that and distinguishing
between trading and non-trading sectors holds up the process and results in poor
implementation. 27 This same reasoning applies to the failure of many large-scale ETS
initiatives, such as auctioning, banking, a safety valve, and a consistent treatment of
offsets. It is difficult for any one Member State to establish any or all of these efficiency-
increasing program, and moreover they have no incentive to since it is not clear how they
will benefit because of the leakage problem. 28 Finally, the decentralized nature of the
program creates a wholly downstream approach, meaning that emissions reduction is
done at the point of emission rather than earlier points in the supply chain. The full chain
is demonstrated in Figure 11, and EU regulation under control of the Member States has
27 Ellerman, 928 Kruger, Pizer, Oates, 7
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only taken place at the electricity generation and industrial boxes. Although a fuller
explanation of upstream and downstream options will be considered in the next section,
suffice to say this increases inefficiency relative to a hybrid upstream downstream
approach. Inefficiency abounds with high transaction costs for small sectors, and it is
difficult to achieve real reductions in sectors besides those in Power and Heat.
Section 3: United States and Global Implications
Designing a U.S. System
If we consider each of the above as lessons learned, we can construct some basic
criteria for what an practical and efficient Emissions Trading System may look like in the
United States in the next few years. The first category of design would be including those
components that increase economic efficiency as established in this paper, and yet were
structural additions that were not included in the original EU ETS. That includes a safety
valve, a partial or complete auctioning, and banking and borrowing systems with a large
horizon. Each of these individual components is relatively easy to establish in the original
construction of a trading scheme. There will certainly be a vigorous debate on the portion
of allowances auctioned as well as the length of the horizon on caps, but it seems
imperative these elements be included in the first national system, even if it is a Learning
Scheme like in the EU.
Figure 10: Offsets Improve Efficiency
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A second category of design is creating a system that links to others efficiently.
Although decentralization prevented effective and systematic linkage between Member
States and other Kyoto participants in the Learning Phase, it is clear that offsets should be
a centralized and consistent part of any new system, as the Phase II European Union
system will attempt to institute. A study by Paltsev and Reilly analyzed different
formulations of the McCain-Lieberman proposal, and found that under almost all
parameters, the more linkages to other trading schemes and offsets, the more efficient the
system was. 29 Likewise, a report to the Congressional Budget Office, demonstrated in
Figure 10, shows how international linkage correlates to a saving in GDP loss. The xmarks represent models without significant offsets, whereas the green squares represent
emissions trading scheme with such provisions .30 It should remain imperative than any
regional or national emissions trading scheme links to the European Union system and
other Kyoto states, if not initially through price harmonization then later linkage. 31
Finally, the issue of decentralization and overallocation in either a regional or
federal US system is the most difficult to project from experience in the European Union
to future application. Decentralization was a cause of many of the problems that plagued
the emissions trading scheme in the EU, yet we have not yet witnessed a more effective
centralized system emerge there. There is also the fact that a multistate system of
sovereign nations in the EU may be inherently more difficult to centralize than states in
the United States federal system. Likewise, overallocation is unavoidable in initial
implementation, but a Learning System and other structural devices may help to
minimize its role. However, one issue that is more concrete to contemplate are the
29 Paltsev and Reilly, 1030 Congressional Budget Office, 531 Market Advisory Committee, 78
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options of downstream and upstream regulation within a more centralized system. Figure
11 demonstrates the variety of points of regulation; while the EU system focused
exclusively on electricity and industrial centers, other options include regulation at
petroleum refineries, transportation, and vehicle manufacturers. Judi Greenwald of the
Pew Center provides a variety of different hybrid regulation systems in a presentation
entitled Cap and Trade Program Scope and Point of Regulation. The system she
recommends as most efficient is a combination of regulation on Natural Gas distributors,
the electric sector, industrial and commercial sectors, and vehicle manufacturers and
airlines.32
This type of hybrid program would send clearer price signals to consumers,reduce costs on smaller sectors, and regulate those sectors upstream for which it is more
efficient. Clearly there is a multiplicity of these hybrid systems, and it is worth examining
those combinations that may work best in either a federal or regional program.
Figure 11: Sites of Regulation
Finally, with the emergence of Californias AB32 Global Warming Solutions Act,
the Northeasts Regional Greenhouse Gas Initiative, and the Western Climate Initiative, it
is likely we will see the emergence of operating regional emissions trading schemes
before a national one. These regional system would face a host of difficult issues relevant
to establishing consistent standard and regulation, but they wont be unimportant. As
32 Greenwald, 13
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Figure 12 establishes, most of these regional systems will be comparable in size to many
other large developing and developed countries .33
Figure 12: Regional US v. National CarbonEmissions
Implications for Global Architecture
Although this section will be short and speculative, it seems valuable to reflect on
what the experience of the EU ETS tells us about the long term feasibility and design of a
global emissions trading scheme. As Ellerman argues, this will be the motor of the
global carbon market. 34 First, on a component level, it is worth thinking about whether
some of the features discussed in Section II as economically efficient, such as a safety
valve or an auction, are even possible on the global level given their difficulty in a
regional multistate system. This begs the greater question of the intractability of
decentralization problems in global architecture. On one hand, if there is any take away
on the structural deficiencies of the EU ETS, it is that the decentralization of the system
is to blame for a variety of economic inefficiencies. On the other hand, if decentralization
is hard to avoid in a regional multistate level, how much harder will it be to avoid in
regulating all states globally? Similarly, it is not clear how economically feasible or
efficient global centralization of the carbon market would be. However, while these
33 Greenwald, 2834 Ellerman, 9
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issues are unclear, it seems consistent that any successful global carbon market will seek
to maximize linkages and offsets between its various regional systems. Finally, in the
long run with the rise of several linked regional trading schemes and a prospective post-
Kyoto architecture, it is essential that the developing world be brought into the fold in
order to make sure the global carbon motor will run smoothly.
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Congressional Budget Office. Near-Term and Long-Term Reductions: Technology,Coverage, and Costs. Panel II, Directors Conference on Climate Change, Washington,DC. 16 November 2007
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