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Design and Legal Consideration for North American Emissions Trading Environmental Challenges and Opportunities of the Evolving 8 North American Electricity Market Secretariat Report to Council under Article 13 of the North American Agreement on Environmental Cooperation Working Paper Design and Legal Considerations for North American Emissions Trading Prepared by: Douglas Russell Global Change Strategies International Date: June 2002 This background paper was prepared for the CEC Secretariat in support of the “Electricity and Environment” initiative undertaken pursuant to Article 13 of the North American Agreement on Environmental Cooperation. These background materials are intended to stimulate discussion and elicit comments from the public, as well as the Electricity and Environment Advisory Board, in addition to providing information for the 29–30 November 2001 Symposium on the “Environmental Challenges and Opportunities of the Evolving North American Electricity Market.” The opinions, views or other information contained herein do not necessarily reflect the views of the CEC, Canada, Mexico or the United States. Commission for Environmental Cooperation of North America 393, rue Saint-Jacques Ouest, Bureau 200 Montréal (Québec) Canada H2Y 1N9 Tel: (514) 350-4300; Fax: (514) 350-4314 E-mail: [email protected] http://www.cec.org © Commission for Environmental Cooperation of North America, 2002 Design and Legal Considerations for North American Emissions Trading TABLE OF CONTENTS EXECUTIVE SUMMARY ...........................................................................................................1 ACKNOWLEDGEMENTS ..........................................................................................................5 INTRODUCTION..........................................................................................................................5 SECTION I: OVERVIEW OF EMISSIONS TRADING IN NORTH AMERICA.................7 SECTION II: KEY ELEMENTS OF EMISSIONS TRADING REGIMES..........................15 Macro Design Options ............................................................................................................ 15 Coverage ................................................................................................................................. 16 Emission Targets..................................................................................................................... 19 Operational Rules.................................................................................................................... 20 Compliance Regime................................................................................................................ 22 Issues Relating to Credit Trading ........................................................................................... 24 Desirable Design Elements..................................................................................................... 26 SECTION III: ISSUES UNDER NAFTA..................................................................................27 Introduction............................................................................................................................. 27 NAFTA Issues ........................................................................................................................ 27 Summary on NAFTA Trade Implications .............................................................................. 31 References for Section III ....................................................................................................... 32 AREAS FOR FURTHER EXPLORATION .............................................................................32 ANNEX: SUMMARIES OF EMISSIONS TRADING REGIMES.........................................34 – i – Design and Legal Considerations for North American Emissions Trading – ii – Design and Legal Considerations for North American Emissions Trading EXECUTIVE SUMMARY This report, prepared for the Commission for Environmental Cooperation (CEC) of North America, explores key issues that should be taken into account when considering a multi- pollutant emissions trading regime that embraces all three NAFTA countries. Consideration of a NAFTA-wide emissions trading system as an environmental policy option is largely in response to the changing dynamics in the North American electricity sector, which have the potential to pose significant air quality and climate change challenges. The report is intended to provide an understanding of the architectural elements involved in designing an emissions trading system and provides insight into which of those elements would be needed to ensure the environmental integrity of such a system. The paper also identifies potential “interface” issues that could arise under the North American Free Trade Agreement (NAFTA) in the event of the implementation of a North American emissions trading system. The report was drafted in a two-step process. A background paper was prepared, which included: an overview of emissions trading systems in North America and results derived from these; a description of architectural elements involved in the design of an emissions trading system, and implications of cross-border harmonization of these with regard to environmental integrity and economic efficiency; and potential trade issues that could emerge by implementing a North American scheme. The background paper was circulated for comment among a wide set of environmental policy experts, comprising, for example, US EPA staff and experts on international emissions trading, and formed the basis for discussion in an informal workshop held in Toronto in December 2001. The workshop, which brought together around 25 cross-sectoral experts in the field from all three NAFTA members, was an informal session with the objective of establishing an open dialogue. Findings and recommendations derived from the workshop were incorporated into the final draft of the report. Experiences in Emissions Trading Experiences in emissions trading in North America cover the gamut from voluntary credit purchasing as a way to test the market and gain trading experience, voluntary pilot programs as means to test design elements of trading systems, to a fully mature and developed emissions trading scheme exemplified by the US Acid Rain Program. North American experience with emissions trading suggests that allowance trading (cap and trade) proves more effective than strictly open market (credit) trading in terms of both economic and environmental results.1 Since credits are project-specific or activity-specific, they generally must be approved before they can be traded, which tends to increase transaction costs and uncertainty, and inhibits trading. 1 While Mexico has not undertaken emission trading schemes, it should be noted that through other nontrading initiatives, the country has experienced some success in reducing the same key environmental pollutants targeted by emission trading schemes in other North American countries. – 1 – Design and Legal Considerations for North American Emissions Trading Conversely, experience has also shown that the initiation of allowance trading systems tends to be complex and politically charged. For example, the US Acid Rain Program’s Phase II has 29 specific allocation methods for its 81 participants and the NOx OTC Program has different rules for different states, such as state-specific allocation systems, which preclude some cost-saving transactions. From a business perspective, Canadian and US experiences in trading have demonstrated that in order for firms to engage in trading they need certainty, to learn-by-doing, and they need confidence (i.e., clear policy signals). Finally, early lessons can be taken from the incipient greenhouse gas emissions trading schemes already operating in Europe (UK and Danish systems): the fragmentation of rules (different sectors, different compliance regimes, different gases) will require significant experience in order to effect cross-border transactions. Desirable Design Elements There is disagreement about which overall design elements would be desirable to have in a North American emissions trading system. For example, some US firms consider hybrid emissions trading programs difficult to implement (difficulty in setting rules, high transaction costs, complex administration, etc.) and would tend towards supporting a permit trading regime. They strongly support gratis allocation of permits and inclusion of multiple gases. In terms of sectoral coverage, the notion that the more diversity the harder it is to effect transactions prevails. Banking would be an essential ingredient and some sort of penalty for noncompliance would have to be imposed. Finally, fungibility rules would need to be clear. Conversely, other groups suggest that a NAFTA-wide system should adopt a cap, credit and trade approach, specifically since there are ample opportunities for reductions in Mexico and opportunities to foster technological innovation in uncapped sectors. Both Canada and the US have had significant experience in project-based activities (USIJI, PERT, GERT, etc.) and valuable lessons have been learned from these. However, the specificity of project requirements remains problematic. Therefore, commonalities within project-based systems2 would require further exploration. Many experts feel it is important to design a system with a strong institutional framework and comparable monitoring and verification procedures (trading infrastructure) that would involve standardization (firm and
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