S. Hawkins and I. Jegou — Linking Emissions Trading Schemes: Considerations and Recom- mendations for a Joint EU-Korean Carbon Market EXECUTIVE SUMMARY Emissions trading schemes (ETSs) are continuing to emerge as a popular climate policy tool as countries look for cost-effective solutions to curb greenhouse gas (GHG) emissions. In theory, companies with relatively low abatement costs will emit less and sell surplus emissions on the carbon market, whereas companies with high abatement costs will purchase allowances to cover their emissions. As a result, emissions reductions are undertaken in the most cost-effective way. South Korea is among the world’s top GHG emitting countries. While the country has no binding reduction commitment under the Kyoto Protocol, it has pledged to reduce its emissions by thirty percent relative to its projected 2020 business-as-usual (BAU) emissions. In order to achieve this reduction target, South Korea has decided to implement an ETS from January 2015. Parallel to the growing number of ETSs, governments are starting to link or consider linking their respective ETSs. Emissions trading schemes therefore have the potential to play an important role in international climate change cooperation. This paper analyses the possibilities for linking the carbon markets in the European Union (EU) and South Korea. It assesses elements of the South Korean ETS to determine which features have the potential to facilitate or prevent linkage with the EU ETS. The paper draws on lessons from previous linkage examples and makes recommendations for the South Korean case. Linkage offers several advantages, such as economic efficiency gains; the creation of a broader, more liquid carbon market; a potentially lower risk of carbon leakage; a lock-in of the climate policy; and support for multilateral climate action via a bottom-up approach. However, linkage also comes with disadvantages, including distributional issues or a loss of regulatory control. Linkage further requires a certain degree of harmonization between some elements of the schemes. Policymakers might therefore have to align certain features of their ETSs. The differences in the design of ETSs largely affect the compromises that linkage would involve. In the end, the decision whether or not to link is a trade-off between the merits and demerits of linkage in light of a government’s priorities. The decision will also be influenced by the form of linkage, which can be direct or indirect. Direct links require an active decision to accept the other system’s allowances and can be unilateral, bilateral or multilateral. A unilateral link is a one-way link whereby one system decides to recognize allowances from the other system for domestic compliance obligations, but not vice versa. Allowance trading will only take place if prices are higher in the system establishing the link. A bilateral link, on the other hand, is a two-way link requiring both systems to recognize each other’s allowances. The higher-price system will purchase allowances from the lower-price system until prices converge at an intermediate level. Multilateral links involve more than two systems. In addition, two systems that do not accept each other’s allowances can become indirectly linked through their respective linkage to a common third system. Bi- and multilateral linkages require a certain degree of harmonization between the ETSs. Differences in some areas are unlikely to prevent linkage, including monitoring, reporting, and verification (MRV) rules; registry systems; provisions for new entrants and plant closures; banking rules; trading periods; and allocation methods. However, others have the potential to pose barriers, such as the stringency of emissions caps, penalty regimes, the eligibility of offset credits, cost containment measures, scope and coverage, and the use of absolute versus intensity targets. The first linkages are starting to take place. The EU ETS has been linked with Norway, Iceland, and Liechtenstein – although this is a special case that some simply consider an extension of the EU 2ICTSD Programme on Global Economic Policy and Institutions ETS. Switzerland and the EU are in the final stages of negotiating a link, and Australia and the EU have agreed to link their ETSs in July 2018 – although this depends on whether the Carbon Pricing Mechanism and planned ETS are repealed under Australia’s new Prime Minister Tony Abbott. Despite their differences, the Norwegian, Swiss, and Australian cases show some common trends and provide interesting practical insights into the linkage issue. They show that linkage requires that the key features of ETSs be sufficiently aligned. Enforcement measures, rules for the use of offset credits, cost containment measures, and scope and coverage are areas where the EU requires sufficient harmonization. However, the cases also show that linkage with the EU does not require complete harmonization, allowing for some differences to persist in the allocation mechanisms, MRV rules, the treatment of new entrants, and trading periods. South Korea particularly stands to gain from linkage with the EU ETS because of its expected high carbon price. Linking with the EU could reduce the carbon cost for South Korean firms. A decrease in South Korea’s allowance price could in turn help reduce its risk of carbon leakage. Given the absence of a binding reduction commitment under the Kyoto Protocol, linkage would further create an institutional lock-in, thereby sending important investment signals to covered businesses. The EU ETS and the planned South Korean ETS have some similarities, which could facilitate linkage in the future. Both ETSs are designed as cap-and-trade systems with equally stringent MRV rules and aligned banking rules. However, there are also differences, some of which have the potential to pose barriers to linkage. The South Korean plans contain provisions for the readjustment of allocations. While requests by South Korean firms for additional allowances from the reserve pool might lead to competitiveness concerns among their EU counterparts, such concerns would exist irrespective of linkage. The scope for such requests is further very restricted. More importantly, the EU is likely to be alarmed by the ability of the South Korean authorities to increase the total amount of available allowances under exceptional economic circumstances, since this would inflate the total number of allowances in the joint carbon market. Given the EU’s recent proposal for the creation of a market stability reserve that would release or withdraw allowances to prevent significant price volatility, the South Korean provision might be less problematic. The conditions for such an overall allocation readjustment would, however, most likely have to be clearly defined. Another unique and potentially problematic feature of the South Korean ETS concerns the ability of the Government to intervene with pre-defined market stabilization measures under specified circumstances to prevent significant price hikes and crashes. However, the controversy surrounding the EU’s back-loading measure and the difficulty of passing this policy show that many in the EU oppose interventions in the carbon market. South Korea might, however, have a strong interest in controlling extreme price developments in both directions, pointing to its lack of a binding reduction commitment under the Kyoto Protocol and the EU’s experience with price volatility. The South Korean market stabilization measures are therefore likely to prove contentious in linkage negotiations. The wider scope and coverage of the South Korean ETS could pose another barrier. South Korea’s plan to include three additional GHGs might be less problematic, since Australia also plans to include methane, which has not proven to be an obstacle for EU-Australian linkage negotiations. However, the coverage of indirect emissions under the South Korean ETS might prove more problematic. South Korea would certainly have to provide evidence of robust accounting methods to avoid double- counting and misallocating allowances. Scope and coverage could turn into a difficult issue if the EU is unwilling to accept an extended scope and coverage or if South Korea opposes a more limited approach. 3 S. Hawkins and I. Jegou — Linking Emissions Trading Schemes: Considerations and Recom- mendations for a Joint EU-Korean Carbon Market Decisions on some scheme elements remain to be taken and could further complicate linkage. The penalty regime could pose a barrier if South Korea does not impose a requirement on non-compliant businesses to surrender missing allowances in addition to paying the fine. In the absence of such a requirement, the price cap on the fine would effectively form a price ceiling for allowances in the joint carbon market. The issue of international offsets might pose a problem for South Korea, since linkage would lead to the propagation of the EU’s offset rules into South Korea, which plans to impose tighter quantitative offset limits and has yet to decide on the acceptance of Kyoto credits. However, the situation could change completely given the EU’s recent announcement that emissions reductions from 2020 will have to be achieved through domestic actions alone, effectively banning international offsets from its ETS. South Korea might further face an undesired propagation of borrowing rules into its own scheme. While it plans to limit the borrowing of allowances at ten percent of a company’s compliance obligations, the EU’s implicit borrowing regulation has no quantitative restrictions. Linkage between the two schemes would extend the EU’s more generous regulation to South Korea. Linkage between the EU ETS and the South Korean ETS would likely require the latter to align several key features. Previous experience shows that the EU does not implement any changes. Instead, its linkage partners have to work towards sufficient harmonization by aligning their schemes with the EU ETS. As a larger carbon market, South Korea might, however, be able to obtain some concessions, for example regarding scope and coverage. South Korean policymakers should clearly assess their interest in a link with the EU ETS, as well as the likely benefits and disadvantages it would involve. This could help South Korea take measures to facilitate linkage in the future, either by developing some elements more closely in line with the EU ETS or by identifying a road map to do so in the future. It is particularly recommended that South Korea and the EU enter a transparent and open dialogue early on in order to specify expectations, requirements, and barriers. This can provide parties with a clearer picture of opportunities and challenges. As the Australian case proves, such an engagement can start even before the ETS is implemented. Prior to a full bilateral link, South Korea could also establish a unilateral link to the EU ETS, just like Norway had done. This would allow the country to achieve some key benefits while its scheme is not yet fully prepared for a two-way link. 4ICTSD Programme on Global Economic Policy and Institutions 1. INTRODUCTION A growing number of countries are developing and implementing ETSs in an effort to curb GHG emissions. Emissions trading schemes generally take the form of cap-and-trade systems. This means that a cap is in place to limit total emissions and permits – or allowances – for emitting GHGs are allocated to covered entities. Participating firms can freely trade these allowances on a carbon market. Alternatively, ETSs can be designed as baseline-and-credit systems. In this case, firms are rewarded with emissions reduction credits for emissions that fall below their performance targets – or baselines.1 The discussion in this paper focuses on cap-and-trade systems. Emissions trading schemes are a market-based policy tool aimed at cutting emissions in a cost- effective manner. In theory, cost-efficiency can be obtained as reductions are undertaken by firms with relatively low abatement costs, whereas firms with higher abatement costs will instead purchase additional allowances.2 Emissions reductions therefore take place where the cost of doing so is lowest. The EU was the first party of the United Nations Framework Convention on Climate Change (UNFCCC) to implement an ETS to curb GHG emissions back in 2005. It was intended to help the EU fulfil its Kyoto commitment of reducing GHG emissions by eight percent below 1990 levels in the period of 2008–12.3 The EU ETS is currently the largest and most significant ETS. Alongside the growing number of ETSs, linkage between domestic ETSs is starting to take place. The EU ETS has implemented or agreed to linkages with several schemes and has a strong interest in establishing further linkages. In 2009, the EU stated its ambition to create an OECD-wide carbon market through linkage to comparable cap-and-trade systems and to extend this to major emerging economies by 2020 with the aim of creating a global carbon market.4 To date, the EU ETS has been linked with the three member states of the European Economic Area and European Free Trade Association (EEA-EFTA). The link was, however, not established through the EU’s linkage provision, but through the adoption of the EU’s ETS Directive by these three states.5 The EU ETS is in fact now seen as comprising the twenty-eight EU member states plus Iceland, Liechtenstein, and Norway.6 This raises the question of whether the EEA-EFTA case should be considered an example of linkage or simply participation in an already existing scheme. Although the literature is divided on this issue, we consider the Norwegian case an example of linkage for the purpose of this paper. Negotiations to link the EU ETS with the Swiss ETS are currently under way and expected to be concluded before summer 2014.7 Finally, in a move towards the first intercontinental link, the EU and Australia have reached an agreement to link their respective schemes.8 However, the EU-Australian link depends on whether the planned ETS is scrapped under Australia’s new Prime Minister Tony Abbott. Linkage offers several advantages, such as economic efficiency gains; the creation of a broader, more liquid carbon market; and support for multilateral climate action via a bottom-up approach. However, linkage also comes with disadvantages, including distributional issues or a loss of regulatory control.9 Linkage further requires a certain degree of harmonization between some scheme elements. Policymakers might therefore find themselves in a situation where they have to align certain features of their ETS with the other scheme. The differences in the design of schemes largely affect the compromises that linkage would involve. In the end, the decision whether or not to link is a trade-off between the merits and demerits of linkage.10 These need to be seen in light of a government’s priorities. 5 S. Hawkins and I. Jegou — Linking Emissions Trading Schemes: Considerations and Recom- mendations for a Joint EU-Korean Carbon Market The potential for a linked EU-Korean carbon market South Korea, which is among the top global GHG emitting countries, has decided to introduce an ETS to curb emissions in major industrial sectors. The scheme will become operational on 1 January 2015. While South Korea has no obligations to reduce GHG emissions under the Kyoto Protocol, in 2012 it passed a bill that paves the way for the introduction of an ETS in an effort to help South Korea achieve new economic growth through the transition towards a low-carbon society.11 The possibility of future linkages has already entered South Korean debates on the ETS. The potential of some design features to pose barriers to linkage makes it worthwhile to consider possible future linkages of the South Korean scheme early on. The size of the EU ETS, combined with its strong interest and first experience in linkage, makes the EU an interesting linkage partner. Assessing the possible linkage of the South Korean ETS with the EU ETS therefore serves as a good starting point. Purpose and outline of the paper The purpose of this paper is to analyse the possibilities for a linked EU-Korean carbon market. It will specifically assess elements of the South Korean ETS to determine which features have the potential to facilitate or prevent linkage with the EU ETS. The paper will draw on lessons from previous linkage examples and make recommendations for the South Korean case. This can serve to inform policymakers involved in the design of the South Korean scheme by helping them to identify their interest in linkage with the EU ETS and make decisions that would facilitate linkage in the future. The paper first introduces the concept of ETSs and provides an overview of the schemes in the EU and South Korea, taking into account their main design elements. This serves to determine the similarities and differences between the EU ETS and the South Korean ETS. Chapter three discusses the concept of linkage, introducing the different forms of linkage, the rationale for linking schemes, the disadvantages, and the barriers posed by design differences. It also touches upon some legal considerations of linkage. The paper then moves onto specific case studies in chapter four, presenting examples of linkages between the EU ETS and other schemes. The selected cases are based on linkages that have already been implemented or agreed. This involves three countries: Norway, Switzerland, and Australia. The previous chapters serve to draw lessons and make recommendations for the potential linkage of the EU and South Korean schemes. Chapter five analyses the specific rationale for linking these two schemes, identifies existing facilitators and barriers, discusses trade-offs, and makes some policy recommendations. The concluding chapter summarizes the main findings and provides some insight into the role that linkage of ETSs can play in international cooperation on climate change. 6ICTSD Programme on Global Economic Policy and Institutions 2. EMISSIONS TRADING SCHEMES IN THE EU AND SOUTH KOREA This chapter introduces the concept of emissions trading and gives an overview of the EU ETS and the South Korean ETS. These descriptions will be used to assess the similarities and differences between the two schemes. 2.1 How Do Emissions Trading Schemes Function? Emissions trading schemes offer a cost- effective solution for achieving emissions reductions. In ETSs, covered entities obtain allowances that they can trade freely on a carbon market.12 Scarcity is the underlying mechanism for the functioning of ETSs.13 The quantitative limit on allowances gives them a value, since firms that use allowances to account for their own emissions lose the opportunity to sell the allowances at the current market price. This opportunity cost creates incentives for firms with relatively low abatement costs to reduce emissions in order to sell permits to firms with relatively high abatement costs. Emissions reductions are therefore undertaken where they can occur most cost-effectively.14 Emissions caps Most ETSs are designed as cap-and-trade systems. In such schemes, a cap is in place to limit the total amount of GHG emissions for a given period. This cap can be absolute or relative. The former works through total emissions reduction targets, while the latter uses intensity targets expressed as emissions per unit of output or input.15 Within the cap, allowances are allocated to the covered installations. Allocation mechanisms Allocation mechanisms can take the form of auctioning, free allocation, or a combination of the two. During the early stage of an ETS, governments often choose to allocate allowances free of charge in order to gradually introduce the new carbon cost. Free allocation may also be intended to address concerns about the potential risk of carbon leakage and distortions in competitiveness. Carbon leakage occurs when emissions that have been reduced in one country as a result of climate change regulations move to countries with less stringent environmental regulations. Distortions in competitiveness relate to the concerns of energy-intensive industries in countries with relatively high carbon costs, as they fear a loss of market shares to firms in countries with no or lower carbon costs. In countries where carbon costs are imposed through ETSs, free allocation of emissions allowances can help alleviate these concerns.16 Free allocation is usually a temporary measure that is gradually replaced by an auctioning mechanism. There are three main methods for distributing allowances free of charge: grandfathering, benchmarking, and output-based allocation. Grandfathering means that allowances are allocated based on past emissions, using average emission levels for a specific period of years. One associated risk is that installations may see no incentive to reduce emissions if they assume that future allocations will be based on current emission levels. Benchmarking addresses this risk by using an allocation mechanism based on the benchmark of the most efficient installations in a given sector. However, the benchmarking method requires that common definitions, reliable data, and good measurement and verification systems be available. Access to detailed production data is particularly challenging. In an output-based allocation system, the number of allowances a firm receives depends on its output in relation to the industry benchmark. The risk of this method is that it may incentivize entities to produce more in order to receive more free allowances, therefore inducing increased emissions.17 7 S. Hawkins and I. Jegou — Linking Emissions Trading Schemes: Considerations and Recom- mendations for a Joint EU-Korean Carbon Market Trading of allowances Installations covered by an ETS are required to submit allowances for every tonne of GHGs emitted in the previous year. They must therefore obtain enough allowances or reduce their GHG emissions. The choice depends on the relative costs. Permits can be obtained by trading between entities and – in many schemes – temporal trading.18 The opportunity costs involved in using allowances to account for emissions instead of selling them at the market price means that firms with relatively low abatement costs will sell allowances to firms with high abatement costs. The option to sell allowances incentivizes firms with low abatement costs to reduce GHG emissions. If no restrictions exist for temporal trading within multi-year trading periods, entities can save unused allowances from the current year for compliance in future years and cover shortages in the current year by borrowing allowances from the following year. The so-called banking of allowances is usually possible across trading periods, while borrowing is restricted to the same trading period.19 Borrowing carries the risk that important emissions reductions could be delayed or never implemented if entities can borrow indefinitely. This is why most ETSs limit borrowing to the same trading period and some impose quantitative restrictions on the amount of allowances that can be borrowed.20 Compliance with the ETS Robust MRV rules are a key component in any well-functioning ETS. It is important for emissions and emissions reductions to be monitored and disclosed in an accurate and transparent manner.21 Covered installations are usually required to monitor and report their emissions on an annual basis. Most schemes additionally require reports to be independently verified, while others request verifications on a case-by-case basis. In order to ensure compliance with the ETS, penalties are imposed on installations that fail to surrender the required amount of allowances.22 Penalties usually involve a fine, and many schemes additionally require firms to submit missing allowances in the following year. 2.2 The EU Emissions Trading Scheme The EU ETS is the main pillar of the EU’s climate policy and its key tool for cutting GHG emissions.23 The EU is the world’s largest carbon market, accounting for over three-quarters of the trading volume in the international carbon market. It covers over 12,000 heavy energy-using power stations and manufacturing plants in the EU member states.24 Since 2008, installations in the three EEA-EFTA states – Iceland, Liechtenstein, and Norway – are also covered by the EU ETS.25 The EU ETS was divided into three initial trading periods. Phase I (2005–07) was a trial period. Phase II (2008–12) introduced some changes to the scheme and coincided with the EU’s first compliance period under the Kyoto Protocol. However, it was Phase III (2013–20) that introduced significant reforms that particularly affect the cap-setting and the allocation of allowances. Emissions reduction commitment The EU ETS was introduced in 2005 through Directive 2003/87/EC in response to the EU’s emissions reduction commitments under the Kyoto Protocol, with the objective of helping to achieve reductions in a “cost-effective and economically-efficient manner.”26 In 1997, the fifteen EU member states had committed to reduction targets under the Kyoto Protocol, agreeing to cut their collective GHG emissions for 2008–12 by eight percent below 1990 levels. This commitment was translated into national emissions reduction and limitation targets. All of the new member states that joined the EU after the adoption of the Kyoto Protocol – except Malta and Cyprus – committed to individual reduction targets under the Kyoto Protocol.27 In spite of the overall low support for a second commitment period under the Kyoto Protocol, with Canada, Japan, and the Russian Federation 8ICTSD Programme on Global Economic Policy and Institutions
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