For over two decades, the international community has struggled to find a cost-effective and politically feasible way to reduce carbon emissions and combat climate change. Economists agree that carbon pricing, through either a carbon tax or a cap and trade program, will be an essential part of any solution to mitigate climate change. The establishment of carbon pricing measures has not been easy, however. While the debate continues about whether a tax or cap and trade system is the best approach, neither has seen widespread international political success. The European Union’s Emissions Trading Scheme (EU ETS) has been the most successful thus far, creating the world’s largest downstream CO2 cap-and-trade system. While a promising first step, the EU ETS has been limited in its environmental effectiveness by only serving the market in which it operates. Attempts to replicate its success in other countries have generally failed (Australia’s program, designed to shift from a carbon tax to a cap and trade system in 2014, was repealed with the election of a new government in 2013 while New Zealand’s fails to require the surrender of permits from the most polluting sector).
Cap and trade schemes have historically been formed either top down or bottom up, each model with its own economic, political and environmental benefits. The top-down approach, which in theory involves a supranational body such as the United Nations giving each country an emissions cap and providing an international market for trading extra allowances, would be the most environmentally effective model. This model is epitomized by the intergovernmental trading system set up in the Kyoto Protocol to run from 2008-2012. The global consistency of a top-down model is also highly efficient in equalizing emissions prices and creating economic efficiency, two key factors that can create challenges in the global marketplace. While this top-down architecture would be the most effective environmentally and economically, it has been shown to be politically unfeasible. Global emissions actually rose during the 2008-2012 period that the Kyoto trading system was in place, and now political turmoil has prevented new top-down cap and trade systems from being successfully implemented.
A more politically-feasible alternative to this top-down approach is a bottom-up structure, with individual countries and sub-national entities implementing their own emissions trading systems. These create a series of fragmented markets with the major benefit of low transaction costs and realistic political feasibility. Because the markets do not need to be coordinated across countries or linked in any way, they can emerge easily and are self-governed. The downside to fragmented markets comes in environmental and economic inefficiencies. These markets are limited in their environmental impact since they only cover a specific area and a small amount of emissions (27% in 2004). Also, because each market sets its own prices and performs its own regulation, fragmented markets cannot ensure the equalization of permit prices and marginal abatement costs, resulting in economic inefficiencies.
Just last month, however, we saw the emergence of what may lead to a new trend in carbon pricing, one that may help bridge the gap between environmental impact, economic efficiency and political feasibility. On January 1st, California and Quebec formally linked their individual carbon markets, creating the first successful trans-national carbon market linkage. Linking carbon markets occurs when two or more regional emissions trading schemes recognize each other’s emissions allowances, creating opportunities for inter-system trading. This architecture, especially when it involves linking sub-national entities, strengthens the environmental, economic and political arguments concerning cap and trade markets. First, including more participants in the market immediately increases the environmental impact of the carbon market, providing greater opportunities for carbon abatement. If a replicable structure can be created for linking markets, it may be easier and more appealing for new entities to join existing cap and trade markets.
Economic efficiencies also arise in this type of market. With more options for abatement and offsetting, resources are directed at the lowest-cost abatement measures, which in turn lowers the overall cost of meeting emissions reduction goals. By joining a pre-existing infrastructure, transaction costs are lowered and more regions are likely to join, resulting in a larger coverage of emissions than typical fragmented markets.
Lastly, creating a framework to link sub-national entities could make it easier for these entities to join into a carbon market. Currently, many national attempts at creating cap and trade markets fail for political reasons. An easy framework for sub-national market linking, however, would allow states or provinces who might desire a carbon market to not be limited by the politics at the federal or national level.
Though they have yet to find the right balance, carbon markets, including cap and trade systems, will be an indispensable part of a solution to climate change. The new connection between California and Quebec could open some new doors for continuing the cap and trade fight, increasing environmental, economic and political effectiveness of these markets.
Image Credit: 1979stl via Wikimedia Commons