Strengths & Weaknesses of the Waxman-Markey Cap-and-Trade Provisions and Lessons for European Policy Makers

24Jul09

In this piece I look at the strengths and weaknesses of the cap-and-trade provisions under the Waxman-Markey bill and the lessons that European policymakers could learn from the US approach.

Strengths

Coverage

The Waxman-Markey provisions cover all six greenhouse gases and 86 percent of US GHG emissions. Once we take into account the inclusion of domestic offsets, there will be very few emission sources that do not participate in the scheme in one form or another. In contrast, the EU ETS from Phase 3 onwards will cover just three greenhouse gases and only 52 percent of EU emissions. EU policy makers need to expand the scheme to include all six greenhouse gases and increase its coverage by including transport fuels and waste amongst the liable sectors.

Allocation

The Waxman-Markey bill makes innovative use of the allocation of allowances. Not only does it allocate allowances with the objective of aiding the worst-affected liable parties, it also aims to use allocation to encourage the development of clean technologies, offset the impacts of rising energy prices and to support domestic and international adaptation and reforestation. As with many schemes, allowances are allocated to energy intensive, trade exposed industries in order to reduce the impact of the scheme on these sectors. However, this represents only a small portion of the total allowances – about 15 percent in 2014, falling to 11 percent by 2020 and close to zero by 2030. The majority of the remaining allowances are still allocated gratis, but in this case to unregulated sectors, with stipulations that the revenue from the allowances be used to offset price increases in electricity, gas and heating oil and to invest in renewable energy, energy efficiency and carbon-capture and storage technologies. A small portion of allowances are also to be allocated to public bodies with the proceeds to be invested in international technology transfer, international and domestic adaptation and the reduction of tropical forests deforestation. In total, between 2012 and 2025 about three-quarters of allowances are to be directed towards consumer assistance and other public benefit programmes. From its inception, the scheme will also include a relatively large portion of allowances for auction – about 16 percent in 2018  rising to 20 percent by 2020 and 70 percent by 2030 – with the revenue recycled back to low and middle income households as a tax credit or dividend. This imaginative use of the valuable resource that allowances represent is in stark contrast to the experience in the EU ETS to date, where allowances have been allocated gratis to liable parties, with no, or limited, safeguards in place to reduce the impact of the scheme on energy prices and on households, or with limited revenue raised to fund additional technology development or other important public schemes. With the centralization of the allocation process under phase 3 of the EU ETS, we will have to hope that the EC is ready and able to take a similarly imaginative view of allocation in the future. The EC’s intention to auction 60 percent of allowances in 2013 is an excellent development, though further information is needed on how that revenue will be used to respond to climate change.

Regulation

The Waxman-Markey bill sets out a very clear framework for the regulation of trading in emission allowances and their derivatives. Under the bill’s provisions, the Federal Energy Regulatory Commission will be charged with the regulation of the cash market in allowances and offsets; while the Commodity Futures Trading Commission will have responsibility for the regulation and oversight of the derivatives market. Notably, the bill would prohibit over-the-counter trading of derivatives, which is the source of potential market-abuse. These provisions, taken in tandem with other proposed US legislation that would require greater disclosure of derivative trading activities and may also impose quantitative limits on non-commercial derivative positions, would create a very strong regulatory framework that would increase confidence in the trading mechanisms and reduce the potential for abuse. In contrast in Europe, the regulation of derivative trading is left largely to individual national regulators, which translates into a lack of consistency, less than transparent reporting and the potential for abuse. In Europe, there is no prohibition on over-the-counter derivative trading and there are no proposals to limit derivative positions as there is in the US.

Domestic Offsets

The Waxman-Markey bill also lays the foundations for the inclusion of domestic emission offsets. Under the bill’s provisions, domestic offsets will be eligible for inclusion in the cap-and-trade scheme. The offset programme will be administered by a dedicated body, created specifically for that purpose – the Offsets Integrity Advisory Panel – reporting directly to the EPA. Further, the bill includes provisions to encourage domestic offsets over international offsets by discounting international offsets by 1.25 starting from 2018. These provisions create a framework for the inclusion of a number of domestic abatement opportunities, create clear rules to ensure the integrity of these offsets and provide greater incentives for domestic abatement over international actions. In contrast, it will not be until phase 3 of the EU ETS when domestic offsets could be accepted under the scheme and at present there have been no further information on the type of domestic offsets that might be eligible, the way in which such a scheme would be administered, and which body would be responsible for overseeing such as scheme. European policy makers need to act promptly to provide clear guidelines on the eligibility, administration and regulation of domestic offsets under phase 3 of the EU ETS.

Weaknesses

International Offsets

The Waxman-Markey bill would allows liable parties to use up to 1 billion international offsets per year towards their compliance obligation (up to 1.5 billion under certain circumstances). This would mean that the US could meet its entire emission reduction task using international offsets from the beginning of the scheme through until 2018. International offsets could represent up to 70 percent of the US emission reduction task in 2020 and 14 percent in 2050. In contrast, under the rules proposed for Phase 3 of the EU ETS, liable parties can use international offsets for up to 50 percent of the emission reduction task, which would equate to an average of about 200 million offsets per annum over the period 2008 to 2020.

Agricultural and Forestry Offsets

The Waxman-Markey bill also includes a number of concessions to the agriculture and forestry industries. A fifth title was added to the bill in its final stages of negotiations in the US House of Representatives. This title would allow the inclusion of emission offsets from agricultural and forestry sources. These provisions are poor for several reasons. First, it is difficult to quantify offsets from even the most straightforward projects. The risks of double-counting, exaggerated baselines and poor verification are well-known. In the case of agriculture and forestry sources, the quantification and verification of emission offsets are made all the more difficult by the complex nature of biological carbon sequestration and the difficulties of making a complete inventory of all GHG sources and sinks. It is doubtful that a robust methodology could be found to cover these sources – at least one that is cost-effective. The second problem with these provisions is that they stipulate that the offsets form these sources are to be subject to review and administration by the US Department of Agriculture, not by the EPA as is the case with other domestic offsets. The USDA has no experience in managing or certifying offset programmes, whereas the EPA has considerable expertise in the regulation of emission sources. It is to be hoped that these provisions will be removed from the final bill – at least until robust methodologies for quantifying net carbon fluxes from agricultural and forestry activities can be established.

Trade Measures

The Waxman-Markey bill also includes provisions that would require The President, in the absence of an ‘equitable’ international agreement to limit GHG emissions, to introduce a system of international reserve allowances for imported goods. These provisions would effectively extend the proposed cap-and-trade scheme to designated imports. Under such a scheme, importers would have to acquire allowances before products covered by the scheme could be sold in the US. This is effectively an import permit program that subject imported goods to a tax adjustment equal to that imposed on domestic goods under the cap-and-trade scheme. The problem with this measure is one of practicalities. The proposed measure is theoretically consistent with WTO rules. However, it is extremely difficult to see how this measure could be implemented in practice. At the most fundamental level it would be necessary to quantify the GHG emissions associated with the imported product and to do so in terms that are identical to that used for the domestic product. At a practical, logistical and administrative level the scheme is probably unworkable.

Lessons for European Policy Makers

  • Expand the coverage of the EU ETS further – include all six greenhouse gases and transport and waste related emissions.
  • Put in place a clear and transparent framework for the inclusion of domestic offsets. Move forward quickly to publish guidelines and protocols for the inclusion of domestic offsets to provide clarity and encourage domestic action.
  • Make more imaginative use of allocation and publish clear guidelines on how rauction revenue will be used.
  • Introduce greater (and consistent) regulation over derivative trading, including the mandatory publication of individual positions and a prohibition on over the-counter derivative trading.
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