Part 2: Offsets, Bubbles, Allowances, Emissions Trading: How We Got Here and Where We are Going
A Changeblock Series…
Diffusion
The pattern for the diffusion of modern technologies is well known. The diffusion begins with a few risk-takers who see the benefit of being first, known as early adopters, while others wait for convincing evidence before making commitments to adopt innovative technologies.
Regulators are risk-averse by training and vocation because environmental mistakes are costly in terms of health, welfare, and cost. Convincing regulators to take unrewarded risks is not easy. Success, however, breeds success, and widely distributed academic articles, prestigious public policy publications, and successful litigation legitimized emissions credit trading. Trading-based regulation within the US was no longer a novelty but was seen as a proper adjunct to conventional command-and-control modes of regulation.[1]
Perhaps the most unambiguous endorsement of trading as a complement to command-and-control came in April 1994 with US EPA’s “Appendix X to Part 51 - Examples of Economic Incentive Programs” containing examples of endorsed Economic Incentive Programs (EIPs). The examples provided information and guidance on various types of regulatory programs, collectively referred to as EIP’s. Examples include programs involving stationary, area, and mobile sources of emissions. The definition section at 40 CFR 51.491 defines an EIP as a program that may include state-established emission fees or a system of marketable permits. It also describes a system of state fees on the sale or manufacture of products the use of which contributes to ozone formation, or any combination, as well as incentives and requirements to reduce emissions.
And importantly, according to EPA, EIP’s are composed of several elements that, in combination with each other, must ensure that the fundamental principles of any regulatory program are met, such as accountability, enforceability, and non-interference with other requirements of the Clean Air Act. Mistakes may be made, but penalties and fast correction allowed the Agency to “iterate to a solution.”[2]
Credit trading leads to quota (allowance) trading
For years, evidence was building that confirmed that harmful economic and environmental effects were being imposed on sensitive lakes and soil. It became clear the culprit was emissions from coal-fired utilities, primarily in the Midwestern, south-eastern, and north-eastern states. The problem was acid rain — SO2 and nitrogen oxides (NOx) — reacting in the atmosphere to form sulfuric and nitric acids deposited by rain or dry processes.
The purpose of Title IV of the CAAA of 1990 was to reduce total annual SO2 emissions in the United States by ten million tons relative to 1980. The program mandated a cap-and-trade allowance-trading program.
Cap-and-trade was the logical extension of the property-right granting programs of one-off transactions. It establishes a fixed number of emission ‘allowances’ for companies to buy and sell as needed. The cap was to be defined by environmental and ecological needs.
Trading among affected parties logically follows when emission control costs are heterogeneous across industries and when the cost-saving is enormous. Thus, nothing stopped the Smithian profit incentive to find a cost-effective solution to a compliance problem faced by many electric utilities and the public service commissions that regulated these local monopolies. Furthermore, an army of engineering and economic consultants and regulatory attorneys were hired by utilities and Public Service Commissions, who pushed for trading-based compliance solutions building on a myriad of technology and economic studies performed for the US Department of Energy and EPA.
Simply put, if annual emissions at a regulated facility exceeded the allowances allocated to that facility, the facility owner could either buy allowances or reduce emissions, whether by installing pollution controls, changing the mix of fuels used to operate the facility, or by scaling back operations. If emissions at a regulated facility were reduced below its allowance allocation, the facility owner could sell the extra allowances or bank them for future use.
The program was a success; by 2007, annual emissions had declined below the nine-million-ton goal despite electricity generation from coal-fired power plants increasing more than 26% from 1990–2007 (EPA 2012; EIA 2011).
In 1989, before the program went into force, the US Environmental Protection Agency estimated the total cost of implementing the Acid Rain Program at $6.1 billion. However, in 1998, the Electric Power Research Institute (EPRI), a utility research organization and Resources for the Future (RFF), an independent and left-leaning think tank, estimated that total implementation costs would be between $1.1 billion and $1.7 billion — less than one-third the projected cost. (NAPAP 2005).
Emissions trading provisions in the Kyoto Protocol
In July 1992, representatives from 155 nations gathered in Rio de Janeiro for the United Nations Conference on Environment and Development. The recognition that climate change was a reality led to the signature of the United Nations Framework Convention on Climate Change (UNFCCC). While some may say that the UNFCCC was deeply flawed, it was the first step toward international cooperation to manage greenhouse gas emissions (GHG) — the cause of global warming.
The UNFCCC resulted in a voluntary commitment by industrialized countries to reduce their emissions to the 1990 levels until the year 2000, and embedded in the Convention was an offset-like emission credit trading provision.
At the first Conference of the Parties (COP 1) to the UNFCCC held in 1994, a political compromise was accepted to have a pilot phase to “test” trading under a program called ‘Activities Implemented Jointly’ (AIJ).
During the AIJ pilot phase, projects were conducted with the objective of establishing protocols and experiences, but the program did not allow the actual transfer of carbon credits between developed and developing countries.
Subsequently, in December 1997, the Kyoto Protocol was conceived during COP (3) of the UNFCCC, and within the Protocol, there were three trading programs. There were two types of credit trading programs — Joint Implementation (JI) and the Clean Development Mechanism (the CDM) — and one type of quota trading.
JI involved GHG emission reduction credits being generated and then used in countries with GHG control commitments, the so-called Annex-1 countries, the developed countries.
While the CDM involved investments by developed countries (Annex-1 countries) in carbon offset projects in developing countries, these projects created internationally transferable emission reduction credits for use in an Annex-1 country whilst facilitating the development of human capacity in developing nations.
Diffusion, Diffusion, Diffusion
Since the Kyoto Protocol encouraged GHG credit trading (sometimes called carbon trading), a constant stream of economic, legal, and advocacy publications confirmed that markets do facilitate cost-effectiveness more than the most omniscient regulator could ever do. As a result, by 2021 use of credit and quota trading has been one of constant expansion. See the maps below in Figures 2 and 3 from the World Bank[3]. The ICAP ETS world map below depicts emissions trading systems currently in force, under development or consideration, as of January 31, 2021.
There were 24 ETS in force, and another eight are under development and expected to be in operation in the next few years.
Fourteen jurisdictions, including Chile, Turkey, and Pakistan, were also considering the role an ETS can play in their climate change policy mix.
Meanwhile, the EU has moved forward with a carbon border adjustment tax.
Finally, the most significant impetus for trading besides ratification of a user-friendly Article 6.2. and Article 6.4 trading programs within the Paris Agreement is the unabashed advocacy of political and commercial opinion leaders promoting voluntary offset trading.
(Figure 2 — Map of Emissions Trading Schemes in North and South America)
(Figure 3 — Map of Emissions Trading Schemes in Europe, Asia, Africa, Oceania)
Evidence of diffusion and institutionalization abound and exhaust the mind’s ability to track all trading-based incentives. To employ just one measure, consider Table 1 below, which illustrates the ascendancy of trading-based emissions control programs.
As noted earlier, emissions trading as a concept was only born in 1976 through the Offset Interpretive Ruling. Below we show the explosion in human capital supporting emissions trading by measuring the number of citations found for two different but related “emissions trading” internet searches.
This crude barometer of the number of academic and citation-worthy papers reveals the growth and institutionalization of emissions trading applications, analyses, and advocacy.
It suffices to say that emission credit and quota trading achieved their purpose. They promoted cost-effectiveness, and the documentation was robust.
How do we evaluate emissions trading? What do we know, and how do we know it?
Emissions trading evolved from a prototype to address conflicting economic and environmental goals to transition into the foundation for international cooperation and a foundation for private sector/public-sector collaboration.
What have we learned from emission credit and allowance trading, and how should we evaluate its application?
Emission trading was designed and developed to promote economic efficiency — cost-effective pollution control programs. And it did. It is a tautology that people in a trade do what they think is in their best interest. Emissions trading is voluntary, so every trade must, by definition, benefit both parties; otherwise, no one would do it.
Nevertheless, some critics claim that emissions trading failed to achieve many goals. But while many of the goals they cite might be laudable, the enunciated goals are sometimes the goals of the critic, not the goal of regulators who supported adopting trading-based programs (i.e., promoting cost-effectiveness). Every tool in the policy maker’s toolbox is suitable for a purpose, and not every tool can optimize the attainment of all social goals. Some goals might be better attained via market or non-market tools.
For example, as recently as 2020, two negative characteristics of emissions trading were debunked. First, it has been claimed that the use of offsets was not environmentally beneficial. While offsets had to result in emission decreases, some critics argued that the ambient benefits of emission trades did not follow. However, Joseph Shapiro and Reed Walker (UC Berkeley) found that for most regions and pollutants, the marginal benefits of pollution abatement exceed mean offset prices by a factor of ten.
Markets work, and prices influence decision-making, hardly big news, but news, nevertheless.[4]
And with respect to “environmental justice,” some advocates have questioned the equity dimensions associated with the application of offsets in the US:
Do US air pollution offset markets disproportionately relocate pollution to or from low-income or minority communities? Concerns about an equal distribution of environmental quality across communities — environmental justice — have growing policy influence. We relate prices and quantities of offset transactions to the demographics of the communities surrounding polluting plants. We found little association of offset prices or offset-induced movements in pollution with the share of a community that is Black, Hispanic, or with mean household income. This analysis of twelve prominent offset markets suggests that they do not substantially increase or decrease the equity of environmental outcomes.[5]
It was inevitable that the market would save money. But that is not the big story. The evolution of trading-based environmental compliance also produced billions of dollars of human capital investments and institution building. Those benefits have long-lasting effects such as building human capital to help price emissions within affected firms, leveraging the interest of engineers and economists to search out low-cost emission control opportunities, elevating the role of the environmental manager, and including environmental matters in strategic planning.
Besides saving money, what else was achieved using emissions trading?
In “Companies and Regulators in Emissions Trading Programs[6], “Joe Kruger summarizes some seemingly non-economic benefits. In fact, as Kruger well documents, these benefits pay multiple dividends immediately and in the future.
Kruger writes, and every consultant who worked for an affected firm knows, compliance planning in an emissions trading program is both simpler and more complex than under command-and-control regulations. That is because, under command-and-control, firms know what to do, how to do it, and by when. Under a trading-based program, their choices among strategies and tactics are great, and their flexibility to modify plans over time is enhanced to accommodate the ever-changing regulatory landscape.
Experience reveals that companies address regulatory and economic complexities in two ways:
First, companies in trading-based programs promoted an interdepartmental approach to compliance planning and operations. To be blunt, previously, environmental, health, and safety (EH&S) workers were not normally involved in financial and strategic planning. But now, trading-based compliance strategies require the involvement of an array of skill sets and departments, such as public relations, EH&S, finance, fuel purchasing, risk, plant management, and legal.
Second, large companies use econometric models to assess costs. In the case of regulated entities like power companies, public utility commissions also used the same or competing simulation models to justify cost increases that inevitably get passed on to consumers. Knowledge was built fast within the regulated and regulatory community and within the engineering, legal, and trading communities that supported affected firms.
What is next?
The evolution of markets is beyond the scope of this paper. Nevertheless, it is common knowledge that markets evolve after property rights are established. First, barter facilitates transactions. Over time, exchange ratios can be established: two yams for one rabbit or five measures of grain for four arrows. Eventually, Intermediaries (merchants) appear who understand exchange ratios and accounting. Currency as we know it slowly emerged as a coin, then paper. Now electronic. Tradable financial Instruments appeared, such as equities and tradable debt. Additionally, the evolution of the limited liability “corporation” and the stock exchange were huge steps forward for trade and risk management.
During the last 50 years, innovations like junk bonds, interest rate swaps, and new derivatives provided the lubrication for moving financial capital from one investment toward another. Trades, once done through intermediaries like brokers, are matched via community websites and now through blockchain-based systems. New technologies create new trading opportunities.
In “Good Derivatives,” Richard Sandor prognosticates that:
The next 40 years will witness the invention of new asset classes. New products will continue to be driven by latent, unsatisfied demand. Environmental and weather derivatives, volatility indexes, and event-based trading are all examples.[7]
But Sandor could not foresee the emergence of artificial intelligence (AI) tools and the use of blockchain, especially blockchain-based smart contracts.
The synergism of Sandor’s linear thinking and the jump-discontinuities implied by the daily application of AI and blockchain mean that big changes are coming. Those changes are not only coming — they are “just around the corner”[8]:
- Smart contracts give buyers and sellers more flexibility than one-size-fits-all trading-based or command-and-control-based compliance strategies. Their deployment has had a profound effect on brokerage and the democratization of trading. The impact today is non-existent. The impact of “tomorrow” will be explosive.
- Peer-to-peer transactions can minimize the time and cost to conclude a transaction.
- Security can be enhanced, and provenance better revealed and understood by buyers of emission credits by virtue of blockchain-based supply chains.
- The liability of buyers and sellers and their collaborators can be better allocated using blockchain-based tracking.
The twin rivers of AI ascendency and blockchain’s diffusion have led to the development of new trading instruments driven by self-interest — either saving money or making money. And it is that self-interest that regulators leverage with emissions trading. Today that trend — the use of markets to better allocate scarce resources — is running deeply among organizations and individuals of influence.
In the world of environmental trading, the results from the confluence of AI and blockchain technologies lead directly toward supporting smart contract trading of environmental assets.
That “confluenced” river has a name, and it’s called “DeFi.” Decentralized Finance, a new commercial paradigm that provides all the enumerated benefits buyers and sellers seek.
There will be no “going back.”
Subscribe to learn more on DeFi in episode 2 of the Changeblock series, the “The Emissions Trading Market: 2022 and Beyond (the Future is Now)”
A special thanks to Billy Richards, Charlie Terry & John Palmisano for writing this article. This piece was written as an illumination of the background conditions that helped to form the Changeblock platform.
[1] Just one publication got traction, which was “Project 88 — Harnessing Market Forces to Protect Our Environment: Initiatives for the New President.” (A public policy study sponsored by Senator Timothy. E. Wirth, Colorado, and Senator John Heinz, Pennsylvania).
[2] See: https://www.law.cornell.edu/cfr/text/40/appendix-X_to_part_51.
[3] See: https://icapcarbonaction.com/en/?option=com_attach&task=download&id=726
July 22, 2021.
[4] In: “Is Air Pollution Regulation Too Stringent?” Joseph S. Shapiro and Reed Walker (UC Berkeley).
[5] In: “Where is Pollution Moving? Environmental Markets and Environmental Justice” Joseph S. Shapiro and Reed Walker (UC Berkeley).
[6] Companies and Regulators in Emissions Trading Programs, Joe Kruger, Resource for the Future, (RFF DP 05–0) 2005.
[7] Good Derivatives: A Story of Financial and environmental Innovation< Richard L. Sando, 2012 John Wiley & Sons. 552.
[8] “Blockchain is arguably the most significant innovation since the internet with individuals, companies and even governments embracing the technology. An appealing feature of blockchain technology is smart contracts. Smart contracts are gaining widespread use and ease of creation as global processes are becoming increasingly digitized. They serve as an alternative to traditional contracts which are often slow and expensive.
Today, smart contracts are available to optimize many financial and business processes. In essence, they are self-executing, self-enforcing protocols that are governed by explicit terms and conditions.
On blockchain, smart contracts can streamline complex processes that involve several intermediaries, and this has led to them becoming one of the most popular and talked about subjects in the blockchain industry. They allow the performance of dependable transactions without the engagement of third parties.”
