How to create a carbon market in seven steps

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By Gareth Phillips

Under a post 2020 climate regime, all countries will have the opportunity (obligation?) to develop and implement effective policies and measures to help meet their climate change commitments. Carbon markets have had a chequered history but their time could be approaching. Here are seven steps to create a carbon market which can be implemented approximately sequentially over a timescale of 5 to 15 years:

Step 0: Remove all subsidies for fossil fuels.

Easier said than done but some countries have recently succeeded and with oil prices at such low levels and renewable technologies still getting cheaper, there may never be a better time.

Step 1: Implement GHG monitoring and reporting legislation for all entities which emit more than 10,000 tonnes of CO2 per annum.

This may be implemented through primary legislation or existing environmental pollution controls but either way it should be hosted by a senior Ministry such as Finance or Planning because in due course, inter-ministerial committees will be required and line Ministries often lack the convening power. Legislation should include monitoring and reporting protocols for captured sectors through which data should be collected over a three-year period in parallel with a training and capacity building program. The government should also provide some financial support for entities who install suitable metering equipment. Then start an audit program with penalties for poor reporting in order to ramp up the quality of data.

Step 2: Implement a modest tax on greenhouse gas emissions.

Keep it simple, with as few exceptions as possible. Use audited data to determine the costs to industry. Resist lobbying efforts by industries and buy the public's support by redistributing the collected tax revenues to popular programs such as education and health. The tax will have a disproportionate impact on poorer segments of society who spend a greater proportion of their income on energy and some industries which are heavily reliant on fossil fuels. Use some of the revenues to support these groups. The tax will also discourage emitting industries from over-reporting their emissions. If the economy includes industries which compete in international markets, assess how many of these markets are also implementing emission taxes or ETS and decide whether or not, or for how long, to provide support to such industries. For example, they may pay a lower rate of tax for a period of time.

Step 3: Create a Ministerial level Climate Change Committee (CCC) chaired by a very senior member of Government.

The CCC is responsible for the overall development and implementation of the carbon market including the progression of key legislation through parliament. The CCC will appoint an advisory committee comprising stakeholders from captured industries, academia, civil society, etc. The Advisory Committee will advise the CCC on overall targets and on the allocation of emissions to the traded and non-traded sectors on a rolling 5-year basis - giving sufficient certainty as to the supply of emission allowances but also having sufficient flexibility to respond to macro-economic trends. All accounts dealing with emission allowances must be transparently reported to Parliament.

Step 4: Construct a domestic emission reduction mechanism by which industries or gases which are not captured under the tax or the proposed ETS can implement emission reduction projects and sell certified emission reductions to tax payers who can use the units to reduce their tax burden. This expands the scope of the tax to non-captured industries and gases and also starts to build emission verification and trading infrastructure and capacity.

Step 5: Institute Phase 1 of an Emission Trading Scheme (ETS): Migrate taxed entities

A Designated Authority implements the ETS legislation under the oversight of the CCC. During the first phase, captured entities buy emission rights at the same rate as the tax, or even at a slight discount - minimizing resistance to the transition. Emission rights can be traded and emission reductions from eligible projects are fungible. To minimize the risk of future distortions, emission rights should not be bankable into the second phase.

Step 6: Institute Phase 2 of the ETS: Move from outright emission rights purchase to auctions.

At the outset of Phase 2, auction enough allowances to ensure that the cost of compliance remains comparable with the cost of compliance under Phase 1. Banking and carry-over of units purchased at auction into subsequent phases is permitted but, the CCC will have the authority to set a negative interest rate on banked units to discourage entities from excessive speculation. Units which are not sold at auction will be retired. When there are insufficient units, the CCC will authorize an entity to enter either the domestic or international market to purchase additional emission rights and will then auction these to incumbents with the expectation that the auction revenues will cover the cost of purchase. In this way, the CCC may ensure that the cap is not breached but at the same time, the economy is not constrained.

Step 7: Merge the ETS with trading partners whose ETS have similar integrity by allowing captured entities to participate in each other's auctions.

Merging helps harmonize prices and provides flexibility to captured entities but avoid any kind of connection to ETS where free or cheaply purchased allowances can be imported - this results in a transfer of wealth and a rapid loss of confidence in, and political support for the mechanism.

Why should any country do this?

Such markets can work because these lessons have been learned through implementation of the UK ETS, Kyoto Protocol, EU ETS, and drafting of the Australian Carbon Pricing Legislation (which was never implemented). The major problem for all ETS to date has been over-supply of allowances in the early stages. This design minimizes the chances of over-allocation, as long as the CCC holds its nerve and transparently resists pressure from lobbyists.

Why do it?

a) Governments have a responsibility to manage a country's resources on behalf of its citizens. Clean air and a stable climate are part of those resources. Not regulating activities that negatively impact upon these resources is increasingly being recognized as a dereliction of duty. In the same way that we regulate some sectors of the economy for the creation of solid or liquid waste, so too should we regulate GHG emissions. Emission trading is simply the most cost effective way of implementing that regulation.

b) Creating an emission trading scheme creates assets which add financial value and liquidity to economies. If the captured sector emits 100 million tonnes of GHG per annum and these are auctioned at US$ 10 per tonne, the ETS adds US$ 1 billion per year to the economy which can be used as collateral to drive investment and innovation in low carbon technologies, building a sustainable green economy and increasing energy security.

Following what I hope will be a successful meeting in Paris in December, dozens of developing countries should start to plan for the implementation of step 0 while developments institutions such as the African Development Bank should be on stand-by to assist them.


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