Greenhouse Gas Emissions Trading:
A Countrys- and Companys-Eye View
The Kyoto Protocol combines ambitious greenhouse gas reduction targets
with innovative market-based mechanisms to help country Parties achieve those targets at
the lowest possible cost. Recognizing that reducing greenhouse gas emissions is many times
more expensive in some countries than in others, the Protocol allows the Parties to use
"emissions trading" and other flexibility mechanisms to meet their commitments
at much reduced cost. This paper describes how emissions trading could work, from the
perspective of a country, and from the perspective of companies and other legal entities.
How Will Emissions Trading
The Kyoto Protocol establishes binding greenhouse gas emissions targets
for 38 countries. These targets take the form of an "assigned amount"
the number of metric tons of greenhouse gases (counted as carbon dioxide equivalent)
that may be emitted by sources within the country during the five-year commitment period
running from 2008 through 2012. Each country must make sure that its emissions during the
five-year period do not exceed its assigned amount.
Articles 3 and 17 of the Kyoto Protocol allow countries with binding
targets to lower the cost of meeting their targets by participating in international
emissions trading. In emissions trading, one country transfers part of its assigned amount
to another. This transfer of assigned amount lowers the number of tons of greenhouse gases
that the first country may emit between 2008 and 2012, and raises the number of tons that
the second country may emit by an equal amount. It is useful to think of each one-ton unit
of assigned amount as a tradeable allowance for one ton of emissions that may be
transferred between countries.
Because the cost of controlling greenhouse gases differs by many times
from country to country, emissions trading will allow enormous savings in meeting the
Kyoto targets. Countries that have relatively inexpensive ways to control greenhouse gases
have incentives to reduce emissions by more than their targets require, because they can
sell tradeable allowances that they will not need to others. Countries facing the most
expensive control measures have incentives to buy less costly allowances from others, and
thereby increase the amount they may emit. Since greenhouse gases are global pollutants,
the environmental impact of reducing them is the same no matter where the reductions take
place. The same overall reduction is achieved, total costs are reduced, and both buyers
and sellers gain from the savings allowed by trading.
While countries can benefit by engaging in emissions trading at the
government-to-government level, far more savings are possible if countries also authorize
their legal entities (companies, individuals, NGOs, etc.) to trade. The cost of
controlling greenhouse gas emissions varies dramatically between companies both within the
same country, and across borders. The private sector can be much more effective than
governments in finding the lowest cost emission reduction opportunities. The greatest
savings can come if private sector companies with the ability to reduce emissions are
allowed to buy and sell allowances with other companies in the same country and with
companies in other countries.
How Would a Country Engage in Emissions Trading?
Trading rules should require a country that wants to trade to have the
necessary capacity and infrastructure to measure and report on its emissions of
greenhouse gases, according to the requirements of Articles 5 and 7 of the Protocol. In
addition, the rules should require the country to establish a national registry
a computerized system to record who holds tradeable allowances; to keep track of
changes in allowance holdings due to emissions trading; and to show which allowances have
already been used to cover past emissions (these would be permanently retired) and which
remain available to be used against future emissions.
A country that wants to increase the number of tons of greenhouse gases
that it is allowed to emit could seek out other countries that are willing to sell some of
their tradeable allowances. Buying and selling countries could arrange their transactions
directly or use brokers or exchanges. Trades would be accomplished by removing allowances
from the national registry of the selling country and adding them to the national registry
of the buying country.
Trading rules should require each country to report to the Secretariat for
the Framework Convention on Climate Change in Bonn at least once each year on the trades
it has conducted and the appropriate increases or decreases in its assigned amount. These
reports would be in addition to the annual reports countries must make to the Secretariat
on their greenhouse gas emissions. Together, this information would serve as the starting
point for determining whether a country had met its commitment to keep emissions within
its assigned amount, as adjusted up or down by trading.
The emissions trading rules could be structured to give countries strong
incentives to comply with basic requirements of the Protocol. For example, a country that
came out of compliance with the Article 5 and 7 measurement and reporting rules, or that
failed to maintain its national registry, could lose its eligibility to trade. The
prospect of losing the savings available from trading could be a strong inducement to keep
buyer countries in compliance. Likewise, the prospect of losing investment revenue could
be a strong encouragement for seller countries to remain in compliance.
How Would a Private Company Engage in Emissions Trading?
In addition to trading at the governmental level, some countries plan to
use both domestic and international emissions trading at the company level as part of
their program to meet their Kyoto commitments. The highly successful U.S. acid rain
program, established in 1990, is a model for how a domestic greenhouse gas trading program
could work. The acid rain program sets a strict limit on the total national emissions of
sulfur dioxide allowed from electric power plants. There is a fixed number of emission
allowances available each year, each one permitting the emission of one ton of sulfur
dioxide. These allowances were allocated to power plant owners. Emissions are rigorously
monitored, and at the end of each year each plant owner must turn back to the government
enough allowances to cover its emissions during the year.
The sulfur dioxide allowances can be bought and sold. Companies facing
high emission control costs have the flexibility to choose their own compliance
strategies. They can reduce their emissions by enough to match their allowance allocation
(e.g., by installing pollution controls, switching to cleaner fuels, or improving
efficiency). They can also choose to purchase more allowances. Companies with inexpensive
opportunities to reduce emissions below their allocations can sell allowances they do not
need. A national registry records all allowance holdings and trades, and shows which
allowances have been used and which remain available for future use. Electric utilities,
brokers, and private individuals, have accounts in the registry recording their allowance
holdings, purchases, and sales. Some allowances have even been purchased by school
children and environmentalists, who have taken them "off the market" to further
The results speak for themselves. Sulfur dioxide emissions are being cut
about 30 percent more rapidly than expected, bringing cleaner air to millions of
Americans. And the total costs of the acid rain program are now projected to be well under
half of original expectations.
Countries could establish similar domestic emissions trading programs for
greenhouse gases. While private companies and other legal entities would be able to hold
and trade allowances, the country would remain fully responsible for compliance with Kyoto
commitments. All legal entity holdings would be recorded in the countrys national
registry. In setting up their domestic programs, countries would have to address many
issues, including which sectors to include in the emissions trading system and which to
address through other policies. Other issues include how to distribute allowances
(allocation or auction?), and how frequently to require emitters to turn them in (every
year, or only at the end of the five-year period?). But the potential savings would make
the effort well worthwhile.
Companies and other legal entities subject to these programs would have
strong incentives to look constantly for innovative ways to control their greenhouse gas
emissions. Those who found inexpensive opportunities to reduce their emissions could sell
the allowances they do not need to other companies who face higher costs. These tangible
rewards for innovation should result in a steady stream of cost-saving breakthroughs and
A countrys domestic emissions trading program would also connect
seamlessly with the international emissions trading system, using the same system of
national registries to keep track of every allowance traded. An international trade
between legal entities of different countries would be carried out by moving the traded
allowances from the account of the selling entity in the registry of one country, to the
account of the buying entity in the registry of the other country. By buying and selling
allowances not only within the same country, but also across borders, companies and other
legal entities would dramatically reduce the overall cost of meeting the agreed Kyoto
And that is the key to success in meeting the ambitious commitments made
in Kyoto, and sustaining and strengthening our efforts to protect the global climate over
the coming decades.