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Carbon Market Analyst

North America

A US Cap-and-Trade Program: Options for Compliance

April 2, 2009


The Emission-to-Cap in the cap and trade program proposed 2 Executive summary
by Rep. Waxman would be 205 million tons in 2012, growing to 2 Introduction
1.4 billion tons by 2020.
2 Sizing up the gap
This gap could be cut in half if complementary policies 6 Compliance options
promoting clean energy and energy efficiency standards are
also passed. The long term impact of the economic recession 10 Market implications
coupled with ambitious policies could create a long market for 12 Conclusion
the first compliance period.
13 Contacts
In 2012, the domestic offsets supply will be too scarce to fill
in the gap. Certified Emission Reductions (CERs) could help
meet the gap, placing US facilities in competition against other
international buyers.

In 2016, because of the limited domestic offset supply, some

fuel switching may be needed, rapidly pushing prices up.
To remedy high prices, we anticipate the development of a
new international offset programs, where sectoral and REDD
credits could play a much larger role.

In 2020, a large reliance on fuel switching would bring prices

up over $50 a ton. These high prices would render economically
attractive most other compliance options, including purchases • Assessing the Impact of the Reces-
of international allowances and a wide range of internal sion on US GHG Emissions
abatement measures • A Post-2012 Global Climate Change
• What Role for International Forestry
and REDD credits

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Carbon Market Analyst North America CMA April 2, 2009

Executive summary
This report provides an overview of compliance options 20 million tons per year, we foresee a shortage of these
under a US cap-and-trade program using the discussion credits.
draft proposed by Rep. Waxman on March 31st, 2009.
International offsets are also unlikely to fill in their quotas,
We first estimate the size of the emission-to-cap (E-t-C), although we forecast a potential supply of Certified
or the difference between projected US greenhouse gas Emission Reductions (CERs) of over 700 million tons
emissions and the cap – this is the amount by which globally in 2015. US facilities would have to compete
covered entities collectively will have to reduce their with European emitters and Kyoto countries for these
emissions to comply with the carbon limits. We estimate credits. Other forms of international offsets could be
this gap at 205 million tons in 2012, growing to 1.4 bn developed, notably sector-based credits and Reduced
tons in 2020, if ‘business-as-usual’ projections follow the Emissions from Deforestation and forest Degradation
path forecasted by the Energy Information Agency. (REDD) credits and help make up the shortfall.

The bill includes a wide array of complementary In terms of internal abatement, fuel switching has the
policies to reduce emissions, notably a renewable largest potential – aside from energy efficiency. The
electricity standard, an energy efficiency standard, and cost of fuel switching can rise rapidly depending on fuel
improvements to fuel economy and carbon-intensity of prices. A high price of carbon would trigger a negative
transportation fuels. These policies could cut the E-t-C in feedback loop and incentivize other internal abatement
half, reducing the gap to 87 million tons in 2012, a mere measures, such as industrial energy efficiency,
1.2 percent of the total cap. Coupled with the effect of improvement to chemical processes, etc. This would
the economic recession, the program could start long in bring prices back down to a level where fuel switching is
the first compliance period (2012-2013). We forecast the the most economical available option.
2020 gap at roughly 760 million tons, 15 percent of the
cap that year. High carbon prices would also create an incentive to
‘link’ with other carbon markets, such as the European
We then investigate the main compliance options for or the Australian emission trading systems. LInkages
filling this gap: offsets and internal emission reductions. with other markets would not necessarily bring prices
The bill authorizes 2 bn offset credits for compliance, down but could help dampen price volatility.
evenly split between domestic and international offsets.

Domestic offsets will likely constitute the least expensive

compliance option, but with a pipeline currently below

Introduction This report provides an analysis of carbon market, assuming no major

supply and demand dynamics under technological breakthrough occurs in
The prospects for a carbon market in a US cap-and-trade program and sets this time frame.
the US are looking better by the day. up the conceptual framework for
Lawmakers in Congress are actively price formation in a future US carbon
discussing a climate bill, and hopes market. Sizing up the gap
are high that cap-and-trade legislation
may be passed by the end of the Hopes are high that Under a compliance program,
demand for emission reductions is
year. cap-and-trade leg- derived from the gap between the
This issue of Carbon Market Analyst islation will pass by emission cap established by the
North America looks at compliance the end of the year government and actual emissions
options under a US cap-and-trade from covered sources.
program. We first estimate the size We provide snapshots of three
of the emission-to-cap (E-t-C), or milestone years during the first Setting the cap
the difference between projected decade of the program - 2012,
emissions under a business-as-usual 2016 and 2020 - and discuss which In the White House budget proposal
(BAU) scenario and the cap, and then compliance option is likely to be released February 27, President
investigate the main compliance preferred in each of these years. Obama stated his reduction targets
options to close this gap: offsets and We look at the carbon price range – 14 percent below 2005 levels by
internal emission reductions. involved and implications for the 2020; 83 percent below 2005 levels

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Carbon Market Analyst North America CMA April 2, 2009

by 2050. More recently, on March

31st, Representative Waxman (D- Table 1: E-t-C in the Waxman-Markey draft proposal
CA) and Markey (D-MA) released a
discussion draft setting even more BAU projections, total BAU projections, Emission-to-Cap
ambitious medium-term targets US emissions covered sectors Cap (EtC)
starting in 2012 at 3 percent below 2012 7 294 4 975 4 770 205
2005 levels, declining to 20 percent
2013 7 301 4 979 4 666 313
below 2005 levels by 2020 and 80
percent below 2005 levels by 2020 2014 7 273 5 506 5 058 448
(see Figure 1 and Table 1). While 2015 7 282 5 513 4 942 571
these targets may change in the final 2016 7 307 6 175 5 391 784
climate bill, we take them as the
2017 7 336 6 199 5 261 938
best available indication of the depth
of the cuts to be expected and use 2018 7 364 6 223 5 132 1 091
them in this analysis. 2019 7 378 6 235 5 002 1 233
2020 7 380 6 236 4 873 1 363
Waxman sets ambi- 2030 7 894 6 671 3 533 3 138
tious medium and
long term emission
reduction targets Agency’s (EIA) Annual Energy existing state renewable portfolio
Outlook released in December 2008. standards. In Figure 1 we chart total
BAU emissions for the US as a whole US emissions (top dotted line) and
We also use the scope proposed are projected to increase from 7,294 emissions from covered sources only
in the Waxman discussion draft, an million tons (mt) in 2012 to 7,380 mt (solid line) against the cap.
economy-wide coverage of all sectors in 2020, a 1.2 percent growth.
except for waste and agriculture. Emission-to-Cap
Some sectors are phased into the These projections account for
program over the first years, creating the new Corporate Average Fuel As shown in Table 1, we find that in
steps in the curves representing the Economy (CAFE) and the renewable 2012, covered sources will have an
cap and the emissions from covered fuel standard passed in the estimated annual emission-to-cap
sectors in Figure 1. December 2007 Energy bill. They (E-t-C) shortfall of approximately
also include the reductions from 205 MmtCO2e, or 4.1 percent of
The sector phase in provision means
only 68.2 percent of US emissions
are covered in 2012-2013, but this Figure 1: Emission-to-Cap in the Waxman-Markey proposal
number increases to 75.7 percent in
2014-2016 when industrial facilities
are phased in, to eventually reach
its maximum at 84.5 percent in 2016
as the requirement extends to local 7,000
Million tons CO2e

distribution companies. The scope 6,000

remains at 84.5 percent of total 5,000
emissions through the rest of the 4,000

Business as usual emissions 2,000

We use with the business as usual -
(BAU) emissions projections, which









illustrate the path US greenhouse gas










emissions levels are expected to take

Business-as-usual projections, total US emissions
given existing environmental policies
Business-as-usual emissions from covered sectors
and regulations. The projections are
Waxman reduction targets from covered sectors
based on the US Energy Information

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Carbon Market Analyst North America CMA April 2, 2009

their estimated BAU emissions.

This gap is anticipated to increase Textbox 1: Energy efficiency: the answer to it all?
to approximately 571 million tons by
2015 and up to nearly 1.4 billion tons Many studies show the potential savings from energy efficiency – most recently,
McKinsey’s report “Reducing US Greenhouse Gas Emissions: How Much at What
by 2020. The shortfall in 2020 is then
Cost?” announced close to one billion tons of GHG emissions could be reduced
22 percent of BAU emissions from from energy efficiency measures alone, at a cost of zero or less (negative cost, i.e.
covered sectors. a net saving). If this is true, why do we even need energy efficiency standards?

Economically, energy efficiency appears to be an obvious investment, yet the shifts

Lower Emissions? toward better-insulated buildings and ultra low-energy appliances are not occurring
on the massive scale that their economic profitability would suggest. Three types
Actual emissions will likely be lower of hurdles typically get in the way of efficiency improvements according to energy
than even the most recent EIA efficiency experts Arthur Rosenfeld and Paul Stern. First, structural issues, like the
forecasts because of recently-passed tenant/landlord dilemma, prevent useful investments from taking place because
the decision-makers and the beneficiaries are disconnected. Second, the economic
policies, proposed policies, and the
profitability of efficiency investments is not always as clear cut as economic theory
impact of the economic recession. would imply. Discount rates (the time-value of money) and interest rates faced by
individuals can be significantly higher than those used by economists in calculating
Enacted Policies the worth of energy efficiency investments. Finally, individuals and companies do
not always behave rationally in the economic sense and may elect to keep pricier
The Obama administration has incandescent light bulbs because they prefer the quality and color of the light to that
passed important policies and large of cost-savings compact fluorescent lights.
investment programs in the past
Because economic rationality is often not enough to trigger these energy efficiency
two months, notably the American investments, standards and public action are needed to overcome structural and
Recovery and Reinvestment Act, financial hurdles. Cap-and trade can also trigger some energy efficiency investments,
better known as the ‘stimulus bill’, and but only if carbon prices are high enough to make a large difference on the energy
the proposed 2010 federal budget. bill.
Both packages contain significant
speed at which the economy will levels in the US. Two sectors are the
investments in clean energy and
recover from the current recession is most likely targets for broad-reaching
energy efficiency, and could by one
unknown. regulations: the power sector and
group’s estimate reduce business-
as-usual emissions by 61 million tons the transportation sector. New
We do not attempt to capture this climate-oriented regulations in both
annually from 2012 onwards (see potential “recession effect” on US
Textbox 2). sectors would evoke large amounts
emission levels but consider possible of emission reduction.
that emissions would be lower than
projected during the first years of Power sector
BAU projections do the program. This would reduce the
not fully account for gap between emissions and the cap A national renewable electricity
the deepening eco- even further. The effects on long term standard (RES), mandating that a
emissions, however, would probably minimum percentage of electricity be
nomic downturn be negligible. generated from renewable energy, is
under discussion in Congress and
Furthermore, the Annual Energy Proposed Policies could be passed as early as this
summer. A proposal introduced by
Outlook projections, dated December In addition to the effects of the Sen. Bingaman (D-NM) early 2009
2008, likely do not fully account for economic slowdown, US GHG would require that 20 percent of
the deepening economic downturn emissions, and therefore the E-t-C, electricity sold in the US come from
and its lasting effect on greenhouse could look dramatically different if renewable sources by 2025. A similar
gas (GHG) emission levels. Analyses some further energy command-and- bill proposed by Rep. Markey aims
of the recession’s effect on Europe’s control measures are passed ahead for 25 percent renewables by 2025.
emissions have estimated close to of or in conjunction with legislation This provision was included in the
six percent reduction in emissions establishing a cap-and-trade Waxman-Markey draft and would
from 2007 to 2008, partially due to program. Such regulations are under reduce emissions by an estimated
decreased industrial output from discussion and would have a large 57 mt in 2012, growing to 279 mt by
energy-intensive sectors such as effect on long term GHG emission 2020 (see Textbox 2).
cement and pulp and paper. The

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Carbon Market Analyst North America CMA April 2, 2009

Energy efficiency standards are

also being discussed in Congress. Table 2: Effect of mandated emission reductions on E-t-C
The Save American Energy Act, All numbers in million metric tons of CO2e
introduced by Rep. Markey (D-MA)
and Sen. Schumer (D-NY) establishes
E-t-C Stimulus RES Energy Efficiency New E-t-C
a federal energy efficiency resource
standard, requiring utilities to 2012 205 61 57 0 87
reduce electricity demand by 15 2013 313 61 52 5 195
percent and natural gas demand by 2014 448 61 104 18 265
10 percent by 2020. This mandate
2015 571 61 103 39 368
could lower emissions by 39 mt in
2015, increasing to 262 million tons 2016 784 61 156 58 508
by 2020 according to the ACEEE (see 2017 938 61 151 88 638
Textbox 2). Other measures included 2018 1,091 61 220 117 693
in the draft bill promote appliance
2019 1,233 61 210 214 747
efficiency standards, improved
building efficiency standards, etc. 2020 1,363 61 279 262 761
and would also reduce emissions.

The E-t-C could be Smaller gap – long market?

Table 3 -E-t-C by compliance period
halved by comple- We account for the emission
mentary energy pro- reduction potential of the ‘big ticket’ Compliance period Annual E-t-C
visions in the climate bill items in the Waxman-Markey bill and 2012-2013 141
estimate the size of the new gap in
2014-2015 316
the short and medium-term, up to
Transportation sector year 2020. Hence we exclude the 2016-2017 573
effects of transportation policies, 2018-2019 720
President Obama lists two key as the main measures are either
measures for the transportation sector 2020 761
unspecified or only take effect after
in his energy agenda: increasing fuel
efficiency standards and passing a
low-carbon fuel standard (LCFS). As Textbox 2: Sources for Emission Reduction Estimates
a Senator, Barack Obama supported
the Fuel Economy Reform Act, which Reduction forecasts for the stimulus bills are drawn from an analysis commissioned
proposed a four per cent per year fuel by Greenpeace in January 2009. Consultancy ICF evaluated sixteen energy,
economy improvement beginning in environment, transportation and technology provisions included in the initial
Economic Stimulus Package and quantified the expected emission reductions from
2009 for passenger cars and 2012 for
each of them.
light trucks. The proposed LCFS set
targets of fuel carbon-intensity at 10 The emission reductions from renewable electricity standards are detailed in a
percent below 2005 levels by 2020. Point Carbon report dated February 23, 2009: Greenhouse Gas Reductions from
The National Commission on Energy Renewable Electricity Standards.
Policy has estimated the combined
For energy efficiency, we used the American Council for an Energy Efficiency
effect of both proposals at 550 million Economy (ACEEE) report: Laying the Foundation for Implementing a Federal Energy
tons worth of reductions by 2020. Efficiency Resource Standard, published March 18, 2009.

The Waxman-Markey bill contains an Our estimate for transportation is based on a memo dated June 2007 by the National
LCFS provision that only takes effect Commission on Energy Policy and the International Council for Clean Transportation.
when the Renewable Fuel Standard The study quantifies reductions from a low carbon fuel standard (LCFS) and the Fuel
ends, in 2022, and mandates the Economy Reform Act and finds the combined measures would yield 550 million
tons by 2020. This forecast is likely overestimated because it does not account for
EPA to harmonize fuel efficiency
the Energy bill passed later that year and uses the 2007 AEO BAU forecast.
standards building on California’s
tailpipe emission standards (the Point Carbon does not support or promote any of the policies studied, nor does it
“Pavley bill”), but does not set associate with the policy positions from the authors of these studies.
specific targets.

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Carbon Market Analyst North America CMA April 2, 2009

2023. As shown in Table 2 and Figure

2, the new E-t-C is roughly halved by Figure 2: What’s left to markets?
the complementary policies, leaving
only half the initial gap to be reduced 6,500
by market forces.
Another way to look at these numbers

Million tons CO2e

is by compliance period (Table 3). The
Waxman-Markey bill establishes two- 5,500 Remaining
year compliance periods, allowing
companies to borrow and bank from
one year to the other within the two- 5,000
year periods. By smoothing out the
differences created by the phase-in 4,500
provision, compliance periods provide
a clearer picture of the reduced but
growing gap over the first nine years 4,000
of the program.
12 013 014 015 016 017 018 019 020
2012 22013 22014 2 20152 20162 2017
2 2018 2 2020
2 2019
The Waxman-Markey RES Energy Efficiency Stimulus
bill sets a generous
ceiling of up to 2 bn Compliance Options switching. For each we offer, to the
extent possible, a volume and price
tons for offsets We now turn to compliance options: assessment.
ways to fill the gap between actual
Because the E-t-C constitutes such emissions and the cap, under a price- Buying offsets: the cheap way
a small percentage (2-5 percent) of driven, market-based mechanism.
the total cap from 2012 to 2014, it
is possible that the program could Companies regulated under a cap-
Offsets are emission reduction
actually be over-allocated in its early and-trade program typically face
credits from project-based activities
years. Should the impact of the three main compliance options:
that can be used to meet compliance
recession be lasting on emission as a supplement or alternative to
• reduce their own emissions
levels, and should the transportation reducing one’s own emissions. The
(‘internal abatement’);
provisions yield early reductions, US use of offsets is usually subject to
emissions could be lower by a few • purchase allowances;
a quantitative limit, or quota, known
hundred million tons, potentially • buy offset credits. as ‘supplementarity.’ The Waxman-
making the system long. This over- Economic theory warrants that Markey bill sets a very large ceiling
allocation would be unlikely to last companies will opt for the least cost for offsets of up to 2 bn tons annually,
because of the steeply declining cap option first, moving up the marginal evenly split between domestic and
and therefore would not threaten the abatement cost curve until their international offsets.
long-term integrity of the program. emissions match their allowances.
In other words, a company will only The total amount of offsets allowed
Conversely, the forecasts could into the system is roughly 1.5 bn tons
attempt to reduce its emissions
be overestimating the expected per year from 2012 to 2015, then 1.7
if it anticipates that doing so will
reductions from the policies – by bn from 2016 to 2020, amounting
cost less than buying offsets or
using an outdated baseline, or to 30% of the cap in average. The
allowances. If the market functions
because of overlap between the draft bill also suggests a 20 percent
without distortions, allowance prices
policies - making the sum less than discount rate for offset credits,
should reflect the marginal cost of
the parts. In this case the gap would calling for 1.25 offset credits to claim
be larger and a larger role left to one ton of CO2e (one allowance).
markets. We take a closer look at the
compliance options most likely to
Domestic offsets
be on the margin: offsets and fuel
The offset market is developing fast

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Figure 3: US carbon offset pipeline with likely eligibility

25 Fuel Switching
Energy Efficiency
Renewable Energy

Industrial Processes
Million tons CO2e


15 Soil Sequestration
Fugitive Emissions/CMM
Agricultural Waste

Landfill Gas


y2000 y2001 y2002 y2003 y2004 y2005 y2006 y2007 y2008 y2009 y2010 y2011 y2012

in the US, largely in anticipation of most likely to qualify under a federal of the cap-and-trade program nears,
a regulated market. Point Carbon’s compliance program: agricultural the increase in available credits is
offset database Carbon Project waste, forestry, fugitive emissions unlikely to get even near the limit. US
Manager North America lists most (coal mine methane), landfill gas offset supply will be constrained by
offset projects in the US and Canada. and soil sequestration. (See our sheer physical limitations - there are
The current pipeline of projects is previous report, US Offsets: Outlook only so many sites (landfills, farms,
about 20 mt annually in 2012. for Supply and Demand, published and fields) that could potentially
January 22, 2009, for more details). qualify and host offset projects. If
Not all offset credits currently traded offsets are discounted at a ratio of
on the voluntary markets would As illustrated in Figure 3, only about 5 to 4 as suggested in the Waxman
qualify under a compliance program, half of the projected volume would bill, the amount of credits would be
however. Restrictions on project qualify if screening out the non- even less adequate. The suggested 1
types and quality would likely weed eligible projects, bringing the supply billion ton limit on domestic offsets in
out a significant number of projects, to about 10 mt in 2012. the bill hence sets a theoretical limit
from which offset credits are currently on demand, but the real limitation
generated. Projects in capped sectors
It is highly unlikely will be on the supply side.
(such as energy efficiency) would not
qualify as ‘offsets’ anymore but as US offsets could ever The role of domestic offsets will be
internal abatement. come close to filling determined by how they compare
The Waxman-Markey bill does not
the E-t-C gap financially to other compliance
options. Current average over-the-
establish an exhaustive list of eligible counter offset prices vary from $4.00
project types. We use elements Could US offsets ever come close to $9.00 a ton depending on project
from previous cap-and-trade bills to to filling the E-t-C gap? It is highly types and certifications, and CCAR
distinguish between projects likely unlikely, if not impossible. Even futures (Dec12 delivery) trade at
to make the cut or not, and conclude though we anticipate investment in roughly $7.00 a ton on the Chicago
that five offset type categories are offsets to rise sharply as the beginning Climate Futures Exchange.

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Carbon Market Analyst North America CMA April 2, 2009

International offsets from JI projects), will be issued by

2012. After 2012, the forecast is Table 4 - International allowances
In addition to domestic offsets, much more uncertain (see Textbox 2012 prices are future prices traded on
international offsets are also likely 3), as the future of the CDM will the exchange (2011/12 for Australia)
to qualify as a compliance option in be renegotiated in Copenhagen in Point Carbon forecast for Phrase 3 EU
the US. Again, the Waxman-Markey December 2009. However, given ETS prices and traded 2012/13 futures
bill allows up to one billion tons in for the Australian CPRS
Point Carbon’s main policy scenario
international offsets for compliance. for post-2012, CER volumes could
increase to 715 mt in 2015, before EUAs (Europe)
The dynamics for international (Australia)
down to 75 mt in 2020 (see our CMA
credits are much more complex, as The Future of the CDM: Supply 2012 15€ ($19) A$21.75
US emitters will be competing with ($14.50)
Forecast to 2022, November 26,
entities covered by the EU Emission 2008). 2015 48€ ($63) A$23.25
Trading Scheme and parties to the ($15.50)
Kyoto protocol for those reduction Prices will play a determining 2020 48€ ($63) Not available
credits. factor in the final use of CERs.
Secondary CERs (Dec12 delivery)
credit types by allowing their use for
are forecasted by Point Carbon at
Sectoral credits enjoy €21 ($28) and usually track European
compliance. Sectoral credits are still
strong political sup- at an early design stage but enjoy
Union Allowances (EUAs) at a
strong political support on both sides
port on both sides of discount. If EUA prices are higher
of the Atlantic (see Textbox 2 and our
the Atlantic than a US allowance price, the use of
Analyst Update: EC’s sector crediting
international offsets will be secure in
proposal, from March 19, 2009).
Europe - but if EUA prices are close
The current international offset to US prices, US emitters could have REDD also enjoy political support but
system is the Clean Development a shot at securing some of these face with major challenges related
Mechanism (CDM) and Joint credits. to accounting, monitoring, and
Implementation (JI) under the Kyoto enforcement. We have no indication
International negotiations are
Protocol. Point Carbon’s database of volume or prices for either of these
increasingly focusing on two new
Carbon Project Manager anticipates mechanisms, but we expect they will
types of international credits:
that around 1,850m Certified play a large role in compliance post-
reduced and avoided deforestation
Emission Reductions (CERs, credits 2012.
(REDD) projects and ‘sectoral credits’
from CDM projects) and Emission
(see Textbox 3). The Waxman-Markey
Reduction Units (ERUs, credits
bill signals a strong interest in both

Textbox 3: Wither the Clean Development Mechanism?

The future of the CDM will be renegotiated in Copenhagen in December 2009, in an attempt to address concerns about the
quality of projects, the countries where they are located, and efforts to redefine eligible project types. An important source of
supply uncertainty stems from the discussion on project types and reforming the approval process. Stricter approval criteria
could lead to a dwindling of the supply, possibly matched by tough import limits by the EU ETS in Phase 3.

Another source of uncertainty comes from the fact that countries currently hosting most of the CDM projects – China, India,
Mexico, South Korea, etc. – might take on mandatory targets after 2012 in a successor agreement to Kyoto, which would
end the supply of offset credits coming from those countries. The emissions reduced by CDM projects taking place in those
countries would then count toward the respective country’s achievement of its emission reduction obligation. This expectation
that more countries will take on legally binding reduction commitments post-2012 explains the dramatic fall in supply between
2015 and 2020.

CERs could be replaced by sectoral credits, a proposed mechanism based on a no-lose target for a set of industrial installations
in advanced developing countries. Under this proposal, the group of installations, ideally covering a whole industrial sector,
would have an emission target below its business-as-usual emissions. If it reduces emissions below the target, it will be given
credits equal to the difference between the target and actual emissions. But there would be no penalty if the targets are not
met. The mechanism is anticipated to generate larger volumes of reduction credits than the CDM.

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Carbon Market Analyst North America CMA April 2, 2009

International allowances
Textbox 4: Towards a global market?
The Waxman bill also permits
emitters to use allowances from Our analysis of the role of international allowances assumes that US emitters could
other emission trading programs purchase allowances from Europe or Australia, but that the reverse is not true. In the
for compliance. Until recently, this long term, however, one could foresee increasingly integrated global markets where
allowances would be freely traded from one compliance program to another. The
would have applied to the EU ETS
European Commission suggested in a recent Communication that it ambitioned to
exclusively, but the implementation see an OECD-wide market - including all major industrialized countries – by 2015.
of a “carbon pollution reduction
scheme” by 2010 in Australia, as If there are no restrictions on the use of allowances in other markets, this would
well as the expectation that other lead to a global, unique carbon price. In practice, countries are likely to set a limit,
countries (New Zealand, South or quota, on how many ‘foreign’ allowances can be used for compliance – creating
different subsets of prices.
Korea) may follow suit, opens up new
possibilities. Even if direct trading of allowances is not allowed, international offsets could
indirectly link different programs, as emitters in each country would be competing
The limitation on the for the same credits. Hence policy developments abroad could play a role in price
use of international formation and market dynamics in the US in the medium to long term.

allowances will come The role of international offsets is Internal Abatement

from prices more uncertain. The CDM may not
be the right vehicle for the long term We now consider ways to reduce
Volumes are potentially large, since supply of credits to the US market. If emissions for large compliance
the entire pool of allowances from the an agreement is found in Copenhagen players, ‘internal abatement’.
other trading programs could be used on sectoral credits and / or on REDD,
for compliance. The Waxman-Markey these would likely constitute the bulk As the import limits of offsets and
bill does not set any limitation on the of the credit flow into the US. international allowances are de facto
use of international allowances for almost unlimited, the split between
compliance, so that the limitation is International allowances could play offset credits and internal abatement
more likely to come from prices. a large role if the various emission as compliance option will mainly
trading programs establish linkages depend on prices.
At current prices, European Union allowing free trade from one program
Allowances (EUAs) and Australian to the other. Emitters have many emission
Emission Units (AEUs) could reduction options, including
constitute an attractive compliance
option. Figure 4 plots prices for EUA
futures (Dec 12 delivery). However, Figure 4: EUA future prices
Point Carbon anticipates prices will
increase in the EU ETS, as the cap 40
for its next compliance phase (Phase EUA 2012
3, 2013-2020) is very strict. We 35
forecast prices at €42 in 2013 and 30
€48 on average over the whole phase
Price €/tCO2e

(assuming no linkage with the US).

To conclude – domestic offsets will 20

not fill much of the gap as they are in 15
short supply. US offsets are currently
the least cost option but this might 10
change if we see the same trend 5
as in the CDM market. CERs are
priced based on their value in use 0
(i.e. as substitutes for EUAs) and not
08 08 08 08 08 08 08 08 08 08 08 08 09 09 09
based on marginal production costs. an- eb- ar- pr- ay- un- Jul- ug- ep- ct- ov- ec- an- eb- ar-
US offsets would then track US
allowance prices at a discount.

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Carbon Market Analyst North America CMA April 2, 2009

Figure 5: Fuel switching curve in the US, spot and 2012 future prices
We use NYMEX spot and 2012 future fuel prices as of March 24, 2009

US Fuel switching curve US Fuel switching curve

fuel spot prices future fuel prices (2012 delivery)
$50 $50

$40 $40
USD per ton of CO2e

USD per ton of CO2e

$30 $30

$20 $20

$10 $10

$0 $0
0 50 100 150 200 250 300 350 0 50 100 150 200 250
Million tons CO2e Million tons CO2e

improvement of industrial processes, region. Switching varies by region, to make the switch economical on
reducing methane leaks in pipelines but the model assumes that price power markets.
and refining, limiting the use of high would trigger the switch regardless
“global warming potential” (GWP) of any technical impediments. Fuel switching has a potential for large
gases – fluorocarbon gases, etc. We volumes of emission reductions.
However, if coal prices are low, the
focus on fuel switching exclusively Reductions from fuel carbon price needed to realize this
because it is more likely to deliver
large numbers of emission reductions
switching are ex- potential can climb very rapidly, as
and thus be on the margin. tremely sensitive to seen in Figure 5b. If fuel switching is
fuel prices expensive and is setting prices on the
Fuel switching carbon market, it will provide a strong
signal for emitters to look into other
Large reductions can come from the Figures 5a and 5b show emissions internal abatement measures. These
power sector: as the price of carbon reductions from fuel switching in abatement measures would create
penalizes more carbon-intensive $5 increments. Figure 5a uses spot a negative feedback loop that would
fuels (coal, petroleum) than natural fuel prices from March 2009 ($4.35 eventually pull back down prices,
gas or carbon-free generation, the natural gas, $49 coal, $63 SO2, $625 to the point where fuel switching
economics start working in favor of Nox) while Figure 5b plots the fuel is more economical than any other
the less carbon-intensive fuels (see switching curve using future prices abatement strategy.
our report The Power of Carbon, June for December 2012 delivery, as of
2008 for a detailed analysis of this March 24, 2009 ($7.45 natural gas,
issue). $67 coal, $35 SO2, $650 Nox.) Market Implications
The amount of reductions at any The figures illustrate the extreme Price formation
given carbon price varies with the sensitivity of fuel switching to actual
relative price of the fuels. Point fuel prices. A carbon price of $10 a Prices on the carbon market are set,
Carbon created a simplified model ton yields over 120 mt of reductions like those of other commodities,
to evaluate the amount of reductions in GHG emissions in one case, and by the intersection of supply and
associated with fuel switching from a mere 10 mt in the other. If natural demand. Figure 6 represents a
coal to gas by applying a carbon price gas is relatively more expensive than conceptual marginal abatement cost
to the electric generation fleet by coal, it takes a higher carbon price curve. In this example, we assume

10 All rights reserved © 2009 Point Carbon

Carbon Market Analyst North America CMA April 2, 2009

domestic offsets are the lowest Figure 6: Conceptual MAC curve

cost compliance option, followed by
international offsets. Fuel switching Price Marginal Abatement
(internal abatement) comes next, cost curve (supply)
with international allowances at the $60
higher end of the range. Demand goes up
as EtC grows
The demand intersects the marginal $50
Int’l Allowances
abatement curve at 205 million

USD per ton of CO2e

tons (the 2012 E-t-C without $40
complementary policies), calling
for some amount of fuel switching Fuel switching
and bringing prices to around $30 $30
a ton. Should energy efficiency and
renewable electricity standards be
adopted, the demand curve would be
lower, and would intersect the MAC
curve at 87 million tons. International Int’l Offsets
offsets would be on the margin, no
US Offsets Demand curve
fuel switching would be needed, and
prices would be below $15 a ton. $0
0 100 200 300 400 500 600 Volume
Conversely, as the size of the E-t-C Million tons CO2e
gap grows over time, the demand
curve will shift to the right because
CERs would constitute the next If the effect of complementary
US emitters will have most attractive compliance option. policies is lower than expected,
If prices on the EU ETS have not market participants will have
to compete with recovered, EUAs could also be part of to procure more offsets and
other countries for the compliance mix and would bring international allowances or turn to
the international credits prices on the US market to about internal abatement.
$20 a ton. If emissions and prices
recover in Europe by 2012, prices in 2016-2018 – A wide array of
emitters will need more allowances the US would likely be set by CERs abatement strategies
to cover a greater shortfall. This will and could therefore track EUAs at a
push prices up the fuel switching discount. This would constitute the By the time the third compliance
curve if no other type of reduction first hint of market linkages. period rolls in, the gap will have
takes place. As discussed above, the grown to over 550 million tons:
MAC curve is itself subject to change It is also possible that the scheme this strong demand for allowances
as offset supply and fuel prices would be somewhat over-allocated if calls for a wide array of reduction
change over time. the recession has an enduring effect strategies. All available US offsets
or if energy efficiency investments will be tapped and the demand for
We now tie the pieces together and deliver their theoretical emission international offsets will increase.
discuss likely compliance strategies reduction potential. The program The gap could still potentially be met
for selected compliance periods in would not be compromised if through international offsets, possibly
the first decade of the cap-and-trade it started with a brief period of including the new credit types from
program. over-allocation, provided that over- sectoral and forestry programs.
allocation is small: participants would
2012-2013 – Few reductions likely bank allowances for later years, If the competition for international
when the caps get tighter. This would offsets was such that offsets could
needed prevent prices from crashing to only cover half the gap, 250 million
The first compliance period would zero. The bank would create a small tons of reductions would be needed.
require about 140 million tons of cushion to help buffer volatility from Such volume of fuel switching would
reductions each year. US offsets fuel prices or unforeseen exogenous call for very high prices, up to $85 a
will not suffice to meet the gap. events. ton. Hence other compliance options
would likely come into the mix –

11 All rights reserved © 2009 Point Carbon

Carbon Market Analyst North America CMA April 2, 2009

provisions – energy efficiency and

Figure 7: Meeting the E-t-C clean energy standards for the power
and transportation sectors – have the
capacity to evoke large reductions
6400 at a fairly low cost, especially for
energy efficiency measures. These
6200 provisions are not only crucial for the
US to meet its target; they will also
lower significantly the price of carbon
on the traded market.
US offsets are unlikely to play a
5600 large role as a cost-containment
mechanism because their supply
is very constrained. An increase
in investment will help increase
the available volumes, but the key
BAU Stimulus RES EnEf Remaining Dom. Int'l Fuel Cap
emissions offsets Offsets switching
limitation is physical rather than

The degree to which the internal

other internal abatement measures. What to expect post-2020 abatement option of fuel switching
International allowances, even priced is deployed largely depends on the
at €50 a ton, could remain attractive. Our analysis was focused on the level of reductions achieved by the
short to medium term as it allowed other options. Some amount of
Figure 7 shows the wide array of us to project the impact of policies switching will occur, but the carbon
compliance options that will be currently under discussion and to cost at which fuel switching becomes
necessary to meet the gap in the assume no major technological economical is very volatile and does
medium term. breakthrough would occur. But with not provide the clear, predictable price
a rapidly declining cap, change within signal needed to redirect investments
2020: The breaking point? the system will quickly become very towards clean technology in the long
costly, providing a strong incentive term.
In 2020, with a gap close to 800 for technologies in the development
million tons, we would approach the stage today like carbon capture and These limitations put the spotlight on
point where meeting the gap under storage or electric cars. Offsets international offsets and allowances,
current technological constraints play a key role in helping keeping where larger amounts of emission
becomes very costly – unless the prices down while this transition reductions could come from
supply of international credits is takes place, since investments in developing countries at lower costs.
sustained and affordable. cleaner power plants and new energy But uncertainties related to the
systems take time. Whereas offsets upcoming international negotiations
High carbon prices could also raise still cloud forecasts both for volumes
provide a temporary fix and a useful
the interest in creating linkages and prices. The experience with
cost-containment mechanism, they
with a large number of countries. the CDM shows, however, that
do not substitute for necessary long
The larger market could help maintaining high standards and
term changes.
dampen the volatility derived from submitting projects to a stringent
fuel prices and would theoretically evaluation process raises prices
enable all participating countries to
take advantage of the lowest cost
Conclusion even for initially low-cost projects.
International allowances and linkages
reductions through the market. All signals indicate that the new with other emission trading system
This is especially true if countries administration and Congress are could also help temper prices in the
like South Korea or Mexico set up serious about their commitment medium term. The outcome of the
their own trading program, where to lower GHG emissions. The Copenhagen negotiations will thus
reduction costs could be lower than dominant strategy involves a mix of have significant implications for the
in Europe or in the US. command-and-control and market- US carbon market.
based mechanisms. The regulatory

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Contacts CMA April 2, 2009

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