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Marginal Social Cost / Benefit v Private

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Marginal Social Cost / Benefit v Private

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7.1 External Effects

Learning Objective

How can society stop people from doing annoying things and encourage them to do pleasing things?

These effects are called external effects, or externalities. An externality Any effect on people not involved in a particular transaction. is any effect on people not involved in a particular transaction. Pollution is the classic example. When another person buys and smokes cigarettes, there is a transaction between the cigarette company and the smoker. But if you are sitting near the smoker, you are an affected party who is not directly compensated from the transaction, at least before taxes were imposed on cigarettes. Similarly, you pay nothing for the benefits you get from viewing your neighbor's flowers, nor is there a direct mechanism to reward your neighbor for her efforts.

Externalities will generally cause competitive markets to behave inefficiently from a social perspective, absent a mechanism to involve all the affected parties. Without such a mechanism, the flower planter will plant too few beautiful flowers, for she has no reason to take account of your preferences in her choices. The odious smoker will smoke too much and too close to others, and the loud neighbor will play music much too late into the night. Externalities create a market failure A situation where a competitive market does not yield the socially efficient outcome. -that is, a situation where a competitive market does not yield the socially efficient outcome.

Education is viewed as creating an important positive externality. Education generates many externalities, including more-and better-employment, less crime, and fewer negative externalities of other kinds. It is widely believed that educated voters elect better politicians. Educated individuals tend to make a society wealthy, an advantage to all of society's members. As a consequence, most societies subsidize education in order to promote it.

A major source of externalities arises in communicable diseases. Your vaccination not only reduces the likelihood that you will contract a disease but also makes it less likely that you will infect others with the disease.

Let's consider pollution as a typical example. A paper mill produces paper, and a bad smell is an unfortunate by-product of the process. Each ton of paper produced increases the amount of bad smells produced. The paper mill incurs a marginal cost, associated with inputs like wood and chemicals and water. For the purposes of studying externalities, we will refer to the paper mill's costs as a private costThe cost borne by the supplier. , the cost borne by the supplier (in this case, the paper mill itself). In addition, there are external costsThe costs borne by third parties. , which are the costs borne by third parties, that arise in this case from the smell. Adding the private costs and the external costs yield the total costs for all parties, or the social costsThe total costs for all parties. . These costs, in their marginal form, are illustrated in Figure 7.1 "A negative externality".

Figure 7.1 A negative externality

In Figure 7.1 "A negative externality", the demand has been labeled "marginal benefit," for reasons that will become apparent; but it is at this point just the standard demand, the marginal value of the product. The paper mill's costs have been labeled marginal private cost to reflect the fact that these costs are only the mill's costs and don't include the cost of the bad smell imposed on others. The marginal social cost is obtained by adding the marginal external cost to the marginal private cost. The marginal external cost isn't graphed in the figure; but the size of it is illustrated at one quantity, and it is generally the difference between marginal social cost and marginal private cost.

Left to its own devices, the paper market would equate the marginal private cost and the marginal benefit to produce the competitive quantity sold at the competitive price. Some of these units-all of those beyond the quantity labeled "Socially Efficient Quantity"-are bad from a social perspective: They cost more to society than they provide in benefits. This is because the social cost of these units includes pollution, but paper buyers have no reason to worry about pollution or even to know that it is being created in the process of manufacturing paper.

The deadweight loss of these units is shown as a shaded triangle in the figure. The loss arises because the marginal social cost of the units exceeds the benefit, and the difference between the social cost and the benefits yields the loss to society. This is a case where too much is produced because the market has no reason to account for all the costs; some of the costs are borne by others.

Figure 7.2 External costs and benefits

Generally, a negative externality like pollution creates a marginal social cost that is higher than the marginal private cost. Similarly, a positive externality like beautification creates a higher marginal social benefitA benefit for all parties. -a benefit for all parties-than the marginal private benefit (demand), with the difference being benefits obtained by third parties, or external benefitsBenefits obtained by third parties. . These are to some extent conventions. One could have incorporated a positive externality by a reduction in cost-but the convention remains. An example of a product that produces both positive and negative externalities is illustrated in Figure 7.2 "External costs and benefits". Streetlights are an example of a product that produces both externalities: Most of us like lighted streets, but they are terrible for astronomers. Similarly, large highways produce benefits for commuters and yet harm nearby residents.

The marginal private benefit The benefit obtained by the buyer. -the benefit obtained by the buyer-and the marginal private cost give the demand and supply of a competitive market, and hence the competitive quantity results from the intersection of these two. The marginal social benefit and the marginal social cost give the value and cost from a social perspective; equating these two generates the socially efficient outcome. This can be either greater or less than the competitive outcome depending on which externality is larger.

Consider a town on a scenic bay that is filled with lobsters. The town members collect and eat the lobsters, and over time the size of the lobsters collected falls, until they are hardly worth searching for. This situation persists indefinitely. Few large lobsters are caught, and it is barely worth one's time attempting to catch them. This sort of overuse of a resource due to lack of ownership is known as the tragedy of the commons Overuse of a resource due to lack of ownership. .

The tragedy of the commons is a problem with a common resource A resource shared by many people. shared by many people-in this case, the lobster bay. Catching lobsters creates an externality by lowering the productivity of other lobster catchers. The externality leads to overfishing, since individuals don't take into account the negative effect they have on each other, ultimately leading to a nearly useless resource and potentially driving the lobsters to extinction. As a consequence, the lobster catching is usually regulated.

Key Takeaways

An externality is any effect on people not involved in a particular transaction.

Pollution is the classic negative externality.

Externalities will generally cause competitive markets to behave inefficiently from a social perspective. Externalities create a market failure-that is, a competitive market does not yield the socially efficient outcome.

Education is viewed as creating an important positive externality.

A major source of externalities arises in communicable diseases. Your vaccination not only reduces the likelihood that you will contract a disease but also makes it less likely that you will infect others with the disease.

Private costs are those borne by the parties to a transaction; external costs are costs borne by others not party to the transaction; and social costs represent the sum of private and external costs.

Private benefits are those enjoyed by the parties to a transaction; external benefits are those enjoyed by others not party to the transaction; and social benefits represent the sum of private and external benefits.

Demand is marginal private benefit; supply is marginal private cost.

The social optimum arises at the quantity where marginal social benefit equals marginal social cost. A different quantity than the social optimum creates a deadweight loss equal to the difference of marginal social benefit and cost.

The tragedy of the commons is the overuse of a resource arising because users ignore the harmful effects of their use on other users.

Exercises

1. A child who is vaccinated against polio is more likely to contract polio (from the vaccine) than an unvaccinated child. Does this fact imply that programs forcing vaccination of schoolchildren are ill-advised? Include with your answer a diagram illustrating the negative marginal benefit of vaccination, and use the horizontal axis to represent the proportion of the population vaccinated.

2. The total production from an oil field generally depends on the rate at which the oil is pumped, with faster rates leading to lower total production but earlier production. Suppose two different producers can pump from the field. Illustrate-using an externality diagram where the horizontal axis is the rate of production for one of the producers-the difference between the socially efficient outcome and the equilibrium outcome. Like many other states, Texas's law requires that, when multiple people own land over a single oil field, the output is shared among the owners, with each owner obtaining a share equal to a proportion of the field under their land. This process is called unitization. Does it solve the problem of externalities in pumping and yield an efficient outcome? Why or why not?

3. Imagine that many students are bothered by loud music playing at 7 a.m. near their dorm. Using economic analysis, how would you improve the situation?

4. A local community uses revenue from its property taxes to build an expressway. Explain how this could give rise to free riders and how to solve the free-rider problem.

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How can society stop people from doing annoying things and encourage them to do pleasing things? These effects are called external effects, or externalities. An externality Any effect on people not involved in a particular transaction. is any effect on people not involved in a particular transaction. Pollution is the classic example.

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Pollution as a negative externality

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Pollution is a significant negative externality and can result from a number of activities. Industrial pollution by sulphuric and nitric acid ('acid rain') can arise as a by-product of the production process in many industries, such as smelting and refining.

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Climate Deal in Paris: Everything You Need to Know

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China has taken the first step towards launching its much-delayed carbon emissions trading scheme by setting emissions quotas for companies in the power sector.

The long-awaited scheme, which is expected to be the world's largest carbon trading market, has been beset by delays and was initially scheduled for launch in 2017.

Environmentalists have hailed the plans for the country's carbon market as a sign that China, regularly criticised for its environmental transgressions, is moving towards a more sustainable future.

"Setting emissions levels and credit allocation is a supremely important signal to companies and an important milestone," said Liu Shuang, a director at Energy Foundation China. "The emergence of a carbon market in China is tremendously influential."

Since announcing plans for a national trading scheme two years ago, China has experienced numerous delays in trying to create a carbon market from scratch.

The biggest difficulty has been establishing a comprehensive data collection system. Data on baseline industrial emissions levels are crucial because they allow policymakers to set target levels and allocate carbon credits accordingly. Companies will be able to buy more credits on the market if they exceed their quotas, and sell credits to others if they emit less.

Although authorities on Tuesday took the first step in allocating emissions quotas for the power sector, there is some time to go before the market will be functional, environmentalists have warned.

The National Development and Reform Commission, a top policymaking body, did not disclose when genuine trading in carbon credits would begin.

Once credits are received, power companies will first test out the system by mock-trading credits, meaning they will not actually pay for trades. Enforcement of emission limits will begin in 2019 or 2020.

Equally important to credit allocations will be setting up a monitoring, reporting and verification system to enforce compliance, according to Jeremy Schreifels, an expert in carbon trading and a fellow at Resources for the Future, a US environmental non-profit organisation.

"If you look at California or the EU, their ETS [emissions trading scheme] programmes were clear about what regulations were going to be implemented, but those regulations weren't enacted for a few years," said Mr Schreifels.

"The way it looks like it's going to happen with China's ETS is compliance will start right away. There is not a lot of time for industry to make changes, which also means the emissions reduction required can't initially be too aggressive," he added.

Meanwhile, the ETS in progress has been greatly reduced from its original scope. Rather than governing eight heavy industry sectors, it will cover just the power generation sector, which is dominated by several large state-owned enterprises and has relatively complete emissions data. A potential carbon tax never materialised.

In November, China scrapped the idea of carbon futures trading during the first stages of its national ETS, a move that could initially tighten liquidity on the market and lead to a stagnation in carbon prices.

"If you do not have a history in trading commodities like China, carbon is probably not the right starting point. It's too complicated," said Paula DiPerna, who helped set up the first of China's seven carbon pilots.

Capping emissions for China's power sector is a daunting undertaking in any case. The sector emits 3.3bn tons of carbon dioxide annually, and a carbon trading scheme regulating it would be about 1.7 times bigger than the EU's carbon market.

While more Chinese companies have taken steps to establish internal carbon monitoring procedures, almost half anticipate that China will only have a fully functional ETS between 2021 or 2025, according to an annual survey administered by the China Carbon Forum (CCF), a Beijing-based environmental non-profit group.

"Harmonising systems, the emissions cap each region is setting, creating a reliable system for verification of emissions: these are all difficult to find consensus on," said Huw Slater, a research manager at CCF. "The majority of people expect it will take a while to happen."
Follow Emily Feng on Twitter: @emilyzfeng

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China moves towards launch of carbon trading scheme

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China has taken the first step towards launching its much-delayed carbon emissions trading scheme by setting emissions quotas for companies in the power sector. The long-awaited scheme, which is expected to be the world's largest carbon trading market, has been beset by delays and was initially scheduled for launch in 2017.

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Chinese industry players are more pessimistic than ever about when the nation will begin trading in a national carbon market, despite announcements of a limited rollout at the end of last year, according to the largest survey of market expectations.

Nineteen per cent of those surveyed expected China's emissions trading scheme (ETS) to be fully functional by 2020 or earlier, down from 47 per cent in 2017's survey results, according to an annual report by the China Carbon Forum, a non-governmental organisation that tracks carbon trading.

That number is also down from 2015's survey, the year China Carbon Forum began asking this question, in which 74 per cent of participants believed a fully functional ETS would begin by 2020 or earlier.

Exactly half of this year's survey participants came from industries that will be directly affected by the ETS, a far greater percentage than in previous surveys, likely leading to greater pessimism, according the survey's authors.

"We see lower numbers because of greater inclusion of more industry players. Before only those who were optimistic may have responded [to our survey] so this year's survey may actually better reflect reality," said Dimitri de Boer of the China Carbon Forum.

The long-awaited scheme, which is expected to be the world's largest carbon trading market, was beset by delays after being initially scheduled for launch in 2017.

Instead, China's National Development and Reform Commission, a top policymaking body, initiated a three-year development plan last December. Under the plan, limited spot trading of carbon credits would begin in 2020 within the power generation sector only, rather than the eight industrial sectors included in original plans for the scheme.

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Pessimism grows over expected start date for China carbon trading

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Chinese industry players are more pessimistic than ever about when the nation will begin trading in a national carbon market, despite announcements of a limited rollout at the end of last year, according to the largest survey of market expectations.

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Policy

International carbon markets can play a key role in reducing global greenhouse gas emissions cost-effectively.

The number of emissions trading systems around the world is increasing. Besides the EU emissions trading system (EU ETS), national or sub-national systems are already operating or under development in Canada, China, Japan, New Zealand, South Korea, Switzerland and the United States.

Carbon markets in Paris Agreement

The Paris Agreement provides for a robust and ambitious basis for the use of international markets and reinforces international targets, transparency and the accountability of Parties.

Recognising the importance of international carbon markets, Article 6 of the agreement

allows Parties to use international trading of emission allowances to help achieve emissions reduction targets

establishes a framework for common robust accounting rules, and

creates a new, more ambitious market mechanism.

Bilateral cooperation

China

In 2014-2017, the European Commission in close cooperation with China carried out a 3-year project to support the design and the implementation of emissions trading in China.

The project provided technical assistance for capacity building and supported the seven regional pilot systems already set up and the establishment of a national emissions trading system.

In the EU-China Joint Statement on Climate Change adopted at the EU-China summit in 2015, the EU and China agreed to further enhance their bilateral cooperation on carbon markets.

Against this background, the Commission and the National Development and Reform Commission of the People's Republic of China agreed on a new project for 2017-2020.

The project titled "Platform for Policy Dialogue and Cooperation between EU and China on Emissions Trading" is now being implemented. It aims to provide capacity building and training to support Chinese authorities (since April 2018 the newly created Ministry of Ecology and Environment) in their efforts to implement and further develop the Chinese nationwide emissions trading system. More information is available on the project website.

The project has also established a policy dialogue between the Commission and the Chinese Ministry of Ecology and Environment, with the first dialogue held in April 2018.

At the EU-China summit in 2018, the EU and China signed a Memorandum of Understanding to further enhance cooperation on emissions trading. It provides a reinforced basis for the policy dialogue, including through further forms of cooperation such as the joint organisation of seminars and workshops, joint research activities and ad-hoc working groups.

Korea

The Korean emissions trading system (KETS), launched in 2015, covers around 66% of Korea's total greenhouse gas emissions. It is the first mandatory emissions trading system among non-Annex I countries under the UNFCCC.

The KETS could trigger the expansion of emissions trading among emerging economies and developing countries.

The European Commission supports Korea through a technical assistance project focused on building the necessary capacity to implement the KETS.

Multilateral cooperation

The European Commission is a founding member of the International Carbon Action Partnership (ICAP), which brings together countries and regions with mandatory cap-and-trade systems. The ICAP provides a forum for sharing experience and knowledge and organises regular training courses.

The Commission also supports the development of domestic carbon markets through the Partnership for Market Readiness (PMR). The PMR is a platform for the exchange of experience on carbon market instruments and assists some 17 countries in preparing and implementing these.

Linking with other cap-and-trade systems

Linking compatible emissions trading systems with each other enables participants in one system to use units from another system for compliance purposes.

Linking offers several potential benefits, including:

reducing the cost of cutting emissions

increasing market liquidity

making the carbon price more stable

levelling the international playing field by harmonising carbon prices across jurisdictions, and

supporting global cooperation on climate change.

The EU ETS legislation provides for the possibility to link the EU ETS with other compatible emissions trading systems in the world at national or regional level.

Conditions for linking include:

system compatibility (the systems have the same basic environmental integrity, and a tonne of CO₂ in one system is a tonne in the other system)

the mandatory nature of the system, and

the existence of an absolute cap on emissions.

The EU and Switzerland have signed an agreement to link their systems. Once the agreement has entered into force, linking would result in the mutual recognition of EU and Swiss emission allowances. Switzerland would keep a separate system from the EU ETS.

The EU and Australia also considered the possibility to link their systems. However, due to the repeal of the Australian system in 2014, the linking negotiations have not been pursued.

Documentation

Eligibility of international credits

Linking with other greenhouse gas emissions trading systems

Encouraging new market mechanisms

Studies

Studies

Faq

Open all questions

Questions & answers on implementation of rules regarding the eligibility of international credits in the EU ETS (10/2014)

When did the new Registry Regulation (Regulation No 389/2013) enter into force?

Regulation No. 389/2013 entered into force on 4 May 2013.

What is the impact of Article 58(2) on projects from Annex B Parties in third countries (i.e. non-EU ETS Parties)?

In accordance with Article 58(2) of the new Registry Regulation, ERUs issued after 31 December 2012 in respect of emission reductions taking place until 31 December 2012 from non-EU ETS Annex B Parties can only be held in ETS accounts in the Union Registry provided that:

The amendment to the Kyoto Protocol including a commitment for such a Party has entered into force OR

The Party has deposited an instrument of ratification OR

The credits are issued under track 2 OR

Where track 2 issuance is not possible, the date of reduction (pre-2013) is certified by an AIE.

How can the user know if a credit is eligible for exchange and holding in an ETS account, since serial numbers are not visible in the Union Registry?

The Registry application itself will flag international credits as eligible or ineligible. This status will be clearly visible in the application. On this basis, an account holder will be able to distinguish eligible credits held on a KP account from those that are either pending eligibility (because further steps are required) or ineligible (in accordance with relevant legislation).

Is there a cut-off date for the use of international credits issued for the Kyoto Protocol's first commitment period (CP1 credits)?

Yes, in Accordance with Article 60 of the Registry Regulation, credits issued in respect of emission reductions occurring in the first commitment period of the Kyoto Protocol can be exchanged until 31 March 2015. These credits cannot be exchanged after this date, even if they are "carried-over" or banked into the second commitment period of the Kyoto Protocol. After 31 March 2015, these credits will be marked as "ineligible" in the Union Registry.

How can holders of international credits identify whether their credits need to be exchanged before 31 March 2015 in accordance with Article 60 of the Registry Regulation?

The serial number of each credit contains both the original commitment period (the commitment period for which the unit was issued) and the applicable commitment period (the period in which the unit can be retired). The original commitment period is visible in the Union Registry. After 31 March 2015, those international credits with an original commitment period of 1 (i.e. those units issued for CP1 reductions) will no longer be eligible for exchange. That is, after 31 March 2015, these credits will be marked as "ineligible" in the Union Registry.

It is important to note, that even if these credits are "carried-over" or banked between commitment periods of the Kyoto Protocol, the original commitment period will remain unchanged and these credits will continue to be ineligible for exchange in the EU ETS.

What if international credits for which ETS holdings are prohibited according to Annex I are held in ETS accounts in the Union Registry after entry into force of the Registry Regulation or after 31 March 2015 (for CP1 credits)?

International credits issued after the respective deadlines set out in Article 58 and Article 60 of the Registry Regulation have become ineligible following the entry into force of the Regulation or, for CP1 units, after 31 March 2015.

In accordance with Article 58(3), and Article 115, the so-called "cleaning" operation, the National Administrators have requested the account holders of these credits to transfer them to an appropriate Kyoto Protocol account.

A similar operation will be undertaken after 31 March 2015 to implement Article 60 of the Registry Regulation in respect of CP1 credits.

When does the exchange of international credits for allowances take place?

The exchange can take place at any point during the calendar year.

The international credit entitlement tables contain entitlements calculated for each installation and aircraft operator by Member States in accordance with the Regulation on international credit entitlements (RICE).

How will the exchange work?

The process for the exchange is described in detail in the Registry Regulation (Articles 59-61). An account representative can request an exchange of eligible international credits from an operator holding account or an aircraft operator holding account in the Union registry. The exchange request needs to be approved by a second person nominated as additional account representative or, if no additional account representative is nominated for the account, by a second account representative different than the one who initiated the request. The exchange process is automated: after the international credits are transferred to a central account, an equivalent number of allowances will be transferred automatically to the account from which the exchange was requested.

An operator can request as many exchanges of credits for allowances as needed, provided it does not exceed its international credit entitlement. Once credits are exchanged for allowances, they cannot be exchanged back into credits.

Is the status of the credit as marked in the registry (e.g. eligible or ineligible) fixed or subject to change?

The information in the Union Registry regarding the eligibility of international credits is subject to change over time based on the best information available.

If the credit is a CER, it will be important to check the effective registration date of the project. If the host Party is not an LDC and the effective registration date is after 2012, CERs from the project will not be eligible for exchange in the EU ETS in accordance with the provisions of Article 11a(8) of the EU ETS Directive.

If the credit is a CER and the effective registration date is before 2013 , it is also important to check that it is not ineligible in phase 3 of the EU ETS in accordance with Regulation 550/2011 (e.g. it is not an HFC-23 project nor an N2O-adipic acid project).

If the credit is a track 2 ERU , check the registration date as above.

If the credit is a track 1 ERU issued by a non-EU Party before 2013, the information in the Union Registry is, to our knowledge, accurate with respect to the provisions in the EU ETS Directive and the Registry Regulation.

Likewise, for CERs, track 2 ERUs and ERUs issued by an EU Member State the information in the Union Registry is, to our knowledge, accurate with respect to the provisions in the EU ETS Directive and the Registry Regulation.

A credit in my account is marked as ineligible but, it should be eligible International Credit Holdings (ICH). How should I proceed?

In the first instance, check the eligibility lists published on our website.

If the credit has been incorrectly marked based on the published criteria, please contact your National Administrator.

If the ERU was issued after 31 December 2012 , the status of the credit will be updated upon successful completion of the certification referred to in Q16.

In all cases, if a change of status is warranted, the status of a credit will be changed the day after the information is updated in the Union Registry.

If my credit is marked as pending/ineligible, what is the impact?

The immediate impact is that such credits cannot be transferred to another ETS account in the Union Registry. These credits can, however, be transferred to a KP account.

After a "cleaning" operation referred to in Article 58 (3) (see Q9) has been completed, it will no longer be possible to hold credits marked as ineligible in EU ETS accounts and these credits will need to be moved accordingly.

When will the ineligible credits need to be moved out of ETS accounts in the Union Registry (in accordance with Article 58(3))?

An initial operation has already taken place and your national administrator should have already contacted account representatives. A further "cleaning" operation will take place to manage units issued in the first commitment period of the Kyoto Protocol. This operation is foreseen after the deadline for the exchange of the credits, 31 March 2015, in accordance with Article 60 of the Regulation 389/2013.

When will market participants be informed about the certification required under Article 58(2)?

Guidance on the certification which applies in accordance with Article 58(2) of the Registry Regulation is available.

Questions & answers on use of international credits in the third trading phase of the EU ETS (January 2012)

Terminology

Least Developed Countries (LDCs) list: As there had been no international agreement at the end of 2010, nor had there been any EU agreements with third countries, article 11a(4-5) provides a default situation of prohibition on using new-project CERs beyond 2013, unless they are from LDCs or can be swapped for CERs from LDCs. What happens if a country loses its LDC status: if the project is at validation stage, if the project is registered, if CERs have already been issued?

The guidance on the DG CLIMA webpage explains that "A project in an LDC that is included in the UN list when the project is registered by the CDM Executive Board may continue to generate credits up to 2020, whatever happens to the list.

Crediting period renewal: Does the registration date pertaining to 'projects that were registered before 2013' referred to in Article 11a(2-4) correspond to the start date of the first crediting period of the project, or to the start date of any subsequent crediting period?

The start date refers to the start date of the first crediting period. Hence credits from projects that were registered prior to 2013 and that have their crediting period renewed after 2012 will continue to be usable (in the absence of use restrictions).

Date of registration: What will be the applicable cut-off date for the registration of CDM projects for being able to produce EU-ETS-eligible CERs post 2012

Subject to no other quality restrictions, credits from projects registered before 2013 will be eligible for use in the EU ETS. The date of registration shall be the registration date determined by the EB, including the effective date of registration in accordance with Decision 3/CMP.6 i.e. "the date on which a complete request for registration has been submitted by the designated operational entity where the project activity has been registered automatically".

Implementation of provisions

Swapping process: As from 2013, recognised international credits must be exchanged into (phase 3) allowances before surrendering them for compliance.

Quantitative limits: Article 11a(8) provides for options whereby operators would be able to use additional volumes of credits beyond the quantity they were allowed to use between 2008 and 2012. What are the steps and timeline of the comitology process to 'specify the exact percentages' of additional allowed credit volumes?

The ETS Directive does not specify the time by which these volumes should be determined. The Commission foresees that the necessary rules should be in place before credits are used in respect of phase 3.

UNFCCC carry-over rules: The Marrakesh rules (Decision 13/CMP.1) state that Parties are allowed to carry over CERs and ERUs 2.5% of their initial Kyoto AAUs to the potential subsequent commitment period. This amount will be confirmed after the true up period in 2015.

a) Can a compliance company, or a non-compliance actor carry over international credits "as credits" to the post-2012 period? In other words, will it be possible to bank CERs/ERUs?

For phase 3, credits can only be used for compliance in the EU ETS if exchanged for phase 3 allowances. This exchange of international credits with a first commitment period identifier into allowances will only be allowed until March 2015, which is before the end of the Kyoto Protocol's true-up period. On the difficulties of banking under the Kyoto protocol of selective CDM CP1 into the future, see chapter 6.2.4. 'Transition and predictability' of the 2008 impact assessment accompanying the revision of the EU ETS.

Future policy development

Process for qualitative restrictions: From 1 January 2013, measures may be applied to restrict 'the use of specific credits from project types' according to article 11a(9).

b) Have any such qualitative restrictions been adopted so far?

From the start of the EU ETS in 2005 full use restrictions have already been applied in the EU ETS to CERs from projects at nuclear facilities and from projects in agriculture and forestry (so-called LULUCF). As of 1 January 2013 CERs and ERUs from projects involving the destruction of trifluoromethane (HFC-23) and nitrous oxide (N2O) emissions from adipic acid production will be prohibited in the EU ETS. An exception is made until 30 April 2013 for destruction from existing projects that is credited before 1 January 2013, for compliance with 2012 commitments.

Programme of Activities (PoAs): According to Article 11a(2) credits from projects registered pre-2013 are eligible for compliance in the EU ETS.

a) Does this imply that CDM Project Activities (CPAs) included after 2012 to PoAs registered pre-2013 are also eligible?

Article 11.a(3) of the EU ETS Directive states that "...competent authorities shall allow operators to exchange CERs and ERUs from projects that were registered before 2013 issued in respect of emission reductions from 2013 onwards for allowances valid from 2013 onwards". This wording would indicate that the moment of registration of a project is to be taken as a cut-off date for determining whether future CERs would be eligible for use in the EU ETS. A PoA is only registered once and CPAs are added to a PoA without a separate registration. It is therefore the Commission's interpretation that CERs from CPAs added after 2012 to a PoA registered prior to 2013 can be used for compliance in the EU ETS.

The Commission is, however, also aware that this interpretation of article 11.a(3) may increase the supply of CERs from non-LDCs. This contradicts the spirit of the Directive to allow only CERs from projects registered after 2012, if they come from LDCs. The Commission will therefore continue to monitor the evolution of PoAs, including their impact on the development of new sectoral mechanisms. The Commission notes that the Directive allows the Commission to propose appropriate regulatory measures under article 11.a(9) of the EU ETS, if the situation would require this.

JI projects registered before 2012: Article 11a(3) allows exchange of credits from projects registered before 2013 issued in respect of emission reductions from 2013 onwards. This applies both to CERs and ERUs. However, in the case of ERUs, issuance and transfer by the Host Party is subject to prior conversion of AAUs. This means that the absence of a second commitment period under the Kyoto Protocol would imply no continuation of JI projects after 2012. Has it been considered how to implement Article 11a(3) with regard to ERUs, in the absence of a second commitment period under the Kyoto Protocol: Continuation of JI project baselines beyond 2012 via a bilateral agreement - would this be a bilateral agreement signed between the EU as a block and various host countries to allow continuation of projects within that country?

Sectoral crediting / trading: The EU intends to develop new mechanisms to scale up the use of carbon markets for climate finance and to provide better incentives for own mitigation action in developing countries.

Stepping up the EU reduction target: The CDM pipeline would imply that CERs from projects registered pre-2013 could be sufficient to cover the demand from the current CER/ERU import limits in phases two and three.

Is the adoption of a 2nd commitment period under the Kyoto Protocol an " international agreement on climate change" in the sense of Art. 11a(7) of the EU ETS Directive and Art. 5(3) of the Effort Sharing Decision?

The ETS Directive (Directive 2009/29) and the Effort Sharing Decision (Decision 406/2009) make clear that the term "international agreement on climate change" refers to the "future" agreement that was expected to be reached at COP15 in Copenhagen and that would apply for the period "beyond 2012". This, however, did not happen in Copenhagen.

Negotiations have continued ever since, resulting in the decision in Durban in December 2011 to "launch a process to develop a protocol, another legal instrument or an agreed outcome with legal force under the Convention applicable to all Parties", to be adopted by 2015 and to come into effect and be implemented from 2020.

The adoption of a second commitment period of the Kyoto Protocol without a legally binding agreement for the period beyond 2012 under which other developed countries commit themselves to comparable emission reductions and economically more advanced developing countries commit themselves to contributing adequately according to their responsibilities and capabilities is therefore not an international agreement as referred to in Article 11a(7) of the EU ETS Directive and Article 5(3)of the Effort Sharing Decision.

Would reaching an international agreement pursuant to Article 11a(7) of the EU ETS Directive and Article 5(3) of the Effort Sharing Decision (ESD) reopen the EU ETS and ESD to CDM credits from projects registered post-2012 other than in Least Developed Countries (LDCs)? What would an agreement mean for eligibility of credits from LDCs?

Articles 11a(7) of the EU ETS Directive and Article 5(3) of the ESD limit the acceptance of CDM credits to those from countries that have ratified the new "international agreement on climate change". They do not "broaden" access in any way.

Thus, once an international agreement pursuant to Article 11a(7) of the EU ETS Directive and Article 5(3) of the ESD is reached, the limitation to CDM credits from new projects from the LDCs for the period starting in 2013 continues to apply. Any broadening of the eligibility criteria to allow new credits from other countries, with the exception of credits used under Article 11a(5), would require an amendment of the ETS Directive. Credits from projects in LDCs and other countries started before 2013 will only be accepted if they originate from countries that have ratified the agreement.

Questions & answers on use restrictions for certain industrial gas credits as of 2013 (November 2010)

Why were use restrictions focused on industrial gas credits?

There are a number of reasons for adopting use restrictions on some industrial gas projects. The acceptance of credits from industrial gas projects has been controversial for some time. Certain gases have a very high global warming potential and abatement is very cheap. This can create huge financial rewards for project developers. The main concerns about these projects are:

a) Additionality - is production and subsequent destruction of the gas higher than what would have happened without a CDM project?

HFC-23 is produced as a by-product during production of another greenhouse gas, HCFC-22, principally in air conditioners and refrigerators. HFC-22 is a powerful ozone depleting substance, which is covered by the Montreal Protocol. Crediting the abatement of HFC-23 can create a perverse incentive to produce more HCFC-22 than would have happened without the CDM, and consequently produce credits that are not additional.

Also, the EU considers that cheap emission reductions in developing countries, such as those from certain industrial gas projects, should not be realised through the carbon market, but instead should be the responsibility of developing countries as part of their own efforts. Alternatively, these reductions could still be in part or fully funded by developed countries based on the actual costs for their abatement.

How could stakeholders contribute?

During the preparations of the Commission proposal and accompanying impact assessment, stakeholders were invited to submit their views on the design of use restrictions for industrial gas credits. Many stakeholders responded and provided valuable written input.

Which countries are the main suppliers of industrial gas credits?

80% of HFC-23 credits and 60% of N2O credits under the CDM come from China. The remainder of these projects are mostly generated in India and some advanced developing countries (some of them OECD-members). Use restrictions are therefore fully in line with an increasing focus of the CDM on LDCs. The EU considers that OECD countries, such as South Korea and Mexico, should contribute to mitigation through measures such as sectoral market mechanisms or emissions trading, rather than through CDM projects.

What will be the market impacts of these use restrictions?

The EU considers there will be enough credits available from the 3300 other projects (non HFC-23, non-adipic acid N2O) registered so far to supply the EU ETS up to the limit allowed over the next 10 years, even without any new credits from sectoral crediting. Therefore allowance prices should be relatively unaffected.

The market was given early notice of the use restrictions, so as to enhance investment in alternative projects that can deliver credits for the EU ETS from 2013 to 2020. The impact assessment shows that even if developed and developing countries fully implement their pledges under the Copenhagen Accord; there would still be sufficient reduction potential in developing countries in areas other than industrial gases at prices below the current European carbon price. This is confirmed by e.g., a recent study by Bloomberg New Energy Finance[1].

Is this not a matter for the UNFCCC?

As the largest purchaser of JI and CDM credits in the world, and to safeguard the integrity of its Emissions Trading System, the EU takes the lead in the UNFCCC process in trying to reform the CDM in order to improve its environmental integrity, effectiveness, efficiency, regional distribution and contribution to sustainable development. The EU will continue to work in the UNFCCC process towards this end. Nonetheless, it is for the EU to ensure the integrity of the EU Emission Trading System and to decide which international credits it allows for compliance, in accordance with the EU ETS Directive (2009/29/EC).

The restrictions proposed would not replace the function of the CDM Executive Board or the Joint Implementation Supervisory Committee. The restrictions apply only to the use of these units for compliance purposes in the EU ETS.

[1] Bloomberg New Energy Finance (2010): "Impact of CER import restrictions on the EU ETS and international carbon market", Carbon Markets - Global - Research Note 20 October 2010.

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International carbon market - Climate Action - European Commission

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Policy International carbon markets can play a key role in reducing global greenhouse gas emissions cost-effectively. The number of emissions trading systems around the world is increasing. Besides the EU emissions trading system (EU ETS), national or sub-national systems are already operating or under development in Canada, China, Japan, New Zealand, South Korea, Switzerland and the United States.

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Climate change and Emissions Trading policy

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Climate change and Emissions Trading policy

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Focus on China

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China recently announced its national emissions trading scheme, advancing market-based approaches to cutting greenhouse gas emissions. Its evolution over coming years will determine whether it becomes an effective part of China's portfolio of climate policies.

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China's emissions trading takes steps towards big ambitions

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China recently announced its national emissions trading scheme, advancing market-based approaches to cutting greenhouse gas emissions. Its evolution over coming years will determine whether it becomes an effective part of China's portfolio of climate policies. Additional access options:

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the background to China's policy

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Q&A: How will China’s new carbon trading scheme work? - Carbon Brief

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Last month, China announced the initial details of its much-anticipated emissions trading scheme (ETS).