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The Promise and Perils of Linking Carbon Markets

The theme of the week is “We’re stronger together“.  This rallying cry applies in lots of places.. including climate change mitigation!   So this week’s blog looks at how this theme is playing out in carbon markets. A good place to start is California’s recent proposal to extend its GHG cap and trade program beyond 2020. One of the many notable developments covered by this proposal is a new linkage between California’s carbon market and the rest of the world.


Notes: The graph plots 2020 emissions caps. Quebec and California have been linked since 2014.  The proposed link with Ontario would take effect in 2017.  Emissions numbers summarized in the graph come from here, and here.

Admittedly, I am uniquely positioned to get really excited about linking the province of Ontario (where I was born and raised) with the state of California (my home of 10+ years) under the auspices of the California carbon market (an institution I spend a lot of time thinking about).  But excitement and interest in this “Ontegration” extends well beyond the Canadian economist diaspora. Why?  Because many see this kind of linkage between independent climate change policies as the most promising – albeit circuitous- means to an elusive end (meaningful climate change mitigation).

How did we get here?

After years of work to establish to globally coordinated “top-down” climate policy with very limited success, there’s been an important pivot towards a more decentralized, bottom-up strategy.  This change in course is motivated  by the idea that more progress can be made if each jurisdiction is free to tailor its climate change mitigation efforts to match its own appetite for climate policy action.  Whether, how, and when these independent carbon policies should link together so that regulated entities in one region can use allowances from another is viewed as “one of the most important questions facing researchers and policy-makers.”

To grease the wheels of this coming-together process, the Paris agreement provides a framework to support bottom-up policy linkages. International organizations such as the World Bank are working hard to translate this framework into on-the-ground success stories.  But so far, real-world carbon market policy linkages are few and far between.

I can count the number of linkages between independent trading programs on one hand (the  EU ETS is  linked to Norway, Iceland, Switzerland, and Liechtenstein. California is linked with Quebec).  Post-Brexit, we’ll probably see one more (after Brexiting, a likely outcome is that the UK will establish its own carbon market to link with the EU ETS).  The California-Ontario link is a good news addition to this list, which is why Ontegration is generating both hope and headlines.

Why link?

The most fundamental argument for linking emissions trading programs boils down to simple economics.  Why pay $20 to reduce a metric ton of carbon in California when you can pay $1 to reduce a metric ton in China?  If marginal abatement costs differ across regional cap-and-trade programs, allowing emissions permits to flow between programs to seek out the least cost abatement options will reduce the overall cost of meeting a collective emissions target. Of course, how this net gain is allocated across linkers will depend on how the linkage is implemented.

Other benefits include:

  • More integrated carbon markets are more liquid and can be less volatile, although market linkages can also propagate shocks more directly from one country to another. The EU ETS provides a case in point. The chaos that followed the Brexit referendum has directly (and significantly) impacted the price of carbon in 31 countries.
  • Economies of scale. Some jurisdictions are simply too small to support a well-functioning carbon market. If program operations are combined, administrative costs and effort can be shared across multiple jurisdictions. Larger markets also reduce risk of market power – a major concern for small jurisdictions trying to go it alone.
  • Political considerations. Politics are critical in determining whether a linkage will fly or die. Ontegration offers a case in point. California is happy to demonstrate that its climate policy initiative has brought other jurisdictions onto the carbon market board. In Ontario, the case for moving ahead with cap-and-trade is easier to make when the proposal involves plugging in to an established carbon market operation versus building a market from the ground up.

Market linkage comes with strings attached

The appeal of a bottom-up climate policy is that individual jurisdictions have the autonomy to pick and choose their own policy parameters.  But I am not going to link my carbon market with yours if I’m worried you’re going to introduce rogue policy changes that drive my carbon price and/or carbon emissions in an unpalatable direction. In other words, mutually acceptable linkage agreements will almost certainly impose limits on autonomy because the policy design choices in one jurisdiction affect outcomes in others.

Linkage does not require that all market design features are perfectly harmonized, but it does require careful coordination of design elements deemed to be critical. The Quebec-California linkage agreement provides a well documented example.   These kinds of deliberations get increasingly complex as the number of jurisdictions increases. Negotiations also become much more complicated when the benefits from linkage are distributed unequally across regions.

An important, related concern is that a linked network of carbon markets is only as strong as its weakest link. If one region lacks the capacity to monitor and enforce market rules effectively, this can undermine the environmental integrity of the entire system.



Limits to linkage?

Recent developments in Europe and California are demonstrating how carbon markets can be linked when partners see (mostly) eye to eye, market designs are similar, and political objectives are aligned.  Given current carbon market conditions, linkages have yet to deliver much (if anything) in terms of economic gains from trade.  But they have expanded the scope of carbon markets and laid down foundations for future cooperation. Some good news for a change.

Forging linkages between less compatible systems will require more effort and ingenuity.   It has been suggested, for example, that regions with more aggressive caps might be convinced to link with countries imposing less aggressive caps if “carbon exchange rates”  define favorable  terms of permit trade for regions with more ambitious mandated reductions.  Distorting market incentives in this way might help eliminate political barriers to linkage – but this would also undermine a fundamental economic reason for linking markets in the first place.  Mitigation costs will not be minimized if linkage agreements drive a wedge between regional mitigation incentives. At some point, the costs of policy coordination start to outweigh the economic and environmental benefits of linking.

We’re stronger when we work together. This is particularly true in fighting a global threat like climate change. But the explicit linking of carbon markets is only one way to join together and move global climate change mitigation forward.  We should celebrate recent carbon market  linkages, but realize they are one means to an end – not an end in themselves.


4 thoughts on “The Promise and Perils of Linking Carbon Markets Leave a comment

  1. “Why pay $20 to reduce a metric ton of carbon in California when you can pay $1 to reduce a metric ton in China? ”
    That could be expanded on: Why pay $120 to reduce 1 tCO2e (in Ontario) when you can pay $20 (in California).
    That’s why Ontario is linking, and my understanding of the reason credits are cheap in California is they are mostly hot air – not reflective of any actual domestic CO2 reductions.
    worthy of celebrating? maybe if you’re used to cheering for the Leafs – but most could find something better to be please about.

  2. I believe that the Carbon Exchange, while the price is low, should be directed at all who emit CO2 emissions and not only the few large industries where it is focused right now.

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