The U.S. successfully developed one of the first cap-and-trade programs that substantially reduced many operating Power Plants’ sulfur dioxide emissions.  Based in part on this successful cap-and-trade program a similar process was incorporated into the Kyoto Protocol.  Protocol signatory ’Developed’ countries agreed to reduce future carbon dioxide and other green house gas emissions, and were allowed to achieve partial reductions through purchasing market based carbon credits.  How successful can the current Kyoto Protocol cap-and-trade program actually be towards reducing future world carbon emissions?

ImageBrief U.S. Cap-and-Trade History – The Federal Government amended the Clean Air Act (CAA) in 1990 to include a Title IV regulation that addressed ‘Acid Rain’.  Acid rain was mitigated by reducing sulfur dioxide (SO2) emissions at 110 existing Power Plants.  Under Title IV individual Power Plant SO2 emissions were capped at maximum levels, which were gradually reduced each year.  Power Plant owners had many options for achieving compliance with future reduced SO2 emission caps.  Feasible SO2 reduction options included switching to lower sulfur fuels, installing new SO2 stack scrubbers, reducing fuel consumption (efficiency increases or reduced operating hours), shutting down existing units, or purchasing SO2 emission ‘allowances’ (SO2 compliance credits) on the open market.

The EPA managed the SO2 cap-and-trade program.  All 110 Power Plants were issued SO2 emission allowances based on their operating capacity (relative to baseline 1980 emissions) and annual emission reduction target caps.  Excess allowances (SO2 credits) could be generated by Power Plants’ that actually reduced their SO2 emissions below maximum target caps and through approved emission reduction strategies.  Approved excess SO2 allowances could then be saved and applied towards future target compliance, or traded/sold in the open market to other Power Companies.  Purchasers of excess SO2 emission allowances could then apply these credits towards meeting current or future emission caps.  Beside ensuring that actual SO2 emission reductions were real and verifiable, the overall program was innovative in allowing the most economical emission reduction solutions be developed and built, and the excess emission allowances traded/sold to other Power Plants whose physical plant upgrade options were more costly.

U.S. SO2 Cap-and-Trade Performance – The CAA Title IV SO2 emission cap-and-trade program was generally successful.  U.S. SO2 emissions were reduced by the required 10 million tons/yr. (1980 basis) target as planned.  The primary solution to achieving reduced SO2 emissions was due to ‘fuels switching’ to lower sulfur fuels.  Secondary solutions included installing new stack SO2 scrubbers and building new cleaner, more efficient new power generation capacity.  Lower sulfur fuels included replacing high-sulfur with low-sulfur coal and switching to natural gas.  Largely due to very economic fuel switching, the Power Industry was able to substantially reduce the costs of CAA Title IV compliance well below original Government estimated costs ($1-2 Billion/yr. actual compliance costs; less than half Agency estimates).

Scope of the SO2 cap-and-trade program was relatively small.  The CAA Title IV program only involved 445 power generation units within 110 Power Plants within the Midwest and East Coast.  This represented a small fraction of total U.S. power generation units (approximately 15,000) and number of power plants (about 5,000).  The relatively small scope made the EPA’s job of managing the Title IV cap-and-trade program much easier than if it applied to the overall Power and Industrial sectors. 

Most of the Power sector and essentially the entire Industrial sector were not covered by the CAA Title IV.  The majority of Power Plants and all Industrial facilities were subject to numerous other (non-cap-and-trade) EPA and State emission reduction regulations.  These other regulations also required substantial reductions in SO2 emissions in addition to reducing essentially all other emissions including: nitrogen oxides, particulate matter, etc.  Impacts of the other environmental regulations on the overall Power and Industrial sectors were very significant.

Overall U.S. Environmental Regulatory Impacts – U.S. environmental regulations have very successfully improved local and regional environments over the past several decades.  All Heavy Industries have been substantially impacted by the CAA and amendments (expanded regulations) since 1970.  Unlike the 1990 Title IV cap-and-trade strategy, most Heavy Industries had few options other than installing new environmental controls at each individual facility in order to meet increasingly strict emission requirements.  Past and current environmental regulations have not only been very costly ($100+ Billion/yr.), but have very significantly impacted the Heavy Industry production capacity and performance.

Heavy Industrial facilities basically had two options for meeting new environmental regulations; either install new costly emission controls or shutdown.  Since 1990 the number of U.S. Heavy Industry facilities declined very significantly.  Industries such as Petroleum Refining, Metal Production/Foundries, Petrochemical Plants, etc. experienced up to about 30% shutdowns of individual processing/production plants 1990-2010.  Fortunately, those plants that had their environmental controls upgraded were also generally expanded to help meet growing domestic demand for the durable & nondurable goods produced.  Unfortunately, total U.S. demand generally grew at greater rates than the expanded remaining Industrial facilities production capacities.  The gap in domestic supply-demand was generally filled by increased imports. 

From 1990 until the 2007-09 economic recession U.S. import trade deficits increased from under $50 Billion/yr. up to $600 Billion/yr.  Due to the recession, U.S. consumption and associated trade deficits declined very rapidly to about $300 Billion/yr.  Since 2009 the overall economy and trade deficits have resumed slowly increasing.  In other words, part of the solution to reducing U.S. Industrial sector emissions as required by Government environmental regulations has been to effectively move the manufacturing capacity to foreign countries.  Environmental (and labor & material) costs in many foreign ‘developing’ countries has been significantly less than increasing or expanding U.S. domestic manufacture of many durable & nondurable goods consumed by the general public.

Brief Kyoto Protocol History – The Protocol was developed and approved by most United Nation (UN) member countries to possibly stabilize world atmospheric green house gas (GHG) concentrations at a level that would prevent harmful anthropogenic (man-made) influence on climate change.  The Protocol requires Annex 1 (Developed) countries (EU, Japan, Canada, etc.) to reduce their GHG’s relative to ‘baseline’ emissions in 1990.  Non-Annex (Developing) countries (China, India, Brazil, etc.) are exempt from any Protocol GHG reductions.  Protocol covered GHG’s include carbon dioxide (CO2), methane (CH4), nitrogen oxides (NOX), sulfur hexafluoride (SF6) and many ‘halogenated’ hydrocarbons. 

Annex 1 countries generally manage their GHG emissions similar to how the U.S. managed SO2 emissions under CAA Title IV.  Each Annex 1 country would set an annual total maximum cap on how many metric tons (MT) of GHG emissions were allowed, consistent to their Kyoto Protocol reduction commitments.  These Annex 1 annual GHG caps are generally based on the total number of ‘carbon emission allowances’ (CEA) allotted each year.  Each CEA is equivalent to one MT/yr. of equivalent CO2.  All CH4, NOX, SF6, etc. GHG emissions are converted to (equivalent CO2) carbon emissions based on their ‘global warming potential’.

To manage total Annex 1 country carbon emissions within annual maximum caps normally involved dividing the CEA’s for a given year between individual facilities or sectors (manufacturing, power, etc.).  Individual companies or facilities are then required to not exceed their allocated CEA’s by adjusting their operations (fuel switching, reduced fuel consumption, etc.), making improvements (increased efficiency, reduced GHG emissions, etc.) or purchasing carbon credits on the open markets.  Excess Annex 1 country allocated CEA’s can be saved and applied to future Protocol compliance carbon caps or traded/sold.

Kyoto Protocol Carbon Credits – The Kyoto Protocol allows Annex 1 countries to achieve part of their carbon emission reduction commitments through different ‘flexible mechanisms’.  Kyoto flexible mechanisms include: 1) ‘Carbon emissions trading’ (CET), 2) ‘Clean development mechanism’ (CDM), and 3) ‘Joint implementation’ (JI).  The CET system is similar to the CAA Title IV SO2 cap-and-trade program.  Carbon credits can be generated from excess CEA’s, JI projects, and approved CDM projects.  The CEA credits are developed by individual Annex 1 countries based on their baseline 1990 carbon emissions and unused CEA’s (issued CEA’s minus actual carbon emissions).  Annex 1 countries can also generate additional carbon credits by building JI projects.  Multiple Annex 1 countries can invest in new JI projects that reduce carbon emissions within Annex 1 countries and share the reduce carbon emission credits generated.  Further carbon credits can also be provided from approved non-Annex countries’ CDM projects.

Due to establishing a 1990 baseline for the Kyoto Protocol approved in 1997, many Annex 1 countries could take credit for carbon emission reductions that occurred during the 1990-97 period.   Examples include West Germany reuniting with East Germany and the Czech Republic formation following the 1989 Iron Curtain collapse.  Due largely to shutting down inefficient heavy industries, Germany and the Czech Republic carbon emissions were reduced by about 100 million (M) MT/yr. each (1990-97).  The breakup of the USSR also gave Russia many 100’s MMT/yr. of carbon credits (1990-97).  The Kyoto Protocol emissions trading mechanism allows Annex 1 countries to buy, sell or trade these carbon credits created from 1990 baselines.

The CDM process facilitates Annex 1 countries purchasing ‘certified emission reductions’ (CER, carbon credits).  Approved CER’s are based on carbon emission reduction projects built or to be built in non-Annex countries.  The CER’s are based on the hypothetical emission reductions of new improved projects vs. future unimproved projects that could be built in the Developing country.  Examples include improving the efficiency of new manufacturing facilities, reduced new facility GHG emissions, etc.  The overall objective of the Protocol CDM is to encourage Annex 1 (Developed) countries to invest in non-Annex (Developing) countries in order to reduce the level of Developing country’s future carbon emission increases. 

Impacts of the Kyoto Protocol Carbon Trading Mechanisms – The CDM process has been problematic.  The UN CDM Executive Board consists primarily of Developing country representatives.  Executive Board member’s bias towards projects within their own and allies country’s has led to issuing excessive CER’s for approved CDM projects.  To date, the vast majority of CDM project CER’s issued are for China and India.  These CER’s coincidentally are being issued to Developing countries with the largest actual increases in carbon emissions since 1997.  Another problem with the CDM process credibility has been the recent approval of supercritical coal power plant projects.

Unlike the CAA Title IV cap-and-trade emission credits that are based on reducing actual existing SO2 emissions, most CDM CER’s are based on hypothetical future reductions in Developing countries’ carbon emissions.  While Annex 1 Developed countries struggle to actually reduce their current carbon emissions, Developing countries are unfortunately encouraged to maximize their carbon emissions.  This allows Developing countries to maximize the potential value of CER credits from future CDM approved projects.  Another factor that can make the Kyoto cap-and-trade process dysfunctional is that Annex 1 countries are motivated to shutdown their higher carbon emission industries (and receive associated reduced carbon emission credits) and support starting up equivalent industries in Developing countries.  This carbon switching strategy is commonly called ‘carbon leakage’.  Annex 1 country ‘carbon leakage’ is nearly identical to what has occurred in the U.S. Industrial sector since 1990 due to a variety of costly environmental regulations.  Carbon leakage unfortunately results in ‘zero net gain’ towards reducing total actual world carbon emissions. 

Can Cap-and-Trade Reduce World Carbon Emissions? – The answer is yes; provided the caps are based on current, actual carbon emissions and the traded credits are based on tangible, verifiable carbon emission reductions.  The current Kyoto Protocol unfortunately has large gaps in the ‘flexible mechanisms’ that can create carbon credits that do not reduce current or future world carbon emission levels.  The UN CDM Executive Board needs improvement to eliminate potential conflict-of-interests and better ensure approved CDM CER’s actually reduce future carbon emissions.  A new audit/review process is also needed to correct previously approved carbon credits when actual performance deviates from original estimates.  Without these and other possible improvements, the probability of the Kyoto Protocol’s cap-and-trade program actually reducing total world carbon emissions in the future does not appear very promising.

California is currently in the process of implementing a new cap-and-trade program.  Many people appear to be extremely optimistic that this new program will be successful and set a new precedent for the rest of the country.  We all await to see if this new cap-and-trade program is as successful as the past CAA Title IV program, or results in significant increased ‘carbon leakage’ (i.e. shutdown of more U.S. industrial facilities and further increased durable/nondurable goods imports and trade deficits).

Remember, ‘cap-and-trade’ is just a process.  It’s the actual results that affect our future environment, the economy and our quality of life that matters most.