Study finds benefits to restricted linking of carbon markets

The study – just published in International Environmental Agreements – lays out the benefits and challenges of “restricted linking” of regional and national emissions trading systems (ETSs). Such analysis is crucial as interest in ETSs grows in the wake of the Paris Agreement and countries consider cap-and-trade programs to drive down their carbon emissions.

Eighteen emissions trading systems now operate across four continents, while another 15 are under consideration. Some argue that the next step is linking them into larger, more global markets, while others note that linking comes with political challenges and the risk of undermining the price and emission objectives of individual jurisdictions.

SEI researchers found that “restricted” linking options could provide a middle ground. Their findings come as California – which has the largest emissions trading system in the U.S. – considers merging its system with one that China launched this year.

“Restricted linking options do not achieve all the potential benefits of full linking, but they offer alternatives that could still lower the cost of reducing emissions and signal enhanced cooperation,” said Michael Lazarus, co-author of the study and director of SEI’s U.S. Center. “They could also allow decision-makers to maintain regulatory autonomy and provide easier off-ramps to terminate linking arrangements.”

The study analyzes three options. Quotas restrict the amount or type of units an emissions trading system will accept from (or sell to) other jurisdictions. Exchange rates allow units to flow among different systems, but assign different emission reduction values to units of each ETS. And discount rates are a variant on exchange rates, assigning greater value to the jurisdiction’s own units.

Researchers assessed the economic implications, feasibility and greenhouse gas (GHG) abatement of each of the three options in comparison with full linking and no linking.

Their results show that restricted linking – in particular, quotas and discount rates – can offer attractive options for jurisdictions to pursue, depending on their policy objectives. If the ultimate goal is full linking, for example, policy-makers could look to quotas as a step toward that end. They reduce overall costs compared to no linking, do not undermine overall GHG abatement, and avoid the perception that each ETS creates units of different value.

Discount rates, meanwhile, have the ability to increase overall mitigation while providing added flexibility for regulated entities. The more entities use the flexibility to import units from another ETS, the more emissions are reduced.

Exchange rates came with the most challenges. Researchers found that they could increase costs and emissions if not set properly, a task that would be inherently challenging in the first place. Exchange rates can, under some circumstances, actually lead to fewer emissions reductions.

“Restricted linking is not a silver bullet. Done poorly, as our analysis shows, it could lead to unintended adverse outcomes with respect to both emissions and cost,” said study co-author and SEI Associate Lambert Schneider. “That said, if done well, it can provide a way to overcome the barriers to linking, and thereby help deliver on its potential environment, economic, and political benefits.”

Read the study in International Environmental Agreements »