It’s the cap, stupid
Josh Burke and Luca Taschini explain the fundamental importance of the cap to the functioning of any emissions trading scheme, a central pillar of climate policy, and explore how carbon dioxide removal might best be integrated by either maintaining the gross cap or setting a new one, as the UK Government consults on this issue.
When James Carville advised Bill Clinton during the 1992 US election campaign that it was “the economy, stupid” that would sway the vote, he was stating one of politics’ most fundamental truths. In the world of climate change mitigation, a similar argument can be made about the cap of an emissions trading scheme (ETS), as this can exert undue influence over market outcomes, impacting the overall efficiency and effectiveness of an ETS.
This may seem esoteric or technocratic, but the cap is particularly crucial to the functioning of an ETS, as it directly affects overall market dynamics by setting the supply, the total allowable emissions, which in turn determines the price of allowances. Examples reliably show compliance markets do not react well to perceived oversupply. Most recently, for example, when the UK released 53 million unallocated allowances back into the market, the proportion of allowances available to industry marginally increased, from 37% to 40%, causing prices to drop significantly. This shows how maintaining a well-managed cap is essential to achieving a well-functioning ETS.
With the allocation of new allowances in compliance markets such as the UK and EU ETS expected to end around 2040, creating a tighter cap, prices are expected to rise. Excessive price spikes and volatility have the potential to undermine the political acceptance and support for emissions trading as a central climate policy instrument, which Pahle et al., (2023) describe as the ‘ETS endgame’: the supply of new allowances will approach zero and the market will undergo changes or could even cease to function.
How should carbon dioxide removal be considered?
Interest in integrating carbon dioxide removal (CDR) – particularly those methods that store carbon in the geosphere – into existing domestic compliance carbon markets has been growing over the past few years as a way to mitigate these challenges and maintain the role of ETSs as a cornerstone of climate policy in the UK and EU. In the UK, integration has implications for the cap as it requires the UK ETS Authority to create and distribute new CDR allowances, which changes the total supply of allowances in the ETS and the corresponding emissions they represent.
However, if CDR is used as a tool to manage the cap and, consequently, the supply of allowances, it raises the question of the risk involved in lowering ambitions for reducing emissions. This underscores the need for responsible governance architecture, including the possibility of a dedicated supervisory institution to enhance the efficiency of carbon markets by managing liquidity and building confidence.
Much has been written about what types of CDR should be integrated and when, but less about how this should be done. With the UK Government now consulting on the mechanics, this warrants a deeper a look at the most likely options for setting the cap and the trade-offs they entail, including the impacts on gross and net emissions, impacts on price and impacts on the revenues and use of allowance value. We weigh up two different options below.
Option 1: Maintain the gross cap
Maintaining the gross cap means all new CDR credits will need to fit within the existing cap. To enable this to happen it means that an emissions allowance (known as a UKA – UK allowance) would be replaced every time an allowance is issued to CDR operators. This is the current stated preference of the UK Government, at least in the short term. It is also how Washington State handles offsets, though the adjustment to the cap there does not happen contemporaneously.
It is conceivable that the integration of CDR into the UK ETS could weaken the ambition to reduce gross emissions in some sectors due to undesirable substitution between emissions allowances and CDR units. To mitigate this, a continuous adjustment of the cap or dynamic adjustments of the cap could be achieved by the ‘conditional integration’ of CDR using qualitative and quantitative restrictions on the amount of CDR that enters the market. A gross cap allows this intervention and can help ensure environmental integrity while managing the impact on the market – as the EU ETS has done in its second trading period. This is common practice within emissions trading schemes, as without adjustments to emissions caps, or tighter restrictions on eligible CDR, even relatively small amounts of CDR could create an oversupply of allowances in the market and put downward pressure on the carbon price.
As the Government’s consultation discusses, this approach ensures that gross emissions reduce over time in line with a net zero trajectory. By maintaining the cap, a clear and consistent signal is provided to the market about the commitment to reducing emissions. This should enhance investor confidence and promote long-term planning and investment.
Maintaining the integrity of the original cap by adjusting it to offset CDR through reducing the supply of allowances does, however, present several challenges. First, this approach does not improve liquidity and undermines the fundamental argument set out in the ETS endgame. Second, offsetting CDR in this manner costs the UK Exchequer through foregone revenue, as the Government has fewer allowances to auction. Third, adjusting the cap in response to the introduction of CDR, rather than in response to changes in the fundamentals of the ETS, can distort the relationship between the value of allowances and the cost of abatement as determined by those fundamentals. Consequently, it may result in either overvaluing or undervaluing allowances.
Lastly, in the event of a ‘reversal’ (i.e. where carbon is re-released into the atmosphere due to extreme weather events, disease, poor site/facility maintenance or poor land use governance), a fixed cap ensures covered emissions are not impacted, which is beneficial from an atmospheric perspective. For example, in the event of a reversal, the New Zealand ETS requires participants to surrender to the Government an equivalent number of ETS units if the credited forestry removals are reversed. The unit repayment liability reduces emissions elsewhere in the system by liquidating other allowances to maintain the overall cap. This is intended to ensure landowners compensate for any reversals of credited forestry removals in a way that maintains the original benefits to the climate.
However, in the event of a reversal, a large and unanticipated reduction in the cap that follows could spike prices. Such a sudden reduction in available CDR allowances would create a supply shock, leading to a significant increase in allowance prices due to the sudden scarcity. This price spike could destabilise the market, making it more difficult for businesses to plan and budget for their emissions reductions. Therefore, a mechanism to address reversals without causing abrupt changes in the cap is crucial to maintaining market stability and ensuring that the system continues to provide consistent incentives for emissions reductions.
Option 2: Set a new cap
The alternative to maintaining a gross cap is to set a new net one. In this option the Government can set a new lower cap but this does not apply to CDR. This means that the UK ETS Authority would reduce the existing cap based on an expected supply of CDRs that would enter the ETS. Allowances issued to CDR operators would then enter the market in addition to the supply of allowances set out by this new cap.
In contrast to the option above, this has the potential to achieve emissions reductions and consequently maintain the desired price level if the future supply of CDR credits is equal to what was expected when the new cap is set. Having an additional supply of allowances enhances overall supply which feeds through to improved liquidity.
However, the supply of CDR credits remains highly uncertain in the short run and relies on the Government having good information about the future supply of CDR. The technologies and methods for generating CDR credits are still developing, and their scalability is not yet proven. Factors such as technological advancements and investment levels can all influence the availability of CDR credits. This uncertainty makes it challenging to accurately predict the future supply of CDR, and any miscalculation could result in either an oversupply or a shortage of allowances. An oversupply would depress allowance prices, reducing the incentive for emissions reductions, while a shortage would drive up prices, increasing compliance costs and potentially destabilising the market. Therefore, this approach introduces significant risks due to the unpredictable nature of CDR credit supply in the short term.
Supposing a liquid supply of CDR is available, and unconstrained integration occurs, this could increase liquidity and reduce concerns of uneven market power as emissions under the ETS approach zero. It has the added benefit of also stabilising revenue to the Exchequer, assuming there is no trade-off between quantity and price. However, it does not allow qualitative or quantitative restrictions, which may be needed to address several risks. The first risk is abatement deterrence. Regulated firms may delay decarbonisation investment until there is more information about the cost and supply of future CDR credits. As Sultani et al. outline, the longer firms wait, the more allowances they will use in the meantime, implying that the price will rise more steeply as the ETS cap approaches zero. This in turn could lead to a softening of the cap when prices surpass the politically acceptable level, which would undermine environmental integrity at least indirectly. Second, if there is an oversupply that puts downward pressure on market prices, the ETS authority has limited measures to intervene within the existing structures and may require the use of other flexibility mechanisms such as supply adjustment mechanisms.
Which would be the best approach?
In the long term, as the cap declines, switching from a gross cap to a new net cap may prove to be a more efficient option, especially as this would lead to net-negative emissions over the longer term, which is the goal. This approach can directly address the challenges arising from the ETS endgame, particularly the issue that there are no longer emissions allowances that can be replaced by allowances from CDR. As the cap becomes progressively tighter, the number of emissions allowances diminishes, making it increasingly difficult to integrate new CDR credits within the existing cap framework.
By adopting a new net cap, the system can accommodate the expected influx of CDR while achieving the desired level of gross/net reductions and maintaining revenues. This approach is the logical long-term solution since over time there will also be more information to better understand the expected CDR supplies, the costs and reversal risks that limit this option in the short term. Furthermore, it provides a structured pathway for incorporating CDR, which is a vital component of achieving net zero emissions.