3. Greenhouse Gas Emissions, Allowances, Offsets and Commitments of Developing Countries

Greenhouse Gas Emission Levels

Although S.139 eventually caps covered entities’ greenhouse gas emissions at their 1990 level, the flexibility mechanisms in the bill are projected to allow covered entities to continue to emit in excess of the target. Covered entities can comply with S.139 without directly reducing their emissions to the specified targets by purchasing credits from noncovered U.S. entities that register emissions reductions, allowances from qualified foreign trading programs, and credits from projects to enhance the biological sequestration of greenhouse gases (sinks).

The S.139 emissions allowance program is expected to have an effect on energy-related investment decisions soon after enactment, thus slowing the growth in emissions somewhat relative to the reference case (Figure 3.1). While the bill’s emissions limits and allowance trading provisions do not start until 2010, credits for early action are expected to induce some changes in emissions before 2010. More significant reductions are expected to begin in 2010 when the Phase I limits go into effect. Emissions over the Phase I period drop beginning in 2010, as covered entities begin to take advantage of the banking provisions and overcomply so as to accumulate banked allowances. In addition, they are expected to purchase allowances from noncovered entities as allowed under the offset provisions of the bill.

Beginning in 2016, when the more stringent Phase II allowance caps go into effect, covered entities would use previously banked allowances, enabling them to reduce their emissions (about 75 percent of the total) to near 1990 levels over the next decade. Emissions from noncovered entities grow moderately through 2025. Total emissions (covered and noncovered) reach 2000 levels by 2025. These changes in emissions do not reflect increases in carbon sequestration and purchases of emissions reductions abroad that are also used to comply with the targets in the legislation.

S.139 is expected to induce increases in biological carbon sequestration in the United States and to result in some reduction of emissions abroad as U.S. entities purchase allowances from countries with verifiable emission inventories that provide compliance at lower cost. The alternative compliance provisions of the bill bring about these changes. These provisions allow noncovered entities to register reductions and receive allowance credits, which they can then sell to a covered entity. If the S.139 greenhouse gas emissions trend is adjusted to account for these changes, the adjusted emissions nearly reach 1995 emission levels by 2025 (Figure 3.2). The difference between the adjusted line and the S.139 case is larger during the 2010-2015 than the 2016-2025 period because of the larger amounts of offsets permitted for use in the first period. Thus, given an adjustment credit for the increase in carbon sequestration and the emission reductions abroad that are induced, S.139 results in adjusted U.S. emissions by 2025 equal to 7 percent above the estimated 1990 level of 1,672 million metric tons carbon equivalent (1,258 million metric tons carbon equivalent in the covered sectors and 414 million metric tons carbon equivalent in the noncovered sectors).⁸⁹

S.139 provides some measures that give entities a certain amount of flexibility in complying with the emissions limits. These provisions include early action credits, allowance trading and banking, and a mechanism to allow participation from noncovered sources. These flexibility measures are expected to result in a relatively smooth transition through the first and second compliance periods. As a result, the economic burden of controlling emissions is rolled in gradually over time. The potential shock that might otherwise occur when the Phase II emissions limits take effect in 2016 is dampened through banking of allowances during the Phase I period (Figure 3.3). By overcomplying during Phase I, covered entities will accumulate a bank balance of allowances through 2015, then gradually withdraw the allowances over the following 5 to 10 years as they adjust to the Phase II limits. After the depletion of their banked allowances around 2020, covered entities are expected to start meeting their Phase II limit with minimal levels of aggregate banking or borrowing.

Allowance and Offset Values

The trading market for allowances and offsets is expected to be affected by banking and arbitrage. The allowance price is expected to approach an equilibrium solution over time, characterized by growth at some aggregate discount rate. For this analysis, we have assumed that trading behavior will be based on a real, after-tax discount rate of 8.5 percent.⁹⁰ For this analysis, a discount rate equal to the real-after tax cost of capital was assumed in the electricity sector, as the most important capital decisions driving the emissions market are expected to take place in that sector. As a result, allowances prices growing at that discount rate are estimated such that the bank of allowances is cleared sometime after 2020, while meeting the bill’s constraints on the use of offsets. After the bank balance reaches zero, the allowance prices are expected to increase by less than the discount rate. These assumptions generally lead to a leveling off of allowances prices after the banking period ends.

Since noncovered entities can obtain offset credits for verifiable emissions reductions, they can participate in the market-based compliance system of S.139. These offset allowances, however, are constrained in the bill. Generally, entities may only meet 15 percent of their Phase I limits through the use of offsets, and 10 percent in Phase II. As a bonus for early action, entities that reduce their emissions to below their 1990 level by 2010 are eligible to purchase 20 percent of their Phase I allowances from offsets.

As a result of the offset limits and the generally low costs of reductions from offset sources, the market price for offsets is expected to clear at prices well below the allowance market in most cases. In effect, two markets develop: one for allowances and one for offsets. If the limit on offsets were not reached in complying with the bill (i.e., if the constraint were nonbinding), the markets for offsets and allowances would be expected to clear at the same price. This result occurs in a sensitivity case that substantially raises the limits on offset use specified in S.139.

Allowances

In S.139, the covered sector greenhouse gas target is 1,465 million metric tons carbon equivalent for 2010 to 2015 and 1,258 million metric tons for 2016 and beyond. This analysis assumes that, in aggregate, a Phase I limit of 16 percent⁹¹ for offsets would apply, taking into account the additional use of offsets allowed for covered entities that take early action. Based on the derivation of the Phase I and Phase II limits (see Chapter 2), the amount of offsets purchased is expected to be capped at 234 and 126 million metric tons carbon equivalent, respectively. Because the Phase II target is more severe and offset flexibility is lower than in Phase I, additional allowances are projected to be banked from covered sectors in Phase I and used during Phase II, when allowance prices are expected to be high. The major effort to adhere to S.139 is borne by the domestic covered sectors, particularly in Phase II. In the S.139 case, allowance and offset prices diverge immediately, because the maximum allowable offsets are used in both periods and additional allowances are banked from domestic covered sectors, reflecting expected higher future allowance prices. Projected allowance prices in the S.139 case rise smoothly from about $79 per metric ton carbon equivalent to about $223 in 2023, when the allowance bank is depleted and prices become more volatile (Figure 3.4).

Excluding the no banking case, allowance prices in the major sensitivity cases are the most responsive to differences in technology assumptions (high technology and no new nuclear/no sequestration cases) and the least affected in the cases where the percentage allocation to the Corporation is varied. Allowance prices in the S.139, corp20, and corp80 cases⁹² are virtually the same, because the total greenhouse gas emission reductions that are to be achieved from covered sectors remain nearly constant under the reference case technology menu. Consequently, the allowance prices remain nearly the same throughout the projection period for these three cases. The more interesting cases are the S.139 high technology case, the no banking case, and the no new nuclear/no sequestration case, which assumes that new nuclear power and carbon sequestration technologies are not successful in becoming commercially viable before 2025. Table 3.1 compares the analysis results in the S.139 case and these three cases (see also Figure 3.5).

In the commercial coverage case, where the commercial sector is included as a covered sector, the greenhouse gas emissions target for covered entities increases to 1,529 million metric tons carbon equivalent for 2010-2015 (instead of 1,465) and 1,318 million metric tons for 2016 and beyond (instead of 1,258). The maximum use of offsets allowed in this case is 245 million metric tons in Phase I and 132 million metric tons in Phase II. Allowance prices are nearly the same as in the S.139 case (Figure 3.5). Offset prices are slightly higher in both phases, however, because the higher base of covered sector emissions allows larger amounts of offsets to be purchased in each period. Because the marginal abatement cost curves are the same as in the S.139 case and larger amounts are taken, the resulting offset prices rise by as much as $8 per metric ton carbon equivalent relative to the S.139 case.

The no banking case illustrates the importance of allowing early actions to bank allowances. When banking is not permitted, allowance and offset prices are not only lower in Phase I but also equal to each other (in equilibrium), with prices ranging from $40 per metric ton carbon equivalent in 2010 to $63 in 2015 (Table 3.1 and Figures 3.5 and 3.6). Moreover, the total offsets purchased in Phase I range from 162 to 177 million metric tons carbon equivalent, far less than the allowed maximum of 234 million metric tons carbon equivalent. Although the power market in this analysis “sees” the need to meet a much tougher target in 2016 and takes some action with capacity planning to ameliorate the price impact, the actions taken are far fewer than necessary to smooth the transition between phases. With no banking allowed, the value of early action is judged to be small by the market. As a result, the allowance price rises to nearly $280 per metric ton carbon equivalent in 2016 to satisfy the new emission target. The quantity of offsets purchased in Phase II is at the cap, 126 million metric tons. The power generation and transportation markets respond strongly to the large price signals in this case and take appropriate technology actions to lower allowance prices significantly. By 2022, the induced technological changes in this scenario are projected to be sufficient to make allowance prices fall temporarily and remain below the price levels in the S.139 case through 2025.

The no new nuclear / no sequestration case illustrates the value of having two carbon-free technologies in the arsenal to meet the requirements of S.139. The absence of these two technologies places a strain on the production from the remaining technologies that might be used to met the greenhouse gas emissions target. Because this case, like the S.139, corp80, and corp20 cases, uses the maximum offsets available in both periods, their offset prices are the same. However, the allowance price rises faster when new nuclear and sequestration technologies are assumed not to be commercially available. Because alternative marginal technology choices with larger abatement costs must be undertaken to satisfy the S.139 requirements, the allowance price starts higher and remains higher than in all other cases except the no banking case from 2016 to 2020. By 2025, the allowance price in the no new nuclear/no sequestration case is projected to reach nearly $300 per metric ton carbon equivalent.

The price at which offsets are available is based on a set of marginal abatement cost curves that represent the estimated supply of offsets (see Chapter 2 for an explanation). These curves establish the quantity of offsets for emissions reductions or carbon sequestration available at particular prices. Generally, the costs of a given level of abatement increase over time (particularly the international sequestration component). As a result, the Phase I offset price is estimated to clear at about $71 per metric ton carbon equivalent (2001 dollars) in 2010 and rise to about $86 in 2015 (Figure 3.6). These prices are somewhat below the emission allowance trading price of $79 to $119 per metric ton carbon equivalent over the same period. In Phase II, with a lower limit on offsets, the clearing price for offsets is projected to range from $35 to $52 per metric ton carbon equivalent.

In the sensitivity case where all entities in the commercial sector are assumed to be covered by the bill, the Phase I and Phase II allowance limits increase, as do the quantities of offsets allowed, because the level of covered emissions is larger and the percentage allowable is the same. In the commercial coverage case, the aggregate offset limits rise by 11 million metric tons carbon equivalent in Phase I and by 5 million metric tons carbon equivalent in Phase II. As a result, the offset prices are higher by $5 to $8 per metric ton carbon equivalent than in the S.139 case. In both the S.139 high technology case and the no banking case, the constraint on offset purchases is not binding in the Phase I period, allowing the offset price to match the allowance trading price.

The cost of offsets differs across the different sources modeled: sequestration, noncovered methane emissions, and international sources. As a result, the quantities of offsets available at the clearing price differ (Figure 3.7). The largest contribution from purchased offsets comes from agricultural and forestry sequestration. The contributions from noncovered methane offsets in 2010 to 2015 are slightly smaller than the international offsets. However, the importance and contributions of international offsets are projected to decline somewhat over time. The price at which international offsets are available is based in part on the international demand for the offsets. As the international demand increases, the price rises, and U.S. purchases are reduced in favor of domestic offsets. Once the Phase II emissions limits go into effect in 2016, the international offsets or no longer competitive with domestic offsets.

Offset Sensitivity Cases

Several sensitivity cases were used to examine the issue of compliance offsets. Covered entities may use offset credits from several sources, subject to an overall cap specified in S.139. The potential sources of offsets include registered reductions from noncovered entities, registered increases in biological carbon sequestration, and emissions allowances from other countries. In one sensitivity case (offset50), the offset limit was increased to 50 percent in both phases. Two other cases were examined to test assumptions regarding the availability and costs of international emissions offsets. In one case (intl100), the assumed supply curve of offsets from international sources was doubled. A second case (intl0) assumed that no international offsets would be available.

Figure 3.8 compares the market-clearing prices for allowances and offsets in the three offset sensitivity cases with those in the S.139 case. In the offset50 case, the limit on offsets is not reached, and the trading prices of offsets and allowances are identical, at levels below those in the S.139 case. Table 3.2 summarizes the energy market outcomes in the offset sensitivity cases. Because the offset50 case effectively reduces the amount of emissions reductions in the covered sectors, the magnitude of changes in the energy sectors to comply with S.139 is reduced. As a result, there is greater coal use and a reduced reliance on renewable, nuclear, and carbon sequestration technologies in the electricity sector in the offset50 case.

In the offset50 case, allowance prices and offset prices equilibrate to the same level throughout the forecast period, at prices that are lower than in the S.139 case. By 2025, the greenhouse gas price is $171 per metric ton carbon equivalent, compared with $221 in the S.139 case. In 2025, the quantity of offsets purchased is projected to increase from 126 million metric tons carbon equivalent in the S.139 case to 346 million metric tons carbon equivalent in the offset 50 case, thus increasing the transfer of funds to international markets by about $27 billion (2001 dollars) in 2025 or about 3.6 percent of net U.S. imports in 2025.

In the intl100 case, the Phase I and Phase II limits on offsets are the same as in the S.139 case. As a result, the primary effect of this case is to alter the mix of offsets available from the three offset sources, increasing the international share relative to the domestic share. In the intl0 case, the unavailability of international offsets raises the offset price to equal the allowance price in Phase I, and the allowance price clears at a level above that in the S.139 case.⁹³ The unavailability of offsets in the intl0 case affects only the Phase I offset prices, which increase by a maximum of 48 percent in 2015 relative to the S.139 case.

Figure 3.9 compares the mix of offsets for 2010, 2016, and 2025 in the intl0, intl100, offset50, and S.139 cases. In the intl100 case, the lower price of international offsets is insufficient to make them competitive with domestic offsets in Phase II, and no international offsets are purchased. In Phase I the offset prices are lower, and more international offsets are included in the mix.

An increase in the supply of international or domestic offsets, as in the intl100 case, can reduce the offset price. In the intl100 case, because the overall use of offsets is limited by the bill, larger available quantities of offsets (supply) yield a lower offset price in the 2010-2015 period (see Figure 3.8). The 100
percent increase in the supply of international offsets reduces the offset price in the 2010-2015 period, but the offset prices in 2016 and beyond are unchanged from the S.139 case because domestic offsets are cheaper than international offsets in the later period. The net impact of a doubling of international offset supplies is that the total cost of offsets is reduced by an average of about $1.6 billion per year (cumulatively, $24 billion in undiscounted dollars over the entire period)—about 0.3 percent of net U.S. imports in 2015.

When it is assumed that no international offsets are available, the domestic market must do more work to achieve the same emission reduction targets. More reductions in the domestic market result in higher allowance prices. The additional costs relative to the S.139 case derive primarily from higher allowance prices. In the 2010-2015 period, domestic allowance and offset prices in the intl100 case equilibrate at quantities below the allowed cap. Although funds expended for international offsets are reduced to zero, domestic offset and allowance prices are higher, because more expensive emission reduction sources are tapped to meet the target. More offsets must be purchased from domestic sources, and more reductions must be achieved from carbon dioxide reductions in the energy system.

In summary, doubling the available offsets assumed in the S.139 case has a negligible impact on the economy and a small but beneficial impact on allowance costs relative to S.139. When international offsets are assumed to be zero, the negative impact on the cost to U.S. energy markets is more significant.

International Commitments of Selected Developing Countries

Senator James Inhofe requested that EIA provide information on the greenhouse gas commitments currently adopted by China, Mexico, South Korea, India, and Brazil.⁹⁴ The country-specific summaries below give overviews of greenhouse gas mitigation activities in those countries.

In contrast to the specific scheduled U.S. emission reduction targets for 2010 and 2016 proposed under S.139, the major developing countries of China, Mexico, South Korea, India, and Brazil have no binding obligations to limit or reduce emissions under the United Nations Framework Convention on Climate Change (UNFCCC) or the Kyoto Protocol. However, a number of the larger developing countries have introduced initiatives to address global climate change and limit growth in greenhouse gas emissions.

Brazil, China, India, Mexico and South Korea have ratified the UNFCCC and the Kyoto Protocol. Under the UNFCCC all signatories are responsible for preparing a national communication that includes an inventory of overall greenhouse gas emissions and an analysis of potential mitigation and adaptation measures. Each of the five nations’ governments has established an entity to coordinate climate change activities in the country. The five countries may also participate in the Kyoto Protocol through the Clean Development Mechanism (CDM), which enables entities in Annex I countries to acquire emission reductions generated in developing countries. In addition, all five countries have introduced specific initiatives to address climate change.

Brazil. In 1996, Brazil established its Climate Change Program with resources from the Global Environment Facility of the United Nations Development Programme and the U.S. Country Studies Program, which supports non-Annex I countries in reporting their climate trends and adaptation measures under the UNFCCC. The Brazilian government is prioritizing work on its inventory of greenhouse gas emissions. A key focus is awareness building, education, and dissemination of information published in Portuguese. The government is also actively promoting projects for inclusion in the CDM. So far, two Brazilian projects have been approved by the Dutch government and one by the World Bank Prototype Carbon Fund (PCF).⁹⁵

In 1999, Brazil’s President ordered the creation of the Inter-Ministerial Commission on Global Climate Change, to coordinate the efforts of various agencies and public participation. The Commission’s web site specifically states, “Brazil does not have commitments to reduce or limit its anthropogenic emissions of greenhouse gases.” However, a number of general energy policies, according to a Pew Center report, have reduced emissions growth by almost 10 million metric tons carbon equivalent, including production and use of ethanol and sugar-cane bagasse, development of the natural gas industry, use of alternative energy sources for power generation, and promotion of demand-side management programs.⁹⁶

China. In 1990, China established its Inter-Ministerial National Climate Change Coordinating Committee to address the issue of climate change. Since then, China has been actively engaged in negotiating the rules for the Kyoto Protocol and the CDM, and it is expected to attract a major share of CDM investment because of the comparatively low cost of emissions abatement in the country, particularly in the power sector. The Asian Development Bank estimates that the Chinese market for emissions reductions could amount to $13 billion per year,⁹⁷ and projects have already been initiated in anticipation of the CDM. In March 2003, the government of the Netherlands agreed to purchase emission reductions from a wind farm in Inner Mongolia, following the guidance set forth for the CDM.⁹⁸

Although energy-related carbon dioxide emissions in China decreased by 5.63 percent between 1997 and 2000⁹⁹ through fuel switching and energy efficiency improvements, they have begun to rise again.¹⁰⁰ China’s energy-related carbon dioxide emissions are expected to more than double between 2000 and 2025, rising from 780 million metric tons carbon equivalent in 2000 to 1,844 million metric tons in 2025.¹⁰¹ As a result, a number of government studies have been undertaken to examine mitigation strategies. For example, China’s Energy Research Institute and others have undertaken the China Energy and Carbon Scenarios Project to define future mitigation options.¹⁰² Efficiency improvements in the power sector, development of a natural gas infrastructure, forest protection, and reforestation are listed as major ecological priorities in China. In addition, the Chinese government is sponsoring a pilot project to test methods for capturing carbon dioxide from power generation.

India. Due to rapid economic growth and continued reliance on fossil fuels, particularly coal, India’s greenhouse gas emissions continue to rise. Although the Indian government has expressed its commitment to reduce greenhouse gas emissions, it is adamantly opposed to declaring a binding reduction target. Still, according to one estimate,¹⁰³ a number of energy-related policies, such as economic restructuring, enforcement of existing clean air laws by the courts, and renewable energy incentives and development programs have avoided an estimated 111 million metric tons of carbon emissions over the past decade.

To support the Kyoto Protocol in its current form, the Indian government has established national procedures for approving greenhouse gas reduction projects for inclusion in the CDM and has so far cleared six project proposals for potential transfer to the Netherlands and the World Bank’s Prototype Carbon Fund. The Dutch government has agreed to purchase emission reductions from three wind and two biomass projects in India.¹⁰⁴

Mexico. Mexico was the first major oil-producing nation to ratify the Kyoto Protocol and has established several policies consistent with greenhouse gas mitigation, including promotion of energy efficiency and conservation, renewable energy and clean fuels, forest conservation, and reforestation. According to one estimate,¹⁰⁵ these policies have avoided 10 million metric tons of carbon emissions annually over the past decade.

Since 1992, Mexico has cooperated closely with the United States and other countries to address climate change. The EPA has helped to train Mexican staff in the areas of modeling Mexican greenhouse gas emissions and updating Mexico’s emission inventory, as well as co-hosting joint workshops with Mexico. In 1992, Mexico signed, with 10 other countries, a treaty to establish the Inter-American Institute for Global Change Research, which provides training and technical support to participating countries in the areas of global change; earth, ocean, and atmospheric science; and technologies and economic aspects associated with mitigating and adapting to global change.¹⁰⁶ In 1996, Mexico and its neighboring Central American countries adopted a Plan of Action to advance the objectives of the San Jose Declaration, which promotes climate change issues and information exchange. During the June 29, 2001, meetings of the Council of the Commission for Environmental Cooperation established under the North American Agreement on Environmental Cooperation,¹⁰⁷ the EPA Administrator initiated a dialogue with the environmental ministers of Canada and Mexico to discuss global environmental concerns. The countries pledged “to explore further opportunities for market-based approaches for carbon sequestration, energy efficiency and renewable energy in North America.” Finally, in March 2003, Mexico and the United States announced their intention to expand and intensify their existing bilateral efforts to address climate change and continue a bilateral dialogue to develop joint activities to combat climate change in such areas as emission inventories, economic and climatic models, energy, adaptation, agriculture/forests, earth observation systems, and carbon sequestration technologies.¹⁰⁸

Finally, a number of local entities have shown interest in greenhouse gas emissions trading as a means to reduce emissions. Mexico City is developing a formal strategy for mitigating climate change and is a member of the Chicago Climate Exchange, which is a voluntary cap and trade program for reducing and trading greenhouse gas emissions, initially among U.S. and Canadian firms. In addition, Mexico’s national oil company Petróleos Mexicanos (PEMEX) has adopted a voluntary and experimental internal emissions trading system based on the cap and trade concept.¹⁰⁹ Under the initial phase of the PEMEX cap and trade system, PEMEX reduced emissions by 3 million metric tons carbon equivalent. This was accomplished by an internal trading system between PEMEX’s 25 business units. Beginning in 2003, the internal trading system will be based on actual money exchanges between business units to meet emission reduction targets.

South Korea. Since 1979, the Rational Energy Utilization Act has required a new 10-year plan to be revised every 5 years to reflect changes in economic and population growth. As forecast by the South Korean government in 1998, South Korea expected growth in carbon dioxide emissions of 5.2 percent annually from 1995 to 2010.¹¹⁰ South Korea is also seeking bilateral cooperation with the United States and Japan.

The South Korean government is taking active measures to slow the growth in greenhouse gas emissions. According to the government’s integrated energy price structure plan to be finalized by June 2006, which includes measures to reduce greenhouse gas emissions, South Korea will expand the use of liquefied natural gas by 77 percent and nuclear energy use by 69 percent by 2010.¹¹¹ The government will also focus on the use of solar power, wind power, fuel cell technology development projects, a 5-year energy conservation plan for energy-intensive companies, duties on petroleum imports, long-term DSM plans, reforestation, methane mitigation in rice paddies and animal husbandry, and waste management plans.

In 2002, the Commerce, Industry and Energy Minister of South Korea proposed the establishment of a national greenhouse gas emission registry system by 2004 in preparation for the international emissions trading system proposed under the Kyoto Protocol.¹¹² The registry and trading system will form part of the country's integrated energy price structure plan and will target greenhouse gas emissions from the manufacturing industry.

3. Greenhouse Gas Emissions, Allowances, Offsets and Commitments of Developing Countries - Tables

Notes