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Paying the Carbon Price

The Subsidisation of Heavy Polluters under Emissions Trading Schemes

Elena de Lemos Pinto Aydos

Paying the Carbon Price analyses the practice of freely allocating permits in Emissions Trading Schemes (ETSs) and demonstrates how many heavy polluters participating in ETSs are not yet paying the full price of carbon. This innovative book provides a framework to assist policymakers in the design of transitional assistance measures that are both legally robust and will support the effectiveness of the ETSs whilst limiting negative impacts on international trade.
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Chapter 1: Contextualising the issue

The Subsidisation of Heavy Polluters under Emissions Trading Schemes

Elena de Lemos Pinto Aydos

There is no Plan B, because we do not have a Planet B

Ban Ki-moon, UN Secretary General, September 2014

1.    INTRODUCTION

This book analyses the methodology of the free allocation of permits in Emissions Trading Schemes or Emissions Trading Systems (ETSs). What motivated the research in the first place was an insight from an earlier work1 on the implementation of carbon taxes in Brazil. The author came into contact with literature suggesting that carbon taxes and ETSs, by unilaterally adding a carbon cost to domestic industries, could lead to carbon leakage and competitiveness distortions.

The aim of carbon pricing is to mitigate greenhouse gas (GHG) emissions. It is intuitive, therefore, that impacts on the profits and, occasionally, on the actual viability of certain businesses are a necessary consequence of an effective environmental policy. However, even now, many heavy polluters participating in ETSs are not paying the full price of carbon.

Concerns with the loss of competitiveness, vis-à-vis international competitors who are not liable under a carbon pricing mechanism, have been at the centre of the political discussions on climate policy in several countries.2 Carbon leakage, that is, the risk that the environmental goals of ETSs might not be achieved if energy-intensive industries move offshore and global GHG emissions, therefore, remain unchanged or increase, has also been a key concern. Nevertheless, the extent to which pricing carbon could affect specific sectors remains unclear in most jurisdictions.3

Paying the Carbon Price discusses the theory and practice of carbon leakage in the context of three independent ETSs. It demonstrates that risk of carbon leakage is not as high as initially predicted by policymakers. Furthermore, the significant discrepancies in the policy framework for free allocation in independent ETSs is problematic as it discriminates between liable entities within and across the different ETSs. If the combined effects of the carbon price and free allocation are not the same for two firms operating in different jurisdictions, which are in competition in relation to the product they produce, then these firms will still face different price constraints. Different allocation rules could affect their profit margins, thereby distorting trade.

Economic data that assesses the sectors liable under ETSs is often discussed within the economics sphere, with little attention from legal scholars.4 As a result, the legal implications of the World Trade Organisation’s (WTO) laws applicable to the free allocation method have been largely disregarded. The final chapters of this book analyse the issue of free allocation of permits in light of the definition of a subsidy in the Agreement on Subsidies and Countervailing Measures (SCM Agreement). As a result, a number of recommendations are made for future scheme design rules that will be both legally robust and will support the effectiveness of the ETSs while limiting any negative impacts on international trade.

2.    THE GREAT EXTERNALITY OF ALL TIMES

The Fifth Assessment Report (AR5) of the United Nations Intergovernmental Panel on Climate Change (IPCC)5 on the physical scientific basis of climate change concluded, with unprecedented levels of certainty, that the atmosphere and oceans are warming at increasing rates.6 Each of the past three decades has been warmer than all the previous decades in the instrumental records, and the first decade of the twenty-first century has been the warmest yet.7

Based on meteorological data independently collected by different centres around the globe, the IPCC concluded that it is virtually certain that maximum and minimum temperatures over land have increased on a global scale since 1950.8 It is also virtually certain that the upper ocean (0–700m) warmed from 1971 to 2010.9

A growing body of scientific evidence demonstrates that the cumulative concentrations of human-induced GHG10 emissions are the primary cause of climate change.11 In 2011, the atmospheric concentrations of carbon dioxide (CO2), methane (CH4) and nitrous oxide (N2O) exceeded the pre-industrial levels by approximately 40 per cent, 150 per cent, and 20 per cent, respectively.

The present concentrations of CO2, CH4 and N2O are the highest ever recorded in ice cores in the last 800,000 years.12 More than half of anthropogenic GHG emissions are generated by energy use and production, with land-use changes, such as deforestation and industrial activities, also playing an important role.13

Concentrations of GHG in the atmosphere are cumulative and the effects to the climatic system are only experienced decades and centuries after the emissions were created. Even in the event of a complete cessation of emissions in the near future, global warming would still remain constant for centuries, representing a ‘substantial multi-century climate change commitment created by past, present and future emissions of CO2’.14

Therefore, a large percentage of climate change is already irreversible and will continue throughout the late twenty-first century and beyond, including the increase in surface temperatures and the heat transfer from the ocean surface to lower depths.15

2.1    Global Emissions Trends

Historically, the developed countries have been responsible for the vast majority of the GHG emissions increases that the world has experienced since the years prior to the industrial revolution. In the 1970s, developed countries were emitting approximately two-thirds of global emissions.16 This trend only started to shift in the twenty-first century, with the reduction in the energy-intensity of big economies, such as the United States (US).

In 2013, the developed countries accounted for approximately 40 per cent of global emissions, while the developing countries (including transitional economies) emitted 60 per cent of the global GHGs.17 At the forefront of this increase are China and India, followed by Indonesia and Brazil, countries which are ‘at stages of development in which growth is highly energy-intensive’.18 In 2013, China, alone, was responsible for 60 per cent of the global coal consumed in industry.19

Emissions in developing countries have increased about eight times faster than those in the developed countries,20 with projections for developing countries to contribute approximately 70 per cent of the global ‘business as usual’ emissions by 2030.21

China’s emissions growth levels since 2000 are larger than the total level of emissions in 2012 of the other BRICS (Brazil, Russia, India, China, South Africa) countries combined. Olivier, Janssens-Maenhout and Peters reported that ‘the increases in China and India caused by far the largest increase in global emissions of 1.0 billion tonnes in 2011’.22 In contrast, the majority of other developing countries contributed very little to global GHG emissions.23

However, China is undergoing a major structural transformation, with focus on sustainability, and GHG emissions from energy are expected to peak before 2025, at least five years before its international commitment to peak emissions around 2030.24

A recent slowdown in global CO2 emissions from energy suggests that peaking GHG emissions in the next decade is still possible.25 Still, there is much yet to be done and any serious attempt to stabilise the global temperature increase at 2°C above pre-industrial levels will necessarily involve large contributions from the highest emitters, including the developed countries and transitional developing countries such as China and India, combined with substantial contributions from other countries.

3.    THE PARIS AGREEMENT

In 1994, a near-universal assembly of countries under the auspices of the United Nations Framework Convention on Climate Change (UNFCCC)26 recognised that the increasing concentration of GHG in the atmosphere from anthropogenic sources is causing climate change and its adverse effects are a common concern for humankind. Parties agreed for the first time in 2009 that the increase in global temperature should be below 2oC above pre-industrial temperature.27

Paradoxically, the same nations have failed for two decades to achieve an effective, legally binding agreement to reduce global GHG emissions. The Kyoto Protocol formalised the strict divide between developed and developing countries.28 The developing countries justified this position on the basis of historical emissions and the principle of common but differentiated responsibilities.29 However, the rigid division impacted on the viability of an effective second commitment period of the Kyoto Protocol, and resulted in the impasse at Copenhagen.30

Over 20 years after the creation of the UNFCCC, at the 21st Conference of the Parties (COP21) in 2015, the Parties reached a historical agreement, known as the Paris Agreement.31 The Paris Agreement aims to hold the increase in the global average temperature to below 2°C above pre-industrial levels. Furthermore, the Parties agree to pursue efforts to limit the temperature increase to 1.5°C above pre-industrial levels.

In order to reach this goal, 195 countries will communicate their intended nationally determined contribution (INDCs), with the exception of least developed countries and small island developing States, which will communicate their strategies, plans and actions for low GHG development. Developed countries have also agreed to finance at least USD 100 billion per year, to meet the needs and priorities of developing countries.

The model for international cooperation adopted by the Paris Agreement is based on fragmented action that reflects national circumstances, with leadership expected to be taken by Parties with the greatest responsibility and highest capacity. Thus, the common but differentiated responsibility principle has been reframed in a way that ensures universal participation while respecting local differences. The Paris Agreement opened for signature on 22 April 2016 and entered into force on 4 November 2016. It has been ratified by 139 Parties of 197 Parties to the UNFCCC.32

3.1    Domestic Climate Change Policies to Meet INDCs

A great effort is now required from all Parties who have communicated their INDCs to adopt policy instruments at the domestic level that will lead to cost-effective GHG emission reductions. The past decades have seen a range of both traditional (non-market-based) and relatively new (market-based) policy instruments being implemented in several jurisdictions to mitigate climate change. Approaches to deal with externalities include, among others, systems for environmental liability,33 taxation34 and cap-and-trade schemes.35

Due to the complexity of climate change and the limitations of a single instrument to promote the internalisation of emissions costs by polluters, it is likely that cost-effective climate change mitigation will require a mix of one or more market-based instrument combined with non-market forms of environmental regulation.36 Carbon taxes and ETSs are occupying an increasing space in this policy mix as ideal instruments to address the climate change externality in a cost-effective way.37 However, the devil is in the detail. Whether or not these instruments will fulfil their intended outcomes depends on how these schemes are designed.

3.2    Carbon Taxes and the Challenges of Determining the Marginal Cost of GHG Emissions

In the 1960s, Pigou proposed that taxes fixed at the amount corresponding to a negative externality, can equalise the private and social marginal costs, leading to the internalisation of the costs by the economic agent.38 In theory, an optimal pigouvian tax is set at a rate that is equal to the marginal social damage generated by a particular activity, leading to a Pareto-efficient level of activity.39 However, in practice, estimating the marginal net damage produced by polluters can be challenging.40

As the value of marginal net damages is often unknown, Baumol and Oats propose an alternative approach, consisting of the selection of (somewhat arbitrary) standards for an acceptable environment, followed by the imposition of taxes at sufficient levels to achieve these standards.41 This approach provides practical feasibility to the use of carbon taxes as a regulatory approach for climate change mitigation.42

Generally, carbon taxes set a fixed price for every tonne of carbon dioxide equivalent (CO2-e)43 emitted by an activity during a specified amount of time, which might be the respective financial year. One of the key criticisms to carbon taxes when comparing it with ETSs is that a carbon tax is not connected to a mandatory emission cap or reduction target. While there is uncertainty regarding the exact levels of emissions reductions, participants know the cost of carbon well ahead, providing predictability for production.

In theory, emissions reductions should occur as long as the tax rate is higher than the marginal abatement costs; this is considered to be the sufficient level to achieve the desired standard.44 A strong tax rate is regarded as capable of incentivising businesses to adopt cleaner technology, invest in abatement projects or reduce production.45

In 2014, the World Bank estimated that, in order to limit global warming to 2.5°C above pre-industrial levels at the least cost, a global CO2 price should be set at approximately US$35 per ton or, alternatively, start at approximately US$30 per ton (in 2014 dollars) in 2020, and then rise at around 5 per cent per year.46 The World Bank report accounted at the time for 11 national carbon taxes47 and one subnational carbon tax48 already implemented worldwide.49

Out of those, currently only four are set at levels consistent with the World Bank’s threshold: the Swedish carbon tax (US$131/tCO2), the Swiss carbon tax (US$86/tCO2), the Norwegian carbon tax (US$52/tCO2) and the Finnish carbon tax (US$60/tCO2).50 Still, most emissions-intensive sectors participating in the European Union Emissions Trading Scheme (EU ETS)51 are exempt from these carbon taxes, in order to avoid a double carbon-pricing burden, that is, double taxation on the same amount of GHGs emitted.52 As the following chapters will reveal, it turns out that these sectors are also, to a great extent, protected from a carbon price under the EU ETS.53 This indicates the complexities of the market instruments and signals the failure of these regulatory instruments, to date, to properly ensure that the climate change externalities are internalised by a number of ‘winners’, who have consistently benefitted from double carbon pricing exemptions.

Carbon taxes often present lower administration and compliance costs compared to ETSs, as the main institutional arrangements necessary to implement and enforce a new tax are already in place under existing taxation regimes. However, stakeholders tend to prefer regulation over taxation, as the former is more susceptible to pressures from lobbying.

International and/or supranational taxes have their own additional challenges. To illustrate, the difficulties in approving a Community-wide energy tax proposed by the EU Commission tax in the 1990s – considering that fiscal measures require unanimous approved by member states – was a decisive factor in the adoption of the EU ETS, which entered into force in 2005.54 Unlike a linked ETS, an international carbon tax would raise concerns about the possible implications to countries’ sovereignty.

3.3    Emissions Trading Schemes

The atmosphere and the climate system are common pool resources, or commons. That is, these are assets ‘that can be used by everyone, for almost any purpose, at zero cost’.55 The issue of continuous depletion of commons was forcefully depicted in ‘The Tragedy of the Commons’, where Hardin stressed that circumstances of non-ownership lead to the inexorable outcome of ruin or overuse.56

Dales analysed this issue in the context of the use of natural water systems in North America57 and suggested an explicit ownership system for water management, as an alternative to the general approach of a shadow prices system. Tradable permits schemes have since been generally regarded as an efficient mechanism to deal with water pollution, distribute fishing or hunting quotas, manage wetlands, incentivise waste recycling, and control deforestation, among others.58

An early example of such a mechanism is the US sulphur dioxide (SO2) tradable permits scheme.59 This nation-wide tradable permits scheme was adopted in 1995 to reduce SO2 emissions from fossil-fuel burning power plants. It is one of several measures in the US to reduce emissions that are connected to acid rain, acid snow, and/or acid dust.60

ETSs are tradable permits schemes aimed at limiting GHG emissions and are also known as Emissions Trading Schemes or Emissions Trading Systems (ETSs). Under an ETS, a central authority, which may be a government, supranational authority or another delegated agent, sets a limit or cap on the amount of GHGs that may be emitted by a specified number of polluters (participants). Explicit rights to emit CO2-e (emissions permits or allowances) are created at a level that corresponds to the respective cap, with each permit representing one tonne of CO2-e, and distributed among participants.61

The ETS market does not develop itself naturally as a result of supply and demand. ETSs are created through extensive government regulation aimed at restricting the right to emit GHGs.62 Initially, the central authority will determine both the demand and supply of this market. The demand for permits is established by specifying the liable sectors participating in the market, while the supply is determined by the cap-setting.63

This artificial creation of a new set of intangible assets is necessarily accompanied by rules on how these assets are issued and traded. Allocation means the issue and distribution of emissions permits to participants, which may take place through either a remunerated transaction (auctioning or for a fixed charge) or a non-remunerated transaction. The free allocation of emissions permits based on historical emission levels is commonly known as ‘grandfathering’.64 While auctioning is the preferred approach as it avoids the political processes of deciding how to allocate free permits to different sectors, and issues to do with subsidisation and competition, free allocation is the most common method.65

Once permits are allocated to participants, they can be traded in the market, privately or through an established market platform. From this point, the carbon market should theoretically work like any other market.66

Participants in an ETS have the choice between reducing emissions, which they will do up to the point where the investment cost equals the permit price, or buy a permit. Where mitigation costs exceed the emissions permit market price, businesses may cover their liability by purchasing the extra emissions permits in the market. Therefore, not only is emissions reduction achieved in an economically efficient manner, but polluters are being continually incentivised to innovate by adopting cleaner technology.67

At the end of the given financial year, each participant must hold one emissions permit per tonne of CO2-e emitted. Participants under the ETS will ‘sell permits as long as their market price exceeds their marginal abatement costs; conversely, they will buy permits as long as their market price falls short of their marginal abatement costs’.68 Where the emissions cap is properly reduced over time, progressive emissions reductions towards medium- and long-term emissions reduction trajectories can be achieved.

While, in theory, ETSs have the potential to generate revenue through the auctioning of emissions permits, similarly to a carbon tax, in practice, due to their vulnerability to political pressures and general concerns with carbon leakage,69 national ETSs have worked with a large percentage of permits allocated free of cost to liable entities in the early stages of implementation.70

The model described above is the most common among existing schemes. As new ETSs are implemented worldwide, with more creative frameworks developed to deal with the practical issues,71 the perceived distinctions between carbon taxes and ETSs are becoming less noticeable and the political polarity less acute.72 Stavins demonstrates that, depending on how these policy instruments are designed, they may resemble each other.73

One of the case studies analysed in Chapter 3 is the Australian Carbon Pricing Mechanism (AUS CPM). The scheme was designed as a ‘hybrid model’, with a three-year period in which permits would be sold for a fixed price in order to provide price certainty and stability during the first years of the scheme.

Other modalities of ETSs also include ‘baseline and credit’ schemes, where polluters must reduce emissions below a baseline level (rather than an emissions cap) which may be achieved through the use of offset credits from GHG abatement projects. For example, following the repeal of the AUS CPM, the Federal Government has proposed a baseline and credit mechanism, also known as a ‘safeguard mechanism’.74 The baseline will reflect the highest level of reported emissions for a facility over the historical period 2009–10 to 2013–14. Businesses will not pay a carbon price unless – and to the extent in which – their emissions exceed the baseline levels. However, with such low ambition levels, very little can be expected in terms of emissions reductions.

4.    THE STRUCTURE OF THIS BOOK

4.1    Chapter 2 Carbon Leakage and Industry Assistance

Chapter 2 discusses the theory of carbon leakage and competitiveness concerns in relation to emissions-intensive and trade-exposed sectors participating in ETSs. Two measures are often considered as alternatives to avoid competitiveness issues and carbon leakage from the implementation of ETSs, that is, border carbon adjustments (BCA) and the free of cost allocation of permits. While BCAs are not very popular, it is possible that, due to the adoption of free allocation of permits, carbon-pricing schemes have been failing to implement the Polluter Pays Principle.

4.2    Chapter 3 Real World Emissions Trading Schemes: Challenges and Lessons Learnt

Chapter 3 introduces the case studies, providing the reader with a basic understanding of the key elements of each ETS, such as the coverages, emissions caps, governance regimes and links with other schemes. It also reflects on the main achievements and challenges particular to each scheme.

For example, the EU ETS has experienced significant problems with surplus emissions permits, and recent reforms are attempting to provide a much-needed stability to the scheme to enable it to reach its goal of promoting cost-efficient emissions reduction.

Australia has attracted the undesirable distinction of being the only jurisdiction to discard a mandatory carbon price and to move away from its key climate change policy. Despite its short life, the AUS CPM remains a relevant case to be studied due to the innovative framework adopted to prevent issues such as price volatility during the first years of the scheme, building on the lessons learned from the EU ETS.

This promising model did not survive the contentious political debate in the country, which exacerbated misunderstandings about the nature of the scheme (carbon tax or emissions trading scheme), and its impacts on the international competitiveness of the domestic energy-intensive trade-exposed (EITE) industries.

Finally, the NZ ETS is the most distinctive of the three schemes, due greatly to the singularity of New Zealand’s economy. The scheme has been resilient and stable, despite significant changes in the country’s approach towards international climate change negotiations.

4.3    Chapter 4 Reconsidering the Eligibility Thresholds for the Free Allocation of Permits

Chapter 4 focuses on carbon leakage and free allocation as an industry assistance measure. It develops the theory of carbon leakage and the parameters for economics research.

This chapter argues that jurisdictions linking independent ETSs would benefit from harmonising the free allocation methodologies in order to minimise the competitiveness concerns and to reduce the trade distortions and other impacts inherent to the free allocation system. It proposes a review of the general thresholds in order to assess the exposures to carbon leakage so as to improve the effectiveness and fairness of the ETSs. The two final key recommendations are the removal of the sole trade-exposure factor from the quantitative assessment in the EU ETS and increasing the stringency of all the thresholds to determine emissions-intensity.

4.4    Chapter 5 Free Allocation and Linking Emissions Trading Schemes: The Case for Harmonisation

Chapter 5 examines aspects of the design of the free-allocation methods that might lead to competitiveness distortions. It reviews the data from the first and second trading periods of the EU ETS, when the different Member States had their own separate National Allocation Plans (NAPs).

In the EU ETS context, the different allocation rules generated concerns over the competitiveness of industries subject to the different NAPs. By analogy, key design elements in the legal framework of the EU ETS and the AUS CPM would be problematic from a trade perspective. For example, the uneven benchmarks and output-based allocation versus the historical emissions data, which could result in a significant variation of the allocation levels, with the potential to impact trade and distort competition between liable installations under the independent ETSs.

4.5    Chapter 6 The Free Allocation of Permits and the WTO Discipline of Subsidies

The literature has extensively analysed the legal implications of the free allocation system from the perspective of the WTO laws on subsidies.75 However, the absence of an interdisciplinary approach resulted in a lack of detailed understanding of the functioning of the ETSs, the free allocation methodology and the economic aspects of distributing permits free of cost. Chapter 6 closes the gap between the doctrinal analysis of the SCM Agreement, the legal frameworks of these schemes in practice and the economic research data.

Chapter 6 concludes that the free allocation of permits is a subsidy in accordance with the definition in the SCM Agreement and analyses whether it could be a prohibited or actionable subsidy, according to the different thresholds for allocation and the levels of assistance set by each scheme.

In relation to the EU ETS sole emissions-intensity threshold, it seems to have been included in the Directive in order to perpetuate a targeted subsidisation of a small number of enterprises from the cement sector, which were already being favoured by the decentralised NAPs during the first and second trading periods. As such, it is an actionable subsidy and may be challenged if it causes adverse effects on other WTO Members. I recommend the removal of the sole emissions-intensity factor from the EU ETS quantitative assessment. The recent proposal for a directive to amend the EU ETS76 is partially in line with this recommendation.

4.6    Chapter 7 Summary of the Main Findings

Chapter 7 presents a summarised version of the key findings of this book.

While the EU ETS, the AUS CPM and the NZ ETS have all subsidised emissions-intensive industries, the consequences of this regulatory model have, in general, escaped the scrutiny of legal scholars. The book closes with an important message, that despite formally participating in ETSs, many heavy polluters are not yet paying their fair share of the carbon price.

5.    FINAL REMARKS

Paying the Carbon Price analyses the free allocation of permits methodologies in the ETSs. It demonstrates that the free allocation of permits discriminates between the liable entities under the ETSs, and that it may have undesirable trade impacts. Furthermore, the free allocation of permits may be deemed to be a subsidy subject to the discipline of the SCM Agreement. In this case, affected countries may bring a dispute to the WTO DSB.

The dual focuses of the book determined the choice of an interdisciplinary approach, one which bridged the economic data and the legal interpretations of the SCM Agreement, based on the framework of the ETSs in the case studies.

It should be noted that, between the commencement of the writing of this book in 2011 and its completion in 2016, a number of significant changes in relation to climate change regulations have taken place in the jurisdictions where the case studies were originated. In the first year of writing, the Clean Energy Bills were introduced in Australia, featuring a market instrument known as the Carbon Pricing Mechanism (AUS CPM) as its key instrument for achieving GHG emissions reductions.

The Australian Clean Energy package was approved and a linkage between the AUS CPM and the EU ETS was announced. The AUS CPM functioned for two years and, unfortunately, this work was concluded after the repeal of the Carbon Pricing Mechanism was enacted.

Both the EU ETS and the NZ ETS have also been subject to several amendments. The proposal for amending the EU ETS Directive, discussed in Chapter 3, is of particular importance. In terms of the international negotiations on climate change mitigation, there are reasons for renewed hope due to the entering into force of the Paris Agreement.

1   Elena Aydos, ‘Tributação Ambiental no Brasil: Fundamentos e Perspectivas' (2010) <http://www.egov.ufsc.br/portal/sites/default/files/anexos/33953-44734-1-PB.pdf>.

2   See also Harro Van Asselt and Thomas Brewer, ‘Addressing competitiveness and leakage concerns in climate policy: An analysis of border adjustment measures in the US and the EU' (2010) 38 (15/09/09) Energy Policy 42.

3   European Environment Agency, ‘Market-based instruments for environmental policy in Europe' (European Environment Agency, 2005) 9. According to the European Environment Agency ‘there is no evidence that existing economic instruments have a major adverse effect on competitiveness at the macro and sector level’.

4   Sanja Bogojevic, ‘Ending the Honeymoon: Deconstructing Emissions Trading Discourses' (2009) 21(3) Journal of Environmental Law 443.

5   Intergovernmental Panel on Climate Change <http://www.ipcc.ch/>. The IPCC is a scientific body established in 1988 under the auspices of the United Nations (UN) with the aim of providing ‘a clear scientific view on the current state of knowledge in climate change and its potential environmental and socio-economic impacts.’ While the IPCC reviews and assesses scientific, technical and socio-economic information produced worldwide, it does not conduct any direct research and/or monitor climate related data or parameters. The IPCC work is conducted by three Working Groups (WGI, WGII and WGIII), coordinated and administrated by a Technical Support Unit (TSU). The WGI assesses the physical scientific aspects of the climate system and climate change. The WGII assesses the vulnerability of socio-economic and natural systems to climate change, consequences of climate change and adaptation options. The WG III assesses mitigation options, including emissions reductions and removals, adopting a solution-oriented approach. Between 1988 and 2015 the IPCC released five Assessment Reports (AR) of the state of knowledge on climate change.

6   Intergovernmental Panel on Climate Change, ‘Climate Change 2013: The Physical Science Basis – Technical Summary' (2013) <www.ipcc.ch>.

7   Ibid.

8   Ibid. Also see Intergovernmental Panel on Climate Change, ‘Climate Change 2013: The Physical Science Basis – Summary for Policymakers' (2013) <http://www.ipcc.ch/>. Note that ‘virtually certain’ indicates a 99–100 per cent assessed likelihood of the outcome or result.

9   Intergovernmental Panel on Climate Change, above n 8.

10 There are seven main Greenhouse gases (GHGs) in the atmosphere: Carbon dioxide (CO2), Methane (CH4), Nitrous oxide (N2O), Hydrofluorocarbons (HFCs), Perfluorocarbons (PFCs), Sulphur hexafluoride (SF6) and Nitrogen trifluoride (NF3). The first three GHGs occur naturally in the atmosphere, while the others are synthetic. Natural (non-anthropogenic) GHGs are essential to life in this planet. They absorb solar radiation and keep the earth warm enough to support life. However, human activities such as energy production, land clearing and agriculture have increased the volume and variety of GHGs present in the atmosphere, with severe impacts to the climate system.

11 Intergovernmental Panel on Climate Change, above n 8, 2.

12 Ibid., 7. CO2 concentrations have increased from 280 parts per million (ppm) in pre-industrial times to over 400 ppm in 2013.

13 Intergovernmental Panel on Climate Change, above n 6; International Energy Agency, ‘Key Trends in CO2 Emissions' (2015); Rosemary Lyster and Adrian Bradbrook, Energy Law and the Environment (Cambridge University Press, 2006) 51.

14 Intergovernmental Panel on Climate Change, above n 8; Intergovernmental Panel on Climate Change, above n 6, 61.

15 Intergovernmental Panel on Climate Change, above n 8, 20.

16 Ross Garnaut, The Garnaut Climate Change Review: Final Report (Cambridge University Press, 2008) 55.

17 International Energy Agency, ‘Redrawing the Energy-Climate Map: World Energy Outlook Special Report' (IEA, OECD, 2013) 22, 13.

18 Ross Garnaut, ‘Garnaut Climate Change Review Update: Global Emissions Trend' (Commonwealth of Australia, 2011) 15. Despite the issues with the increasing emissions levels, the current stages of development of the large non-OECD countries are promoting a much needed ‘improvement in living standards in the regions that had been home to the most desperate and deeply entrenched development problems, including in most of Africa’ and the ‘augmentation of opportunity for better lives for most of the world’s people’: at 7.

19 International Energy Agency, above n 17, 33.

20 Garnaut, above n 16, 56.

21 Garnaut, above n 18, 24–8.

22 International Energy Agency, above n 17.

23 Jos Olivier, Greet Janssens-Maenhout and Jeroen Peters, ‘Trends in global co2 emissions: 2012 Report' (The Hague: PBL Netherlands Environmental Assessment Agency; Ispra: Joint Research Centre, 2012) <http://www.pbl.nl/en/publications/2012/trends-in-gobal-co2-emmissions-2012-report> 10.

24 Fergus Green and Nicholas Stern, ‘China’s changing economy: implications for its carbon dioxide emissions' (2016) Climate Policy 1.

25 International Energy Agency, IEA Finds CO2 Emissions Flat for Third Straight Year Even as Global Economy Grew in 2016 (17 March 2017) <https://www.iea.org/newsroom/news/2017/march/iea-finds-co2-emissions-flat-for-third-straight-year-even-as-global-economy-grew.html>; ibid.

26 United Nations Framework Convention on Climate Change, opened for signature 9 May 1992, 1771 UNTS 107 (entered into force 21 March 1994) (‘UNFCCC’).

27 Conference of the Parties, United Nations Framework Convention on Climate Change, Report of the Conference of the Parties on Its Fifteenth Session, Held in Copenhagen from 7 to 19 December 2009 – Addendum – Part Two: Action taken by the Conference of the Parties at Its Fifteenth Session, UN Doc FCCC/CP/2009/11/Add.1 (30 March 2010) (‘COP 15’) para 1.

28 Kyoto Protocol to the United Nations Framework Convention on Climate Change, opened for signature 11 December 1997, 2303 UNTS 148 (entered into force 16 February 2005).

29 On the principle of common but differentiated responsibilities, see Christopher D. Stone, ‘Common but Differentiated Responsibilities in International Law' (2004) 98(2) The American Journal of International Law 276.

30 COP 15, above n 27.

31 Paris Agreement to the United Nations Framework Convention on Climate Change, opened for signature 26 April 2016, UNTS I-54113 (entered into force4 November 2016).

32 Number of countries that ratified the Paris Agreement by March 2017.

33 Steve Shavell, Economic Analysis of Accident Law (Harvard University Press, 1987); Guido Calabresi, The Costs of Accidents. A Legal and Economic Analysis (Yale University Press, 1970).

34 Arthur Pigou, The Economics of Welfare (Macmillan, 4th edn, 1962).

35 John H. Dales, ‘Land, Water and Ownership' (1968) 1(4) The Canadian Journal of Economics 791. For a comprehensive analysis and comparison of a range of command and control and market-based instruments, see Stefan Weishaar, Emissions Trading Design (Edward Elgar Publishing, 2014) 10–29.

36 OECD, The Economics of Climate Change Mitigation: Policies and Options for Global Action Beyond 2012 (2009) 23.

37 World Bank Group, ECOFYS and Vivid Economics, ‘State and Trends of Carbon Pricing' (2016); European Commission, ‘EU action against climate change. EU emissions trading – an open scheme promoting global innovation' (2004). In 2004, the European Commission predicted that the cost of meeting its Kyoto target through the implementation of the EU ETS would be between EUR 2.9 billion and EUR 3.7 billion annually, which is equivalent to less than 0.1 per cent of the EU’s GDP. In contrast, the cost to meet the same levels of emission reductions in the absence of the EU ETS could reach up to EUR 6.8 billion a year. However, see Robert Stavins, ‘The problem of the Commons: Still Unsettled after 100 Years' (2011) 101 American Economic Review 8170, 95. Stavins demonstrated that although aggregate social costs are minimised by the use of market instruments, these systems can be more costly for individual firms, which will incur the abatement cost and still pay taxes on residual emissions.

38 Pigou, above n 35; Janet E. Milne and Mikael Skou Andersen, ‘Introduction to Environmental Taxation Concepts and Research' in Janet E. Milne and Mikael Skou Andersen (eds), Handbook of Research on Environmental Taxation (Edward Elgar, 2012) 153, 17.

39 Pigou, ibid.; William J. Baumol and Wallace E. Oates, ‘The Use of Standards and Prices for Protection of the Environment' (1971) 73(1) The Swedish Journal of Economics 42, 43. Baumol and Oates explained that:The optimal tax level on an externality generating activity is not equal to the marginal net damage it generates initially, but rather to the damage it would cause if the level of the activity had been adjusted to its optimal level. (…) If there is little hope of estimating the damage that is currently generated, how much less likely it is that we can evaluate the damage that would occur in an optimal world which we have never experienced or even described in quantitative terms.

40 Ibid., 43. Baumol and Oates described the difficulties in measuring marginal social damage:However, it is hard to be sanguine about the availability in the foreseeable future of a comprehensive body of statistics reporting the marginal net damage of the various externality-generating activities in the economy. The number of activities involved and the number of persons affected by them are so great that on this score alone the task assumes Herculean proportions. Add to this the intangible nature of many of the most important consequences – the damage to health, the aesthetic costs – and the difficulty of determining a money equivalent for marginal net damage becomes even more apparent.In the case of carbon taxes, the intricacies become even further aggravated by the complexities of climate change.

41 Ibid., 44–45.

42 Ibid. The authors recognised that this approach ‘represents what we consider to be as close an approximation as one can generally achieve in practice to the spirit of the Pigouvian tradition’. Also see Milne and Andersen, aboven 38, 18.

43 As explained in Chapter 2, CO2-e is a standard metric used to compare the emissions of different GHGs, expressing the warming influence of a particular GHG on the global climate system, based on the radiative forcing of Carbon Dioxide (CO2).

44 Claudia Kettner, Daniela Kletzan-Slamanig and Angela Köppl, ‘The EU Emission Trading Scheme: is there a need for price stabilization?' in Larry Kreiser et al (eds), Environmental Taxation and Green Fiscal Reform, Critical Issues in Environmental Taxation (Edward Elgar, 2014) vol XIV, 113, 114.

45 Mikael Skou Andersen, ‘Environmental and Economic Implications of Taxing and Trading Carbon: Some European Experiences' in The Reality of Carbon Taxes in the 21st Century (Vermont Law School 2008) 64–65. Andersen suggested:One expects carbon-energy taxes to provide incentives in two directions: a demand effect, whereby the demand for energy is reduced as a result of the price-increase caused by the tax; and a substitution effect, whereby carbon-fuels are substituted by low-carbon or carbon neutral fuels to the extent that these are available at lower costs. (…) In other words, we would expect to see changes in energy and carbon intensity as a result of carbon pricing.

46 World Bank Group and ECOFYS, ‘State and Trends of Carbon Pricing' (2014) 4, 32. Most carbon taxes currently in place are currently below this level, with the exception of the Finnish carbon tax (US$48/tCO2), the Swiss and Norwegian carbon tax (approximately US$68/tCO2) and the Swedish carbon tax at an impressive US$168/tCO2.

47 Denmark, Finland, France, Iceland, Ireland, Japan, Mexico, Norway, Sweden, Switzerland and the UK.

48 British Colombia.

49 World Bank Group and ECOFYS, above n 46, 25.

50 Group, Ecofys and Economics, above n 37.

51 On the theory underpinning ETSs see below. See further details on the EU ETS in Chapters 4–6.

52 World Bank Group and ECOFYS, above n 46, 77.

53 See Chapters 4–7.

54 Jean-Philippe Barde and Olivier Godard, ‘Economic Principles of Environmental Fiscal Reform' in Janet E. Milne and Mikael S. Andersen (eds), Handbook of Research on Environmental Taxation (Edward Elgar, 2012) 33, 47; Denny Ellerman, Frank Convery and Christian De Perthuis, Pricing Carbon: the European Union Emissions Trading Scheme (Frank J. Convery, Christian de Perthuis and Emilie Alberola trans, Cambridge University Press, 2010) 50, 58. For further details on the EU ETS, see Chapter 4.

55 Dales, above n 35, 795.

56 Garret Hardin, ‘The Tragedy of the Commons' (1968) 162 Science 1243.

57 Dales, above n 35.

58 OECD and IEA, ‘Act Locally, Trade Globally: Emissions Trading for Climate Policy' (2005).

59 Established as a result of the enactment of the Clean Air Act Amendments of 1990, 42 USC (1990).

60 For further details on the SO2 tradable permits scheme see Richard Schmalensee and Robert Stavins, ‘The SO2 Allowance Trading System: The Ironic History of a Grand Policy Experiment' (MIT Center for Energy and Environmental Policy Research, 2012). Also see Denny Ellerman, ‘Ex-post evaluation of tradable permits: the U.S. SO2 cap-and-trade program' (CEEPR, 2003).

61 Legal recognition of allowances as property rights varies according to jurisdiction.

62 This feature may have consequences for International Economic Law when determining the market baseline in a benefit analysis related to subsidies. For further discussion on this topic, see Chapter 7.

63 Joseph Kruger, Wallace Oates and William Pizer, ‘Decentralization in the EU Emissions Trading Scheme and Lessons for Global Policy' (2007) 1(1) Review of Environmental Economics and Policy 112.

64 Ellerman, Convery and Perthuis, above n 54.

65 European Commission, ‘Green Paper on Greenhouse Gas Emissions Trading within the European Union' (2000) 18.

66 Christian Egenhofer et al, ‘The EU Emissions Trading System and Climate Policy towards 2050: Real incentives to reduce emissions and drive innovation?' (CEPS, 2011) 3.

67 Stephen Smith, ‘Environmentally Related Taxes and Tradable Permit Systems in Practice' (OECD, 2007) 3, 7.

68 OECD, above n 36.

69 It is not the object of the thesis to exhaust climate policy issues related to carbon taxes. However, the issue of carbon leakage, which is a common issue to carbon taxes and ETSs, is further explained in Chapter 4.

70 Tatiana Falcão, ‘Providing Environmental Taxes with an Environmental Purpose’ in Larry Kreiser et al (eds), Market Based Instruments: National Experiences in Environmental Sustainability (Edward Elgar, 2013) 4158. Falcão demonstrates that ‘the problem derived from this mechanism [ETS] is that (so far) governments have not been able to consistently receive cash funds they need in order to finance green actions (…)’.

71 For example, see the hybrid structure of the former Australian Carbon Pricing Mechanism in Chapter 3.

72 World Bank Group and ECOFYS, above n 46, 29.

73 Stavins, above n 38. Stavins pointed out that: ‘If allowances are auctioned, a cap-and-trade system looks much like a carbon tax from the perspective of regulated firms. Likewise, if tax revenues are refunded in particular ways, a carbon tax can resemble cap and trade with free allowances.’

74 Australian Government, The Emissions Reduction Fund: The Safeguard Mechanism Department of Environment <https://www.environment.gov.au/climate-change/emissions-reduction-fund/publications/factsheet-erf-safeguard-mechanism>; National Greenhouse and Energy Reporting (Safeguard Mechanism) Rule 2015 (Cth); National Greenhouse and Energy Reporting Amendment (2015 Measures No. 2) Regulation 2015 (Cth); National Greenhouse and Energy Reporting (Audit) Amendment Determination 2015 (No. 1).

75 See, e.g., James Windon, ‘The Allocation of Free Emissions Units and The WTO Subsidies Agreement' (2009) 41 Georgetown Journal of International Law 1898; Felicity Deane, Emissions Trading and WTO Law: A Global Analysis (Edward Elgar Publishing, 2015) 8; Lauren Henschke, ‘Going it Alone on Climate Change. A New Challenge to WTO Subsidies Disciplines: Are Subsidies in Support of Emissions Reductions Schemes Permissible Under the WTO' (2012) 11(1) World Trade Review 27.

76 Proposal 2015/148 (COD) for a Directive of the European Parliament and of the Council Amending Directive 2003/87/EC to enhance cost-effective emission reductions and low-carbon investments [2015].