Cooperate Management Strategy
under Emissions Market

Junko Ogawa
Environmental Group, Institute of Energy Economics, Japan

1. Introduction

Recently, the discussions for international and domestic frameworks for greenhouse gas emission reductions have weighed its focus on emissions trading system. At present, however, there have been no modalities and procedures determined for the implementation of international emissions trading under the Kyoto Protocol(1), nor any single country that has experienced the introduction of GHGs emission trading system as an option of their national emission control measures portfolio(2). Therefore, the current discussion on "emissions trading" is mainly about how to design the modalities of the system, and not about what kind of market strategy options are available after the introduction of emissions trading regulatory framework. This paper explores how each corporation subjected to regulatory framework can utilize and benefit from emissions market, using available experiences of the sulfur dioxide (SO2) emissions allowance trading programme implemented and ongoing in the USA, and the result of European simulation study for the trading of carbon dioxide (CO2) emissions and electricity.

2. Characteristics of the climate change mitigation measures

2.1 International trend

As an international framework to address climate change issue, the United Nations Framework Convention on Climate Change (UNFCCC) was adopted in 1992, and the "Kyoto Protocol" was signed (but not yet ratified) in its third Session of the Conference of the Parties (COP 3) held at the end of the year 1997. The major outcomes of the Protocol are: (i) setting the commitment of quantified targets for GHGs emissions for industrialized countries, and (ii) introduction of flexible mechanisms (so-called Kyoto Mechanisms) as powerful tools to comply with the commitments. Quantified commitments specified in the Kyoto Protocol are applicable for 39 developed countries (most OECD member countries and countries in economic transition) listed in the Annex B of the Protocol. The Protocol further stipulates that each Annex B country must comply with the emissions target imposed upon that country during the 5-year period of 2008 to 2012. On contrary to such international framework development, some countries may have their CO2 emission estimates for 2010 significantly surpassing their targets.(3) It will be extremely difficult for such countries to comply with the targets bound by the Protocol using domestic reduction measures alone.(4) Especially for those countries that will not be able to comply with the targets by domestic measures must procure necessary emission allowances or credits from other countries in order to comply with the targets.

"Kyoto Mechanisms," which are means to procure emission credits, provide economically efficient win-win options through market principles to minimize overall emission reduction costs. To be specific, the Mechanisms contain international emissions trading (emission allowance trades between industrialized countries), Joint Implementation (emission reduction units transfer through joint emission reduction projects between industrialized countries), and Clean Development Mechanism (certified emission reduction transfer through joint emission reduction projects between developed and developing countries). In the process of establishing the international framework for these instruments, the focus is now shifted to emissions trading as a major internationally flexible measure to comply with Kyoto commitments for industrialized countries.

2.2 Domestic measures

As the next step beyond the target setting in an international framework, each country needs to examine the options portfolio to meet the Kyoto target. In addition to the use of international measures such as "Kyoto Mechanisms", each Party must fulfill its emission reduction target by implementing domestic measures, as well. Mainly the domestic measures may include cap-and-trade type emissions trading, taxes/levies on energy use, regulation to promote energy savings (to improve emission intensity), subsidies for energy saving, voluntary agreements, etc.

Japan's emission reduction target is 6% reduction during 2008-2012 in average against 1990 level. Cap-and-trade type domestic emissions trading is, if used appropriately, a way to ensure the compliance of such target, since it keeps the cap of emissions in principle. Other domestic measures do not guarantee the targeted emissions.(5)In view of securing the targeted reductions, cap-and-trade type emission trading can have a significant role.

3. Mechanisms of Emissions Trading

Emissions trading is a system, in which market mechanism is used to meet the emission cap automatically, in principle.(6) This section outlines the mechanism of emissions trading briefly as well as the reason why those entities subjected to a regulation wish to participate in emissions trading regime, if they have option to do so.

First of all, every trade transaction will not take place unless both sides of a transaction, a buyer and a seller, are to have mutual benefits through such transaction. So, each entity will participate in emissions "trading" when that entity can find potential merits, if it is compared with the case without trading.

Emissions trading system will effectively function where each participating entity has different cost to reduce emissions.(7) For example, a company with less cost to reduce CO2 emissions per unit can find benefits from the sales of such excess reductions to another company. A company with higher emission reduction cost, in turn, may be able to decrease the overall cost to meet the target by purchasing the permit outside of the company (see Fig. 1). In other words, a company can find out other companies' marginal cost of emission reductions from the price tag on emission permit. This company can then determine how much in-house measure to take and how much emission permit to buy/sell for what extent. Then, the company can review the best and most rational combination of in-house reduction measures and emission permit purchase.(8)


Fig. 1 Basic concept of cost reduction through emissions trading

[Note] When emission targets are imposed upon a company A and a company B, and if company A is assumed to have the reduction cost of $50/t-CO2, company B is to have $150/t-CO2, and emission credit price is $100/t-CO2, the deal between A and B will provide a benefit of $50/t-CO2 for both parties (emission permit prices are to be negotiated between the companies). Secondly, the cap-and-trade type emissions trading system will enable gross emission control over a broader scope of emission sources. Therefore, the market will likely to realize the various types of low cost options for emission reductions, which have not been covered by conventional regulatory frameworks, upon the discretion of each participating company. As a result, such trading system will be able to warranty to keep the gross emissions within the limits with reduced costs.

4. SO2 emissions allowance trading regime in USA

Next, the actual application of the emission trading system is examined to learn lessons to apply the GHGs emissions trading. A typical case of emissions trading scheme is the cap-and-trade type emission allowance trading scheme for SO2 implemented in the United States. The Acid Rain Programme of USA's EPA (Environmental Protection Agency) started with 263 power generation units(9), and aimed to reduce gross SO2 emissions to 5.5 million ton/year in phase I (1995-1999). Under this SO2 emission allowance trading scheme, every utility company was able to succeed in achieving the 100% compliance of the target,(10) and the allowance trading market have shown significant progress in its development. Therefore, the system may present a good example for designing the future GHGs emissions trading market.

4.1 Lessons learned from the pioneer schemes Since

1980s, EPA introduced systems to control the various air pollutant emissions regionally, by letting the excess emission reductions attained at one emission source to account for the reduction at another emission source. The systems, however, were not well-designed and required frequent revisions and modifications, so that its monetary value of the credit contained some intrinsic uncertainties. Moreover, its high transition costs associated with verification and certification processes resulted in non-liquid system functions. Underdevelopment of monitoring system and time-consuming processes to verify reduction quantities added the reasons for system malfunction. With the extent of uncertainties in the scheme, these emissions trading schemes lost their reliability and ceased to provide clear incentives for participation.

4.2 SO2 Emission Allowance Trading System

From its failed credit-type emissions trading system mentioned above, EPA concluded that emissions market would only function under "a firm system framework with less uncertainties." Therefore, upon designing the SO2 emission trading system, EPA paid particular attention in building a highly reliable system. Because of such consideration, the SO2 allowance trading system has been able to achieve 100% compliance, and succeeded in reducing SO2 emissions from power companies drastically in comparison with their1980 emissions.

What is a firm system that has been a very factor in achieving compliance and building a better-functioned market? First, EPA determined the targeted allowance level on emission cap with some allocation formula to each emission source, and then established strict penalties for non-compliance. In operation, the program has become a highly reliable system by setting an strict monitoring system, and establishing a tracking plan that enables the up-to-date identification of allowance holders and verifies the allowance quantity held and traded. In this programme, targeted companies have had clear incentives to comply with the emission targets. Furthermore, the introduction of flexible mechanisms (such as a banking system) clearly helped to motivate for an active and assertive compliance.

4.3 SO2 Emission Allowance market

Within the framework of this highly reliable program, an "emission allowance" issued in the programme was able to build its credibility, also. The targeted companies actively used the emissions trading to adopt lower cost of emission reduction options, which, in turn, activated the trade in the allowance market. In addition, the openness of allowance market allowed the participation of any parties other than targeted. Admission of broker participation further improved market fluidity. Moreover, active market trade led to the introduction of financial instruments such as derivatives that enabled the participating companies to hedge their risks. These activities further promoted market fluidity, creating a spiral of favorable conditions. With trade intensified, the prices of SO2 emission allowances dropped to around $100-200/ton-SO2, which was considerably lower than prices projected at the initial stage of programme design.(11)


Fig. 2 SO2 Emissions: Trends and Projections

Reference: EPA
[Note] With the acid rain programme, SO2 emissions were reduced in actual values and projections. In relation to the stepped up control level (gross emission cap: dotted line), SO2 emission reductions accelerated after the introduction of the Programme, and by 1998 recorded 30% greater reductions than the mandate. The programme allows the banking of unused allowances for use during Phase II (after 2000) with strengthened regulation, so the market has incentives to choose smooth trajectory to attain more cost-effective reductions.

4.4 Corporate strategy in SO2 emission allowance market

Another major factor for the success of this program was because the targeted companies were well aware of the program merits and adopted proper actions. In other words, it is important for the success of such a program to determine how each targeted company will utilize the emissions market, i.e. how a power company responds to the emission control.

First, in the case of cap-and-trade system, each power company can voluntarily choose the compliance options, although the total cap of emissions were controlled. In addition, SO2 emission reduction program and allowance market were well established as described above, so there were a variety of emission reduction options each could choose, such as the installment of desulfurization equipment, improved efficiency of power generation, multi-power source operation, fuel switching, electric power trades, emissions trading, etc. In the trading of electric power or emissions, financial market instruments (derivative market) were applicable so a company could manage better their risks. As described here, a company was able to set up an appropriate portfolio of emission reduction options with their selection of compliance methods.

Second, many power companies already had plans to comply, based on the integration of every available knowledge and information. To minimize the cost of pollution control, it was necessary to consider and evaluate many factors,(12) so some companies even formed inter-divisional cooperation team for the purpose of integrating expert knowledge in each field. The Potomac Electric Power Company (PEPCO), a major electric power company in the mid-Pacific coast region of USA, for example, gathered relevant experts from its various divisions including the division of power generation, engineering, utility sales, management planning, fuel purchasing, environmental control, and allowance trades, in order to prepare their compliance plan.

Founded on such firm system and fluidized market, each targeted company took appropriate actions and made it possible to comply with SO2 emission targets as well as to reduce emission reduction costs. Furthermore, the environmental protection cost arisen from the Acid Rain Programme as a whole was $1 billion, much less than the expected cost of $4 to 8 billion.(13)

5. Experimental trades on CO2 emission reduction

5.1 Experimental trades of electric power and CO2 emissions by UNIPEDE/EURELECTRIC

In 1999, 19 member companies of UNIPEDE / EURELECTRIC made a simulation on the trading of CO2 emissions and electric power.(14)

In this simulation, 16 virtual power companies were assumed to control their CO2 emissions within the designated limit, while providing sufficient power supply conforming to the increased demands for two periods of 2005-2007 and 2008-2012. Each virtual company had to achieve two targets of power supply to meet demand and CO2 emission ceiling (generally these two are contradictory), by utilizing options such as expansion of power generation facilities, multi-power source operation, fuel switching, CO2 emission trading, and power trading. At the end, 14 virtual companies attained the emission targets, and among them 4 companies resulted in realizing the extensive emission reductions against the target.

Their report pointed out that "the companies participated in the simulation promptly developed a skill to use trade mechanism", and indicated a factor of higher compliance as "each virtual power company gathered experts from every division from power generation to sales and made the most appropriate strategy from multiple viewpoints." Furthermore, the report stated, "this experiment demonstrated that emissions trading would be feasible without technical difficulties."

Notable in this result is the fact that virtual power companies in Europe have been able to get used to emissions trading and about 90% of these companies have attained the compliance with targets. In other words, Europe was able to successfully utilize emissions trading and to comply with targets whether each country had experiences in emissions trading or not. (see Fig. 3) A possible reason of success is that each virtual company skillfully adopted an optional portfolio to minimize costs of their investment for new power generation capacity. They could decide how much they have to invest and to trade electricity and emission permit. Whether appropriate investment strategy is adopted or not particularly affected the compliance of CO2 emission target, and in this term, the inclusion of corporate management viewpoints, besides the viewpoint of emissions trading related divisions, for compliance action planning led to such successful result.

The report also mentioned that the main objective of this simulation was "to let power company employees to get used to the (combination of) electricity trade and CO2 emission trade." So, it was a part of capacity building efforts to build and aggregate knowledge in each type of "trade," and the participants were able to get hints on their decision-making for optimizing the balance of power generation and CO2 emissions. The simulation is noteworthy in terms of active interests on emissions trading raised among European power companies.

The simulation is now left the hand of IEA, which supported its first stage, and ongoing into its second stage incorporating many energy-intensive industries and energy/emission brokers. The reporting of its result is expected during COP 6.


Fig. 3 Actual trade of CO2 emissions

Reference: UNIPIDE/EURELECTRIC
[Note] During the first simulation period (2005-2007) and the second simulation period (2008-2012), the trading was most active toward the end of the period. This is because the companies with high probability of exceeding emission limits tried to realize compliance through the emissions trading. The graph also shows how trade volume increases as the participants get used to the trade and the regulation becomes more stringent.

5.2 GHGs emissions trading experiment at GISPRI/IEEJ

Global Industrial and Social Progress Research Institute (GISPRI) and the Institute of Energy Economics, Japan (IEEJ) have established a research team led by Prof. Saijo of Osaka University in February 2000 and planned to experiment on international GHGs emissions trading sponsored by the Tokyo Commodity Exchange. Unlike the case of UNIPEDE, the main objective of this experiment is to determine how the system design of emissions trading will affect its efficiency. What kind of system and market design will maximize economic affluence while minimizing transition costs? In other words, the study focuses on what kind of a system can bring a preferable market and secure compliance effectively.

As explained in the Section 4 using the case of SO2 emissions trading, to function GHGs emissions trading scheme properly would require a preferable market under firm system. For this, how to design a system is an essential element and requires painstaking efforts. In other words, the system should be designed to lead to fair and efficient market. The experiment of GISPRI/IEEJ aims to provide useful study in the designing of future emissions trade system. Moreover, emissions trading experiment conducted with above objective may derive additional knowledge that can be valuable not only for the discussion of emissions trading system, but also for the designing of socio-economic infrastructure, including financial, security, and commodity markets. With such knowledge, CO2 emissions trading may manifest as an "environmental policy" to target compliance, and at the same time may realize the potential to function as a market of a "commodity."

Since the founding of a research team for the joint project between GISPRI and IEE, the team is making a comprehensive review of theories and experiments related to emissions trading and is studying exclusively what items to experiment. As a result, the planned simulation is expected mainly to verify the effects of (i) types of trading (OTC (Over-the-Counter) trading and/or trading at the exchange), (ii) liability (seller or buyer), (iii) commodity design (commodity grading, spot trade or with derivatives, (iv) contents, timing and methods of information disclosure, (v) penalty setting for non-compliance, etc. Prior to the actual experimentation of these items, ongoing are the study of experimental items to be incorporated into software as well as the experiment methods, and the development of web-browser base software. Theoretical research including the theory group's quantitative measurement study would be undertaken simultaneously with the progress of experiments.
The result of this simulation also will be presented at the COP 6.

6. What will be important for Japanese Companies

6.1 Current situation of emissions trading discussion in Japan

Considering the active discussion and experiments of emission trading ongoing among developed countries, what is the current stage of emissions trading review in Japan? Unfortunately, emissions trading has not been the subject of concrete and practical discussion among the Central Environment Policy Council, and the Energy Policy Council. In Japan, the discussion is rather for the environmental taxes, as shown in the current direction of discussion at the Government Taxation Council. If we are to aim for the ratification of the Kyoto Protocol by 2002, and to expect for the secured compliance of emission targets, there will be a growing significance of early action in the study of a domestic emissions trading system as well as of environmental taxes.

6.2 Utilization of emissions market - environmental issues and market liberalization

Considering the efforts of the Intergovernmental Panel on Climate Change (IPCC) to accumulate the latest knowledge on how climate change may cause extreme weather irregularity and various other effects, and the fact that the UNFCCC, one of the most extensive worldwide treaties, has been ratified already and about to expand further, climate change mitigation measures will persist to be one essential element of our society for the future. Moreover, there has been the growing worldwide recognition on the merit of market-based instruments for climate change mitigation, since the Kyoto Conference. In this term, whether COP 3 will be ratified or not (which depends on the mood of US Congress), the methodology to utilize market mechanism, such as emissions trading, will not decrease but increase its values nationally and internationally in the future.

At the same time, the competition over energy and other resource markets will become severer due to the worldwide trend for liberalization. Like the case of ENRON, an energy conglomerate of USA with highly sophisticated risk management techniques, entering into Japanese energy market, energy-related industry in Japan will be exposed to direct competition with such foreign companies keen on risk management. Even in the domestic public utility sector, such as power industry, the key issue is how to manage the company in the trend of market liberalization by controlling the risks and strengthen its advantages.

Based on the successes of SO2 emissions trading program in the US and the simulation of emission and electricity trading in Europe, emissions trading is the method that goes with the trend of market liberalization, and can be considered as an important instrument that integrates environmental control and market liberalization

Finally, regarding the utilization of emissions market in Japan, it is possible to learn valuable lessons from the result of CO2 emissions and electricity trade simulation tested in Europe. Europe and Japan have some common factors such as not entirely free market for electric power(15) and no experiences in actual emissions trading. Even in Europe where such conditions exist, the simulation participants actively participated in a virtual emissions trading, to develop their knowledge, and demonstrated that it is possible to harmonize emission target compliance with benefit optimization by utilizing the emissions trading. As a preparation for the agreement of international compliance regime such as the Kyoto Protocol, it will be worthwhile for Japan to take early action on emissions trading (including the trade of emission reduction credits, such as CDM) to accumulate knowledge and to get accustomed to actual market.

Incidentally, the world's first futures market is said to be the Dojima Rice Exchange in Osaka, where they started the "rice-on-book dealing" as a risk-hedging instrument to settle the deal by transferring money on accounts since 1716. This shows that the risk management instrument such as emissions trading is not necessarily be out of character for Japan.

Acknowledgement:
Upon the preparation of this paper, I received much advice from Dr. Naoki Matsuo of IGES/GISPRI, and would like to express my sincere appreciation to him. Also, Mr. Hiroki Kudo and Kenichiro Honda, both of Institute of Energy Economics, offered valuable comments. I thank them also.

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(1) The outline of operation rules is expected to be determined at COP 6 at the end of 2000. (BACK)

(2) In North America, there are baseline-and-credit type (project base) emissions trading introduced voluntarily by the private sector, however such deals are not subject to governmental regulations. Also, Denmark and UK plan to partially introduce a cap-and-trade (gross control) type emissions trading from 2001. (BACK)

(3) Refer to the United States Department of Energy, International Energy Outlook 2000 (2000). (BACK)

(4) Especially in Japan, the GHGs emissions are expected to increase by about 20% over the 1990 emission level, according to the governmental forecasts (1997) for the period until 2010. (BACK)

(5) The assessment of various domestic measures is a key discussion item, and many domestic and international studies are ongoing for this subject. For the details of discussion in Japan, please refer to the report of "A way of greening mechanism economic society" (Japan Environmental Agency, 2000), and "Proposal of the framework on domestic policies and measures for climate change mitigation in Japan, in terms of Kyoto Protocol compliance" (Naoki Matsuo, 2000). (BACK)

(6) Distribution of the emission quota to each regulated entity is important in the system designs, but this paper will not cover them. (BACK)

(7) To be accurate, it is the marginal emission reduction cost, i.e., additional cost required to reduce one unit of CO2 emitted. (BACK)

(8) Actually there are many in-house emission reduction options, and their costs vary in time (for example, purchase of electric power rather than power generation). So it is necessary to adopt a portfolio, including derivatives of various emission 'reduction' options such as emission trading (refer to the later sections). (BACK)

(9) In Phase II (2000-2027), the program will cover all thermal power plants of every power company. (BACK)

(10) Reference: EPA, 1998 Compliance Report, Acid Rain Programme. (BACK)

(11) The allowance prices projected in 1992 (prior to the start of SO2 allowance trade) were $309/ton (Resource Data International) to $981/ton (United Mine Workers). (BACK)

(12) Variable factors include market price of electricity, price of each fuel, allowance prices, power demands, and other various factors concerning the management of company. These factors may show time-dependency and require risk management. (BACK)

(13) Reference: www.epa.gov/acidrain/. (BACK)

(14) Reference: http://www.iea.org/envissu/poltech.htm. (BACK)

(15) Many European countries are implementing deregulation of electricity market based on the directive of the European Commission, but their overall liberalization rate is about 61% (as of 1999). (BACK)