Emissions trading is a cost-effective way of reducing greenhouse gas (GHG) emissions that are the main cause of climate change. Emissions trading systems are operating across four continents, regulating about 15% of global GHG emissions. A number of systems are also being considered in major economies in Southeast Asia and Latin America. An emissions trading system (ETS) (also known as “cap and trade”) is a market instrument that puts a price on emissions. A total cap on the number of emissions is set in one or more sectors of the economy and the government distributes tradable allowances among the regulated entities. Each regulated entity must submit enough allowances to cover their emissions. Under an ETS, emissions are reduced where it is most cost effective to do so. Regulated entities have the option of reducing their own emissions, trading with other entities, or—depending on the design of the ETS—purchasing offset credits.
One major advantage of emissions trading is that systems can be linked to create a common carbon market. Once linked, allowances in one system can be used in another for compliance, which has several advantages. For example, a bigger market opens up more (and potentially cheaper) reduction options, which in turn decreases the overall mitigation costs for the linked market. It also creates a level playing field for companies across the linked market and signals climate change leadership. However, as linking shifts the initial allowance price and may change the initial design of the jurisdiction’s ETS, this can create new “winners and losers”, due to the fact that certain companies, households, or sectors may be better off than others. It may also raise concerns about the level of emissions being reduced in the different jurisdictions that are part of the linked system. Finally, linking can also diminish a jurisdiction’s capacity for market intervention, because operating a joint market will require a certain level of coordination and cooperation with the linking partner.
Several linked markets currently operate around the world. In North America, the Western Climate Initiative (WCI) links California and Québec, while a separate linked system, the Regional Greenhouse Gas Initiative (RGGI), brings together several states in Northeast US. In Japan, the prefectures of Tokyo and Saitama have linked their systems, and in Europe, the European Union (EU) and Switzerland have signed a Linking Agreement (pending ratification at the time of publication). Furthermore, many jurisdictions that have, or are developing, an ETS are exploring the possibility of linking or other forms of cooperation through bilateral talks or through broader forums such as the Pacific Alliance.
Linking can occur on a spectrum from gradual alignment to restricted linking to full, two-way linking. This Guide largely focuses on full, two-way linking, where allowances from both systems can be used for compliance. However, mitigation may also need to be attributed and accounted for across the linked market under the Paris Agreement if allowances cross national borders. At the time of publication, the rulebook on cooperative approaches (article 6 of the Paris Agreement) is still being negotiated. Policymakers will need to consider the resulting international framework and how it relates to their linked market if it involves the international trading of allowances.
The Guide builds on the existing experiences with linking in order to identify practical lessons for policymakers who are interested in linking or emissions trading more broadly. The main arguments for and against linking are outlined at the outset (chapter 2). Following this, potential pathways to implement a link are considered (chapter 3). In order to operate a functioning and robust linked carbon market, specific ETS design elements need to be discussed and aligned (chapter 4). Throughout the linking process, policymakers also have to consider how and when to involve stakeholders (chapter 5). Once a common understanding has been reached, a linking agreement is often concluded to provide a shared understanding and common basis for the linked market (chapter 6). To ensure the market runs smoothly, joint management and coordination structures may need to be adapted or established (chapter 7). The Guide closes with the future outlook for emissions trading and potential pathways to a global carbon price (chapter 8).