NRT-2006258 – Final Report

Transitioning an Emissions Trading System from
Intensity Allocations to a Binding Cap

Prepared for:
National Round Table on the Environment and the Economy
Ottawa

Prepared by:
Erik Haites
Margaree Consultants Inc.
Toronto

March, 2007

120 Adelaide Street West, Suite 2500, Toronto, M5H 1T1, Canada
Tel: +1 416 369 0900, www.margaree.ca

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Consultants Inc.

Executive Summary
This report discusses the issues involved in transitioning an intensity-based emissions
trading system to one with a binding absolute cap, specifically:
• The relationship of the absolute cap to the national emissions target;
• The change in the method of distributing allowances; and
• How participants manage their compliance before and after the transition.
An intensity-based system distributes allowances free to each participant annually based
on its actual production during the year and a specified intensity factor. Total allowable
emissions fluctuate annually due to changes in the output of the participants. With an
absolute cap, the government specifies the allowable emissions for each year in advance.
Allowances equal to the cap are distributed by auction or free based on historic data
(“grandfathering”) or recent data (“updating”).
In terms of the total allowable emissions, a transition in 2026 from a limit that fluctuates
annually to one that is specified in advance poses no problems. The main issue is setting
the cap at a “reasonable” share of the national target with a “reasonable” reduction from
the allowable emissions in 2025. The information needed to ensure that the proposed cap
is reasonable from both perspectives will not be available until 2022 to 2024.
For allowance distribution, the simplest transition from an intensity-based free allocation
is to a free distribution based on updating. An abrupt transition to auctioning would have
a major financial impact on participants and probably would be resisted. A transition to
grandfathering would use very old data or create a strong perverse incentive to increase
emissions. Unfortunately, the cost of meeting a given cap is higher with an updating
formula than for auctioning or grandfathering.
An intensity-based allocation also could be implemented with a declining share of the
allowances distributed free over time with the balance of the allocation being auctioned.
Then continuing the phase out of free allowances using the intensity-based allocation and
auctioning the balance of the cap would be the simplest transition.
Certainty relating to the rules of the emissions trading system, knowledge of the
allowance allocations several years into the future, allowance banking, and liquid markets
for current and future allowances help participants to minimize their compliance costs. A
liquid market for future allowances requires advance distribution of at least some
allowances, which means an auction or a grandfathering formula.
Ultimately, the cost of the emission reductions implemented by the participants in the
emissions trading system is borne by individuals in their capacities as consumers,
shareholders, employees, taxpayers, and recipients of government services. Free
distribution of allowances benefits the shareholders of the participating firms and
employees in trade-exposed industries. If the allowances are auctioned, who benefits
depends on how the revenue is used.

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Table of Contents
Executive Summary ............................................................................................................. i
1. Background and Scope ...................................................................................................1
2. An Emissions Trading System........................................................................................2
2.1 An Intensity-based Emissions Trading System ................................................2
2.2 An Emissions Trading System with an Absolute Cap ......................................3
2.3 Distribution of the Compliance Costs...............................................................4
3. Total Allowable Emissions .............................................................................................6
3.1 Relationship of the Cap to the National Target ................................................6
3.2 The Magnitude of the Reduction in Total Emissions .......................................7
3.3 Summary ...........................................................................................................7
4. Distribution of Allowances .............................................................................................9
4.1 Rationales for Free Distribution of Allowances ...............................................9
4.2 Transition to auction .......................................................................................10
4.3 Transition to grandfathering ...........................................................................10
4.4 Transition to updating .....................................................................................11
4.5 Transition if Free Intensity-based Allocations Decline Over Time................11
4.6 Summary .........................................................................................................12
5. How Participants Manage the Transition......................................................................13
6. Summary .......................................................................................................................14
References..........................................................................................................................16

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1. Background and Scope
The Government of Canada has asked the National Round Table on the Environment and
the Economy (NRTEE) to provide advice on, inter alia, medium-term (2020–2025)
targets for greenhouse gas emission reductions by industrial sources, recognizing the
outlook for Canadian economic growth and the Government's intention to build upon the
emissions intensity approach with targets that are ambitious enough to translate
effectively into a fixed cap on absolute emissions.
This report discusses the issues involved in transitioning an intensity-based emissions
trading system to one with a binding absolute cap. Such a transition involves three
groups of issues:
•

The change from a limit on total allowable emissions that fluctuates annually
under an intensity-based system to an absolute cap on allowable emissions
established by the government and the relationship of the absolute cap to the
national emissions target;

•

The change in the method of distributing allowances from free distribution to
participants based on their current output in the intensity-based system to free
distribution, based on some other formula, or an auction in the system with an
absolute cap; and

•

How participants manage their compliance given the rules of the emissions
trading system before and after the transition.

Allowances have a market value, so allowance distribution involves a distribution of
wealth. Thus the issues relating to the distribution of allowances involve the largest
economic stakes and are the most complex.
An intensity-based emissions trading system is assumed to be implemented for two eight
year periods – 2010 through 2017 and 2018 through 2025 – with the transition to an
absolute cap taking place on January 1, 2026. The participants are assumed to be fossilfired electricity generating units and large industrial facilities, which collectively account
for approximately half of Canada’s total greenhouse gas emissions.
The next section outlines the relevant features of intensity-based and absolute cap
emissions trading systems. Section 3 discusses the issues related to setting the absolute
cap and the transition to such a cap. Issues related to changes to the method of
distributing allowances are discussed in Section 4. How the transition affects the
behaviour of participants is analyzed in Section 5. Section 6 provides a summary.

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2. An Emissions Trading System
An emissions trading system regulates specified emissions by a defined set of sources. It
is assumed that Canada implements a system to regulate the greenhouse gas emissions
due to fuel combustion and industrial processes by electricity generators and industrial
plants that exceed specified size thresholds. Allowances – each of which permits the
owner to discharge 1 tonne of CO2 equivalent 1 are assumed to be distributed annually. 2
At the end of each year, every regulated source (participant) must remit to the
government enough allowances to cover its actual emissions during the year or incur a
non-compliance penalty.
With full compliance, the actual emissions of all participants can not exceed the
allowable emissions as indicated by the allowances distributed. In an intensity-based
system, total allowable emissions are determined by the output of the participants and
hence fluctuate from year to year. With an absolute cap, total allowable emissions are
determined in advance by the government. In all systems allowances are tradable, so
sources that reduce their emissions can sell surplus allowances to participants with high
emission reduction costs. 3
This report focuses on the transition from an intensity-based system to one with an
absolute cap. This affects both the total allowable emissions and the distribution of
allowances. Allowance banking – permission to save (bank) surplus allowances for use
during a future year – is assumed to be a feature of the trading system throughout. 4 Other
features of the emissions trading system – monitoring and reporting requirements, the
non-compliance penalty, ability to use credits from approved offsets, 5 the ability to use
allowances from linked trading systems, 6 treatment of new entrants, etc. – are not
specified but are assumed to remain unchanged.
2.1 An Intensity-based Emissions Trading System 7
In its simplest form, an intensity-based emissions trading system distributes allowances to
each participant annually based on its actual production (such as KWh generated or
tonnes of steel produced) during the year and a specified intensity factor (such as tonnes
of CO2 per kWh, or tonnes of CO2 per tonne of steel). 8 The intensity factor differs by
industry and usually declines over time, either annually or at specified intervals, such as
the end of each of the proposed eight years periods. The intensity factor for a new
participant may be lower than that for existing sources in the same industry since a new
source has the opportunity to adopt more modern technology.
Key features of this design are that:
•

Total allowable emissions fluctuate from year to year due to changes in the output
of the participants as well as the establishment of new sources required to
participate in the system. 9

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•

All allowances are distributed to participants free.

The greenhouse gas emissions intensity of Canadian industry has been declining since the
early 1990s. Over the period 1990 through 2004 the emissions intensity of Canadian
industry declined by more than one-third – over 3% per year – due to improved emissions
efficiency of industry and a shift toward less emissions-intense products. 10 Unless the
intensity factors decline at a corresponding rate, the emission reduction targets for
participants become less stringent.
An intensity-based distribution of free allowances acts as a production subsidy. 11 This
reduces the output decline due to imposition of the emissions trading system and so helps
reduce the adverse impacts on trade-exposed industries. 12 But this protection for tradeexposed industries comes at a cost. Higher output means higher emissions, higher
marginal emission control costs and lower profits than under an allowance distribution
not based on current production. 13

2.2 An Emissions Trading System with an Absolute Cap
With an absolute cap, the total allowable emissions (the cap) for each year is specified in
advance by the government. The cap usually declines annually or at specified intervals.
Allowances equal to the cap are distributed using some combination of auction and free
distribution based on a specified formula. Due to their effects on behaviour, formulae are
divided between those based solely on historic data (“grandfathering”) and those based
on data after the system is implemented (“updating”).
With an auction, the government sells the available allowances. 14 An auction, rather than
sale at a specified price, is used because the government is not able to determine the price
at which all of the available allowances will be purchased. 15 The government can use the
auction revenue for various purposes, including reduction of existing taxes, 16 measures to
benefit the environment, incentives to develop emission reduction technologies, or
assistance to adversely affected firms, employees and consumers.
Grandfathering distributes allowances free to participants based on historic – prior to the
start of the emissions trading system – data. The allocation to each participant is usually
based on its emissions, output, or energy input during a specified period shortly before
implementation of the emissions trading system is announced. The calculated allocations
are scaled to match the overall cap. 17 Rules are needed for participants that cease
operation and new sources required to join the system. 18
Updating distributes allowances free to participants based on current or recent data that
are updated over time. For example, the allocation for 2015 may be based on data, such
as emissions, output or energy input, for 2013. Updating is very similar to intensitybased allocation, but with an absolute cap the calculated allocations need to be scaled to
match the cap. The updating formula can be applied to new sources and those that cease
operation.

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Key features of an emissions trading system with an absolute cap are that:
•

The overall cap on allowable emissions is a fixed quantity for each year specified
in advance by the government. The cap may decline annually or be adjusted
periodically.

•

Allowances equal to the cap are distributed some any combination of (1) an
auction, (2) free based on historic data (grandfathering), or (3) free based on
current/recent data (updating).

Updating, like an intensity-based allocation, acts as a production subsidy. As a result, the
economic cost of achieving a given cap is higher with an updating distribution of free
allowances than with auctioned allowances or free distribution based on historic data
(grandfathering). 19 Since total emissions are capped, updating shifts allowances from
less rapidly growing to more rapidly growing participants. 20

2.3 Distribution of the Compliance Costs
Implementing an emissions trading system imposes costs on the participants. 21 Part of
the cost is passed on to customers through higher prices and part of the cost is absorbed
by shareholders through a reduction in the value of the firm’s assets. The price increases
reduce demand, so output falls and employment may be reduced. The magnitude of the
price increases and output reductions will differ by participant depending upon factors
such as the emissions-intensity of the product, competition from firms in other
jurisdictions, the elasticity of demand for the product, 22 and how the allowances are
distributed.
Participants that produce products whose demand is not price sensitive can raise prices
and, if allowances are distributed free, earn higher profits. This has been the case for
electricity generators under the European Union emissions trading scheme. 23 Participants
that face competition from foreign firms not subject to comparable emissions control
regulations may not be able to raise their prices. The result can be a transfer of
production to foreign competitors with perhaps no reduction of global emissions and
economic losses to the shareholders of the Canadian firms. 24
Participants raise their prices if they can. Their output may decline, profits may be lower
and asset values may be reduced. Other firms are affected by the higher prices and lower
output, which in turn affects more firms. 25 Employment may be reduced at firms where
output falls. Output, employment, and possibly profits, rise at firms that supply emission
reduction technologies. Government revenue may be affected by the changes in profits
and employment. Ultimately, the net cost is borne by individuals in their capacities as
consumers, shareholders, employees, taxpayers, and recipients of government services. 26

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How the allowances are distributed affects how the cost is distributed. Free distribution
of allowances can compensate for the loss of asset value, which benefits shareholders.
Free distribution can help protect the output of trade-exposed industries, which benefits
employees and shareholders of firms in those industries. If the allowances are auctioned,
who benefits depends on how the government uses the revenue; how it spends the
revenue or which taxes is reduces.

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3. Total Allowable Emissions
Under the intensity-based system, total allowable emissions fluctuate from year to year
due to changes in the output of the participants. With an absolute cap, the limit on
allowable emissions each year is specified in advance by the government. The transition
to an absolute cap raises issues of:
•

The relationship of the cap to the national target; and

•

The magnitude of the emission reductions imposed on participants.

3.1 Relationship of the Cap to the National Target
Canada is expected to adopt short-, medium- and long-term emissions targets.
Participants in the emissions trading system will account for approximately half of
Canada’s greenhouse gas emissions. Since the emissions trading system represents a
large fraction of total emissions, the absolute cap will need to be consistent with the
national emissions target at the time.
To meet the national emissions target, Canada will need to implement policies to limit
emissions by sources not covered by the emissions trading system. A number of different
policies are likely to be needed to limit emissions by sources, such as agriculture,
buildings, forestry, transport and waste. Policies to promote increased sequestration by
carbon sinks and implementation of CO2 capture and storage may also be adopted.
The absolute cap for the emissions trading system will need to reflect the national
emissions target at the time. But the relationship between the national target and the cap
for the emissions trading system is not precise. If participants in the emissions trading
system account for exactly half of Canada’s greenhouse gas emissions the cap need not
be 50% of the national target, but it almost certainly will be between 40% and 60% of the
target.
Whether the cap is higher or lower than the participants’ share of national emissions will
depend on how the government chooses to distribute the emissions reduction burden.
This will be influenced by considerations such as the marginal costs of emissions
reductions for other sources relative to the market price for allowances, the effectiveness
of the policies to limit the emissions by other sources, and the economic impacts of the
policies adopted for different sources. 27
The participants in the emissions trading system, their emissions and the costs of
reducing emissions will change significantly over the next 20 years due to new entrants,
firms that cease operation, changes in production technology, implementation of emission
reduction measures, and other factors. Even if the national target for 2026 is known now,
other variables that affect the cap for 2026 will not be known until a few years before the
transition.
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To develop efficient compliance plans participants need information on the level of the
cap and, ideally, allowance prices at least five years into the future. Thus, the initial caps
should cover at least the years 2026 through 2030. But the information needed to set
those caps probably will not be available until between 2022 and 2024. However,
participants will have a sense of the likely range for the caps before this, since they are
unlikely to differ significantly from the trading system’s share of national emissions.

3.2 The Magnitude of the Reduction in Total Emissions
The transition in the nature of the limit on allowable emissions – from one that fluctuates
annually with actual output to one that is specified in advance – does not create any
problems. This transition is comparable to a reduction in the allowable emissions due to
lower intensity factors or a reduction of the absolute cap. With a few years’ forewarning,
participants can develop strategies, including emission reductions and allowance banking,
to cope with the change.
Since the intent is to reduce total greenhouse gas emissions over time, the cap for 2026 is
assumed to be lower than the forecast allowable emissions for 2025. How large a
reduction is “reasonable” for participants in the emissions trading system? The size of a
“reasonable” adjustment depends on whether the intensity factors have been constant or
declining for previous eight years. If the intensity factors have been constant for eight
years, a reduction of 25% to 35% from 2025 to 2026 is probably reasonable. 28 If the
intensity factors have been declining by about 3% per year, a reduction of 2% to 10%
from 2025 to 2026 is probably reasonable. 29
The larger the bank of accumulated allowances, the more easily participants can cope
with a given reduction as part of the transition to an absolute cap. Thus, the size of the
accumulated allowance bank provides another yardstick for the size of a “reasonable”
reduction. A reduction equal to 20% to 30% of the forecast allowance bank at the end of
2025 is probably reasonable. 30 The emissions and accumulated allowance bank through
the end of 2025 probably can not be projected accurately until a few years earlier. Thus it
will be difficult to assess the size of the emission reduction implied by a proposed cap
and whether it is “reasonable” until a few years beforehand.

3.3 Summary
The transition from a limit on allowable emissions that fluctuates annually with actual
output to one that is specified in advance does not create any problems. The issue is the
level of the cap for 2026 and subsequent years. The cap should be a “reasonable” share
of the national target and be a “reasonable” reduction from the allowable emissions in
2025.

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What constitutes a “reasonable” share of the national target depends on the emissions and
marginal costs of emissions reductions for the participants in the emissions trading
system and the other sources of greenhouse gases. What constitutes a “reasonable”
reduction from 2025 emissions depends on the history of previous reductions, the size of
the allowance bank, and the costs of other compliance options available to participants.
The information needed to ensure that proposed caps are reasonable from both
perspectives will not be available until a few years beforehand, probably 2022 to 2024.
However, participants will have a sense of the likely range for the caps before this, since
the caps are unlikely to differ significantly from the trading system’s share of national
emissions.

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4. Distribution of Allowances
The transition from an intensity-based system to one with an absolute cap requires a
change in the method of distributing allowances. The intensity-based system distributes
allowances free to participants based on their output during the current year. A system
with an absolute cap distributes the allowances using an auction or free distribution based
on a grandfathering or updating formula. This section discusses the transition to each of
these three methods. First the rationales for distributing allowances free are reviewed.

4.1 Rationales for Free Distribution of Allowances
Allowances are financial assets, so participants want to receive them free. The way
allowances are distributed affects the behaviour of participants. Free intensity-based or
updating allocations act as a production subsidy that encourages higher output and hence
higher emissions or, with a fixed cap, higher compliance costs. In contrast, distribution
by auctioning or grandfathering does not distort the behaviour of participants.
Free distribution of allowances is widely accepted as justified as:
•

Compensation for the loss in value of existing assets due to introduction of the
emissions trading system; and

•

Protection for firms in trade-exposed industries. 31

Typically, not all of the available allowances would be needed for these purposes. 32 The
balance could be auctioned. 33
Introduction of an emissions trading system can reduce the profits and hence the value of
existing assets of some participants. Free allowances can compensate for that loss of
value. To maintain an incentive to minimize emissions, the size of the free distribution
should be determined before the system begins operation and not vary with subsequent
output or emission levels. A free intensity-based or updating allocation is not an efficient
method of providing compensation for the loss in value of existing assets.
In trade-exposed industries introduction of an emissions trading system could lead to
transfer of output to competitors in jurisdictions not subject to comparable emissions
control obligations. A free allocation to firms in such industries based on each firm’s
production helps protect against such transfers of output. A free intensity-based or
updating allocation can provide such protection, although the quantity allocated usually is
not determined by the level of protection needed.

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4.2 Transition to auction
Operationally a transition from an intensity-based free distribution to an auction of
allowances is simple; allowances for 2025 are distributed free based on actual output
during 2025 and allowances for 2026 are auctioned. Some trade-exposed firms might
still need protection in 2026. Those firms could receive free allowances and the
remaining allowances could be auctioned.
But the transition from a free distribution to an auction involves a major financial change
for participants. For 2025 each participant would receive a large fraction of the
allowances it needs for compliance at no cost. The next year each participant would have
to buy all of the allowances it needs. This abrupt transition from getting free allowances
to having to buy all of the allowances needed for compliance would be very unpopular
with participants. Thus a transition to auctioning the allowances probably would need to
be implemented gradually.
The transition to an auction removes the production subsidy effect of the intensity-based
distribution, which should make compliance with the new absolute cap less costly to
Canadian society. 34 The auction raises revenue that the government can use to reduce
existing taxes, or spend on measures to benefit the environment, develop emission
reduction technologies, or assist adversely affected firms, employees and consumers.

4.3 Transition to grandfathering
A transition from an intensity-based distribution to a free distribution based on “historic”
data (grandfathering) does not impose a financial burden on participants since all
allowances continue to be distributed free. If some trade-exposed firms still need
protection in 2026, they can be given the allowances allocated by the grandfathering
formula or the allowances needed for protection, whichever is higher. 35
But grandfathering is difficult to implement for a transition that occurs on January 1,
2026. A grandfathering formula that takes effect in 2026 typically would be based on
data relating to one or more years between 2020 and 2024. Using that period as the basis
for the grandfathering formula would create a very strong perverse incentive to raise
output, and hence emissions, during those years. This because the participant will be
awarded more allowances for the year in question due to the intensity-based allocation
and more allowances every year from 2026 on due to the grandfathering formula.
The perverse incentive created by using future years as the “historic” period for the
grandfathering formula can be avoided. One option is to use a historic period that ends
prior to 2007 for the formula that takes effect in 2026. Given the changes to the
participant population during the intervening 20 years, the resulting allocation might be
considered unfair. Another option is to announce that post-2025 allocation will be based
on updating and to switch to grandfathering based on 2020 to 2024 data in 2026. To
succeed, this strategy must be kept secret until after the end of the “historic” period.

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The transition to a grandfathering distribution removes the production subsidy effect of
the intensity-based distribution. Compliance with the new absolute cap should be easier
and less costly as a result. But, grandfathering does not raise revenue.

4.4 Transition to updating
A transition from an intensity-based free distribution to a free distribution based on
current data (updating) is very simple. In principle the same intensity-factors can
continue to be used. 36 The only change needed is to scale the calculated allocation to
each participant so that the total number of allowances distributed is equal to the
emissions cap for the year. If some trade-exposed firms still need protection in 2026,
they can be given the allowances allocated by the updating formula or the allowances
needed for protection, whichever is higher. 37
The transition to an updating formula does not impose a financial burden on participants
since all allowances continue to be distributed free. However, an updating formula acts
as a production subsidy, so the compliance cost for a given absolute cap will be higher
than with grandfathering or an auction. And updating does not raise revenue.

4.5 Transition if Free Intensity-based Allocations Decline Over Time
The above discussion assumed the intensity-based allocation involved free distribution of
all of the allowances indefinitely, as is usually the case. Instead, the share of the
intensity-based allocation distributed free could decline over time with the balance of the
allocation being auctioned. 38 For example, the fraction of allowances distributed free
could start to decline when sources in the United States are subject to comparable
regulations governing their greenhouse gas emissions. 39 This intensity-based allocation
reduces the strength of the production subsidy over time and generates revenue for the
government.
Assuming that an increasing share of the intensity-based allocation is auctioned, the
transition issues discussed above are modified as follows:
•

The transition to all allowances being auctioned in 2026 is a much smaller
financial shock for the participants because only a fraction of the allowances are
distributed free in 2025. To provide a more gradual transition, the phase out of
the free allowances could continue until it reaches zero.

•

The transition to grandfathering still faces the same problem of the perverse
incentive created by using future years as the “historic” period for the allocation
formula. After reducing the share of the allowances distributed free for many
years, increasing the share to 100% again in 2026 is unlikely. If the phase out of
the free distribution is sustained, the incentive to increase output during the

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“historic” period is much smaller because the grandfathering formula covers only
a small and declining share of the allowances after 2026. Rather than
implementing a grandfathering formula for a small share of the allowances for a
few years, the free intensity-based allocation could continue until it reaches zero
with the remaining allowances being auctioned.
•

The transition to updating is still simple, but the share of the allowances
distributed free would rise to 100% again in 2026, which is unlikely. Instead, the
phase out of the free distribution could continue until it reaches zero when all
allowances would be auctioned.

In summary, if the share of the intensity-based allocation distributed free declines over
time, reverting to 100% free distribution with the transition to the absolute cap is
unlikely. A continued phase out of the free distribution is more likely. An abrupt shift to
an auction of all allowances is equally unlikely. Rather, continuing the phase out of the
free distribution with an intensity-based allocation is simplest solution.

4.6 Summary
Free distribution of allowances is widely accepted as compensation for the loss in value
of existing assets due to introduction of the emissions trading system and protection for
firms in trade-exposed industries. An intensity-based allocation is not an efficient
method of providing compensation for the loss in value of existing assets. An intensitybased can provide protection for trade-exposed industries, although the quantity allocated
usually is not determined by the level of protection needed.
The simplest transition from an intensity-based free distribution of allowances is to a free
distribution based on current data (updating). An abrupt transition to auctioning has a
major financial impact on participants and probably would be resisted. A transition to
grandfathering must rely on very old data or create a strong perverse incentive to increase
emissions. But an updating formula acts as a production subsidy, so the cost of meeting
the cap is higher than for auctioning or grandfathering.
An intensity-based allocation also could be implemented so that the share of allowances
distributed free declines over time with the balance of the allocation being auctioned to
raise revenue. Then continuing the phase out of free allowances using the intensity-based
allocation would be the simplest approach.

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5. How Participants Manage the Transition
Participants must manage their compliance before and after the transition. They will use
the mechanisms available – banking, purchases/sales of allowances for future years,
investment in emission reduction measures – to minimize the cost of compliance.
Managing compliance is easier if each participant knows what its free allowance
allocation will be and what allowance prices will be several years into the future.
An intensity-based emissions trading system distributes allowances to each participant
annually based on its actual production during the year. Allowances are distributed when
the actual output is known, which is usually only a few months before the compliance
deadline. This reduces the liquidity of the allowance market, which increases costs. 40
Liquidity can be improved by basing the current year’s allocation on the previous year’s
output, or by distributing a share, say 80%, of the previous year’s allocation at the
beginning of the year. Such changes make allowances available to the market earlier.
The best way to generate allowance prices for future years is to distribute some of the
allowances in advance. This enables allowances for future years to be traded, generating
prices that participants can use to evaluate emission reduction investments. 41 Advance
distribution requires that some of the allowances be distributed by auction or a
grandfathering formula. Distributing all allowances free on the basis of current output in
an intensity-based system or by an updating formula means allowances can not be
distributed in advance.
A bank of allowances, access to credits from approved offsets, and links to other trading
systems give participants more flexibility in planning their compliance. 42 These
provisions increase the quantity of allowances and credits participants can use to achieve
compliance. They can also improve the liquidity of the markets for current and future
year allowances.
In principle an emissions trading system may allow borrowing – use of allowances issued
for a future year for compliance during the current year – to increase liquidity. Only the
New South Wales Greenhouse Gas Abatement Scheme allows borrowing and the amount
of borrowing is limited. 43 Other systems allow the market to structure such transactions
and so place the risk of default on the participant rather than the environment. 44
Participants must manage their compliance before and after the transition. They will use
the mechanisms available – banking, purchases/sales of allowances for future years,
investment in emission reduction measures – to minimize the cost of compliance.
Certainty relating to the rules of the emissions trading system, knowledge of the
allowance allocations several years into the future, and liquid markets for current and
future allowances help participants to minimize their compliance costs. This requires
distribution of at least some allowances several years in advance, which means an auction
of at least some of the allowances or a grandfathering formula.

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6. Summary
This report discusses the issues involved in transitioning an intensity-based emissions
trading system to one with a binding absolute cap, specifically:
•

The change from no explicit limit on allowable emissions to an absolute cap on
emissions and the relationship of the absolute cap to the national emissions target;

•

The change in the method of distributing allowances; and

•

How participants manage their compliance before and after the transition.

An intensity-based system distributes allowances free to each participant annually based
on its actual production during the year and a specified intensity factor. Total allowable
emissions fluctuate from year to year due to changes in the output of the participants.
With an absolute cap, the total allowable emissions for each year are specified in advance
by the government. Allowances equal to the cap are distributed using some combination
of auction and free distribution based on historic data (“grandfathering”) or recent data
(“updating”).
An intensity-based distribution of allowances acts as a production subsidy. It is not an
efficient method of providing compensation for the loss in value of existing assets due to
imposition of the emissions trading system. While it can provide protection for tradeexposed industries, the intensity-based allocation usually is not determined by the level of
protection needed. An intensity-based allocation means higher emissions, higher
marginal emission control costs and lower profits than for an auction or grandfathering.
With respect to the limit on total emissions, a transition from a limit on allowable
emissions that fluctuates annually with actual output to one that is specified in advance
does not create any problems. The main issue is setting the cap at a “reasonable” share of
the national target and with a “reasonable” reduction from the allowable emissions in
2025.
What constitutes a “reasonable” share of the national target depends on the emissions and
marginal costs of emissions reductions for the participants in the emissions trading
system and the other sources of greenhouse gases. What constitutes a “reasonable”
reduction from 2025 emissions depends on the history of previous reductions, the size of
the allowance bank, and the costs of other compliance options available to participants.
The information needed to ensure that proposed caps are reasonable from both
perspectives will not be available until a few years beforehand, probably 2022 to 2024.
However, participants will have a sense of the likely range for the caps before this, since
the caps are unlikely to differ significantly from the trading system’s share of national
emissions.

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For the allowance distribution, the simplest transition from an intensity-based distribution
is to a free distribution based on updating. An abrupt transition to auctioning has a major
financial impact on participants and probably would be resisted. A transition to
grandfathering must rely on very old data or create a strong perverse incentive to increase
emissions. But an updating formula acts as a production subsidy, so the cost of meeting
the cap is higher than for auctioning or grandfathering.
An intensity-based allocation also could be implemented so that the share of allowances
distributed free declines over time with the balance of the allocation being auctioned.
Then continuing the phase out of free allowances using the intensity-based allocation
would be the simplest approach.
Participants will use the mechanisms available – banking, purchases/sales of allowances
for future years, investment in emission reduction measures – to minimize the cost of
compliance. Certainty relating to the rules of the emissions trading system, knowledge of
the allowance allocations several years into the future, and liquid markets for current and
future allowances help participants to minimize their compliance costs. This requires
distribution of at least some allowances several years in advance, which means an auction
of at least some of the allowances or a grandfathering formula.
Ultimately, the net cost of the emission reductions implemented by the participants in the
emissions trading system is borne by individuals in their capacities as consumers,
shareholders, employees, taxpayers, and recipients of government services. How the
allowances are distributed affects how the cost is distributed across individuals. Free
distribution of allowances benefits the shareholders of the participating firms and
employees in trade-exposed industries. If the allowances are auctioned, how the revenue
is used – lower taxes or spending to benefit the environment, incentives to develop
emission reduction technologies, or assistance to adversely affected firms, employees and
consumers – determines who benefits.

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References
Ellerman, A. Denny, 2003. “Lessons from Phase 2 Compliance with the U.S. Acid Rain
Program,” Center for Energy and Environmental Policy Research, Massachusetts
Institute of Technology, Cambridge, available at:
http://tisiphone.mit.edu/RePEc/mee/wpaper/2003-009.pdf
Ellerman, A. Denny, and Ian Sue Wing. 2003. “Absolute versus Intensity-Based
Emission Caps,” Climate Policy, v. 3, supplement 2, December, pp. S7–S20.
Fischer, Carolyn, 2003. “Combining Rate-Based and Cap-and-Trade Emissions Policies,”
Discussion Paper 03–[32], Resources for the Future, Washington, D.C., May, available
at: http://www.rff.org/Documents/RFF-DP-03-32.pdf
Haites, Erik, 2003. “Output-Based Allocation as a Form of Protection for Internationally
Competitive Industries,” Climate Policy, v. 3, supplement 2, December, pp. S29 - S41.
Haites, Erik, 2005. “Behavioural Impacts due to Restrictions on Allowance Banking in
Tradable Permit Systems,” Environment Canada, Gatineau, January 28.
Herzog, Timothy, Kevin A. Baumert and Jonathan Pershing, 2006. Target: Intensity, An
analysis of greenhouse gas intensity targets, World Resources Institute, Washington,
D.C., November.
National Commission on Energy Policy (NCEP), 2007. Allocating Allowances in a
Greenhouse Gas Trading System, National Commission on Energy Policy, Washington,
D.C., March, available at: www.energycommission.org
National Emissions Trading Taskforce (NETT), 2006. Possible Design for a National
Greenhouse Gas Emissions Trading Scheme, National Emissions Trading Taskforce,
August, available at: www.emissionstrading.net.au
Nyboer, John, Chris Joseph and Paulus Mau, 2006. Greenhouse Gas Intensity Indicators
for Canadian Industry 1990 to 2004, Canadian Industrial End-use Energy Data and
Analysis Centre, Simon Fraser University, Burnaby, BC. Prepared for Environment
Canada and Natural Resources Canada, March.
Sijm, J.P.M., Y. Chen, M. ten Donkelaar, J.S. Hers and M.J.J. Scheepers, 2006. “CO2
Price Dynamics: A follow-up analysis of the implications of EU emissions trading for the
price of electricity,” ECN-C-06-015, Energy Research Centre for the Netherlands, Petten,
The Netherlands, March.

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Notes
1

Carbon dioxide (CO2) is the most abundant of the greenhouse gases. Others emitted by human activity
and controlled by the Kyoto Protocol are methane (CH4), nitrous oxide (N2O), hydrofluorocarbons (HFCs),
perfluorocarbons (PFCs) and sulphur hexafluoride (SF6). Emissions of the other gases are often expressed
as CO2 equivalents by multiplying the quantity emitted by the global warming potential (GWP) of the gas
over 100 years. The GWP is a measure of the radiative effect of 1 kg of a gas relative to that of 1 kg of
CO2 over a specified time period.
2
Allowances are also called permits, credits, quotas and names unique to the trading system. As discussed
in Section 3 allowances can be distributed free based using a specified formula, by auction, or by any
combination of the two.
3
A source whose emission reduction cost is higher than the market price of an allowance can reduce its
compliance cost by buying allowances rather than reducing its own emissions.
4
Existing emissions trading systems have rules that range from no banking to unrestricted banking, with
less restrictive rules being environmentally compatible with and more common for greenhouse gases. Most
existing trading systems have accumulated a relatively large bank of surplus allowances during the initial
years (Haites, 2005). Although banking is assumed it could be restricted, for example by a limited life
(e.g., 2 to 5 years) for allowances.
5
Actions by specified non-participants that reduce emissions can earn “credits” in many emissions trading
systems. Such offset credits are equivalent to allowances for compliance purposes, but where they are used
they typically constitute a small share (less than 5%) of the allowances.
6
An emissions trading system may agree to accept allowances from another system for compliance (and
possibly vice versa) thus linking the systems. Most existing and proposed trading systems for greenhouse
gases have absolute caps. Fischer, 2003 reviews the issues that arise when linking an intensity-based
system and a system with an absolute cap.
7
For more on intensity-based systems see Ellerman and Wing, 2003 and Herzog, et al., 2006. These papers
and others discuss intensity-based limits mainly in terms of country commitments under an international
agreement. Haites (2003) discusses intensity-based limits for participants in a domestic emissions trading
system.
8
Mathematically, the allocation (ai,t) to a participant (i) in industry (j) for year (t) is: ai,t = fj,t * oi,t where fj,t
is the intensity factor for industry (j) in year (t), such as tonnes of CO2e per tonne of finished steel; and oi,t
is the actual output of firm (i) during year (t), such as tonnes of finished steel. The total allowable
emissions (At) is the sum of the allocations: At = Σi ai,t. The actual emissions of participant (i) for year (t)
are ei,t measured in tonnes of CO2 equivalent. If ei,t < ai,t participant (i) has surplus allowances to sell or
bank for use in future years. If ei,t > ai,t participant (i) needs to buy allowances or use allowances banked
from previous years to achieve compliance.
9
The allocation to a source that ceases operation is zero because its output is zero.
10
Nyboer, et al., 2006, pp. 12-13.
11
The strength of the subsidy depends on the allocation per unit of output relative to the actual emissions
per unit of output as well as the basis for the free distribution, for example current output or a moving
average of the output during the past few years.
12
An intensity-based distribution of free allowances might be challenged as a production subsidy under
World Trade Organization (WTO) or North American Free Trade Agreement (NAFTA) rules. The risk of
a challenge is relatively low as long as competitors in the United States and developing country parties to
the Kyoto Protocol are not subject to comparable emissions control regulations. To reduce the risk of a
successful challenge, the National Emissions Trading Taskforce in Australia proposes that the free
allocation to firms in trade-exposed, energy-intensive industries be equal to the impact of the emissions
trading system on energy prices (NETT, 2006, p. 131).
13
Haites, 2003.
14
Auction design can affect the behaviour of the bidders, so an appropriate design must be chosen. The
auction should be designed to sell a relatively large quantity of homogeneous items (allowances) to
multiple successful bidders at a uniform price. Government auctions of Treasury Bills are a possible
model. A growing number of emissions trading systems are gaining experience with allowance auctions.

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If the government set a price that is too high, some of the available allowances would not be sold, making
the compliance burden more onerous for participants. If the government set the price too low, the demand
for allowances would exceed the quantity available so quantities would need to be rationed.
16
Reducing existing taxes lowers the cost of the emissions trading system to the economy.
17
For example, if the allocations are based on actual emissions during 2005 and the cap during a given year
is equal to 90% of 2005 emissions, each participant would receive an allocation equal to 90% of its actual
2005 emissions.
18
Some systems continue to give allowances to participants that cease operation, while others discontinue
allocations to such participants immediately or with some delay. Some systems give allowances to new
participants, while others do not give them any.
19
An auction imposes higher financial costs on participants than free distribution of allowances, whether
based on an updating or grandfathering formula. However, the cost to the economy is higher with a free
distribution based on an updating formula, than with auctioned allowances.
20
If the participants as a group are growing and the cap is fixed, only those that grow faster than average
get a larger allocation. Participants that grow at less than the average rate get a smaller allocation.
21
NCEP, 2007.
22
Elasticity is a measure of the sensitivity of the change in demand for a product to a change in its price.
23
Sijm, et al., 2006.
24
If the price does not change, demand for the product does not change. Since the emissions trading
system raises the costs of the Canadian firm, its output is likely to be reduced. This means more of the
demand is supplied by foreign competitors not subject to comparable emissions control regulations. If the
emissions intensity of the foreign competitors is the same as that of the Canadian firm, global emissions do
not change.
25
The effects will be felt by firms that are not participants in the emissions trading system.
26
While most of these individuals will be residents of Canada, some of the consumers and shareholders
will be foreigners.
27
An economically efficient set of policies would impose the same marginal cost on all emissions sources.
Thus policies to limit the emissions of other sources could be designed to have a marginal emission
reduction cost comparable to the market price for allowances.
28
In the US SO2 acid rain program the allocations to Phase 1 participants were constant from 1995 through
1999 and then dropped by about 50% for 2000 and subsequent years. The Clean Air Interstate Rule
(CAIR) currently being implemented will reduce the allowable SO2 emissions by participants in the eastern
US by a further 50% in 2010.
29
In the RECLAIM NOx and SOx programs in the greater Los Angeles area the annual cap dropped by
between 5% and 15% from 1994 through 2003 and has been constant since. Allowance banking is
prohibited in the RECLAIM program.
30
In the US SO2 acid rain program the allowance bank at the end of Phase 1 was about 115% of the
allowable Phase 2 emissions. The reduction in the allocation to Phase 1 sources in 2000 was roughly 50%,
representing between 20 and 25% of the allowance bank.
31
NETT, 2006, pp. 124-138. The trade-exposed industries might not be participants in the emissions
trading system, but they could still be awarded free allowances as protection.
32
The quantity needed to protect trade-exposed industries in Canada could be large in the near term. A
large fraction of the Canadian economy is open to international trade. Canada’s main trading partner, the
United States, and developing countries currently do not impose greenhouse gas emissions control
obligations on their firms. Over time, those jurisdictions are expected to introduce such obligations, which
would reduce the need to protect Canadian firms.
33
NCEP, 2007.
34
Auctioning the allowances raises the financial cost to system participants, but removing the production
subsidy effect reduces the cost of meeting the specified emissions cap and hence reduces the cost to
Canadian society.
35
The allocations to all participants would still be adjusted to match the overall emissions cap.
36
A new updating formula could be used after the transition, but such a change might be resisted by the
participants whose allowance allocations would be reduced.
37
The allocations to all participants would still be adjusted to match the overall emissions cap.

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38

Mathematically, the allocation (ai,t) to a participant (i) in industry (j) for year (t) is: ai,t = gt * fj,t * oi,t
where gt is the fraction of the allocation distributed free in year (t); fj,t is the intensity factor for industry (j)
in year (t); and oi,t is the actual output of firm (i) during year (t). The total allowable emissions (At) is still
be At = Σi fj,t * oi,t. Then gt * At allowances would be distributed free and (1 - gt) * At allowances would be
auctioned for year (t).
39
For example, if sources in the United States are subject to comparable regulations governing their
greenhouse gas emissions starting in 2012, the free allocation could decline by 5% per year from 100% in
2011 to 30% in 2025
40
Liquidity is the ease with which a good can be bought or sold. A liquid market is one where a buyer
(seller) can purchase (sell) the desired quantity of the good quickly at the market price. If liquidity is
limited participants do not know how many allowances will be available and/or what the price will be.
They then tend to implement emissions reduction measures internally to achieve compliance. The cost of
the internal measures may be higher than the market price.
41
Forward contracts and options can provide such information, but their transaction costs are much higher
than those for the sale of issued allowances. A forward contract or option involves a promise by a firm to
deliver allowances at a specified price at a future date. The credit ratings of the parties are critical to such
contracts. Thus the contract negotiation is much more complex than a purchase of allowances for a future
that have already been issued.
42
See Ellerman, 2003 for an analysis of the use of the banking provision of the SO2 acid rain program to
manage the transition from Phase 1 to Phase 2.
43
Borrowing is limited to 10% of the amount needed for compliance and the quantity borrowed must be
repaid the following year.
44
A participant that expects to have surplus allowances for future years but needs allowances for the
current year can purchase the latter to achieve compliance and sell, directly or via a forward contract,
surplus allowances for the future year(s). The participants bear the risks of default. If borrowing is
allowed and the participant ceases operation before repaying the borrowed allowances, the environment
suffers.

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