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“Combating Air Pollution In the PRD: Emissions Trading As A Promising Policy Tool?� Adam S. Krotman and Daniel L. Malech Abstract: This study aimed to: (1) develop a conceptual framework for evaluating the viability of emission trading systems (ETSs) and (2) apply such a framework to assess the prospects for emissions trading in the Pearl River Delta (PRD) region in light of an emissions trading pilot scheme recently released by the Hong Kong SAR and Guangdong governments, respectively. For any emissions trading system (ETS) to work, a viable regulatory property regime that properly internalizes the externalities of pollution must exist. Given this central precondition and conceptual framework for evaluating emissions trading systems, establishing an environmentally effective and economically efficient ETS in the PRD faces the formidable obstacles of instituting more stringent emissions regulations; developing the necessary legal, administrative, and technical infrastructure to implement these regulations; and creating credible institutional capacity to link these intra-regional regulations in a regional ETS. Currently, insufficient levels of regulation on both sides, a lack of faith in the ability of the Guangdong side to enforce compliance, doubts about the integrity of the proposed ETS, and the narrow scope of the pilot scheme suggest that participation, and thus actual emissions reductions and cost-savings will be limited at best. Achievements will likely entail developing institutional capacity for future ETSs and emissions regulation in general. The degree of success in this area will depend on whether the pilot scheme induces even limited levels of participation. Although conditions at present do not seem ripe for the development of a wide-scale ETS, political and economic currents appear to be moving towards this point.
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1. INTRODUCTION 1.1: Air Pollution In China and the Pearl River Delta Region (PRD) The industrial revolution and rapid technological advances over the past two and a half centuries created an unparalleled era of global growth and economic development that continues to the present day, but such growth has been far from costless. Air pollution ranks as one of the most substantial negative externalities in our increasingly industrialized global society. In many regions, and perhaps on a global scale, the cost to human health and to the health of Earth itself has reached unacceptable levels. Pollutants that pose the gravest threat to us today include sulphur dioxide (SO2), the primary cause of acid rain; nitrogen oxides (NOx), another cause of acid rain and the main component of “smog”; respirable suspended particulates (RSPs), a carcinogenic pollutant; and green house gases (GHG), which risk inducing global climate change. All these pollutants present grave hazards to human health, depending on concentration levels. 1 Rapid economic development and industrialization over the past few decades has given China the dubious distinction of the world’s highest emitter of many of these pollutants. Recently, it surpassed the U.S. as the world’s largest emitter of CO2, the main GHG. 2 It is the world’s largest emitter of SO2, releasing 25 million tons in 2005, with power plant emissions accounting for over half of these emissions. 3 The problem is especially acute in Guangdong
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For additional information about specific pollutants, see Christine Loh and Simon Ng, Air Pollution In China: The Air That We Breathe, Hong Kong: Civic Exchange, April 2005, http://www.civicexchange.org/publications/2005/CLSAA.pdf. Downloaded on 1 July 2007. 2 Netherlands Environmental Assessment Agency, “China now no. 1 in CO2 emissions; USA in second position”, 2007. Data from figure GlobalCO2 emissions from fossil fuel use by region http://www.mnp.nl/en/dossiers/Climatechange/moreinfo/Chinanowno1inCO2emissionsUSAinsecondposition.html Accessed 23 November 2007. 3 World Bank, Cost of Pollution In China: Economic Estimates of Physical Damage, Beijing: World Bank, February 2007, p. 4,
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Province, where 63% of the region is under a special acid rain control area by the State. 4 NOx and RSP emissions also occur at high globally comparative levels throughout China. Based on a World Bank study, The Financial Times reported that high levels of air pollution in Chinese cities leads to 350,000-400,000 premature deaths per year, although World Bank officials informed reporters that the Chinese government warned them not to publish these statistics. 5 Hong Kong, too, suffers from high levels of the same pollutants caused by both local emissions and regional emissions from Guangdong. Health experts estimate total avoidable economic costs to Hong Kong due to illness, hospitalization, work days lost and deaths caused by air pollution at over HK$21 billion. 6 Notwithstanding measuring difficulties, one cannot ignore the fact that pollution in Hong Kong imposes substantial economic costs relating to human health, quality of life, and future investment. What is the source of this pollution? In 2002, a joint study between Hong Kong and Guangdong revealed that 95%, 80% and 87% of total RSP, NOx and SO2 emissions, respectively, in the PRD were generated in Guangdong. 7 However, a recent study found that 53% of the time, air pollution in Hong Kong comes from local sources, suggesting that local emitters contribute substantially to the problem. 8 Within Hong Kong, electricity generation accounts for the largest share of air pollution. In 2005, it produced about 91%, 51%, and 48% of total local SO2, NOx, and RSP emissions, http://siteresources.worldbank.org/INTEAPREGTOPENVIRONMENT/Resources/China_Cost_of_Pollution.pdf. Downloaded on 22 July 2007. 4 Clear The Air, Submission Paper From Clear the Air To the Legislative Council Regarding the Pilot Scheme, 28 March 2007, http://www.legco.gov.hk/yr06-07/english/panels/ea/papers/ea0328cb1-1201-4-e.pdf. Downloaded on 20 July 2007. 5 Richard McGregorin, “Beijing Censored Pollution Report”, Financial Times, 3 July 2007. 6 Anthony Hedley et al., Air Pollution: Costs and Paths to a Solution, June 2006, http://www.civicexchange.org/publications/2006/VisibilityandHealthE.pdf. 7 Environment and Food Bureau, “Improving Air Quality in the Pearl River Delta Region”, Information paper submitted to the Legislative Council Panel on Environmental Affairs, Hong Kong: HKSAR Government, 2002. 8 Alexis Lau et al., Relative Significance of Local Vs Regional Sources: Hong Kong's Air Pollution, Hong Kong: Civic Exchange and Hong Kong University of Science and Technology, March 2007, http://www.civicexchange.org/publications/2007/airmarch.pdf. Downloaded on July 22, 2007.
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respectively. 9 Indeed, Chief Executive (CE) Donald Tsang has publicly recognized that “emissions from power companies in Hong Kong are regarded as the main source of air pollution.” 10 Two power companies operate in Hong Kong: CLP Power Hong Kong Limited (CLP) and Hong Kong Electric Company (HEC). In addition, CLP, the larger of the two, imports electricity from the Guangzhou Pumped Storage and Guangdong Daya Bay Nuclear Power Stations, and exports a growing amount of its excess capacity to Guangdong. 11
1.2: Using Market-Based Instruments To Reduce Air Pollution In the PRD Cities, regions, or countries committed to combating air pollution prefer to do so as cost effectively as possible. In theory, utilizing Market-Based Instruments (MBIs) in environmental regulation offers promising cost-savings opportunities versus mere command-and-control regulations. Emissions trading is one frequently used MBI. Emissions trading allows emitters with higher marginal costs of abatement to satisfy their emissions reduction requirements by paying for emitters with lower marginal costs of abatement to make actual emissions reductions. Lower-cost emitters profit by receiving payments for excess reductions. It is important to note that emissions trading is a flexibility mechanism that emitters can use to meet their actual current or anticipated regulatory requirements, and not a replacement for these underlying regulations. On 30 January 2007, the Environmental Protection Bureau (EPD) of the Hong Kong Special Administrative Region Government (HKSARG) and the Environmental Protection Bureau (EPB) of the Guangdong Provincial Government (GPG) announced the implementation
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Environmental Protection Department, Supplementary Information on Emissions Trading Pilot Scheme for Thermal Power Plants in the Pearl River Delta Region, 28 March 2007, http://www.legco.gov.hk/yr0607/english/panels/ea/papers/ea0328cb1-1201-9-e.pdf. Downloaded on 19 June 2007. 10 “HK Urges Power Companies to Meet Emission Targets”, Reuters News Service, 2 August 2006, http://www.planetark.com/dailynewsstory.cfm/newsid/37473/story.htm. Downloaded on 22 June 2007. 11 See FN 7 supra, p. 63.
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framework for the Emissions Trading Pilot Scheme for Thermal Power Plants in the Pearl River Delta Region (ETPS). 12 The framework, while rather vague on many of the finer design features, invites eligible thermal power plants in Hong Kong and Guangdong to trade credits representing SO2, NOx, and/or RSP reductions on a strictly voluntary basis. Sections 1 and 2 in the ETPS list its objectives and purposes, which largely entail its use as a flexible mechanism for power plants to achieve emissions reductions and a stepping point for developing a more comprehensive ETS in the PRD region in the future. 13 It is the first emissions trading scheme introduced to the region, although other regions throughout China have been experimenting with pilot ETSs for over a decade. 14 This study aims to ascertain the prospects for both the ETPS to successfully meet its specified objectives, and for the development of an effective ETS in the PRD in the longer term. The study identifies the most substantial obstacles to environmentally effective trading, including significant potential design flaws in the ETPS. It is also important to conceptualize a catalog of general pre-conditions and design feature pre-requisites essential for any ETS to function effectively. For any ETS to work, a viable regulatory property regime that properly internalizes the externalities of pollution must exist. Given this central precondition, establishing an effective and efficient ETS in the PRD faces the formidable obstacles of instituting more stringent and certain emissions regulations; developing the necessary legal, administrative, and technical infrastructure to implement these regulations; and creating credible institutional capacity to link these intra-regional regulations in a regional ETS. Currently, insufficient regulation levels and 12
Environmental Protection Department, Emissions Trading Pilot Scheme for Thermal Power Plants in the Pearl River Delta Regions, February 2007, http://www.legco.gov.hk/yr06-07/english/panels/ea/papers/ea0226cb1-972-5e.pdf. Downloaded on 5 June 2007. 13 See FN 12 supra, Sections 1-2. 14 See infra Section 3.2 for a discussion of pilot schemes in China.
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certainty on both sides, a lack of faith in the ability of the Guangdong side to enforce compliance, doubts about the integrity of the proposed ETS, and the narrow scope of the pilot scheme suggest that participation and thus actual emissions reductions and cost-savings will be limited at best. Any achievements will likely entail developing institutional capacity for future ETSs and emissions regulation in general. The degree of success in this area will depend on whether the pilot scheme induces even limited levels of participation. Although conditions at present do not seem ripe for the development of a comprehensive regional ETS, political and economic currents appear to be moving towards this point. Part 2 provides a more detailed discussion of emissions trading and catalog preconditions necessary for an ETS to work. Part 3 considers the politics of Chinese environmental regulation and Chinese experiences with emissions trading. Part 4, focuses on the PRD, examining the respective political economies of the energy sector in Hong Kong and Guangdong, and current and anticipated local and regional air pollution regulatory systems. Part 5 analyzes the prospects of the ETPS and emissions trading in the PRD in general, and Part 6 presents our conclusions.
2. EMISSIONS TRADING PRE-CONDITIONS Emissions trading has 2 objectives: (1) to achieve environmental objectives (2) as efficiently and cost-effectively as possible. Although for the purposes of simplicity in writing this paper may sometimes use the term “allowance” and “credit” interchangeably, it is important to note that these are distinct concepts. The term “allowance” typically refers to a unit of emissions under a cap-and-trade
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scheme, where an emitter is issued allowances equal a certain number of units of pollutant that they are permitted to produce; the total number of allowances under the scheme is determined by an overall emissions target set by a regulatory authority. This limit encompasses all participating sources within the scheme. These allowances may be allocated through a variety of mechanisms, and then traded among emitters. In a cap and trade scheme the absolute limit is on total pollution output. Thus, cap and trade schemes are in theory very good at controlling actual emissions. A typical example of this is the EU ETS scheme, designed to help participating nations fulfill their Kyoto Protocol requirements. The term “credit” is typically used in the context of a baseline-and-credit or project-based scheme. In this case, an emitter engages in a bilateral arrangement with another party. The second party, if it is a polluter, will reduce their emissions below the “baseline” level at which they would have otherwise emitted. Alternatively, the third party will remove a certain amount of pollutant from the atmosphere (e.g. a carbon sequestration project). The first emitter will then pay for the credits generated, equal to the amount of pollutant that would have otherwise been emitted or have remained in the atmosphere. Credit-generating schemes are often used in conjunction with cap-and-trade schemes, but the two types of schemes can operate independent of each other and the “allowances” or “credits” each respective scheme uses are conceptually distinct.
2.1 Political, Legal, Environmental and Economic Preconditions There are a number of preconditions that should exist in the legal, political, environmental and economic conditions of any jurisdiction considering emissions trading. 2.1.1 Heterogeneity of Abatement Costs Market-based instruments work most effectively when different pollution sources have
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differing costs of lowering their emissions. Some sources will find lowering their emissions below required levels, and selling the resulting credits, more cost-effective; on the other hand, some sources will find that compliance is more costly than simply buying reduction credits from other sources with cheaper abatement options. 15 In this situation, the total abatement costs resulting from the use of market-based instruments will be lower than under command-andcontrol abatement, making trading attractive to both government and industry. 16 Additionally, sources should have a wide range abatement options. These can include shutting down older, less efficient facilities, changing to a more efficient fuel mix, or implementing technological fixes such as scrubbers. 17 In addition to lowering overall costs, a wide range of allowable compliance options stimulates innovation of more efficient and environmentally friendly technologies. 18 2.1.2 Adequate Regulatory Experience The U.S. SO2 program was created in the context of a well-developed market state, with a wealth of regulatory experience and a long history of transparent, accountable government and rule of law. The vast majority of successful emissions trading platforms have been developed in contexts with adequate legal and political infrastructure. “No environmental policy can exist in an institutional vacuum. Rather, environmental policies—like all others—operate in a context of laws, regulations, government and industry behavior, and even cultural norms.” 19
15
United States Environmental Protection Agency, Tools of the Trade: A Guide to Designing and Operating a Cap and Trade Program for Pollution Control, Office of Air and Radiation, June 2003, p. 2-2. 16 Richard Morgenstern, Robert Anderson, Ruth Greenspan Bell, Alan Krupnick, and Xuehua Zhang, Demonstrating Emissions Trading in Taiyuan, China, 148 Resources 7, Summer 2002. 17 United States Environmental Protection Agency, Tools of the Trade: A Guide to Designing and Operating a Cap and Trade Program for Pollution Control, Office of Air and Radiation, June 2003, p. 2-3. 18 Ibid. at 3-5. 19 Richard Morgenstern et al., “Emissions Trading to Improve Air Quality in an Industrial City in the People’s Republic of China”, Resources For the Future Discussion Paper 04-16, April 2004, p. 10, http://www.rff.org/Documents/RFF-DP-04-16.pdf. Downloaded on 20 July 2007.
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A scheme can be extremely well-designed and all other preconditions can exist, but if the regulatory infrastructure cannot support the implementation of such a scheme, it faces major challenges to its eventual success. “Unlike many other physical commodities, emissions allowances are a legal construct, and the legal and regulatory frameworks that support them are of crucial importance.” 20 2.1.3 Adequate Authority for Enforcement Because any emissions trading scheme is, at the most basic level, simply a flexibility mechanism for regulatory compliance, clear and effective authority for enforcement must exist in each participating jurisdiction. If multiple agencies are responsible for compliance and enforcement, as well as ensuring that national policies are implemented on the local level, there must be clear lines of authority and communication between different agencies and regulating bodies. 21 Additionally, if trading is across multiple jurisdictions, there must be a sufficient degree of consistency in design elements, regulation, and implementation for a trading scheme to be effective. 22 In addition to enacting and enforcing regulation, the USEPA reports that, “The regulating authority must have the authority to require standardized methodologies for emission measurement, collect emissions data to determine compliance, and publicize emission and allowance data to provide transparency and promote confidence in the program.” 23 2.1.4 Adequately Developed Private Sector It is essential that actors are behaving as true private-sector entities. Of particular importance are developed property rights and contracts; a private sector that operates along 20
Overview Report: Legal Framework for Emissions Trading in the European Union, 2006, p. 3, available at http://akseli.tekes.fi/opencms/opencms/OhjelmaPortaali/ohjelmat/ClimBus/fi/Dokumenttiarkisto/Viestinta_ja_aktivo inti/Julkaisut/Projektiaineistot/2005/Raportit/Legal_Overview_Report.pdf. Downloaded on 20 July 2007. 21 United States Environmental Protection Agency, Tools of the Trade: A Guide to Designing and Operating a Cap and Trade Program for Pollution Control, Office of Air and Radiation, June 2003, p. 2-3. 22 Ibid. 23 Ibid. at 3-3.
Krotman & Malech 10 principles of profit maximization; government that is accustomed to allowing private businesses to make strategic decisions on how to achieve objectives with a minimum of interference; and a respect for rule of law and impartial, consistent and transparent enforcement of regulation. 24 2.1.5 Adequate Cross-Border Complementation of Regulation Although the need grows in importance with a true cap-and-trade system and a liquid market for emissions credits, any cross-border market-based instrument for regional pollution control needs to account for differences in legal systems, taxation, financial services, commercial arbitration, and other financial and legal infrastructural issues. 25 2.1.6 Technological Capability In order to provide for reliable emissions reductions through technological means, as well as to provide adequate technology-based monitoring, a country must have sufficient technological capabilities and expertise to design/procure, maintain, and operate these systems.
2.2 Design Features The United States Environmental Protection Agency recommends five general design considerations for emissions trading: simplicity, accountability, transparency, predictability, and consistency. 26 The environmental integrity of a trading scheme depends largely on its design features. Of particular importance is the choice between cap-and-trade and project-based schemes. The former has a high degree of environmental integrity (provided limits are actually enforced and
24
Ibid. at 2-4. Overview Report: Legal Framework for Emissions Trading in the European Union, 2006, p. 3, available at http://akseli.tekes.fi/opencms/opencms/OhjelmaPortaali/ohjelmat/ClimBus/fi/Dokumenttiarkisto/Viestinta_ja_aktivo inti/Julkaisut/Projektiaineistot/2005/Raportit/Legal_Overview_Report.pdf. 26 United States Environmental Protection Agency, Tools of the Trade: A Guide to Designing and Operating a Cap and Trade Program for Pollution Control, Office of Air and Radiation, June 2003, p. 3-1. 25
Krotman & Malech 11 compliance is achieved), due to the fact that the state is regulating an absolute limit on total emissions. Project-based schemes, on the other hand, have had fairly limited success both environmentally and economically. Even in the United States, project-based state schemes have achieved very limited success. 27 Given the strong regulatory culture and long experience with these types of schemes in the United States, it generally seems that similar programs in areas like China, with much less regulatory experience, transparency, accountability, and a whole host of other institutions that are more strongly developed in the U.S. will have even greater troubles achieving environmental goals. The U.S. experience may point to initially “grafting” some kind of market-based instruments, such as “bubbles” (where pollutions sources are given a total emission limit for a particular facility or set of facilities and allowed to decide for themselves how to meet that requirement), as well as project-based approaches, onto existing technical requirements. 28 2.2.1 Meaningful Regulation Commodity of Value Emissions reductions under a scheme are, unlike most valuable commodities, are artificially created. Emissions reductions are not valuable to a pollution source unless they are given value through some sort of regulatory structure. Generally, a national commitment to emissions reduction is essential to achievement of actual domestic reductions. 29 The threat of future regulation will sometimes create enough incentive to reduce emissions to give reduction credits some kind of artificial value, but in general meaningful regulation along with sufficient 27
Emission Reduction Credit Trading Systems: An Overview of Recent Results and an Assessment of Best Practices, Environmental Law Institute, September 2002, p. 1. 28 Personal communication with Roger Raufer, July 2007. 29 Inho Choi, Global Climate Change and the Use of Economic Approaches: The Ideal Design Features of Domestic Greenhouse Gas Emissions Trading with an Analysis of the European Union's CO2 Emissions Trading Directive and the Climate Stewardship Act, 45 Nat. Resources J. 865, Fall 2005.
Krotman & Malech 12 penalties for noncompliance is a necessary precondition for making emissions reduction credits a valuable commodity. 30 Regulatory Limits By far the most important cornerstone of any working scheme, whether it is cap and trade or project-based, is adequate regulation. These include the optimal cap levels, as well as issues like length of compliance period. However, at its most basic level caps must be set low enough (ideally where the marginal cost of abatement equals the marginal environmental benefit) to cause some sources to be buyers and some sellers; or, in a project-based program, at a level where enough emitters are positioned as buyers of credits. Interface With Existing Regulation One question for any jurisdiction instituting a new emissions trading scheme is how it will interface with existing pollution control measure. These may take a variety of forms, mainly command-and-control technical regulation and/or Pigouvian (price-based) levy systems. In evaluating the Chinese case, Morgenstern et al present three options for reconciling an emissions trading scheme in Taiyun with the existing Chinese pollution levy system: allow the levies to exist alongside the trading system, due to the fact that they are relatively low; eliminate levy charges for participating entities, but auction allowances; or give away allowances but impose a surcharge equal to the levy. 31 Penalties Penalties for noncompliance are also a crucial feature. One method is to simply lower the allowed emissions for the next compliance period for a non-complying emitter. However, this is
30
Ibid. Richard Morgenstern et al., “Emissions Trading to Improve Air Quality in an Industrial City in the People’s Republic of China�, Resources For the Future Discussion Paper 04-16, April 2004, p. 27, http://www.rff.org/Documents/RFF-DP-04-16.pdf. Downloaded on 20 July 2007. 31
Krotman & Malech 13 not ideal as it can lead to speculation on the price of credits/allowances for the next compliance period, particularly in cases of a volatile market. 32 Any financial penalties should be set “significantly higher than the expected marginal abatement cost (i.e. the expected share price)”. 33 Additionally, the US EPA recommends criminal penalties for designated individuals, for example directors 34 Non-compliance with verification procedures (reporting, monitoring, etc.) of the program should also carry stiff penalties. Penalties should be collected and enforced as soon as possible after a violation. 35 Experience from both the early years of the U.S. SO2 program as well as attempts at pilot schemes in China has shown the importance of a strong national regulatory authority with oversight of the entire project. 36 Moreover, “enforcement officials must not be constrained by fears that they will run afoul of powerful interests or that, in taking an aggressive enforcement posture, they will endanger their own salaries and social benefits. This is a critical issue in the PRC, in which the [environmental protection agencies] are not independent of the local People’s Congress and the political apparatus.” 37 2.2.2 Flexibility Allowing for flexibility in how emissions credits are generated, traded, and used is important in making them attractive commodities for industries to generate and trade. Banking
32
United States Environmental Protection Agency, Tools of the Trade: A Guide to Designing and Operating a Cap and Trade Program for Pollution Control, Office of Air and Radiation, June 2003, p. 3-24. 33 Ibid. 34 Ibid. 35 Richard Morgenstern et al., “Emissions Trading to Improve Air Quality in an Industrial City in the People’s Republic of China”, Resources For the Future Discussion Paper 04-16, April 2004, p. 28, http://www.rff.org/Documents/RFF-DP-04-16.pdf. Downloaded on 20 July 2007. 36 Personal communication with Roger Raufer, July 2007. 37 Richard D. Morgenstern, Piya Abeygunawardena, Robert Anderson, Ruth Greenspan Bell, Alan Krupnick, Jeremy Schreifels, Cao Dong, Wang Jinan, Wang Jitian, and Steiner Larsen, Emissions Trading to Improve Air Quality in an Industrial City in the People’s Republic of China, Resources for the Future, April 2004, p. 28.
Krotman & Malech 14 A system which allows firms to bank emissions credits “allows for flexibility, and creates incentives for overcompliance”, both of which are key factors in achieving long-term emissions reductions. 38 Firms already meeting their emissions targets in a cost-effective manner will still have an incentive to overcomply and generate extra emissions reductions if they have the option to bank extra credits. Under a voluntary scheme, banking system may also provide companies who would not otherwise participate with an extra incentive to do so, given that they will have the option to create and keep valuable assets (i.e., emissions credits). This can result in earlier emissions reductions, as well as early development and adoption of new technologies. It also can increase support for the program among businesses and the public.39 The US SO2 program provides an example of the value of credit banking. “While the market demand for extra reductions might not materialize in the short-term, sources knew that they would have to operate against a permanent cap on their emissions…the opportunity to bank extra reductions for future use all but guaranteed that those extra reductions would be economically valuable.” 40 Obviously the value of banking relies on adequate regulation; banking is only an attractive option when sources have an expectation that either they or another company under the emissions reduction scheme will have need of credits in the future. 41 A relatively long validity
38
Joseph Goffman, Title IV of the Clean Air Act: Lessons for Success of the Acid Rain Emissions Trading Program, 14 Penn St. Envtl. L. Rev. 177, Winter 2006, p. 186. 39 United States Environmental Protection Agency, Tools of the Trade: A Guide to Designing and Operating a Cap and Trade Program for Pollution Control, Office of Air and Radiation, June 2003, p. 3-19. 40 Joseph Goffman, Title IV of the Clean Air Act: Lessons for Success of the Acid Rain Emissions Trading Program, 14 Penn St. Envtl. L. Rev. 177, Winter 2006, p. 188-9. 41 Interview with Hong Kong power companies, July 2007.
Krotman & Malech 15 period for credits or allowances (i.e. the period during which they can be used to meet emissions limits) can function similarly to an explicit banking system. 42 Borrowing Credit borrowing under cap and trade schemes is another flexibility mechanism that adds to the attractiveness of any scheme for potential participants. Borrowing allows emitters to use allowances from a future compliance period in the current period. 43 In particular, borrowing is a useful instrument for encouraging early adoption technology in cases where the potential risks might otherwise deter investment. 44 One way in which borrowing adds to the attractiveness of early technology adoption within credit trading systems is by allowing for “long-term technology investments without risk of ‘excessive capital obsolescence.’” 45 Additionally, concerns about possible risks of failure in technological investment projects can be mitigated by the use of borrowing mechanisms. Lastly, borrowing can provide a buffer against volatility if technological solutions provide unworkable in the short term. 46 2.2.3 Mitigation of Economic Risk to Participants Removal of Uncertainties Pollution sources will be much more willing to engage in emissions trading, and to buy, create, or bank allowances/credits if they have a relative certainty that these allowances or credits will hold their value in the future. There are a number of threats to the possible value of credits and allowances. If their legal status is uncertain, whether that certainty arises from differing laws 42
Ibid. United States Environmental Protection Agency, Tools of the Trade: A Guide to Designing and Operating a Cap and Trade Program for Pollution Control, Office of Air and Radiation, June 2003, p. 3-19. 44 Ibid. 45 Inho Choi, Global Climate Change and the Use of Economic Approaches: The Ideal Design Features of Domestic Greenhouse Gas Emissions Trading with an Analysis of the European Union's CO2 Emissions Trading Directive and the Climate Stewardship Act, 45 Nat. Resources J. 865, Fall 2005, p. 927. 46 Ibid. 43
Krotman & Malech 16 across jurisdictions or a lack of adequate definition of their legal status, they will not be as attractive a commodity. Additionally, if it is uncertain whether an emissions trading scheme will be continued in much the same manner in the future, or if there is uncertainty over how certain types of credits or allowances can be used or will be able to be used in the future, these credits or allowances will prove much less attractive. If the value of credits or allowances proves volatile in the long term, there is an added element of economic risk. There are a number of mechanisms to address these concerns. 47 Regulatory Consistency The most obvious threat to any kind of emissions trading scheme is a lack of political will to maintain the program in the long term; firms will be reticent to commit resources and planning to account for an emissions trading program that may not last more than a few years. 48 Therefore, the longer the timescale of the scheme and the greater the confidence that emitters have in the political will of the regulating authority, the more willing they will be to fully participate. 49 It is essential that the regulating authority demonstrate a firm long-term commitment to a scheme in order to stimulate trading activity, and provide assurances that it has the capacity and will to implement the program as a part of its long-term environmental plan. Additionally, it is important that emissions sources are aware in advance of what sorts of regulation they will expect in the future. Ideally, regulating authority will make available the specifics of how caps or regulatory limits will decline well in advance. This will allow time to structure business plans, and will allow sources “sufficient time to adjust to new cap levels.� 50 Price Caps on Allowances 47
Personal communication with Hong Kong power companies, July 2007. Ibid. 49 Personal communication with lawyers from Mallesons Stephens Jaques, July 2007. 50 United States Environmental Protection Agency, Tools of the Trade: A Guide to Designing and Operating a Cap and Trade Program for Pollution Control, Office of Air and Radiation, June 2003, p. 3-9. 48
Krotman & Malech 17 Under a cap and trade program, a regulating authority is essentially directly regulating total emissions output; unlike a levy-based system, where prices for pollutants are fixed and total emissions are variable, a cap and trade system leaves prices variable. This leaves the risk that prices can become volatile and allowances will become prohibitively expensive. One way to mitigate this risk is to impose price caps on allowance prices. Although this is not necessarily appropriate for a project-based scheme, it has proved to be effective in cap and trade programs, and can reduce risks and make the program more attractive and economically safe for emitters. 51 Adequate Definition of Regulatory Property Although credits or allowances are “owned” by an emitter, they do not represent tangible property held by that actor alone. Instead, they represent a portion of a public good, namely the absence of whatever pollutant is represented by the credit. The EU ETS experience has shown that this is not just a conceptual issue; in order to minimize legal uncertainties and litigation, it is important to adequately define the nature of this so-called regulatory property and determine how it will be treated under the law. 52 One example of this is in the case of the Swedish approach to allowances under the EU ETS versus the Finnish approach. Allowances are treated under Finnish law as “intangible rights similar in nature to patents, trademarks, licenses, and other intellectual property.” 53 Sweden categorizes allowances as financial assets. 54 These two differing categorizations will have different impacts on, for example, financial accounting statements and corporate taxation. England, which is not under a civil law system like Sweden or Finland, takes a completely
51
Ibid. at 2-6 Overview Report: Legal Framework for Emissions Trading in the European Union, 2006, p. 3-6, available at http://akseli.tekes.fi/opencms/opencms/OhjelmaPortaali/ohjelmat/ClimBus/fi/Dokumenttiarkisto/Viestinta_ja_aktivo inti/Julkaisut/Projektiaineistot/2005/Raportit/Legal_Overview_Report.pdf. 53 Ibid. at 6. 54 Ibid. 52
Krotman & Malech 18 different approach, allowing courts to largely define how allowances should be treated and categorized. 55 These divergent approaches have an impact on business goals, and will affect the price of allowances. While the problem of how to define regulatory property has been most pronounced in a multi-jurisdictional cap and trade context (i.e., the EU ETS) it is certainly something that parties need to be cognizant of under any sort of scheme using allowances or credits. This will be particularly true under a scheme that requires widespread support from involved companies, for whom the definition will impact financial statements and directly affect business goals. Contracts One concern, particularly with project-based schemes, is proper contracting. Clean Development Mechanism (CDM) experience has shown that proper contracting can be a major benefit to all parties, reducing transaction costs and lowering risks. In CDM project-based emissions reductions, parties often enter into agreements with little knowledge of the specifics of each other’s operations, and with limited funds and legal resources. Contracts that include “delivery guarantees, penalties and strict enforcement clauses” can turn the project “from an asset to a liability.” 56 In the case of CDM, “many carbon contracts are also missing elements common to other long term purchase agreements, such as price adjustment clauses and limitations on liabilities.” 57 Contractual certainty is a major tool for reducing risk; features such as arbitration clauses and choices of governing law can either be built into the scheme itself, or be contracted on a project-by-project basis. 58
55
Ibid. at 6-7. CERSPA Guidance Document Version 1.0, April 2007. Available at www.cerspa.com/downloads/CERSPA_Guidance_Doc_Eng_v1_4-2007.doc. Downloaded on 25 July 2007. 57 CERSPA Guidance Document Version 1.0, April 2007. Available at www.cerspa.com/downloads/CERSPA_Guidance_Doc_Eng_v1_4-2007.doc 58 Personal communication with lawyers from Mallesons Stephens Jaques, July 2007. 56
Krotman & Malech 19 It is also possible to build hedging instruments into contracts, or to use reductions projects as a hedging tool rather than relying on them to meet regulatory limits. 59 Risk can also be reflected in the price of credits, or buyers can impose risk on sellers by limiting the percentage of credits they can sell under a reduction plan. 60 There have also been thoughts about using insurance, but this has not received widespread implementation. 61 The EU ETS experience has shown that standardized contracts are useful for reducing transaction costs and minimizing risk. 62 Standardized contracts are being developed for CDM, which could conceivably be modified and used to reduce transaction costs under any projectbased scheme. 2.2.4 ENVIRONMENTAL INTEGRITY OF SYSTEM Regardless of what system will function, to function effectively it must achieve its environmental objectives. If an ETS functions without achieving environmental objectives for too long, the system will lose credibility and political support. Baseline/Additionality Determination One of the most difficult verification aspects of any project-based scheme is ensuring additionality. Additionality is a determination of whether the credit-generating project would have happened anyway, without the financial incentive of credit trading. Without proper additionality determination procedures, the environmental integrity of any project-based scheme is undermined. 63
59
Ibid. Personal communication with Roger Raufer, July 2007. 61 Ibid. 62 Overview Report: Legal Framework for Emissions Trading in the European Union, 2006, p. 3-6, available at http://akseli.tekes.fi/opencms/opencms/OhjelmaPortaali/ohjelmat/ClimBus/fi/Dokumenttiarkisto/Viestinta_ja_aktivo inti/Julkaisut/Projektiaineistot/2005/Raportit/Legal_Overview_Report.pdf. 63 United States Environmental Protection Agency, Tools of the Trade: A Guide to Designing and Operating a Cap and Trade Program for Pollution Control, Office of Air and Radiation, June 2003, p. 2-7. For a thorough analysis of additionality determination procedures under CDM, see The World Bank, Ministry of Science and Technology, P.R. 60
Krotman & Malech 20 Economies such as the PRC where political considerations are as much a part of corporate decision-making as are pure cost versus profit determinations add a further complication. A project that is not determined to be economically efficient without the added credit revenue might still have happened due to non-economic factors such as governmental pressures or overall strategy. This has proved to be a widespread concern about CDM projects in the China and elsewhere, and has served to undermine confidence in the environmental integrity of the CDM program. 64 The World Bank recommends, based on case studies of a wide variety of Chinese CDM projects, a simplified baseline setting methodology. Their analysis has not found significant leakage problems (see section below on leakage), given the energy shortages and fast pace of development already underway in China. However, they do find considerable problems with a number of the standard baseline setting methodologies, and recommend a more streamlined approach for both general simplicity and to reduce transaction costs. 65 Additionality is not only crucial to the efficacy of any project-based program, but an imprecise process that is complicated and still under review. Leakage Leakage occurs when an emissions reduction in one source causes adverse environmental effects from a source outside of the area participating in an emissions reduction scheme. For example, a power plant participating in an emissions trading program reduces its output. This in turn causes electricity to be imported from outside the capped area, causing that electricity China, The Deutsche Gesellschaft f端r Technische Zusammenarbeit, German Technical Cooperation Unit (GTZ), Federal Ministry of Economic Cooperation and Development, Swiss State Secretariat for Economic Affairs, Clean Development Mechanism in China: Taking a Proactive and Sustainable Approach, The World Bank: September 2004. Available at http://www.worldbank.org.cn/English/content/cdm-china.pdf. 64 Personal communication with Tom Heller, July 2007. 65 The World Bank, Ministry of Science and Technology, P.R. China, The Deutsche Gesellschaft f端r Technische Zusammenarbeit, German Technical Cooperation Unit (GTZ), Federal Ministry of Economic Cooperation and Development, Swiss State Secretariat for Economic Affairs, Clean Development Mechanism in China: Taking a Proactive and Sustainable Approach, The World Bank: September 2004, p. 76. Available at http://www.worldbank.org.cn/English/content/cdm-china.pdf.
Krotman & Malech 21 generator to increase production, while emitting the same or higher levels of pollutants. Though overall emissions have gone down within the capped area, net emissions have remained the same; however, the power plant that decreased its production still earns emissions reduction credits. 66 Leakage can occur with project-based or cap and trade schemes, and has the potential to undermine the environmental benefits of any such program. The Environmental Law Institute reposts that “because states have not found objective tests for additionality of credit-generating projects, emissions credit systems are “leaky,” and may provide credit for reductions that sources would have made anyway. “Credit trading programs depend on a strong regulatory program surrounding the subject sources, together with good rules for trading, to prevent them from increasing overall emissions to the airshed.” 67 In addition, it is necessary to set a large enough project boundary within which the environmental effects will be assessed to account for possible leakage. 68 Well-Designed Initial Allocation Under a cap and trade scheme, the initial allocation of credits is an important design feature to consider. The three most common ways to allocate credits initially are auctioning, grandfathering (i.e. freely giving credits to pre-existing sources), and free allocation based on market share. 69 Studies have found that auctioning is the most economically efficient method for
66
United States Environmental Protection Agency, Tools of the Trade: A Guide to Designing and Operating a Cap and Trade Program for Pollution Control, Office of Air and Radiation, June 2003, p. 3-5. 67 Emission Reduction Credit Trading Systems: An Overview of Recent Results and an Assessment of Best Practices, Environmental Law Institute, September 2002, p. vii. 68 The World Bank, Ministry of Science and Technology, P.R. China, The Deutsche Gesellschaft für Technische Zusammenarbeit, German Technical Cooperation Unit (GTZ), Federal Ministry of Economic Cooperation and Development, Swiss State Secretariat for Economic Affairs, Clean Development Mechanism in China: Taking a Proactive and Sustainable Approach, The World Bank: September 2004, p. 10. Available at http://www.worldbank.org.cn/English/content/cdm-china.pdf. 69 Inho Choi, Global Climate Change and the Use of Economic Approaches: The Ideal Design Features of Domestic Greenhouse Gas Emissions Trading with an Analysis of the European Union's CO2 Emissions Trading Directive and the Climate Stewardship Act, 45 Nat. Resources J. 865, Fall 2005.
Krotman & Malech 22 initial allocation. 70 However, this will often not be a politically acceptable solution to affected industries. Additionally, pure auctioning can impose large barriers to entry. On the other hand, the regulatory property created by allocating credits represents real value. An initial allocation that imposes no costs on pollution emitters represents a large wealth transfer to and among industries. A partial grandfathering/auctioning scheme has been suggested as an attractive option, as it can “minimize short-term cost impact” on highly polluting industries “while slightly impacting the program’s performance, foregoing only a very small percentage of its revenue”. Ideally, the revenues raised from an auction would be used to help with costspreading for the most pollutant-intensive industries within the program. 71 The USEPA recommends that allocation methodologies could be left up to individual jurisdictions, noting that there is little differing environmental impact between methods if properly enforced. 72 Optimal allocation would be at a level where marginal abatement cost is equal to the marginal utility of emissions reduction, but this value is very difficult to quantify. 73 2.2.5
Transaction Costs
Minimizing Tracking Costs One of the major differences between project-based and cap and trade systems are the levels of administrative involvement and the procedures used to verify emissions reductions. Because cap and trade programs rely on economies of scale, allowances are allocated at the outset and verification procedures can be standardized, the level of administrative involvement and transaction costs are much lower. 74 Conversely, “project-based trading can reduce the costs
70
Ibid. Ibid. 72 United States Environmental Protection Agency, Tools of the Trade: A Guide to Designing and Operating a Cap and Trade Program for Pollution Control, Office of Air and Radiation, June 2003, p. 2-3. 73 Ibid. at 3-9 and 3-10. 74 Ibid. at 2-8. 71
Krotman & Malech 23 of attaining an emission goal, but the administrative and transaction costs per unit of emission reduction are often higher than cap and trade programs; there is greater uncertainty and risk associated with an offset than an allowance (e.g., due to baseline, permanence, and leakage issues); and extensive involvement and oversight by the regulating authority are required to ensure environmental integrity.” 75 Size Distributions Skewed size distribution in terms of emissions output between different sources can also pose a challenge to any trading scheme. Size by itself, however, is not necessarily the determining factor. Morgenstern et al. report that “a skewed size distribution exists in Los Angeles. Nevertheless, monopoly behavior has not been an issue in the California-based Regional Clean Air Incentives Program (RECLAIM) program, in which a few power plants dominate in terms of quantity of emissions.” 76 Large Range of Compliance Options. A wide range of compliance options is allowable under either a cap and trade or a baseline and credit scheme. The more flexible the compliance options, the wider the marginal costs of abatement will be across a scheme. 77 In practice, limited technological abatement options may not prove to be a major obstacle, particularly in seeking project-based emissions reductions. A 2001 study found that
75
Ibid. Richard Morgenstern et al., “Emissions Trading to Improve Air Quality in an Industrial City in the People’s Republic of China”, Resources For the Future Discussion Paper 04-16, April 2004, p. 29, http://www.rff.org/Documents/RFF-DP-04-16.pdf. Downloaded on 20 July 2007. 77 Joseph Goffman, Title IV of the Clean Air Act: Lessons for Success of the Acid Rain Emissions Trading Program, 14 Penn St. Envtl. L. Rev. 177, Winter 2006, p. 186.. 76
Krotman & Malech 24 80% of emissions reduction credits (ERCs) generated under the U.S. Clean Air Act offset credit trading program came from shutdowns of older, inefficient sources. 78 Well-Designed Monitoring and Verification Any market-based approach requires complex monitoring capabilities, in addition to a strong enough threat of enforcement to deter noncompliance or cheating. “To ensure accountability and induce technical improvements in emissions calculations, conservative accounting rules and centralized verification procedures need to be enforced.” 79 As noted, the costs of monitoring can vary depending on the type and scale of the scheme introduced. Project-based approaches are more difficult and costly to monitor and verify due to the high level of government involvement and the lack of a centralized and standardized verification procedure. 80 However, even under cap and trade systems verification costs can be high. The best approach to monitoring is through Continuous Emissions Monitoring System (CEMS). However, they may be too expensive and technologically sensitive for use in some programs. CEMSs are required under the CAA’s SO2 program in the U.S., and costs have proved to be quite high. 81 Additionally, monitoring data is only as good as the equipment used to gather it, and only as reliable whoever is in charge of its operation and upkeep. This same principle applies to emissions reduction technologies, such as scrubbers, if CEMS or similar direct monitoring
78
Emission Reduction Credit Trading Systems: An Overview of Recent Results and an Assessment of Best Practices, Environmental Law Institute, September 2002, p. i. 79 Inho Choi, Global Climate Change and the Use of Economic Approaches: The Ideal Design Features of Domestic Greenhouse Gas Emissions Trading with an Analysis of the European Union's CO2 Emissions Trading Directive and the Climate Stewardship Act, 45 Nat. Resources J. 865, Fall 2005. 80 Ibid. 81 Ibid.
Krotman & Malech 25 technology is not in place. There are concerns that Chinese-made and -operated scrubbers and CEMS are not particularly reliable. 82 Auditing Without very thorough independent auditing and/or regulatory oversight by a reliable authority, there is always the risk that these technologies will be installed and simply not used. 83 Independent third-party verification can be valuable in providing additional oversight and credibility, particularly in project-based schemes. It is best to use accredited auditors, such as mandated under the CDM system. HSBC, based on their experience using project-based and voluntary carbon trading to reduce their carbon footprint, has recommended the use of independent auditors for these types of projects. 84 However, regulatory oversight is still essential, even if independent auditors are used. However, the process could encourage less-than-accurate information by auditors if they are in a business relationship with the company they are auditing. 85 There is also the risk that companies will select the lowest-cost auditors, who might not have a sufficient level of expertise. The use of proper accreditation and regulatory oversight should largely address these concerns. “If independent parties are involved, the regulating authority should have oversight, certification, and review procedures in place to promote accountability.� 86 Additionally, the regulatory body should compare data obtained directly from the emitter with field audits,
82
Personal communication with Roger Raufer, July 2007. Personal communication with Tom Heller, July 2007. 84 Ricardo Bayon, Amanda Hawn, and Katherine Hamilton, Voluntary Carbon Markets: An International Business Guide to What They Are and How They Work, Earthscan, 2007, p. 97. 85 Inho Choi, Global Climate Change and the Use of Economic Approaches: The Ideal Design Features of Domestic Greenhouse Gas Emissions Trading with an Analysis of the European Union's CO2 Emissions Trading Directive and the Climate Stewardship Act, 45 Nat. Resources J. 865, Fall 2005. 86 United States Environmental Protection Agency, Tools of the Trade: A Guide to Designing and Operating a Cap and Trade Program for Pollution Control, Office of Air and Radiation, June 2003, p. 3-5. 83
Krotman & Malech 26 particularly when equipment such as CEMS are used. 87 This will obviously add to the costs of the program. An issue that may arise, particularly in the PRC context, is having an adequate supply of accredited verifiers. 88 The Environmental Law Institute, in a comparative analysis of state-by-state Discreet Emissions Reduction programs (DERs) in the United States, finds that “a complete technical audit by the regulatory agency at the time of credit generation” is preferable to the use of independent auditors or a “buyer beware” system where the state reserves the right to do a spot audit at a later date. 89 One interesting suggestion is that, if independent auditors are used, the quality of the auditing could actually be reflected in the price of credits. 90 2.2.6
Transparency/Public Discourse Transparent information and public discourse are essential for any trading program to
provide an additional and crucial level of oversight. The U.S. SO2 program provides a good model. Almost all aspects of the program are made public, including allocations and trading information. This helps to build confidence as well as provides an additional level of oversight. 91 There is research indicating that public acceptance of a policy is crucial to implementation, and builds trust in the policies and institutions. 92 “Providing public access to source-level emission and allowance data promotes confidence in the program and provides an additional level of
87
Ibid. at p. 4-4. Personal communication with Roger Raufer, July 2007. 89 Emission Reduction Credit Trading Systems: An Overview of Recent Results and an Assessment of Best Practices, Environmental Law Institute, September 2002, p. v. 90 Personal communication with Roger Raufer, July 2007. 91 Richard Morgenstern et al., “Emissions Trading to Improve Air Quality in an Industrial City in the People’s Republic of China”, Resources For the Future Discussion Paper 04-16, April 2004, p. 28, http://www.rff.org/Documents/RFF-DP-04-16.pdf. Downloaded on 20 July 2007. 92 United States Environmental Protection Agency, Tools of the Trade: A Guide to Designing and Operating a Cap and Trade Program for Pollution Control, Office of Air and Radiation, June 2003, p. 5-1. 88
Krotman & Malech 27 scrutiny to verify enforcement and encourage compliance. In some jurisdictions these data are classified as confidential and may require legal changes to make them publicly available.” 93 Project-based emissions reduction programs all have stringent reporting requirements used to form emissions registries, the results of which are posted on the internet. This greatly increases the transparency of these programs, and should provide a model for future projectbased schemes. However, these registries suffer from poor organization of data, inconsistency of data, and lack of summaries of data. 94
3. ENVIRONMENTAL REGULATION IN CHINA 3.1: The Politics Of Environmental Regulation In China A proper discussion of air pollution regulation in the PRD, particularly on the Guangdong side, mandates a brief overview of environmental regulation in China as a whole. Although the central government passes legislation and “supervises” administration and enforcement through the State Environmental Protection Administration (SEPA), it is really the provincial and local Environmental Protection Bureaus (EPBs) that implement national rules and regulations. These efforts on the ground are often thwarted by a lack of resources, local priorities on economic development, government ownership of the entities they regulate, and inadequate penalties for non-compliance. 95 For instance, SEPA has just 250 staff, compared to U.S. EPA’s
93
Ibid. at 3-2. Emission Reduction Credit Trading Systems: An Overview of Recent Results and an Assessment of Best Practices, Environmental Law Institute, September 2002, p. vi. 95 See Environmental Defense, “Picking Up the Pieces: Environmental Disaster In China Brings Opportunity for Reform”, Solutions, Vol. 37, No. 2, April 2006, p. 1, http://www.environmentaldefense.org/documents/5175_0306Solutions.pdf. Downloaded 15 July 2007. 94
Krotman & Malech 28 18,000. 96 Moreover, the judicial system often cannot independently enforce compliance, since judges are appointed and paid by provincial and local governments. 97 This creates a vicious cycle fraught with corruption, in which local and provincial governments own the entities they regulate, appoint and pay the EPB officials charged with implementing regulations, and appoint and pay the judges responsible for ensuring compliance. Although a proliferation of environmental law drafting and public rhetoric over the past decade and a half indicates that there is a real interest in combating air pollution at the national level in China, implementation is another story. For instance, the previous 10th FYP (2001-2005) called for a 10% nationwide reduction in SO2 emissions by 2005 based on 2000 levels. 98 Not only did China fail to meet its 10% reduction pledge, but its 2005 emissions exceeded 2001 levels by over 28% (see Figure 1). Spurred largely by rapid economic development, dramatic increases in total energy consumption by 70% between 2000 and 2005 (see Figure 2), with coal consumption accounting for 75% of this increase, partially explains the failure to meet SO2 emission targets. 99 While energy intensity, measured by energy consumption per unit of GDP decreased significantly between 1978 and 2001, it increased in the 2002-2005 period. 100 The 11th FYP (2006-2010) made the same pledge of a 10% reduction based on 2005 levels, and calls for a 20% reduction of energy consumption per unit of GDP to improve energy efficiency. 101
96
Ibid. p. 1. See generally Richard Morgenstern et al., “Emissions Trading In Taiyuan, China”, Resources, Issue 148, Summer 2002, http://www.rff.org/Documents/RFF-Resources-148-emissions.pdf. Downloaded 10 July 2007. 98 U.S. Embassy In Beijing, China’s Emissions Trading Pilot Projects, May 2003, http://www.usembassychina.org.cn/sandt/ptr/Emissions-Trading-prt.htm. Downloaded 14 July 2007. 99 World Bank, Cost of Pollution In China: Economic Estimates of Physical Damage, Beijing: World Bank, February 2007, p. 7, http://siteresources.worldbank.org/INTEAPREGTOPENVIRONMENT/Resources/China_Cost_of_Pollution.pdf. Downloaded on July 22, 2007. 100 Ibid. pp. 7-8. 101 “Speech by Ma Kai, Minister of National Development and Reform Comission”, The 11th Five-Year Plan: Targets, Paths and Policy Orientation, 19 March 2005, http://english.gov.cn/2006-03/23/content_234832.htm. Downloaded July 22 2007. 97
Krotman & Malech 29 These political realities have important implications for environmental regulatory programs on the ground in Guangdong, even when the benefits of compliance to society may exceed the costs. Such a pattern of setting overly ambitious pollution reduction objectives and then retreating from these commitments can undermine future attempts to regulate. Any regional ETS must either work around this context or wait for conditions to change. By contrast, Hong Kong exists within a drastically different political context under the “1 Country, 2 Systems� framework. It is a small, wealthy capitalist city-state with a relatively developed regulatory system, well-established common-law judicial institutions, and an energy sector that has been independent from the government for over one-hundred years. The different political contexts of Guangdong and Hong Kong poses both jurisdictional challenges and trading opportunities under the ETPS.
Figure 1: Environmental Targets for the 10th Five Year Plan vs. Environmental Performance (million tons) 102
102
World Bank, Cost of Pollution In China: Economic Estimates of Physical Damage, Beijing: World Bank, February 2007, p. 1, http://siteresources.worldbank.org/INTEAPREGTOPENVIRONMENT/Resources/China_Cost_of_Pollution.pdf. Downloaded on July 22, 2007. Downloaded on 22 July 2007.
Krotman & Malech 30
Figure 2: Total Energy Consumption in China, 1978-2005 103
In sum, while the national government has instituted a series of environmental emissions regulations that look good on paper, decentralized implementation and the priority placed on economic development and energy supply undermine effectiveness.
3.2: Domestic Emissions Trading In China
Discussions in the PRC about emissions trading pilots date back to academic case studies conducted by SEPA as early as the 1980s. 104 They have since flowered into a number of pilot schemes, many of which are still ongoing, jointly coordinated by SEPA, local and provincial EPBs, the U.S. EPA, and various global environmental NGOs. The schemes have varied in their
103
Ibid., p. 8. Richard Morgenstern et al., “Emissions Trading to Improve Air Quality in an Industrial City in the People’s Republic of China”, Resources For the Future Discussion Paper 04-16, April 2004, p. 19, http://www.rff.org/Documents/RFF-DP-04-16.pdf. Downloaded on 20 July 2007.
104
Krotman & Malech 31 geographical scope, ambition, and form, ranging from the municipal to the provincial level, and from government-coordinated project-based schemes to cap and trade systems. 105 Progress in these pilot schemes continues to move forward at a slow pace and with several challenges. Undeveloped regulatory infrastructure and institutions and inadequate penalties plague many of the schemes. The results have been lax enforcement, hesitancy to participate, and a failure to meet specified objectives. Trades tend to be coordinated by the State rather than arise naturally among participants. 106 However, signs of progress include symbolic milestones, such as the first inter-city trade in China in 2003 between two power plants in Jiangsu Province. 107 Key lessons to derive from these experiences are that: (1)
Regulatory infrastructure and compliance mechanisms in typical areas of China need to progress substantially to support a complex MBI like emissions trading, and;
(2)
Without experience functioning in a free market system like the U.S., government involvement in a Chinese ETS is likely necessary to achieve desired levels of participation.
At the same time, the failures of the pilot schemes should not undercut accomplishments. Even skeptics concede that the development of computer and allowance tracking systems and the passage of emissions trading laws represent steps forward in building the institutional capacity for a full-fledged ETS. 108 Further, if China needs to develop its regulatory institutions and
105
For more extensive descriptions of these various pilot schemes, see Morgenstern 2004; Christine Loh and Roger Raufer, The Emissions Trading Game, Hong Kong: Civic Exchange,. January 2007, p. 36. 106 Personal communication with Roger Raufer, July 2007; Personal communication with lawyers from Mallesons Stephens Jaques, July 2007; Personal Communication with Tom Heller, July 2007. 107 U.S. Embassy In Beijing, China’s Emissions Trading Pilot Projects, May 2003, http://www.usembassychina.org.cn/sandt/ptr/Emissions-Trading-prt.htm. Downloaded 14 July 2007. 108 Ruth Greenspan Bell, “Choosing Environmental Policy Instruments in the Real World”, OECD Global Forum On Sustainable Development: Emissions Trading, Paris, France: OECD, 2003, http://www.oecd.org/dataoecd/11/9/2957706.pdf. Downloaded on 20 July 2007.
Krotman & Malech 32 receive exposure to free market contexts, why not learn by doing? Experience with these pilot schemes can serve as a platform to pursue such objectives, a potentiality that the ETPS in the PRD does not fail to recognize.
4. ENVIRONMENTAL REGULATION IN THE PRD 109 Section 2 above emphasized the paramount importance of adequate and well-defined preexisting or anticipated regulatory caps for an ETS to function. Thus, it is important to consider current and anticipated regulations in the PRD, in addition to the political-economic context discussed in section 3.
4.1: Region-Wide Air Pollution Regulations Serious region-wide regulations began in April 2002, when the HKSARG and GPG released their Regional Air Quality Management Plan (Management Plan). They had formally agreed to jointly study air pollution in the PRD region in 1998 through the Hong KongGuangdong Joint Working Group on Sustainable Development and Environmental Protection (Joint Working Group). 110 Under the Plan, the two governments reached a consensus to reduce regional emissions of four major air pollutants on a “best endeavor basis�. They sought to lower SO2, NOx, RSP, and volatile organic compounds (VOC) emissions by 40%, 20%, 55%, and 55%, respectively, using 1997 as a baseline year. 111 Though not legally enforceable, politicians at the highest levels remain staunchly committed to meeting the targets on time. As recently as August 2, 2006, both sides reconfirmed 109
For a far more extensive discussion of environmental regulation in Hong Kong, see generally See FN 7 supra. See FN 7 supra, p. 96. 111 See FN 9 supra. 110
Krotman & Malech 33 their determination to reach the targets. 112 On both sides, governments, the energy sector, manufacturers, and the transport industry have invested in and completed a variety of projects designed to reduce emissions. They have mostly sought to increase energy efficiency, using cleaner fuels, and installing pollution control equipment such as scrubbers. 113 Despite these positive signs, statistical progress towards the objectives is mixed for Hong Kong, and the numbers are not available on the Guangdong side. Increases in power plant emissions in SO2 and NOx and delays in VOC and RSP reduction projects explain the imperfect progress towards the targets. See Table 1 below for details on Hong Kong’s progress.
Table 1: Overall Progress In Hong Kong Against 2010 Target As of 2004 114
In addition to setting joint reduction goals, the two governments successfully compiled a regional emissions inventory in 2003 to update figures from 1997, although this information is not public at the present time. 115 On November 30, 2005, the two sides launched the PRD Regional Air Quality Monitoring Network, which allows for daily publication of the Regional
112
Environment, Transport and Works Bureau, Review of Air Quality Objectives, 27 November 2006, p. 8. For a comprehensive listing of such measures taken, see FN 9 supra, Annex III (Hong Kong measures) and Annex IV (Guangdong measures); See FN 7 supra, pp. 66, 70-71. 114 Environmental Protection Department, Review of Air Quality Objectives, 27 November 2006, p. 3. 115 See FN 7 supra, p.100. 113
Krotman & Malech 34 Air Quality Index on the Internet and provided the basis for reports on regional monitoring results on October 31, 2006, and April 24, 2007. 116 While it is uncertain whether they will reach all their 2010 targets or that they are putting forward their “best endeavors�, both sides continue to take concrete steps towards these goals and to publicly endorse them. Though they are not formal caps, they form the basis in part for existing caps on the power companies in Hong Kong, both of which claim to structure their operations and investments in pollution prevention projects to meet these targets.117
4.2: Hong Kong Air Pollution Regulations The regulations imposed on the emissions of power companies are particularly relevant to this study. 118 Primarily, they consist of emissions caps and environmentally-friendly technological requirements 119 . Under the current regulatory framework, the EPD imposes caps on individual facilities of CLP and HEC through the Air Protection Control Ordinance (APCO). First, under the APCO, the EPD sets non-legally enforceable Air Quality Objectives (AQO) that specify a recommended ceiling on concentrations of various pollutants in ambient air. 120 Next, the APCO identifies specified processes, such as electricity generation, that emit particularly high levels of the pollutants regulated by the AQOs. Last, the APCO mandates that entities wishing to engage in such processes apply for and receive a Specified Process License (SPL), containing caps on
116
Ibid. p. 97. Personal communication with Hong Kong power companies, July 2007. 118 For a discussion of regulations on the transport industry, see See FN 7 supra, pp. 32-62. 119 Ibid. p. 66 (For instance, coal units in power plants installed after 1991 must be fitted with flue gas desulphurisation systems and low-NOx technology equipment). 120 As opposed to air quality standards (italics added), which are legally enforceable in Hong Kong. See Christine Loh and Simon Ng, Air Pollution In China: The Air That We Breathe, Hong Kong: Civic Exchange, April 2005, 11, http://www.civic-exchange.org/publications/2005/CLSAA.pdf. Downloaded on 1 July 2007. 117
Krotman & Malech 35 pollutant emissions set by the EPD and based on consideration of the AQOs. 121 The SPLs are renewed every two years or so, as specified in the license, and caps become progressively tighter. It then becomes an offense punishable by fines and/or imprisonment to exceed these caps. 122 In addition, under the new 2008 Scheme of Control Agreements (SCA), the HKSARG now links the permitted rates of return for Hong Kong power companies to total emissions levels. 123 The SCAs are long-term regulatory contracts that grant power companies a fixed rate of return on their capital investment in return for providing a sufficient supply of electricity to meet demand at all times at the lowest reasonable cost. Exceeding SPL emissions caps can decrease the rate of return up to 0.4%, while achieving emissions objectives can increase the rate of return up to 0.1%, depending on the amount that emissions exceed or fall below total caps, respectively. 124 This provides financial incentives for the power companies to reduce emissions even below SPLmandated levels, and hopefully to participate in the ETPS. While emissions regulation of power companies is relatively new in Hong Kong—the first SPL caps were in 2005—regulatory institutions are robust and compliance is expected. The more pressing issue is whether the caps are stringent enough to induce power companies to explore flexible mechanisms for achieving compliance such as the ETPS. At present, Hong Kong power companies can easily meet their
121
See FN 7 supra, p. 65. Personal communication with lawyers from Mallesons Stephens Jaques, July 2007. 123 The Scheme of Control Agreement entered into by the Government of the Hong Kong Special Administrative Region and the following companies: CLP Power Hong Kong Limited, ExxonMobil Energy Limited, and Castle Peak Power Company Limited, 2008, Schedule 4, http://www.enb.gov.hk/en/resources_publications/agreement/files/SCA_of_CLP_Eng.pdf. Downloaded on 24 January 2008; The Scheme of Control Agreement entered into by the Government of the Hong Kong Special Administrative Region and the following companies: The Hongkong Electric Company, Limited and HongkongElectric Holdings Limited, 2008, Schedule 4, http://www.enb.gov.hk/en/resources_publications/agreement/files/SCA_of_HEC_Eng.pdf. Downloaded on 24 January 2008. 124 Ibid. Schedule 4. 122
Krotman & Malech 36 caps through in-house emissions reduction projects, 125 but the hope is that over time the HKSARG will tighten them considerably.
4.3: Guangdong Air Pollution Regulations Emissions regulations imposed on power plants, to the extent that they exist at all, are not transparent at the present time. They are set uniformly for generating units at the national level, and vary according to the given age, fuel type and technology systems of a given generating unit. Although China has switched to an amount-based Total Emissions Control (TEC) regulatory policy, the Guangdong emissions regulation limits seem to operate on a concentration-based standard as “General Performance Standards” for the purposes of the ETPS. A supplemental paper relating to the ETPS released by the HKSARG Legislative Council on March 28, 2007 lists the permitted emissions limits in Guangdong and the original implementation framework for the scheme lists the “General Performance Standards” used to calculate baselines for Guangdong plants under the ETPS. Presumably, the GPS rates in the implementation framework, listed in terms of grams of pollutant/kWh, match the emissions limits listed in the supplement in terms of m/m3. 126 Such complex calculation illustrates the lack of transparency on the Guangdong side. These same emissions limits presumably form the basis for China’s Pollution Levy System (PLS) in Guangdong. The PLS operates like a uniform national two-tiered tax, imposing a levy rate per ton of pollutant (SO2) emitted. Emitters will reduce total emissions to the point at which the marginal cost of additional reductions equal the levy, with the levy increasing in cases
125 126
Personal communication with Hong Kong power companies, July 2007.. See FN 9 supra, Annex II; See FN 12 supra, 10-11.
Krotman & Malech 37 where the discharge of pollutants exceeds the limit set by the state.127 In reality, lack of enforcement often leads to far less than 100% compliance. As the wealthiest province in China, it is expected that levy rates in Guangdong are higher than most other provinces in China. A 2000 World Bank study found that the ratio of rates between Guangdong and its neighboring province, Jianxi, was 2.6:1. 128 While the PLS is a regulatory mechanism currently in place in Guangdong, its stringency, compliance rate, and overall impact are doubtful and largely unknown. In addition, the GPG has implemented several project, technology, and fuel-switchingbased emissions reduction regulatory projects with the aim of combating air pollution. 129 In 2006, the GDEPB reported that “all large-scale thermal power plants in the PRD Economic Zone had complied with the national emissions requirements in 2006.” 130 Though Guangdong’s emissions regulations appear somewhat vague and confusing and the compliance rate is questionable, the caps themselves are not far off those in place in Hong Kong, suggesting that the GPG, or at least the national government, may have begun to take Guangdong’s air pollution problem as seriously as the HKSARG. 131
4.4: Anticipated Future Air Pollution Regulations On a regional basis it is unclear what will happen with emissions reduction targets post2010. Future targets await the results of both sides in meeting the 2010 objectives, and will likely be sensitive to issues of energy supply and economic development. As the region 127
See Hua Wang & David Wheeler, Endogenous Enforcement And Effectiveness of China’s Pollution Levy System, Development Research Group World Bank, 2000, http://www.p2pays.org/ref/22/21753.pdf. Downloaded on 21 July 2007. 128 Ibid. p. 11. 129 See FN 9 supra, Annex IV for a list of measures the GPG has taken and plans to take in the future. 130 Ibid. p. 4. 131 See FN 9 supra, Annex II.
Krotman & Malech 38 continues to move towards fuel-switching from coal to natural gas, it will become politically and economically feasible to set stricter targets. Currently, however, the government refuses to set a definite time-frame for the review of emission reduction targets beyond 2010. 132 In Hong Kong, there are two anticipated events that will impact regulations on emissions levels. Second, a study commissioned by the government that will form the basis for a revision of the AQOs is slated to conclude in the third quarter of 2008. After a thorough “public engagement process”, the HKSARG plans to promulgate new AQOs and set forth a long-term strategy on air quality management within 2009.133 Since the AQOs and long-term reduction targets largely determine the emissions caps power companies face in their SPLs, they will affect energy sector emissions regulation in Hong Kong for the foreseeable future. The stringency of these regulations will impact the incentives for power companies to engage in flexible mechanisms for emissions compliance, such as emissions trading. Recent proposals in the Legislative Council demand stricter caps in line with the 2010 objectives incorporated into the power companies’ SPLs. 134 The future of power plant emissions regulation in Guangdong is far less certain, but the current trend is moving towards more stringent regulations. As Guangdong becomes increasingly wealthy and its pollution woes continue to take human and economic tolls, demand to control and reduce air pollution will likely increase. Professor Heller, an environmental economist and law professor who has worked closely with the Guangdong government, predicts that emissions caps reducing pollutant emissions by 50-75% over time may be forthcoming in
132
Panel on Environmental Affairs, Minutes of Special Meeting On Emissions Trading Pilot Scheme, 28 March 2007, http://www.legco.gov.hk/yr06-07/english/panels/ea/minutes/ea070328.pdf. Downloaded on 15 July 2007. 133 Environment, Transport and Works Bureau, Review of Air Quality Objectives, 27 November 2006, p. 10. 134 Environmental Protection Department, A Proposal to Amend the Air Pollution Control Ordinance (Chapter 311), December 2007, http://www.legco.gov.hk/yr07-08/english/panels/ea/papers/ea1217cb1-418-7-e.pdf. Downloaded on 24 January 2008.
Krotman & Malech 39 the near future. 135 As emissions regulations now stand, they are supposed to tighten progressively up to 2020. 136 If so, flexible emissions reduction mechanisms such as emissions trading could become very popular as long as heterogeneity in marginal costs of abatement exist. The effectiveness of such mechanisms will of course depend on the resolution of institutional regulatory issues in China. Moreover, motivation to participate will likely not materialize until the regulations become more certain and penalties are raised to adequate levels. Overall, actors in both Hong Kong and Guangdong expect caps to progressively tighten, but it remains highly uncertain how much and when this will occur past 2010. Such uncertainty, especially given the relative ease of meeting current obligations, presents a formidable impediment to emissions trading.
5. ANALYSIS OF THE ETPS With a clearer picture of the regulatory framework and political economic context under which power plants in the PRD operate, as well as a conceptual framework by which to evaluate e i missions trading systems, we turn now to an analysis of the ETPS.
5.1: Details of the Pilot Scheme As Part 1 indicated, the ETPS is a voluntary emissions trading scheme for eligible thermal power plants in the PRD to trade credits in SO2, Nox, and/or RSP reductions. The ETPS adopts the following objectives and purposes 137 : 135
Personal communication with Tom Heller, July 2007. See FN 7 supra, p. 99. 137 See FN 12 supra, pp. 1-2, para. 1.2-2.4 136
Krotman & Malech 40 •
“…by making use of market forces, to provide greater flexibility for emission sources to meet the emission reduction requirements set down by the government in a cost effective manner.” (para. 1.2) (italics added)
•
“…to allow thermal power plants/power companies (hereafter referred to “power plants”) in the PRD Region to participate, on a voluntary basis, in emission trading and by making use of its flexibility to reduce air pollutant emissions in the whole PRD Region in a way meeting the interests of various parties.” (para 1.3) (italics added)
•
“To help both governments to develop the main details, management and implementation methods for an emission trading scheme, and to establish audit standards and emission guidelines system for the emission trading.” (para. 2.1) (italics added)
•
“To promote the use of emission trading as a tool to reduce pollutant emissions by major emission sources in the Region.” (para. 2.2) (italics added)
•
“To lay the foundation for the development of a practicable and comprehensive emission trading system in the PRD Region in the future.” (para 2.3) (italics added) The confusing terminology of the ETPS appears to establish a hybrid cap-and-trade and
baseline-credit system, 138 but the voluntary nature of the scheme and lack of detail about how and when allocation will take place lessen the possibility of imminent cap-and-trade emissions trading until further details are announced. In addition to direct supervision by governmental authorities, an Emission Trading Management Panel (Management Panel) will provide supervision and oversight. 139 We will discuss additional details of the ETPS over the course of our analysis below.
138 139
Ibid., see Section 3 for example. Ibid., see Section 4 and Appendix 5.
Krotman & Malech 41
5.2: Analysis Our analysis will proceed along the conceptual framework laid out in Part 2 by evaluating the extent to which each precondition is met in the PRD and the ETPS. It is an imperfect task, since some structural preconditions conceptually overlap with design feature preconditions, but it provides for a relatively organized analysis. 5.2.1 Structural Preconditions Nature of the Environmental Problem Since the problem the ETPS seeks to address is one of ambient air quality in the PRD strongly tied to air flow over an entire region, it adequately satisfies this structural precondition. Concerns regarding local hotspots of pollution are relatively unfounded, since the pollutants that the high smoke-stacks of thermal power plants emit often disperse substantially before they affect ambient air quality. Eventually, authorities may wish to consider extending the scheme to other regions neighboring the PRD, the emissions of which likely also impact ambient air quality in the PRD. Heterogeneity in Marginal Costs of Abatement Given the stricter levels of regulation and relatively more advanced emissions control technology in place in Hong Kong, heterogeneity in marginal costs will likely exist between the Hong Kong plants and many of the Guangdong plants. For instance, many Guangdong plants may opt to install desulphurization technology available from certain domestic companies for as low as 짜400. 140 In addition, fuel-switching opportunities to environmentally cleaner natural gas for some power plants will create further heterogeneity. Issues here mainly revolve around the availability of cost-effective technological machinery that operates as advertised. For instance, 140
Clear The Air, Submission Paper From Clear the Air To the Legislative Council Regarding the Pilot Scheme, 28 March 2007, http://www.legco.gov.hk/yr06-07/english/panels/ea/papers/ea0328cb1-1201-4-e.pdf. Downloaded on July 20, 2007..
Krotman & Malech 42 many Chinese scrubbers cost far less than their foreign counterparts, but then fail to deliver their promised emissions reductions. 141 Regardless, ample economic opportunities appear to exist for potential emissions trading pairing, especially between Hong Kong and Guangdong power companies, although buyer demand on the Hong Kong side is a separate issue. In addition, adequate heterogeneity certainly exists between Guangdong plants, making intra-Guangdong trading an economically viable possibility. 142 Lastly, reduction opportunities on the Hong Kong side placing Guangdong plants as potential buyers exist as well, with thirteen out of the sixteen coal-fired generating units in Hong Kong lacking flue gas desulphurization technology. 143 In sum, the capacity for fuel-switching, technological options ranging from high-cost cleaning technologies to cheap limestone injections, and shutdowns that exist on both sides of the border create substantial heterogeneity in marginal costs of abatement. Developed Private Sector And Market-Economy Hong Kong ranks as one of the oldest capitalistic market economies in the world, under which a well-developed private sector has grown and thrived. For the last century or so, energy companies have been privately owned and are accustomed to making financially-based decisions in a market-context. 144 Property and contract law are thoroughly developed within the Hong Kong legal system. While involvement in a complex emissions reduction MBIs is new terrain both for these companies and regulatory authorities, background and context should help smooth the bumps and encourage participation in a market-based program.
141
Personal communication with Roger Raufer, July 2007. Personal communication with Tom Heller, July 2007.. 143 See FN 7 supra, p. 82. 144 Personal communication with Hong Kong power companies, July 2007. 142
Krotman & Malech 43 On the other hand, Guangdong and its energy sector, despite its status as a “Special Economic Zone� and as one of the first areas in China to experiment with free markets, has far less experience operating in a market economy. The state still holds a substantial financial stake in energy companies. Though its private sector and market economy is more developed than the other pilot ETS regions in China, it still lags far behind Hong Kong, which may impact decisions to participate in the ETPS. Adequate Regulatory Experience Even in Hong Kong, regulations capping power plant emissions emerged as late as 2005. Although the caps have been publicly released, the SPLs that contain them remain out of the public domain and are not necessarily readily accessible upon request.145 Nevertheless, in relative global terms, the HKSARG regulates transparently and efficiently, with due accountability despite its lack of status as a full-fledged democracy. Regulatory bodies and institutions are well-defined, and its common-law judiciary generally enforces the rule of law. By contrast, Guangdong faces serious challenges in this area. Its transparency, efficiency, and accountability regarding regulatory measures are all questionable. Judicial institutions and administrative bodies are plagued by the same symptoms identified above in Part 3 as the rest of China. The advent of TEC provides a useful starting point, but experience thus far has proved frustrating and an archaic tradition of government opaqueness regarding regulatory information stunts progress. 146 Guangdong lacks meaningful regulatory experience with any sort of MBI. Shortcomings in this area are a major concern among both potential
145 146
Personal communication with lawyers from Mallesons Stephens Jaques, July 2007. Ibid.
Krotman & Malech 44 participants and interested spectators, since the generation of project-based credits under the ETPS requires extensive regulatory involvement. 147 These concerns have been voiced loudly by both academics and the Hong Kong power industry, and should be taken seriously. More generally, the lack of real markets in China, cast some doubt on the viability of more complicated regulatory artificial markets. 148 However, even if this proves to be a major stumbling block to the pilot scheme meeting its economic and environmental goals, the general consensus seems to be that the scheme will still be useful in building regulatory and institutional capacity in Guangdong and Hong Kong, as well as in the cross-border context. Inter-Jurisdictional Legal Differences Drastic differences in the legal systems of the respective sides precipitate both administrative issues for the two governments and uncertainties for potential participants. The ETPS and HKSARG handle this issue by allotting each respective government the authority to set regulations and handle non-compliance in their jurisdictions according to their own laws, and leave jurisdictional uncertainties such as buyer liability in cases of seller non-delivery up to private contractual determination. 149 Specific jurisdictional uncertainties are discussed further below, but it is significant to note that the power companies have vocally expressed hesitancies to participate in the ETPS due to concern over these issues. 150
147
Personal communication with Hong Kong power companies, July 2007; Personal Communication with Roger Raufer, July 2007; Personal communication with lawyers from Mallesons Stephens Jaques, July 2007. 148 Personal communication with Roger Raufer, July 2007. 149 See FN 12 supra,; Administration's response on summary of views on the Emissions Trading Pilot Scheme for Thermal Power Plants in the Pearl River Delta Region, 23 April 2007, p. 2, http://www.legco.gov.hk/yr0607/english/panels/ea/papers/ea0423cb1-1374-5-e.pdf. Downloaded on 25 July 2007. 150 Personal communication with Hong Kong power companies, July 2007.
Krotman & Malech 45 Technological Capabilities For the ETPS to work, participants must have the capacity to monitor their emissions. The ETPS recognizes this by requiring that all participating power plants install “suitable emissions monitoring systems�. 151 All Hong Kong plants currently have CEMS installed, as well as most large Guangdong plants, so the precondition seems to be met. However, commentators have voiced concern over how well the CEMs are maintained and how often they are actually operating on the Guangdong side, 152 although this is more of an implementation concern. In order for the ETPS to accomplish its environmental objectives, continuous monitoring capabilities must be maintained and enforced. 5.2.2 Design Feature Preconditions Meaningful Regulation For potential actors to consider participating as buyers, caps must be low enough to give credits value. Currently, Hong Kong power companies, the likely buyers under the ETPS, emit well below their caps and plan to meet their future emissions targets through in-house projects. 153 Unless caps are tightened substantially in years to come, a shortage of interested buyers will limit participation in the ETPS. While the stringency of anticipated regulation may also serve as a sufficient motivator, a lack of clarity on these regulations past 2010 creates too much uncertainty for power companies to engage in large-scale emissions trading. 154 On the Guangdong side, current levels of regulation, to the extent that they exist at all, do not seem to place them as buyers, although some predict that substantial emissions reduction
151
See FN 12 supra, Scheme, para. 3.11. Personal communication with Raufer. 153 Section 4 supra; Personal communication with Hong Kong power companies, July 2007. 154 Personal communication with Hong Kong power companies, July 2007. 152
Krotman & Malech 46 regulations are forthcoming. 155 An issue the ETPS fails to address is how it will interface the existing PLS in place in Guangdong with the caps it sets in the Scheme. To the extent that the GPG continues to enforce the PLS and does so effectively enough to impose substantial costs on Guangdong plants, it can contribute towards the necessary level of de facto caps to bring Guangdong actors to the table as buyers. Unfortunately, the track record of the PLS is not especially encouraging. It will boil down to how serious the GPG and the national government becomes about reducing emissions through command-and-control regulation. In addition to low caps, regulations must impose penalties sufficient to deter actors from violating them. On the Hong Kong side, financial disincentives and criminal penalties in the APCO and SCAs provide a sufficient deterrent. 156 By contrast, on the Guangdong side, the only known penalty are levies under the PLS, which have proved historically ineffective as a deterrent to non-compliance, although this may be more a function of inadequate enforcement. In a scheme in which there are only two actors in Hong Kong who qualify as potential buyers, the long-term viability of the ETPS or any ETS in the PRD will require that actors on the Guangdong side become buyers. Lower caps and higher enforceable penalties in Guangdong are essential. At present, the level of caps even in Hong Kong fails to provide considerable incentive to seek out emissions trading opportunities as buyers. Hope remains that power companies, especially on the Hong Kong side, will take this opportunity to gain experience in emissions trading through the ETPS that will lower future costs of participation and help develop a future regional ETS that will provide a cost-effective flexibility mechanism for compliance with increasingly tighter caps.
155 156
Personal communication with Tom Heller, July 2007. Personal communication with Hong Kong power companies, July 2007.
Krotman & Malech 47 Adequate Authority for Enforcement A host of administrative concerns separate from the design of the ETPS within Hong Kong, within Guangdong, and across the two jurisdictions present potential problems for the scheme’s successful operation. Within Hong Kong, despite the obvious interconnection between energy and environmental policy, until recently, the agencies responsible for each respective area frequently fail to work together. The Special Panel charged with setting the “best endeavors” emissions reduction targets under the Management Plan by the Joint Working Group contained a representative from the EPD, but no members from the EDLB, the body that regulates power supply. 157 By contrast, the SCAs governing power companies in Hong Kong were previously negotiated between the power companies and the EDLB, without the direct participation of the EPD. 158 The most recent SCAs, released in January 2008, finally consulted the EPD. Such historic conflicting authorities make meaningful regulation tied to developing an effective ETS difficult to coordinate, though steps in the right direction seem promising. This is a concern voiced by the Hong Kong power industry as well as academics, and has the potential to undermine confidence in the scheme. On the other hand, Guangdong and Hong Kong have a relatively good track record of working together on policy issues, if not actual regulations. Thus, their history of interaction is a good starting point for addressing these concerns. 159 Second, within Guangdong, while similar horizontal administrative issues exist between departments responsible for energy and environmental policy, additional vertical issues of regulatory enforcement exist between local EPBs, provincial EPBs, and national EPBs. There, 157
Environmental and Food Bureau, Guangdong and Hong Kong Cross-boundary Cooperation in Environmental Issues, May 2001, http://www.legco.gov.hk/yr00-01/english/panels/ea/papers/a1151e.pdf. Downloaded on 25 July 2007. 158 See FN 7 supra, pp. 80-81. 159 Personal communication with lawyers from Mallesons Stephens Jaques, July 2007.
Krotman & Malech 48 not only is authority for environmental regulatory enforcement weakened by resistance from those wedded to energy supply objectives, but also by a lack of local ownership of the regulations and political will to engage in implementation by the EPBs themselves for reasons discussed above in Part 3. Such administrative issues threaten the success of any environmental regulatory program, including the ETPS. It is unclear how the ETPS will deal with these horizontal administrative issues, although the GPG could choose to include representatives from its energy policy department on the Management Panel like the HKSARG. Since the scheme is the product of nearly ten years of cooperation between the HKSARG and GPG through the Joint Working Group, perhaps there is enough commitment to the ETPS to minimize vertical administrative issues. However, based on international comparative experience, re-centralization of local regulation is the real solution to inadequate administrative implementation. The success of the U.S. SO2 program, in large part, was due to strong regulation by the USEPA; local authorities, even in the United States, were much less reliable in enforcing compliance. By contrast, SEPA tends to take very little action. 160 Enforcement is a local issue in China, but there must be strong national oversight for this scheme to work and to ensure regulation is enforced. 161 Third, authority for enforcing inter-jurisdictional regulatory programs presents the further complication of coordinating supervisory activities and conducting them in a standardized manner among agencies of the respective governments. Again, the ETPS seeks to resolve such issues through its Management Panel, consisting of representatives from each side. One task of the Management Panel is to provide technical advice for a variety of methodological tasks under
160 161
Personal communication with Roger Raufer, July 2007. Ibid.
Krotman & Malech 49 the ETPS, such as total emission calculation and approaches for allocating emissions credits. 162 The scheme allows the governments to alter membership in the Management Panel as they see fit, which will provide a flexible means to sync inter-jurisdictional activities among relevant agencies should the problem manifest. 163 Whether the respective government agencies are up to the task of implementing the ETPS is another matter, but the Management Panel should succeed as a mechanism for allocating this authority and standardizing procedures. Prior installation of CEMS in Hong Kong plants and most Guangdong plants, as well as the compilation of emissions inventories and the launch of the Air Quality Monitoring Network provides the necessary informational infrastructure for coordination to occur. Experience in Taiyuan has shown that computer systems to track emissions trading activity can feasibly be created under these circumstances. 164 The most substantial challenge here will likely entail regulatory implementation issues on the Guangdong side due to recurrent Chinese institutional problems at the local level, with recentralization of implementation as the most effective institutional prescription. Flexibility: Banking and Borrowing There seems to be uncertainty over whether the Pilot Scheme will include banking or borrowing. 165 Although these details have not been finalized, the general sense is that banking will not be allowed, at least initially, under the scheme. This seems to be more for reasons of simplicity than anything else. 166 Regardless, any banking system would likely have to be
162
See FN 12 supra, Appendix 5. See FN 12 supra, Appendix 5. 164 Ruth Greenspan Bell, “Choosing Environmental Policy Instruments in the Real World�, OECD Global Forum On Sustainable Development: Emissions Trading, Paris, France: OECD, 2003, http://www.oecd.org/dataoecd/11/9/2957706.pdf. Downloaded on 20 July 2007. 165 Personal communication with lawyers from Mallesons Stephens Jaques, July 2007; Personal communication with Hong Kong power companies, July 2007. 166 Personal communication with Hong Kong power companies, July 2007. 163
Krotman & Malech 50 engineered into the power plant licenses themselves rather than the Pilot Scheme. It is unclear whether validity periods will be made long enough to serve much the same function as banking. While not including banking for reasons of simplicity is a legitimate stance, there are major reasons to consider such a feature. To begin with, it would likely increase support for the scheme among possible participants. Additionally, experience with banking in other emissions trading schemes, as mentioned above, has yielded major benefits such as overcompliance and the early adoption of technologies. Risk (1) Definition of Regulatory Property The recently released 2008 Scheme of Control Agreements partially clarifies the definition of regulatory property regarding credits, at least on the Hong Kong side, but still leaves certain aspects ambiguous. The power companies would like to see credits defined as financial instruments that will positively affect their permitted rate of return, and would also like to see rewards for transactions, such as including negotiating trades in management time as an asset to count towards the permitted rate of return. 167 The 2008 SCAs do allow emissions trading “credits” or “allowances” to count towards “permissible” emissions, which in turn is matched with actual emissions to determine applicable adjustments to the rates of return. 168 Thus, credits do now have some roughly definable value as a financial instrument, although further clarification on the associated transactions costs, banking options, and other aspects impacting value may still be necessary before participation becomes an attractive and risk-free option. It is too early to tell whether power companies will begin trading in response to the 2008 SCAs.
167 168
Ibid. See FN 123 supra, Schedule 4.
Krotman & Malech 51 (2) Consistency of the Program Additionally, there is concern that the scheme is a “fad�, and that credits accumulated will become sunk costs and lose all future value if the scheme is abandoned or greatly modified. 169 (3) Predictability of Caps There are also concerns that over-compliance stimulated by trading under the scheme will simply be treated by the government as evidence that baselines and regulatory caps can be lowered further. 170 Power companies are working on a five to ten year timeframe in terms of their business plans; on the other hand, regulatory limits, licenses, and the details of the pilot scheme are defined for a much shorter time-frame. It would be preferable to have longer-term concrete regulations in order to reduce the perceived risk to power companies and allow them to factor the scheme into their medium-term business plans, but the HKSARG has refused to set new caps until the new AQOs are set in 2009. 171 This will diminish the incentive for power companies in Hong Kong to participate in the ETPS. (4) Contractual Uncertainty One of the major concerns among Hong Kong power companies seems to be the lack of contractual provisions included either in their licenses or in the pilot scheme itself regarding issues such as liability in the case of seller non-delivery. 172 The power companies make the argument that the penalties for non-compliance are quite high and thus the lack of a clear provision limiting seller liability in the event of non-delivery is a major deterrent to
169
Personal communication with Hong Kong power companies, July 2007. Ibid. 171 Administration's response on summary of views on the Emissions Trading Pilot Scheme for Thermal Power Plants in the Pearl River Delta Region, 23 April 2007, http://www.legco.gov.hk/yr0607/english/panels/ea/papers/ea0423cb1-1374-5-e.pdf. Downloaded on 25 July 2007. 172 Ibid. 170
Krotman & Malech 52 participation. 173 While the government seems largely to be holding firm on their position that the risk of non-performance Hong Kong power companies will face in Pilot Scheme transactions with Guangdong will be no different from any other business risks, the power sector makes the argument that these risks are qualitatively different, considering the fact that there are criminal as well as financial penalties for non-compliance.174 Additionally, they voice concerns over jurisdiction in the case of contract disputes or non-delivery, arguing that agreeing on choice of law and venue for arbitration will add significantly to transaction costs. 175 One way some in the Hong Kong power industry propose to address this problem is by engineering in a “safety valve� similar to those used in some U.S. programs. This would provide that as long as the original credit purchase agreement was made in good faith, if non-delivery resulted in non-compliance by a Hong Kong power company some financial penalties and all criminal penalties would be waived. This would have to be incorporated into the power plant license, rather than the pilot scheme itself. 176 These concerns by the Hong Kong power industry may or may not be well-grounded. It seems that the Hong Kong power industry could draw on the body of contract experience gained from CDM and apply it to transactions under the pilot scheme. The first CDM project in China was the Huitengxile windfarm project, which currently provides credits to the Dutch government. The contracts for this project admittedly took years to finalize, and key documents are still under revision. 177 It includes provisions for right of refusal for surplus credits generated by the project. Despite the very high transaction costs associated with this project, it will likely
173
Personal communication with Hong Kong power companies, July 2007.. Ibid. 175 Ibid. 176 Ibid. 177 World Bank CDM 174
Krotman & Malech 53 provide a wealth of experience for future project-based contracts in China. 178 Additionally, there are a number of projects under development creating publicly available template contracts for China CDM projects, which could just as easily be used for Pilot Scheme agreements with a minimum of revision (see CERSPA and IETA). Although the transaction costs will likely be high, contracting under the Pilot Scheme does not seem to be an insurmountable obstacle. Additionally, one could either engineer hedges into the contract itself, or use the pilot scheme as a hedge rather than a primary compliance method. 179 There are a number of tools available to limit and re-allocate risk, such as a limit on the percentage of generated credits a buyer will purchase. 180 Environmental Integrity, Verification, and Third-Party Auditing The main problem in analyzing the environmental integrity of the Pilot Scheme is that the details are not well-developed enough. Future caps past 2010 remain unclear on both sides, and the potential for known caps to induce substantial emissions reductions is questionable. Without adequate command-and-control regulations, no meaningful environmental objectives can be accomplished. It is also unclear whether the system will be a strictly project-based program or have a hybrid cap and trade element as it develops. At present, trades will most likely be projectbased, with Hong Kong power plants positioned as buyers and Guangdong plants positioned as sellers. Thus, the same problems that typically apply to project-based schemes like the CDM will apply here as well, such as additionality and leakage, although the limited geographic and sectoral scope will minimize these issues. 181 It is beyond the analytical scope of this paper to
178
Ibid. Personal communication with lawyers from Mallesons Stephens Jaques, July 2007. 180 Personal communication with Roger Raufer, July 2007. 181 Personal communication with Tom Heller, July 2007. 179
Krotman & Malech 54 evaluate the technical integrity of the baseline evaluation and monitoring methodologies included in the Implementation Framework. 182 However, some general concerns exist. Guangdong, as the richest province in China, largely has the technical and institutional capacity for adequate verification and tracking systems. Hong Kong power plants seem to acknowledge this capacity, although they question the integrity of implementation and data reporting, as well as the general lack of transparency of information. 183 The high degree of administrative involvement specified in the ETPS raises transaction costs, but also addresses some credibility and compliance concerns. 184 However, there are additional concerns about the quality of emissions reduction and monitoring technology that could compromise the integrity of verification. Scrubbers and CEMS manufactured in China vastly undercut the cost of more reliable foreign-made models, and there are serious doubts about their efficiency and accuracy. 185 In addition, with less developed regulatory institutions, Guangdong may face a shortage of qualified consultants, operators, and verifiers. 186 The scheme proposes to safeguard environmental integrity through the use of third-party auditors. This is a good start, but more details need to be addressed to ensure that the program meets its environmental goals. Because of the moral hazard issues associated with independent auditors hired by the firms they will be reviewing, there is a need for Kyoto-accredited auditors, who will likely be in short supply and add to transaction costs. Additionally, there is a need for either strong
182
See FN 12 supra, Appendices 2 and 7. Personal communication with Hong Kong power companies, July 2007. 184 Personal communication with Roger Raufer, July 2007. 185 Ibid. 186 Ibid. 183
Krotman & Malech 55 government oversight of auditors, or additional government audits of projects to ensure real compliance. 187 One possibility is that the actual price of credits will reflect the quality of the auditor associated with the project. However, it is far too soon to speculate on this point. Low Transaction Costs: (1) Free Markets for Credits Nothing indicates that the government will interfere with the free flow of credit transfers among actors and across borders. Though the ETPS mandates that transacting parties receive the approval of the relevant authorities, no significant transaction costs apart from the verification process necessary for the formation of the credit in the first place is required. 188 (2) Economies of Scale The primary criticism of the ETPS here is that its sectoral limitation to large thermal power plants in its eligibility criteria unduly reduces the number of potential participants, 189 since smaller generating units and factories from other industries also contribute substantially to air pollution on the Guangdong side. 190 While extending eligibility to such actors is a valid goal for a future ETS, administrative concerns weigh strongly against including these smaller entities, which are even more difficult to regulate. For now, a sectoral approach appears preferable from the standpoint of regulatory capacity and meaningful experience with emissions trading, even if it fails to maximize economies of scale. (3) Large Range of Compliance Options
187
Ibid. See FN 12 supra, Appendix 6. 189 Ibid. Appendix 1. 190 Personal communication with Hong Kong power companies, July 2007.. 188
Krotman & Malech 56 The ETPS wisely does not limit the options for power plants to reduce their emissions and generate credits. Instead, it merely provides examples of acceptable measures. 191 Although a wide variety of reduction projects may increase transaction costs, since regulating authorities will have to scrutinize each different kind of project separately, it is preferable to keep the ETPS as flexible as possible at this point to encourage participation. (4) Verification The verification costs in the ETPS are relatively high, due to heavy government involvement in the baseline, additionality, and actual verification procedures. 192 In addition, machinery such as CEMS and scrubbers need a high degree of technical expertise to install, calibrate, operate, and maintain. But such administrative and operational transaction costs at initial stages have been characteristic of other successful ETSs, like the U.S. Acid Rain Program, which began as a closely regulated, largely government-coordinated series of project-based “bubble trades,” and then gradually evolved into a full-fledged cap-and-trade ETS. 193 High verification-related transaction costs at this early stage are “natural” growing pains and alone should not cripple the development of the ETPS if historical examples carry any weight. On the other hand, keeping these “natural” verification costs within reason requires adequately developed regulatory institutions, especially on the Guangdong side, a substantial concern discussed above. Transparency and Communication Emissions trading depends in large part upon public and private support, as well as transparency and open communication, to ensure a further level of oversight and participation from NGOs and the general public. In the case of the ETPS, despite general faith in the accuracy 191
See FN 12 supra,; See FN 9 supra. See FN 12 supra,. 193 Personal communication with Raufer. 192
Krotman & Malech 57 of information, there is a need for much greater transparency on the Guangdong side and to a lesser degree in Hong Kong. Publication of relevant law, up-to-date emissions statistics from individual facilities, and full disclosure of source-by-source regulation is necessary, and as yet far from forthcoming. Additionally, there does not seem to be an adequate level of understanding or public discourse on either side about the economic, environmental, or philosophical underpinnings of emissions trading. Some Hong Kong power companies have expressed concerns about being seen as “paying to pollute”, and as a “philosophical matter” preferring to address their emissions requirements personally rather than out-sourcing them across the border. 194 Whether or not these concerns are genuine, they reveal the need for public education and discourse on the possible benefits and mechanics of emissions trading. This should largely be the role of the Management Panel, which needs to have the authority, resources, and political will to open lines of communication, disclose all relevant data, and actively engage stakeholders (emitters, government officials and agencies, NGOs, and the general public) in a public discourse. This will be the only way to gain the level of acceptance, understanding, and public oversight necessary to successfully implement the scheme.
6. CONCLUSION This analysis seeks to point out the strengths, weaknesses, and uncertainty relating to the ETPS. Although at the time of this writing, a trade under the ETPS has yet to occur, it is premature to speculate whether emissions trading will or will not work in the PRD. We only wish to clarify challenges and opportunities and provide a coherent conceptual framework for 194
Personal communication with Hong Kong power companies, July 2007.
Krotman & Malech 58 assessing ETSs. While the Implementation Framework is a good first step towards setting up a marketbased mechanism in Hong Kong and Guangdong to address pollution problems, many issues need to be addressed before the scheme can become a reality. Proceeding as a limited, projectbased scheme with large degrees of government oversight co-existing with present commandand-control regulation, in much the same way that the U.S. SO2 program did in its early stages, is a step in the right direction. However, political will seems to be lacking at all levels of government, a coherent plan and vision for the plan is not fully developed, and both governments need to do a much better job of designing and “selling� the scheme in such a way that it becomes attractive to emitters on either side of the border. This includes adequately defining how the scheme will be carried out, increasing transparency and communication, and addressing risk concerns. The 2008 SCAs move in the right direction by more adequately ascribing measurable value to emissions credits. Additionally, there will be significant legal, technological, and transaction cost problems associated with ensuring the environmental integrity of the program. More so than any other factor, the success of the Pilot Scheme, both economically and environmentally, depends on meaningful and strictly enforced regulation of pollution on both sides. Caps must not only tighten, but the time horizon setting such caps must extend far enough into the future for potential participants to use emissions trading as a business planning tool to meet their obligations. Emissions trading schemes are simply flexibility mechanisms for implementing regulatory measures, and are meaningless without them. The ultimate measure of this scheme will be regulation that seriously addresses the pollution problems in the Pearl River Delta.