The Climate Trust | Linkage

Linkage

Linking occurs when an Emissions Trading System (ETS) allows regulated entities to use units (allowances or credits) issued in one or more other systems for compliance purposes. Such links can be one-way, that is, where entities in one ETS can buy units issued from one or more other systems, but not vice versa, or two-way, where both systems recognize the units of the other system. If two or more systems recognize credits from the same offset mechanism, this gives rise to an indirect link.

Linking can be attractive for a number of reasons. It reduces aggregate compliance costs. Allowing two systems to trade emissions allowances increases efficiency in the same way as trade between two companies. The larger the difference in equilibrium allowance prices between the linked systems, the greater the gains from trade. Linking also increases market liquidity and depth. It may also promote price stability, allowing shocks to one part of the ETS to spread across a larger number of participants. If linking partners are also trade partners,the equalization of carbon costs can also reduce the risk of emissions leakage. Finally, linked systems can share some of the responsibility for governing the market and thereby reduce the costs associated with administrative functions.

However, for linkages to work, jurisdictions need to find compromises to align design elements—in particular to guarantee comparable levels of environmental integrity for emissions units; this may require adjustment of certain ETS design features. While linking allows for aggregate gains from trade, if prices significantly differ between jurisdictions, the associated price convergence process can be challenging—either because high price jurisdictions will be concerned that their climate ambition is being diluted, or because low price jurisdictions are concerned by the higher prices they will see. The associated financial flows may also be politically challenging. In addition,although price stability will be greater on average, there is a risk that links transmit large shocks from one system to another, with undesirable effects.

To address these potential disadvantages, jurisdictions may want to carefully choose linking partners, consider potential safeguards such as restricting the extent to which they link, or define conditions under which the link will be terminated. In terms of a linking partner, if there is a concern about the disadvantages of price convergence, and if linking is also regarded as a way to increase liquidity and depth, or reduce leakage, then linking with economically similar jurisdictions may be preferable. If the focus is more on lowering aggregate compliance costs and encouraging cooperation to promote greater mitigation, dissimilar linking partners will be preferred. To date, most links have been between systems in socioeconomically similar jurisdictions, with relatively similar pre linkage allowance prices. Some small jurisdictions’ ETSs were designed from the outset to link with a larger market or operate as a multijurisdictional system. Placing restrictions on the extent of linkage will reduce its cost effectiveness, but may be useful if there is a need to trade off some of the advantages of linking against some of its disadvantages, especially around the desire to preserve incentives for domestic emissions reductions and also ensure that linkage supports overall mitigation ambition.

When a decision has been made as to whom to link with and on what terms, in-depth review of respective programs may help further assess alignment of design elements. Linking typically requires clear agreement on acceptable levels of ambition in each jurisdiction, including on the stringency of the cap and certain key design features, such as the nature of the cap or the length of commitment periods. Some other design elements must be aligned to allow effective linkage, including the robustness of Measurement Reporting and Verification and criteria for offset use. Aligning other design elements such as a system’s scope and allowance allocation methods may improve the functioning of a link or address political considerations, but this is not strictly necessary. Linking partners may also wish to consider aligning design features that will transmit market signals across links, such as banking, borrowing, and allowance reserves.

When the terms of linkage have been set, jurisdictions can form and govern the link. Whether linkage occurs alongside the launch of an ETS or afterwards may depend on the objectives for linking. Jurisdictions need to choose the legal instrument for governing the link depending on their legal context, as well as the institutions responsible for market oversight and processes for implementing any changes to the link. Further, arrangements should include a contingency plan for delinking.


Further Reading

The Climate Trust Rings in the New Year with a Forecast of Top 10 Carbon Market Trends | Jan 4, 2017
The Question of Linkage | September 5, 2017

Attribution: Content from Partnership for Market Readiness (PMR) and International Carbon Action Partnership (ICAP). 2016. Emissions Trading in Practice: a Handbook on Design and Implementation. World Bank, Washington, DC. License: Creative Commons Attribution CC BY 3.0 IG