The document outlines the implementation and technical design elements of emissions trading schemes (ETS), detailing the scope, cap setting, and allowance distribution. It emphasizes the importance of defining the ETS's geographical and sectoral scope, as well as the methods of allocation such as auctioning versus free allocation. Additionally, it discusses how market dynamics influence carbon pricing and the need for regulatory interventions to maintain price stability.

1. IEA 2021. All rights reserved.
ETS implementation: determining the cap, price
setting, scope and allowance distribution
Kieran McNamara, Environment and Climate Change Unit, International Energy Agency
IEA/OECD CEFIM Implementation and technical design elements of ETS schemes, 14 December 2021

2. IEA 2021. All rights reserved.
Defining the scope of an ETS
• The scope of an ETS defines which entities will be regulated by the ETS:
- Geographical scope - Economic sectors
- Greenhouse gases (GHGs) - Sources of GHGs
• Decisions on the scope - Comparison of advantages
More Fewer
Sectors/
Gases
covered
• Greater opportunity for low-cost reductions.
• Avoid risk of leakage between sectors.
• Greater ability to align ETS with economy-wide
emissions reduction targets.
• Lower administrative costs.
• Less risk of leakage between jurisdictions.
Point source of emissions Upstream
Point of
regulation
• Direct incentives for polluters to reduce GHGs.
• Possible behavioural benefits.
• Can build on existing regulatory frameworks.
• Cheaper and simpler to administer.
• Greater coverage with fewer points of regulation.
• Reduces competitive distortions between/ within
sectors.

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Without ETS
What’s the function of the ETS cap?
The emission cap is the total amount of emission allowance permits; one allowance permit generally
corresponds to one tCO2e.
Emissions
(tCO2e)
Time
Emissions cap
With ETS
8
Countries
18
Provinces
/ States
6
Cities
ETS in force in 2021
+ EU ETS

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What’s the function of the ETS cap?
• An ETS cap is the maximum amount of total emissions generated by covered sectors over a defined
time period.
• Cap type:
Absolute cap – Up-front limit on the quantity of emissions allowed within each compliance period.
Intensity-based cap – Prescribed amount of allowances issued per unit of output/ input.
• Cap’s ambition: How quickly shall covered sectors decarbonise?
{Tighter/ More ambitious cap  Fewer allowances  Greater allowance scarcity  Higher CO2e price}
- Aligning cap ambition with overarching emissions reduction strategy (Step 1)
- Effort sharing between covered and unregulated sectors
- Balancing ambition and system cost increases.
• Cap setting requires a robust data foundation regarding historic emissions, estimates of future
emissions and estimates of technical/ economic emissions reduction potential.
Points to
consider

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Comparison of allocation mechanisms in terms of impacts
Auctioning
Free allocation
• Addresses competitiveness
concerns
• Minimises carbon leakage
• Politically acceptable
• Some methods fairly easy to
implement (Grandparenting)
• Transitioning approach
• Generates additional government
revenues, which can help to
address distributional concerns
and correct market distortions.
• Creates strong incentives for
cost-effective abatement
• It is a more transparent, just and
effective approach in the long-run

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Free allocation methods (1/2)
• Simple application
• Little data requirement
• May reduce trade in early years
• Can penalise early movers
• Objective application
• Reward early movers
• High quality data requirements
• Complex industrial processes
Source: ICAP, 2020

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Free allocation methods (2/2)
• Reduces carbon leakage
• High data requirements
• Can reduce carbon incentives
Source: ICAP, 2020

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What can we expect from an auction?
• Auctioning ensures the efficient functioning of the trading market and strong
incentives for carbon abatement
• It also creates a source of public revenue that can then be distributed to a wide
range of potential beneficiaries
• Frequent auctions will help provide transparency and a steady price signal to
participants and consumers, and could reduce carbon price volatility
- Advantages: income can be used to support other climate policies, improve
economic efficiency, address distributional concerns; less political
involvement, price discovery and market liquidity, less distortions, rewards
early movers
- Disadvantages: small firms may struggle with auction; no protection against
carbon leakage and do not compensate firms for losses from stranded
assets.

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Free allocation to allowance auctioning in industry
• Treatment of industry: requires careful thought, create competitiveness and carbon leakage concerns
• All ETS attempt to prevent the carbon price from lowering the competitiveness
• Most ETS provide free allowances to industries considered at risk of carbon leakage.
• Longer term need to phase down free allocation and transition over time to allowance auctioning

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How does pricing work?
• In theory, the market will set the price that balances supply and demand at any
point in time
• When an economy is growing emissions rise and increase the total level of
abatement necessary to meet the cap and prices should rise. Conversely, when
the economy is slowing or in recession, the price should fall.
• Expectations about the allowance market are also a driver of price formation.
• Exogenous shocks, regulatory uncertainty and market imperfections also
influence prices.
• Intervention may be required if prices go too low or too high:
- Low prices; reserve prices, market intervention or surrender charge
- High prices; offset limits, allowance reserve or prices cap

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Thanks for your attention!