The carbon market in 2020: volumes, prices

and gains from trade

Marcel Brinkman, Samuel Fankhauser, Ben Irons
and Stephan Weyers
November 2009
Centre for Climate Change Economics and Policy
Working Paper No. 13
Grantham Research Institute on Climate Change and
the Environment
Working Paper No. 11

1
The Centre for Climate Change Economics and Policy (CCCEP) was established
by the University of Leeds and the London School of Economics and Political
Science in 2008 to advance public and private action on climate change through
innovative, rigorous research. The Centre is funded by the UK Economic and Social
Research Council and has five inter-linked research programmes:
1. Developing climate science and economics
2. Climate change governance for a new global deal
3. Adaptation to climate change and human development
4. Governments, markets and climate change mitigation
5. The Munich Re Programme - Evaluating the economics of climate risks and
opportunities in the insurance sector

More information about the Centre for Climate Change Economics and Policy can be
found at: http://www.cccep.ac.uk.

The Grantham Research Institute on Climate Change and the Environment was
established by the London School of Economics and Political Science in 2008 to
bring together international expertise on economics, finance, geography, the
environment, international development and political economy to create a world-
leading centre for policy-relevant research and training in climate change and the
environment. The Institute is funded by the Grantham Foundation for the Protection
of the Environment, and has five research programmes:
1. Use of climate science in decision-making
2. Mitigation of climate change (including the roles of carbon markets and low-
carbon technologies)
3. Impacts of, and adaptation to, climate change, and its effects on development
4. Governance of climate change
5. Management of forests and ecosystems

More information about the Grantham Research Institute on Climate Change and the
Environment can be found at: http://www.lse.ac.uk/grantham.

This working paper is intended to stimulate discussion within the research community
and among users of research, and its content may have been submitted for
publication in academic journals. It has been reviewed by at least one internal referee
before publication. The views expressed in this paper represent those of the author(s)
and do not necessarily represent those of the host institutions or funders.

2
 The Carbon Market in 2020

Volumes, Prices and Gains from Trade

a b a, b a
Marcel Brinkman , Samuel Fankhauser , Ben Irons and Stephan Weyers

10 November 2009

Abstract

Carbon markets are central to the global effort to reduce greenhouse gas emissions.
This paper introduces a new carbon market model that aims to simulate the
development of the global carbon market over the next 10-20 years. The model is
based on detailed regional and sectoral marginal abatement cost data and takes an
“investor perspective”. That is, it takes into account market distortions like taxes and
accounts for imperfections in policy delivery. We estimate that implementing all the
carbon market proposals that are currently contemplated would result in global
emission reductions of 7 GtCO2 by 2020 – substantial, but well short of the
mitigation effort required for a 450ppm CO2e pathway. The global carbon price
would vary from €30 per tCO2 in Europe to €15 per tCO2 on the international offset
market and in the new US emissions trading scheme currently under discussion.

Keywords: climate change mitigation, carbon markets, CDM, EU ETS

JEL codes : G15, Q47, Q54, Q58

a
McKinsey and Company, 1 Jermyn Street, London SW1Y 4UH
b
Grantham Research Institute and Centre for Climate Change Economics and Policy, London School
of Economics, Houghton St, London WC2A 2AE. Corresponding author ([email protected])

This paper has benefited greatly from comments and feedback by Alex Bowen, Raphael Calel and
Luca Taschini. Fankhauser and Irons would also like to acknowledge the financial support from the
Grantham Foundation for the Protection of the Environment and the Centre for Climate Change
Economics and Policy, which is funded by the UK’s Economic and Social Research Council (ESRC)
and by Munich Re.

3
 The Carbon Market in 2020

Volumes, Prices and Gains from Trade

1. Introduction

Carbon trading has emerged as one the key policy instruments in the fight against
climate change. Economists have long argued that putting a price on carbon is an
essential and effective way to curtail greenhouse gas emissions.1 In theory, this can be
achieved either through a tax on carbon emissions or a cap-and-trade scheme, where a
restricted number of emission allowances is traded on dedicated markets. The relative
merits of the two approaches is still debated in the literature,2 but in practice policy
makers have overwhelmingly opted for cap-and-trade.3 They are swayed by the
political economy advantages of carbon trading, for which political support is much
easier to build (Hepburn 2006, 2007).

In 2008 the global carbon market was worth $126 billion – twice as much as in 2007
and four times as much as in 2006 (Capoor and Ambrosi 2009). Thanks to growing
trading volumes (which offset depressed prices) 2009 promises to be another record
year. The biggest market by far is the EU Emissions Trading Scheme (EU ETS),
which accounts for over 70% of activity. The Clean Development Mechanism
(CDM), the world’s biggest baseline-and-credit (or offset) market, accounts for
around 25%, most of it secondary market transactions. Smaller schemes like Joint
Implementation, international emissions (or AAU) trading or the voluntary carbon
market and regional systems, for example, in New England and New South Wales,
contribute the rest.

These schemes could all be dwarfed by a new federal US cap and trade scheme that is
currently being debated by Congress and which observers expect could be up and
running within five years. Carbon trading is also being deliberated in Australia, New

1
See for example Fisher et al. (1996) for an early articulation, and subsequently Stern (2006), among
others.
2
See Hoel and Karp (2001), Hepburn (2006) and Newell and Pizer (2003). The classic reference is
Weitzman (1974).
3
A prominent supporter of taxation is Nordhaus (2005).

4
Zealand and – to a lesser extent – Canada, Japan and Mexico, among others.
Meanwhile, the negotiations on the international climate change regime post-2012
may well result in an extended scope for global carbon trading, for example through
an enhanced CDM and new trading instruments for forest-based carbon or
international transport emissions.

This paper asks how the international carbon market may develop over the next ten
years if these systems are put in place as currently contemplated. The analysis is
based on a new carbon market model, which extends and draws on previous work by
McKinsey (2009) on the cost of greenhouse gas mitigation.4 The model uses
differences in marginal abatement costs between countries and sectors to calculate
potential trading volumes, gains from trade and the equilibrium price of carbon in
different market segments.

Using marginal abatement cost estimates to simulate arbitrage opportunities is a fairly

common piece of analysis. Most regionally disaggregated energy-economy models
and integrated assessment models function in that vein, using either top-down
(production function-based) or bottom-up (engineering-based) cost information.5

An important feature of our model versus other (particularly top down) energy models
is the granularity of the abatement data, which is modeled by lever/technology, by
industry and by region. Detailed and consistent cost information allows us to model
individual policy proposals at much higher resolution than other models and isolate
the consequences of detailed policy choices, such as constraints on the use of forestry
offsets or regulatory policies to force renewable energy uptake (two prominent
features of the EU’s climate change and energy package).

Further real-world flavor is added by incorporating policy distortions (such as most

taxes and subsidies), firm-level constraints (such as high costs of capital) and limits to
the uptake of some abatement options (for example due to insufficient or poorly
4
Other sources of “bottom up” marginal abatement cost data include for example AIM (Kainuma et al.
2007), GAINS (Amann et al. 2009b), IMAGE (Bouwman et al. 2006) and POLES (European
Commission 1996, Russ et al. 2009). See also Amann et al. (2009a).
5
See for example the results of the EMF-22 model comparison (Clarke et al. 2009) and the IPCC
mitigation cost discussion (Barker et al. 2007a). For a critical assessment of the use of MACs see
Morris et al. (2008).

5
executed policies). In other words, our analysis takes an investor perspective, rather
than the social planning perspective typical of economic models. We are less
interested in the theoretical economic potential of carbon trading than in the actual
financial flows, trade volumes and carbon prices that may materialize in the real
world.

We start our discussion, in the next section, with a brief description of the carbon
market model on which the analysis is based. Section 3 then looks at likely carbon
market developments up to 2020, based on the implementation of the policy proposals
on the table in summer 2009. These proposals are still in flux and bound to evolve.
Section 4 therefore highlights the sensitivity of market developments to some
pertinent policy choices, in particular the overall level of ambition and the degree of
trading flexibility over space (through linking) and time (through banking /
borrowing). Section 5 concludes.

2. Modeling the carbon market

Trade in carbon emissions is driven by differences in abatement costs. The larger the
differences in costs, the larger the scope for trading and the bigger the gains from
trade. At the core of our carbon market model are the detailed marginal abatement
cost data gathered by McKinsey and summarized in version 2 of its global cost curves
(McKinsey 2009).

McKinsey’s cost curve model is a bottom up, microeconomic model that assesses the
technically available abatement potential versus a business-as-usual (BAU) reference
case solution. It does so at a granular level – covering approximately 200
technologies, in 13 sectors, and 21 regions. The G8+5 nations are covered
individually, with a further 8 regional assessments ensuring global coverage.

The carbon markets model splits the original cost data further into different carbon
market segments: international emissions trading among governments (the AAU
market), domestic cap-and-trade markets in Annex 1 countries (including the EU
ETS, and the new US trading system) and the international offset market (a reformed
and expanded CDM, say). Separate cost curves were derived for “traded sectors” that

6
are expected to be covered by the various carbon markets and non-traded sectors that
are likely to remain outside. The analysis also accounts for regulatory policies that
mandate particular abatement options, such as energy efficiency standards in
buildings and renewable energy targets.

The original McKinsey cost curves are estimates of the economic potential for cost-
effective GHG mitigation. For the current purpose, this economic perspective was
replaced by an investor perspective. This required two adjustments.

First, economic costs were translated into financial costs by introducing existing
policy interventions like fuel taxes and energy subsidies (such as feed-in tariffs).
Financing constraints were introduced by replacing the social discount rate of the
original cost curves (4 % real) with a higher, differentiated rate (on average 11%) that
reflects firms’ actual costs of capital – varying by industry and geography.6

The net effect of these corrections typically is to make the cost curves steeper. Energy
efficiency measures with negative costs tend to become even more attractive if energy
is subject to tax,7 while the higher cost of capital increases the cost of capital-
intensive investments like renewables. There are also some changes in the merit order,
as measures with particularly high upfront costs become more expensive and move
further up the cost curve.

The second adjustment acknowledges limits in policy effectiveness. Rather than

assuming the full implementation of all cost-effective mitigation options, as the
original cost curve implicitly does, our analysis recognizes that the uptake will be less
than perfect as a result of insufficient policy ambition, ineffective policies and poor
execution. This is similar to the approach taken by the UK Committee on Climate
Change, which also distinguishes between technical / economic potential and actual
uptake, which is a function of the policy environment (CCC 2008).8

6
Discounting is one of the most controversial issues in climate change economics. A good synthesis is
Dasgupta (2008).
7
The inverse happens in countries with energy subsidies, still a frequent occurrence in many parts of
the world.
8
Of course, policy makers anticipating an imperfect uptake of policies may ramp up their measures to
counterbalance that effect.

7
To do so we made an assessment of the current policy proposals in each of the 21
regions and 13 sectors of the model. Each of those proposals was rewarded a policy
ambition score, which scaled the abatement potential (see Chart 1). These policy
ambition scores are based on a literature study of the effectiveness of climate change
policy. Further, each country was awarded a policy execution score, which is based on
McKinsey staff assessments informed by a range of governance indicators.9 The
technical abatement potential was then multiplied with the two factors in order to
derive an assessment of the achievable abatement, given expected government policy
effectiveness. Note that this does not include the expected outcome of the carbon
market, which effectively provides the financing for the positive cost measures.

The result of this adjustment was to reduce the uptake of cost effective measures to 24
GtCO2 in 2030, compared with a technical potential of 38 GtCO2 in the original
analysis (see Chart 2). Alternative assumptions on policy effectiveness will be
introduced in section 4.

The model is solved over four steps (see Chart 3). The first step is to balance supply
and demand in the international offset market. Second, the regional cap-and-trade
systems are balanced using the market-clearing offset price calculated in step one.
Third, the AAU price is set equal to the offset price. These steps allow us to calculate
the prices in each of the markets, the amount of (domestic) abatement achieved as
well as the trading with other markets (typically import of international offsets).

In the fourth step banking and borrowing is introduced, assuming a five-year time
horizon for companies under a cap. That is, companies are assumed to bank (borrow)
allowances, if the expected price five years later is much higher (lower) than in the
current year.

Since banking and borrowing of allowances can increase or reduce the offset demand
in the given year, an iterative algorithm is used. Linkage of carbon markets (beyond
the international offset market) is possible, but not set in the default model.

9
UNDP (2004) provides a useful survey of available governance indicators.

8
The international offset market is the key market mechanism in the model, balancing
global supply and demand across markets. The offset supply curve depends on sectors
and regions participating in the offset market, policy effectiveness, and rules
governing eligible offsets (for example, NPV-positive levers may be excluded as non-
additional).10

For each of the regional cap-and-trade systems, the demand for international offsets is
dependent on the offset price assuming that companies will always choose the
cheapest option between regular allowances, abatement under the cap-and-trade
system, domestic offsets, international offsets and, where applicable, strategic reserve
allowances. The offset demand on a country level (as opposed to the cap-and-trade
system) is assumed to be inelastic and is calculated as the gap between a country’s
reduction target and the abatement achieved through domestic actions (both inside
and outside a cap-and-trade system) after perfect AAU trading.11

3. The carbon market in 2020

The first application of the model was to analyze carbon market developments under a
“Follow me” scenario, that is, the expectation that the low range of all currently
announced or proposed policies will be implemented. More specifically, we
considered carbon market policies as contemplated in summer 2009 (see Table 1 for
details). The scenario was derived from a range of policy documents, including the
December 2008 climate change and energy package of the EU and the Waxman-
Markey bill (version passed by the House of Representatives) in the US.

The scenario foresees the establishment or expansion of national cap -and-trade

schemes in Europe (EU and neighboring states like Iceland, Norway and
Switzerland), the US, Australia and Canada. It foresees an expanded global baseline-
and-credit (or offset) market modeled on a reformed CDM and the continuation of
international emissions (or AAU) trading between Annex I governments. The various
cap-and-trade markets are not linked, although they are all connected to the global

10
See IETA (2008), Michaelowa and Pallav (2007), Michaelowa and Umamaheswaran (2006), Streck
and Lin (2008) and Wara (2007) for a discussion of CDM additionality and CDM performance.
11
We ignore the effect of penalties for non-performance.

9
offset market and AAU trading, which creates an indirect link. Importantly, we
assume that avoided deforestation (so called REDD) offsets are only eligible and
available to a limited extent.

The main results are summarized in Chart 4. In the AAU market, the Annex-I cap-
and-trade caps total an estimated 16.7 GtCO2 in 2020 and 12.6 GtCO2 in 2030. Of
the abatement required to meet these targets in the developed world, about two thirds
will be realized domestically, with the remainder through offsets. Offsets are the
price-setting (i.e., marginal) supplier of abatement to developed world, suggesting that
AAU prices will be equal to offset prices.

The EU ETS has 1.7 GtCO2 of emission allowances in 2020 and potentially 1.4
GtCO2 in 2030. The majority of the required abatement to meet these targets is
realized domestically, as the offset quotas are tight (about 1.6 GtCO2 over 2008-12).
The tight targets and offset quotas means the EU ETS has the highest prices of all
carbon markets, peaking at €40 per tCO2 in 2025. The price-setting abatement
capacity is domestic. Banking of offsets can reduce the risk of price drops, but unlike
the US ETS there are no other stabilization mechanisms in place.

The US ETS (as proposed in the Waxman-Markey bill) is assumed to be operational

as of 2012. The market has 5.1 GtCO2 of emission allowances in 2020 and 3.5
GtCO2 in 2030. Initially most abatement is realized through domestic and
international offsets (1 GtCO2 out of 1.4 GtCO2 in 2015), but over time domestic
abatement starts to play a larger role (2.5 GtCO2 out of 4.1 GtCO2 in 2030). The US
ETS market price will be set by offsets, even after taking into account the 4:5 discount
rate that is currently contemplated.

The offset market is assumed to continue in the future, with avoided deforestation
offsets remaining limited to 20-40% of global offset supply. Demand for offsets
comes mainly from the US ETS and AAU countries.

Overall, carbon trading is estimated to trigger incremental investments of almost €800

billion between 2016 and 2020, much of it in electric power and transport, and over
three quarters of it in China, the US and the EU.

10
Chart 5 displays price developments. It shows a substantial price differential between
the EU ETS, where the allowance price could rise above €35 in 2025, and the
international offset and US allowance prices, which we expect to increase to €23 by
2030. In Europe, where the use of offsets is constrained, the carbon price is
determined by the marginal cost of domestic abatement, assumed to be various
renewable energy technologies (for example, wind alongside fuel switching in 2015,
solar alongside small hydro in 2020). In the US, which currently foresees a more
liberal use of international offsets, the allowance price is expected to follow the
(discounted) offset price, since offset purchases are the preferred abatement activity at
the margin.12

It is important to note that in both markets, a large share of the abatement will be
covered and achieved through mandated policies like the EU’s Renewable Energy
Directive. Chart 6 shows this in more detail for the case of the EU ETS. The chart
shows the EU marginal abatement cost curve, reordered to give priority to mandated
actions and to factor in the contribution of offsets. The chart also shows how the
prevalence of cheap abatement opportunities encourages banking. We will come back
to this issue in section 4.

The offset price, in the meantime, is kept low by a steady flow of low cost emission
reductions in sectors like electric power, industry, forestry and waste (two thirds of it
from China). In fact offset prices could remain almost constant over time as the
growth in offset supply is in line with growing demand (see Chart 5 above). But even
at this relatively low price offset trading is a financially attractive activity, creating
substantial trade flows and yielding substantial benefits. Chart 7 shows the net trade
flows in the offset market and the gains from trade.

4. The impact of different policy designs

Although currently announced initiatives provide a good indication of how policy

might develop, the debate is clearly still in flux and much will change as options are

12
See Goettle and Fawcett (2009) for a detailed analysis of cap and trade impacts in the US.

11
reviewed and political consensus is built. The academic debate on the merit of
different design mechanisms is also ongoing and will influence policy choices (see for
example Fankhauser and Hepburn 2009). In this section, we ask how different policy
choices would affect the price and volume dynamics in the carbon market. In
particular, we look at four design options: (i) a change in policy effectiveness and
abatement ambition (ii) the linking of regional markets and (iii) changes to the rules
on banking and borrowing.

4.1 Different levels of ambition

The policies currently announced, which form the backbone of section 3, would result
in global emission reductions of 7 GtCO2 in 2020 and 15 GtCO2 in 2030. This is well
short of the 25-40% reduction in global emissions that the IPCC called for in its
fourth assessment report (Barker et al. 2007b) and the 17 GtCO2 of reductions that
Project Catalyst (2009) estimates will be needed by 2020 to stabilize concentrations at
around 450ppm CO2e, and thus have a fighting chance of limiting global warming to
2oC. However, even the low targets used in the "Follow me" scenario are not ratified
yet.

We also looked at two other carbon market scenarios reflecting different degrees of
ambition. The first scenario, labeled a “High ambition”, includes a stricter, 20%
reduction target, relative to 1990, – with correspondingly tighter domestic caps and
offset limits – and increased policy effectiveness: 100% of technical potential
mandated in Annex I countries in non-market sectors and increased ambitions in the
developing world.

The second alternative is a pessimistic “Head in the sand” scenario, where only
policies that are already into effect (for example the EU ETS) are included. Crucially,
this excludes federal carbon trading in the US. The two scenarios are detailed in Table
2.

Chart 8 shows difference in carbon prices for the two scenarios, and Chart 9 displays
the impact on global emissions reductions. Higher levels of ambition have a strong
impact on carbon prices, in part offset by improved policy effectiveness, which

12
increases supply. In the "Head in the sand" scenario, offset prices could fall to around
€5 per tCO2 by 2020 without the US joining the global carbon markets.

In contrast, the effect of more ambitious scenarios on overall emission reductions is

relatively limited (Chart 9). Under a “High ambition” scenario only about 60% of the
theoretical potential is taken up. This is mainly due to the fact that emissions will
continue to grow strongly in countries that are currently at a low level of
development, including India. To change that and move closer to the 450ppm
pathway, much more comprehensive targets that cover most countries would be
required, as well as more aggressive policies on sectors like forestry and agriculture
that are not covered by the carbon market.

4.2 Linking of markets

Key design question is to what extent regional markets will be linked up. This
particularly concerns the link between the world’s two biggest carbon markets in the
US and the EU. In our main results, we assumed that the two markets would be linked
only indirectly through the international offset market, on which they both draw.

It is instructive to explore what would happen if the two markets were more closely
integrated, at the extreme through the unrestricted exchange of allowances between
the two jurisdictions. It is an aspiration among many European policy makers to
achieve such a link as early as 2015 (Lazerowicz 2009).

The enthusiasm for linking is understandable. Conceptually, flexibility in space is key

to keeping down compliance costs. In practice, a number of preconditions will have to
be met before such a link becomes realistic (Fankhauser and Hepburn 2009). Chief
among them are consistent levels of ambition between the two policy spheres.
Linking a system that is designed to be high price with a low-price scheme would
create policy tensions as trading will inevitably equate prices across systems. In
addition there is a need for coordination on regulatory arrangements, including the use
of, and quality standards for, offsets.

13
A linked market would result in prices very close to the prices in an autarkic US
market (chart 10). This can be explained by the much smaller size of the EU ETS
compared to the US system and the generous US offset limit that is not exhausted in
the autarky case.

4.3 Banking and borrowing

Banking and borrowing (or flexibility over time, in the terminology of Fankhauser
and Hepburn 2009) is similarly important. Complete flexibility to allocate abatement
effort over time would allow firms to smooth short-term fluctuations (for example,
related to fuel prices) and coordinate emission reductions with the investment cycle
and the replacement of the capital stock.

For example, the summer 2009 drop in the EU allowance price would have been
much sharper if it had not been possible to bank surplus emissions into the post-2012
period. Conversely, the price collapse in the first phase of the EU ETS would have
been avoided if surplus emissions could have been banked into the second trading
period. In fact, self-contained trading periods without banking or borrowing lead, by
design, to price spikes or troughs at the end of that period unless installations are able
to plan their emissions to perfection.

Despite its conceptual advantages, most systems constrain intertemporal flexibility.

Banking from one commitment period to the next is generally allowed, but there tend
to be limits to the amount of borrowing that is permitted, both between commitment
periods and within individual periods. This is due to a (political) preference for timely
abatement, but also concerns about time inconsistency – that is, the possibility that
delayed commitments may not be honoured in full (Fankhauser and Hepburn 2009).

The simulation results show how banking and borrowing can soften price fluctuations.
The effect is particularly strong in the EU ETS, where tight targets and limited offset
quotas may lead to a price spike in 2025 in the absence of intertemporal flexibility.
Borrowing between trading phases is not allowed in the EU ETS, but banking alone is
capable of reducing the spike from €65 per tCO2 to €38 per tCO2 (Chart 11).

14
The US ETS, as currently envisaged, would allow borrowing one year ahead for free
and from subsequent years at an 8% interest rate. This is anticipated to have minimal
effect however, as the offset price is the predominant driver of the US ETS price.

5. Conclusion

The global carbon market could grow spectacularly over the next ten years. If current
proposals are implemented – and this crucially includes a Waxman-Markey-style
federal trading scheme in the US – the market volumes might reach $800 billion by
2020, compared with $126 billion in 2008.

In our main scenario, which is based on ‘current proposals’, we see the EU ETS
prices rise from €13 in 2015 to €38 in 2025 before falling back to about €30. The high
price is driven primarily by limited offset quotas. In the US, where offset quotas are
more generous, prices stay much closer to the offset market price – rising from €13 in
2015 to €23 in 2030.

However, ‘current proposals’ result in an abatement outcome of just 7 GtCO2,

bringing emissions down from a business-as-usual level of 61 GtCO2 in 2020 to 54
GtCO2. This compares to 17 GtCO2 that might be needed by 2020 to stabilize
concentrations at 450ppm, according to Project Catalyst (2009), and underscores the
fact that the unilateral commitments in both developed and developing countries
remain insufficient. Even in our most aggressive "High ambition" scenario, only
about 60% of the theoretical emission reduction potential is taken up. To change that,
much more comprehensive targets would be required that cover most countries, as
well as more aggressive policies on forestry and agriculture.

The shortfall in all our scenarios also underscores that carbon markets, while central
to the global mitigation effort, are on their own not enough. The carbon market will
only provide about 40% of the total abatement effort. Carbon trading has to be
complemented by additional policy instruments to address non carbon price-related
externalities. They may include standards (for example, renewable electricity
standards, building codes and fuel efficiency standards), targeted revenue support
(such as feed-in tariffs) and technology support in the form of subsidies for R&D and

15
pilot programs. Moreover, additional public finance will be needed to provide a
strong, additional impetus for abatement in developing countries, particularly those
currently not covered by the carbon market.

Much will depend on how carbon markets are designed – how comprehensive they
are, how ambitious, how well they are regulated and so on. This will determine to a
large extent how much abatement we can achieve and at what overall cost.
Particularly pertinent will be links to other markets, including the amount of offsets
allowed and direct linking with other developed country schemes. The banking and
borrowing mechanisms will determine the inter-temporal price development, and
could influence price strongly as abatement will become cheaper over time when the
abatement potential increases.

The model we used to derive these conclusions is relatively simple in terms of its
economic structure, but very rich in terms of the country and sector level mitigation
strategies it details. These data were taken from the McKinsey cost curves, which
provide comprehensive, internally consistent cost data for a wide array of countries
and sectors. Cost data are of necessity uncertain, but even accepting these
uncertainties it is clear that there is substantial scope for efficiency gains from carbon
trade. Carbon markets can make an important and effective contribution to the global
transition to a low carbon economy.

16
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Table 1: Assumptions for ‘Follow me’ scenario

AAU ETS Offsets

2020 reduction targets EU ETS Sectors in scope

▪ EU: 20% (of 1990) ▪ 2.02 Gt emissions in 2005 ▪ Power
▪ US: 20% (2005) ▪ Targets: 1.72 Gt in 2020 and 1.36 Gt in 2030 ▪ Industry
▪ Canada: 20% (2006) ▪ Sector scope: power, cement, steel, petroleum, other ▪ Waste

Working Draft - Last Modified 12.10.2009 15:27:48

▪ Japan: 15% (2005) industry ▪ Afforestation
▪ Russia: 10% (1990) ▪ Offset limits: 0.12 Gt in 2015 and 2020, no offsets ▪ Limited avoided
▪ Ukraine: 20% (1990) thereafter. 0.6 Gt offsets banked in 2008 - 2012 deforestation3
▪ Australia: 5% (2000) ▪ Banking allowed (5 year business foresight)
▪ NZ: 25% (1990) Rules
▪ South Korea1: 108% US ETS (Waxman Markey) ▪ No NPV positive projects
(2005) ▪ 6.09 Gt emissions in 2005 allowed in general
▪ Annex I: 10% (1990) ▪ Targets: 5.06 Gt in 2020 and 3.53 Gt in 2030 ▪ Mandatory projects
▪ Sector scope: power, industry, transport, buildings eligible (L- rule)
2050 reduction targets ▪ Domestic offsets: 0.3 – 0.7 Gt p.a. in 2015 - 2030 ▪ NPV positive power levers
▪ EU: 80% (of 1990) ▪ Int’l offset limits: 1.5 Gt in 2015 and 2020, 1.4 Gt in 2025, affected by feed-in tariffs

Printed
▪ US: 83% (2005) 1.3 Gt in 20302 (discount of 80% as of 2017) allowed (E- rule)
▪ Canada: 60% (2006) ▪ Banking and borrowing allowed (5 year business foresight)
▪ Japan: 60% (2005) ▪ Minimum price of $10/t in 2012 rising by real 5% annually
▪ Russia: 60% (1990)
▪ Ukraine: 50% (1990) Australian and Canadian ETS
▪ Australia: 60% (2000) ▪ 75% of country emissions in scope for Australia, scope as
▪ NZ: 50% (1990) in US for Canada
▪ Annex I: 70% (1990) ▪ Targets in line with country targets
▪ No offset limits
1 Targets growing with BAU CAGR after 2020
2 Domestic and international offsets together must not exceed 2 G
3 Total offset supply of 0.3 Gt in 2015, 0.7 Gt in 2020 and 0.8 Gt in 2025 and 2030 to be used in US ETS

Table 2: Assumptions for other scenarios based on ‘Follow me’

AAU ETS Policy

▪ Only binding targets ▪ Only EU ETS ▪ Mandates in non-EU

for EU ▪ Offset limit 0.06 Gt in 2025 developed countries at 25%
and 2030 (half of 2015 and of ‘Follow me’

Working Draft - Last Modified 12.10.2009 15:27:48

‘Head in the 2020 limit) ▪ No mandates in non-Annex I
sand‘ ▪ Market-driven policy score
at 50% of ‘Follow me’ for
non-EU developed countries
and at 25% for non-Annex I

▪ EU 30% and US ▪ Targets for ETS systems ▪ 100% mandates in

20% reduction adjusted according to country transport, buildings,
Printed

compared to 1990 targets agriculture, forestry and

in 2020 ▪ Additional ETS in Japan and waste in Annex I
▪ Reduction target on South Korea ▪ 50% mandates for global air
‘High average 20% of ▪ Offset limits increased by and sea transport
ambition' 1990 in 2020 and 100% of additional reduction ▪ Mandated policy score
75% in 2050 in in 2015 and 2020 and 50% in doubled (maximum of
Annex I 2025 and 2030 in EU ETS 100%) in non-Annex I
▪ No hot air ▪ Market-driven scores at
100% for Annex I and 50%
for non-Annex I

20
Chart 1: Market-driven policy effectiveness scores in ‘Follow me’ scenario
Market driven policy ambition by policy execution resulting in a policy effectiveness score , %

U.S. and
Groupings Canada OECD China Fiscally strong emerging India and other developing

Rest of Eastern
Policy execution

Rest of OECD
Rest of OECD

Rest of devel-
Rest of Africa
Rest of EU27

Rest of Latin
South Africa
score

Middle East

oping Asia
Germany

America
Canada
Policy ambition

Europe

Europe
Mexico
France

Russia
Pacific
Japan

China

Brazil

India
score

U.K.
Italy
U.S.

Working Draft - Last Modified 12.10.2009 15:27:48

Power 100 * 100 = 100 100 * 100 = 100 80 * 90 = 72 77 * 80 = 61 73 * 100
100 70 ==51
100

Buildings 100 * 90 = 90 85 * 90 = 77 63 * 70 = 44 30 * 60 = 18 25 * 50 = 13

Road 90 * 90 = 81 67 * 90 = 60 40 * 70 = 28 47 * 60 = 28 40 * 50 = 20
Transport

Agriculture 25 * 80 = 20 60 * 80 = 48 50 * 60 = 30 40 * 60 = 24 30 * 50 = 15

5 Industry 90 * 100 = 90 90 * 100 = 90 74 * 90 = 67 72 * 80 = 58 73 * 70 = 51

sectors

Printed
Waste 35 * 90 = 32 45 * 90 = 41 100 * 80 = 80 100 * 60 = 60 100 * 70 = 70

Sea transport 30 * 60 = 18

Air transport 50 * 80 = 40

Forestry 85 * 100 = 85 75 * 80 = 60 50 * 50 = 25 40 * 40 = 16 65 * 60 = 39

U.S., Canada, OECD and Brazil Other developing Rest of Rest of

Forestry is grouped differently to reflect importance of Fiscally strong Africa devel-oping
Brazil, Indonesia and Rest of Africa Asia (incl.
Indonesia)

Chart 2: Abatement cost curve after investor perspective Economic

perspective
adjustments Investor
Abatement cost 2030, € per tCO2e perspective

200

Working Draft - Last Modified 12.10.2009 15:27:48

150

100

50

0
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40
Printed

-50 Abatement
GtCO2e per year
-100

-150

-200

-250

21
Chart 3: Calculation flow of carbon markets model

▪ Reduce ETS abatement target while calculating ETS offset

demand in case of borrowing
▪ Increase abatement target in case of banking
▪ Start values: No banking and borrowing 3

Working Draft - Last Modified 12.10.2009 15:27:48

Relevant ETS
curves 2

Offset supply
curve 1

Supply 5 ▪ Offset price ▪ ETS price 6

ETS demand and ▪ Actual offset ▪ Banked or
demand borrowed 7

Printed
graphs 3 supply and
approach demand volume
▪ Linkage 8

Non-ETS
demand AAU price (equal
4 to CER price

▪ Increase non-ETS offset demand in case of ETS borrowing

▪ Decrease non-ETS offset demand in case of ETS banking
▪ Start values: No banking and borrowing 4

Chart 4: Carbon markets in 2020

Follow me Scenario

Developing
Developed countries
countries

Working Draft - Last Modified 12.10.2009 15:27:48

International AAU markets
• BAU: 20.6 Gt
AAU
• Emission permits 16.7 Gt
• Price: 13 EUR/t

0.5 Gt import
EU ETS US ETS Other ETS1 (in excess of
• BAU: 2.3 Gt • BAU: 7.2 Gt ETS import)
Printed

• Permits: 1.7 Gt • Permits: 5.1 Gt

ETS
• Price: 29 EUR/t • Price: 16 EUR/t
• 42 Mt banked • 0 Mt banked

1.1 Gt import
0.1 Gt 0.2 Gt
(0.9 Gt after
import import Offsets
discount)
• Total demand: 1.9 Gt
Offsets
• Price: 13 EUR/t

1 Australia and Canada

22
Chart 5: Carbon prices
€ per tCO2e, Follow me Scenario

40

35

Working Draft - Last Modified 12.10.2009 15:27:48

EU ETS
30

25
US ETS

20
Offset

Printed
15

10

0
2015 2020 2025 2030

Chart 6: EU ETS cost curve 2020 Mandated

€ per tCO2e compared to GtCO2e, Follow me Scenario
Offsets
Permits
Realized by market
Not realized
100
Abatement

Working Draft - Last Modified 12.10.2009 15:27:48

target

50

Price
Printed

0
0,1 0,4 0,5 0,6 0,7 0,8 0,9 1,0 1,1 1,2 1,3 1,4 1,5 1,6 1,7 1,8 1,9 2,0 2,1 2,2 2,5
Indirect Banked
non-ETS volume
abate-
ment
-50

23
Chart 7: Capital flows and abatement cost
Revenue in 2020, € billion, Follow me Scenario

Capital flows Cost of abatement1 Total revenue / cost

China 10.2 -5.4 4.8

Working Draft - Last Modified 12.10.2009 15:27:48

Rest of non-Annex I 12.1 -10.1 2.0

India 2.0 -0.7 1.3

Canada -1.6 -0.5 -2.2

+ =
Japan -2.1 -1.0 -3.1

Printed
Rest of Annex I -0.9 -3.3 -4.2

EU -4.1 -5.2 -9.4

US -15.5 -14.0 -29.5

1 Negative cost set to zero

Chart 8: Carbon prices under different climate scenarios EU ETS

€ per tCO2 US ETS
Offset
Head in the sand Follow me High ambition
60 60 60

Working Draft - Last Modified 12.10.2009 15:27:48

50 50 50

40 40 40

30 30 30
Printed

20 20 20

10 10 10

0 0 0
2015 2020 2025 2030 2015 2020 2025 2030 2015 2020 2025 2030

24
Chart 9: Abatement under different climate scenarios
GtCO2e

70 BAU

65 Head in the sand

Working Draft - Last Modified 12.10.2009 15:27:48

60

55 Follow me

50
High ambition

Printed
45

40

35
Full technical
potential
0
2005 2010 2015 2020 2025 2030

Chart 10: Carbon prices before and after linkage

€ per tCO2e, Follow me Scenario

40

35

Working Draft - Last Modified 12.10.2009 15:27:48

EU ETS
30 without linkage

Linked market
25
US ETS
without linkage
20
Printed

15

10

0
2015 2020 2025 2030

25
Chart 11: Carbon prices with and without banking
€ per tCO2e, Follow me Scenario
EU ETS without banking
EU ETS with banking
US ETS without banking
US ETS with banking
70

Working Draft - Last Modified 12.10.2009 15:27:48

65
60
55
50
45
40
35

Printed
30
25
20
15
10
5
0
2015 2020 2025 2030

26