Cap & Invest in Washington State

Shorter Answer

Banking of allowances is a compliance flexibility mechanism to keep the overall system compliance costs down, and is a common feature in carbon cap programs that can help limit price volatility and encourage earlier emissions reductions.  A prominent example, the European Union Emissions Trading System (EU-ETS), saw allowance prices crash at the end of a compliance period that did not allow banking and have since allowed unlimited banking from the second compliance period into the third.  According to Schmalensee and Stavins, “provisions for allowance banking have proven to be very important for achieving maximum gains from trade.”   If banked allowances accrue due to the cap being set too high initially, this can lead to higher emissions in later years as banked allowances are used for compliance.  It is important to set the cap at stringent enough levels to require some effort for compliance. However, banked emissions that result from additional early action to reduce emissions are a positive outcome as it is cumulative emissions, rather than a single year’s target emissions in the future, that has a greater impact.   Banking of allowances need not be a choice of unlimited or none at all. A program could include banking, but limit it in time to any number of years if that makes more sense for a jurisdiction or program than unlimited banking. It could also limit which entities can rely on banking, such as those in particular pollution hot spots or those given allowances rather than required to purchase allowances in auction.

More detailed answer

Banking of emissions allowances is one type of compliance flexibility mechanism, which have the goal of keeping the overall system cost-effective without compromising the integrity of the cap as a tool to reduce collective emissions.  Banked emissions must come from extra allowances in a previous compliance year that were not needed or used, meaning that emissions were lower than the cap.  Banking is a common feature in carbon cap programs.

Restricting banking of allowances can lead to substantial price volatility.  For example, allowance prices spiked thirty-fold in California’s Regional Clean Air Incentives Market (RECLAIM) in 2001, in part due to an absence of banked allowances.  Another example, from the European Union Emissions Trading System (EU-ETS), saw allowance prices collapse leading up to the end of the first compliance period when banking was not allowed.  The EU-ETS was subsequently reformed to allow unlimited banking between phases 2 and 3 (along with a more stringent cap, a greater share of auctioned allowances, and more limits on offset usage).

In reviewing three decades of cap programs, Schmalensee and Stavins noted that “provisions for allowance banking have proven to be very important for achieving maximum gains from trade.”

For banked emissions to factor into compliance, the overall emissions in a compliance period would need to be lower than the cap requirements.  This situation could arise for one of two reasons: (1) the cap was higher than it should’ve been, or; (2) emissions decreased faster than the cap required due to additional actions by the covered emitters.   

The first is much more problematic.  This is particularly so if the allowances were distributed for free rather than auctioned.  In that case, no obligation from the covered party in the near-term was required, yet they would still be eligible to claim credit in the long-term.  Therefore, the cap needs to be set stringent enough to require some effort for compliance.

In the second situation, the cap motivated more near-term emissions reductions than anticipated or required.  In isolation, this is a positive result. However, there are concerns that banking these emissions will put emissions limits in a future compliance year at risk.  If this applies to a single year target, such as 2035 for Washington state, the program could be viewed as failing to achieve its target.  

In general, establishing a cumulative emissions target (e.g. a linear glide path to a targeted 2035 emissions target) is more meaningful than establishing a single-year target.  This appropriately values additional near-term reductions without compromising longer-term targets. If cumulative limits for emissions reduction are set that accurately reflect the societal aims, then designing a cap to meet the cumulative reduction limits and allowing banking that motivates earlier emissions reductions is a positive outcome.

With all that said, the discussion about banking tends to compare unlimited banking to no banking.  A program could include banking, but limit it in time to any number of years if that makes more sense for a jurisdiction or program than unlimited banking. If the main benefit of banking is a mechanism to encourage earlier emissions reductions and keep cost volatility low, some banking is likely required, but need not compromise cumulative emissions reductions.  Perhaps banking from one compliance phase to the next may be sufficient to keep price volatility contained without overly jeopardizing any single year targets or cumulative emissions reduction limits. Another option is that banking could be limited for certain types of covered parties (e.g. those receiving free allowances or those in particular pollution hot spots) without causing overall disruption in the program.