This website provides a broad introduction to the legal character of emissions entitlements and the significance of their legal characterisation. It represents the outcomes of an Australian Research Council Discovery Project (ID: DP130100607) awarded in 2013.Play Now
History so far
Emissions trading has continually, albeit gradually, gained prominence as a key mechanism to combat human-induced climate change. The use of market-based mechanisms to combat climate change, and in particular the development of emissions trading, was first established by the Kyoto Protocol in 1997.
The European Union Emissions Trading System was adopted in 2003 and was launched in 2005 following a cap and trade principle.
This was a 3-year pilot of ‘learning by doing’ to prepare for phase 2, when the EU ETS would need to function effectively to help the EU meet its Kyoto targets.
Taken from ec.europa.eu/clima/policies/ets/pre2013_en
Lastly, the Regional Greenhouse Gas Initiative implemented a new cap on emissions in 2014 and became the first mandatory emissions trading scheme in the United States. The initiative encompasses Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New York, Rhode Island and Vermont. The Regional Greenhouse Gas Initiative involves a cap on the amount of carbon emissions that power plants emit in the states. The allowances conferred or bought by the power plant owners can then be sold and purchased on the market.
There has also been setbacks in the development of emissions trading schemes. For instance, Australia became the first country to withdraw its emissions trading scheme following a change in government in 2014.
Now, there are 17 emissions trading schemes worldwide. Of these, five were established in 2015. A minority of the schemes are inter-linked, such as Switzerland’s emissions trading market with the EU’s emissions trading market. This means that regulators from Switzerland and the EU will accept tradeable emission entitlements allocated in the other jurisdiction. Another example of an inter-linked scheme is the California Cap-and-Trade Program with the Québec Cap-and-Trade System. Inter-linking schemes allows the market to work better because it expands the participants. Theoretically then, inter-linking emissions trading schemes will more cost-effectively reduce emissions than a single emissions trading scheme.
The Paris Agreement entered into force on the 5 October 2016. This agreement solidified the role of emissions trading in combatting climate change and set the groundwork for an international emissions trading scheme at Article 6(4). In particular, the Paris Agreement allows parties to transfer their emission reductions on a country-to-country level based on cooperative approaches to reducing emissions. This may involve, for instance, country A investing in renewable energy project in country B, and the emission reductions from the project count towards country A’s emission reduction commitments. In addition, the Paris Agreement seems to support the development of a worldwide emissions trading scheme that both public and private actors can be involved in.
China, one of the world’s largest emitters, plans to establish a nation-wide emissions trading scheme for 2017, which will build off its pre-existing regional schemes. When established, China’s emissions trading scheme will be the world’s largest.
Current Methods for Characterising Entitlements
Of the emissions trading schemes that are in force or going into force, most of these define emission entitlements as a unit that is tradable and is the equivalent of a particular volume of greenhouse gases. In fact, 21 emission trading scheme that are in force or under consideration define their entitlements in this way. For example, New Zealand defines an emission reduction unit to mean: ‘a unit derived from a joint implementation project, issued by converting an assigned amount unit or removal unit, and designated as an emission reduction unit by—(a) the [NZ] Registry; or (b) an overseas registry of a Party listed in Annex B of the Protocol’
Emissions trading schemes established in California, Washington and through the Regional Greenhouse Gas Initiative 2013 (An agreement reached between Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New York, Rhode Island, Vermont and implemented into state laws) characterise emission entitlements as “not property”. Thus, these states consider emission entitlements to be something less than something subject to private property rights.
Emissions trading schemes in Alberta, Ontario, Quebec (Canada) and New Zealand restrict an owner of an entitlement from dividing their interest. This means, for instance, that an entitlement holder in these jurisdictions cannot make their entitlements the subject of a trust or, potentially, create security interests on the basis of the entitlement. It also restricts the ability of the owner of an entitlement to transfer the right to use the entitlement to another while retaining ownership.
Although Australia’s emissions trading scheme is no longer in force, Australia had declared emission entitlements to be “property”. This meant that all the laws in Australia relating to the transferal of property, such as under insolvency or succession laws, applied to the emission entitlements.
The legal uncertainty across these dimensions in turn affects emissions trading. Market actors feel more confident trading in a market where the rights, duties and liabilities in relation to the commodity being traded are clear. Market actors also need to feel confident that their property cannot be taken away by the government.
The Financial Markets Law Committee of the Bank of England released a report on the uncertain legal nature of emission entitlements, in which they stated:
It might be argued that the fact that trading in emission allowances is already taking place, and that market infrastructure is being developed, indicates that there are theoretical issues which will not, in practice, prevent the successful development of a market where the commercial interests of operators and financial institutions require it. The Financial Markets Law Committee does not believe that this is the case: the reason why these uncertainties have not so far impeded the early stages of the development of the market is simply that they have not been appreciated (Page 15, Paragraph 4.1)
The legal nature of an entitlement is also important in the context of inter-linking emissions trading schemes. Inter-linked schemes mean that emission allowances allocated in one jurisdiction are accepted in the other.
The different legal nature of entitlements presents a barrier to inter-linking. For instance, if country A recognised an emission entitlement as property capable of forming the subject matter of a trust and country B did not, then policy makers will have to compromise regarding the characterisation of entitlements.
The 3 key issues
Depending on a country’s constitution, a government can be required to pay compensation for interfering with private property rights. If an entitlement is not property, then the government will have significantly more flexibility when modifying an emissions trading scheme by, for instance, reducing the cap on emissions.
The legal nature and scope of rights and duties in an entitlement determines how the entitlement can be legally created, transferred and cancelled. The way entitlements are characterised will also affect how they are treated for financial reporting and tax accounting purposes including whether an entitlement can form the basis of a security interest.
Financial derivative products are contracts agreed to on the basis of future market expectations in relation to the price of a particular asset. Where the legal nature of the underlying asset is unclear, there is arguably a higher risk that the asset will be valued incorrectly, that is, the asset may be sold for too much or too little.
As the nature of the underlying asset-emission entitlements- is unsettled, the secondary market could be significantly affected by the ongoing lack of legal certainty. Alternatively, the value of the underlying asset and the derivative product could be affected by a regulator altering or clarifying the character of an emission entitlement.
We suggest that legislatures consider precisely outlining a holder's rights and duties in relation to an entitlement as well as the contexts in which the government may vary and terminate an entitlement.
Courts have various limitations on their ability to precisely scope the nature of rights and duties in an emission entitlement. They are limited to the facts of the case before them, and courts work within existing legal frameworks and concepts that are applicable to more traditional and established property relationships such as an owner of land.
The Copyright Act 1968 (Cth) outlines the nature and duration of copyright ownership, identifies acts that will or will not infringe the rights of a copyright owner as well as remedies and offences associated with infringement. A similar approach could be used for statutory entitlements .
One model to legislatively characterise entitlements stems from intellectual property law, and in particular copyright law. Similar to emissions trading schemes, intellectual property laws have to reconcile private interests (i.e. in reclaiming their investment into the art or innovation) with the public interest (i.e. in accessing the art or innovation).
The 6 Principles
When creating an emission entitlement, statutes should identify whether entitlements are designed to be transferable or non-transferable and expressly explain the policy rationale underpinning the transferability of an entitlement. This will help ensure that, where legal issues arise, courts make decisions consistent with legislative intentions.
Statutes should be drafted in a way that accounts for the different property relationships that exist between the holder to the government and the holder to third-parties. For instance, an entitlement may be “property” between the holder and a private third-party, but not between the holder and the government.
Statutes should identify whether derivative financial products can be created on the basis of an emission entitlement, and how such interests can be created. Regulation of emissions trading and trade in derivative products from emission entitlements should be coherent and collaborative. This will ensure that governance of emissions trading does not become too fragmented.
Government bodies can limit their liability by expressly stating that an entitlement is either: inherently susceptible to alteration, a revocable license or “not property”. However, statutes should carefully delineate the circumstances in which a government body can alter an entitlement. This gives the regulator flexibility to change the scheme as required, but helps preserve market confidence, as a regulator’s discretion is limited and exercised in a predictable, consistent manner.
Government bodies should consider whether and which:
Duties & Liability Outline
Where specifying the legal nature of entitlements, statutes should outline not only the rights, but also the duties and liabilities that holders and third-parties have in relation to the entitlement.