Developing a CO 2 Emissions Trading Design for Slovakia

Transcription

1 Developing a CO 2 Emissions Trading Design for Slovakia May 2002 Eric Williams Stanislav Kolar Ellina Levina Jia Li ACKNOWLEDGMENTS The authors of this paper acknowledge a number of people who made valuable contributions to this study. We thank Ned Helme, Executive Director, and Catherine Leining, Senior Policy Analyst, of the Center for Clean Air Policy for contributing their guidance, ideas, and comments. The authors extend thanks to Ivan Mojik and Gabriela Fischerova, Slovak Ministry of Environment, for their insight, guidance, and comments, and for their inspiration to get this study started. Gratitude is also extended to Jiri Balajka, Jan Judak, Jozef Peschl, and Helena Princova from Profing, for their diligence and resourcefulness in obtaining and analyzing data, and for their vast knowledge of Slovak energy and data issues. Finally, the authors thank the US EPA for providing financial support for this study.

2 DEVELOPING A CO 2 EMISSIONS TRADING DESIGN FOR SLOVAKIA Contents 1. INTRODUCTION 1 1.A CCAP S APPROACH TO THE STUDY 1 1.B ORGANIZATION OF THE REPORT 2 1.C APPENDIXES 3 2. EXISTING ENVIRONMENTAL REGULATORY FRAMEWORK IN SLOVAKIA 4 2.A AIR POLLUTION CONTROL 4 2.A.1 EMISSIONS FEES 4 2.A.2 EMISSION FINES 4 2.B EXISTING MRV INFRASTRUCTURE 5 2.C EXISTING ENFORCEMENT MECHANISMS 7 2.D EXPERIENCE WITH EMISSIONS TRADING 7 3. COMPOSITION OF GHG EMISSIONS IN SLOVAKIA 9 3.A OVERVIEW OF GHG EMISSIONS DATA 9 4. SCOPE OF CO 2 EMISSIONS TRADING IN SLOVAKIA 11 4.A POSSIBLE OPTIONS OF TRADING SYSTEM DESIGN 11 4.A.1 UPSTREAM TRADING SYSTEM 11 4.A.2 DOWNSTREAM TRADING SYSTEM 12 4.A.3 UPSTREAM DOWNSTREAM HYBRID APPROACH 13 4.B SELECTION OF A TRADING SCHEME FOR SLOVAKIA 14 4.C RECOMMENDATIONS WHO PARTICIPATES IN THE TRADING SYSTEM? 16 5.A DEFINING SYSTEM COVERAGE 16 5.A.1 SECTOR SELECTION 16 5.A.2 SECTOR AND SOURCE CO 2 EMISSIONS 17 5.A.3 SECTOR ADVANTAGES 19 5.B FURTHER CONSIDERATION OF KEY CRITERIA 19 5.B.1 ENVIRONMENTAL EFFECTIVENESS AND ECONOMIC EFFICIENCY 19 5.B.2 ADMINISTRATIVE FEASIBILITY 19 5.B.3 EFFECTS ON COMPETITIVENESS 20 5.B.4 AVOIDING ECONOMIC DISTORTION 21 5.C DEFINING A SOURCE 21 5.C.1 RECOMMENDATIONS FOR DEFINING A SOURCE 23

3 6. ALLOCATION OF EMISSION ALLOWANCES 24 6.A ALLOCATION METHODS 24 6.A.1 AUCTIONING 24 6.A.2 GRANDFATHERING 24 6.A.3 OUTPUT-BASED ALLOCATION 25 6.B HOW SHOULD NEW ENTRANTS BE TREATED? 27 6.C GRANDFATHERING ALLOWANCES ON THE BASIS OF HISTORIC EMISSIONS 28 6.C.1 CHOOSING THE MEASUREMENT FOR ALLOWANCES ALLOCATION 28 6.C.2 CHOOSING THE BASE YEAR 29 6.C.3 CONSIDERING THE POTENTIAL FOR GROWTH 29 6.C.4 ALLOWANCE ALLOCATION FORMULA 30 6.C.5 REAL-LIFE ALLOWANCE ALLOCATION 30 6.C.6 TOTAL ALLOCATION AND BANKING 31 6.D. ALLOWANCE SET-ASIDE 32 6.E ADDITIONAL ISSUES TO BE CONSIDERED 32 6.E.1 EFFECTS OF ALLOCATION SCHEME ON FAIR COMPETITION 32 6.E.2 COSTS AND POLITICAL COMPLICATION OF GRANDFATHERING PAMS FOR NONPARTICIPATING SOURCES AND SECTORS 34 7.A EXAMPLES OF POSSIBLE POLICIES AND MEASURES 36 7.A.1 ENERGY EFFICIENCY STANDARDS 36 7.A.2 TAXES, TAX CREDITS, AND SUBSIDIES 36 7.A.3 RENEWABLE ENERGY PROGRAMS 37 7.A.4 INFORMATION PROGRAMS 37 7.B SPECIAL PROGRAMS THAT ADDRESS NON-CO 2 GASES AS WELL AS SOURCES AND SEQUESTRATION 37 7.B.1 TRANSITION ( CROSSWALK ) FROM PAMS TO TRADING MONITORING, REPORTING, VERIFICATION, AND VALIDATION OF EMISSIONS UNDER A CAP-AND-TRADE PROGRAM 38 8.A INTRODUCTION 38 8.B MRV FRAMEWORK 39 8.B.1 UNFCCC AND THE IPCC GUIDELINES 39 8.B.2 COUNTRY-LEVEL VERSUS COMPANY-LEVEL MRV 40 8.B.3 MRV DEFINITIONS AND PRINCIPLES 40 8.B.4 ACCOUNTING FRAMEWORK 42 8.C MONITORING TECHNIQUES 44 8.C.1 MEASUREMENT 44 8.C.2 CALCULATION 45 8.D CONCLUSIONS ON THE MONITORING FRAMEWORK 51 8.D.1 PRINCIPLES AND ACCOUNTING FRAMEWORK 51 8.D.2 EMISSIONS DETERMINATION TECHNIQUES EMISSIONS REPORTING 53 9.A OVERVIEW 53 9.B OPTIONS FOR REPORT FORMATS 53 9.C CONCLUSIONS AND RECOMMENDATIONS ON REPORTING EMISSIONS VERIFICATION AND VALIDATION 58

4 10.A OVERVIEW B VALIDATION FUNCTIONS B.1 CHECKING THE INTEGRITY OF THE EMISSIONS REPORT B.2 EXAMINING UNDERLYING DATA C WHO SHOULD VERIFY AND VALIDATE IN SLOVAKIA? ENFORCEMENT A EXISTING ENFORCEMENT MECHANISMS IN ENVIRONMENTAL PROTECTION IN SLOVAKIA B ENFORCEMENT EXPERIENCE WITH THE NEW SO 2 QUOTA PROGRAM C ENFORCEMENT FOR THE EXPECTED CO 2 CAP-AND-TRADE PROGRAM C.1 TYPE OF SANCTIONS C.2 LEVEL OF SANCTIONS C.3 WHO ENFORCES? C.4 ENFORCEMENT TOOLS AND MECHANISMS D CONCLUSIONS ON ENFORCEMENT 66 APPENDIX 1 EMISSIONS PROJECTIONS BASIC ASSUMPTIONS ACTIVITY GROWTH AND ENERGY CONSUMPTION ENERGY EFFICIENCY CARBON INTENSITY SCENARIOS SECTORAL PROJECTIONS DEVELOPMENT ELECTRICITY INDUSTRIAL SECTOR DISTRICT HEATING OTHER SECTORS 77 APPENDIX 2 ECONOMIC ISSUES OF THE ALTERNATIVE ALLOCATION METHODS ECONOMIC EFFICIENCY IMPACTS ON INVESTMENT DECISION AND TECHNOLOGICAL INNOVATION DISTRIBUTIONAL IMPLICATIONS 81 APPENDIX 3 MONITORING EMISSIONS: SPECIAL CONSIDERATIONS CHARACTERIZATION OF BOILER COMBUSTION PROCESSES CHARACTERIZATION OF ENGINES AND TURBINES COMBUSTION PROCESSES FUEL SPECIFIC ISSUES RELATED TO MONITORING TECHNIQUES COAL OIL PRODUCTS NATURAL GAS CHARACTERIZATION OF INDUSTRIAL PROCESS-RELATED EMISSIONS IRON AND STEEL REFINERIES CEMENT MONITORING SUMMARY DETERMINATION METHODS: MEASUREMENT AND CALCULATION APPLICATION OF THE CALCULATION APPROACH WASTE FUELS AND FUELS PRODUCED ON-SITE CONCLUSIONS AND RECOMMENDATIONS 105

5 1. Introduction Since the Third Conference of the Parties to the United Nations Framework Convention on Climate Change (UNFCCC) in Kyoto in 1997, Slovakia has been among the most proactive countries in Central and Eastern Europe in putting the Kyoto Protocol to work. It has fully embraced the global goal of mitigating the potential threat to our climate by limiting or reducing emissions of greenhouse gases (GHGs). To address Slovak GHG emissions, the government is considering adopting a domestic carbon dioxide (CO 2) cap-and-trade system. Under a cap-and-trade program, a cap would be set limiting the total level of CO 2 emissions over a specified period of time, and emissions allowances in aggregate equal to the cap would be distributed to individual emission sources. Each allowance would represent the right to emit 1 ton of carbon dioxide. Companies that reduced their emissions below the number of allowances they held could sell the allowances they did not need, and companies with emissions exceeding allowances would have to buy additional allowances. CO 2 emissions trading will not be the first emissions trading system in Slovakia. Beginning in 2002, sulfur dioxide (SO 2 ) emissions is regulated under a cap-and-trade program that covers more than 80 percent of the country s SO 2 emissions. This innovative approach to environmental regulation is the first and only emissions trading system among the economies in transition and among the first such programs in Europe. As an economy in transition, Slovakia s financial resources are scarce, and the government believes that addressing SO 2 emissions through a market-based emissions trading scheme is the least expensive and, perhaps, most effective option for reducing environmental damage. The Slovak government believes that a similar program can be established for CO 2 emissions and asked the U.S. Environmental Protection Agency (U.S. EPA) and the Center for Clean Air Policy (CCAP) to design a potential cap-and-trade program for CO 2 emissions in Slovakia. CO 2 emissions represent 80 percent of Slovakia s GHG emissions; 1 the cap-andtrade program proposed in this study would cover more than 60 percent of Slovakia s CO 2 emissions. Other sources of carbon dioxide and, potentially, other GHG emissions could be covered under the cap-and-trade program at a later stage. 1.A CCAP s Approach to the Study This report is the result of a successful formula of analysis and consensus building that CCAP has applied to its work on similarly complex domestic and international environmental policy issues. In this approach, we used the high-quality analytical ability of CCAP staff and key experts to characterize issues, assess options, and develop policy proposals. Throughout the project, our analysis and preliminary recommendations were presented to and discussed with the dialogue group comprising leading stakeholders from Slovak government, industry, academia, and nongovernmental organizations as well as key experts from the U.S. EPA. The group met three times, and one industry-specific workshop took place, in which CCAP staff and U.S. EPA officials delivered short, targeted presentations to focus discussion. Both before and following the meetings, we produced working papers that outlined key issues, 1 Second National Communication of Slovakia to the UNFCCC. Page 1

6 conclusions, and unresolved questions. Those efforts and the interaction among dialogue members provided valuable insights and a shared sense of priorities. The results of these meetings enabled us to prepare recommendations that reflect concerns and suggestions of various stakeholders (interest groups) and are based on the existing policy framework and priorities in Slovakia. This final report summarizes all the working papers and discussions that focused on specific areas and issues and presents recommendations to the Slovak government on a domestic CO 2 cap-and-trade system. Our analysis shows that Slovakia can establish an effective and administratively feasible capand-trade program that will cover more than 60 percent of the country s CO 2 emissions. Domestic trading and allocation of emission allowances to companies will establish the basis for Slovak companies participation in international emissions trading. Because Slovak GHG emissions are below the Slovak Kyoto target and many cost-effective opportunities exist for further reductions, Slovakia can become a net seller of emissions allowances under the envisioned international trading program. By selling emissions allowances on the international market, Slovak companies and the government could generate revenue, which could be invested in clean fossil, renewable energy, and energy efficiency technologies. 1.B Organization of the Report Chapter 1 introduces the topic and reviews the report s organization. Chapter 2 examines the existing environmental regulatory framework in Slovakia. It reviews how emissions of conventional pollutants are regulated, the role of various government agencies in their regulation, and the experience with emissions trading in Slovakia s SO 2 capand-trade program. Chapter 3 focuses on historic and current GHG emissions in Slovakia. The data show the breakdown of emissions by economic sectors and historic trends in emissions. We developed both bottom-up and top-down GHG emissions inventory for 1990 and for the period 1996 to The detailed tables and figures on emissions by sources and sectors are presented in Appendix 1. Chapter 4 examines the potential scope of the trading program. Our recommendation is to establish a downstream emissions trading system that sets emission caps for the most important sectors of the Slovak economy: electric power production and selected industrial sectors. Our recommendation for the specific downstream system is based on analysis of Slovakia s existing environmental regulatory framework, political and administrative constraints, and compatibility with the expected European Union (EU) GHG trading program. Chapter 5 defines the trading system coverage. This part of the analysis presents options for including or excluding certain sectors or sources in the trading system according to various criteria, such as environmental effectiveness, administrative feasibility, competitive distortions, and EU compatibility. The proposed trading system will include fewer than 300 sources greater than 5 MW thermal capacity and an equivalent size for industrial process emission sources and industrial process emissions of equivalent size. The percentage of captured CO 2 emissions would be greater than 60 percent. Page 2

7 Chapter 6 addresses the mechanisms of allocating emissions allowances to the participating emission sources. We recommend a combination of grandfathering and auctioning as the most economically and politically acceptable option. Chapter 7 recommends specific policies and measure (PAMs) for the sectors and sources that will not participate in the cap-and-trade program. Sources responsible for almost 40 percent of CO 2 emissions in Slovakia would not be included in the trading program. To achieve environmental goals in an effective and equitable fashion and to avoid economic and competitive distortions, those emissions must be dealt with in some manner. We examine both market-based and non-market-based approaches and provide specific PAM options. Chapter 8 presents the requirements for monitoring, reporting, and verification (MRV), which are critical parts of an effective cap-and-trade program and should be designed to place only the minimum required burdens on the participating entities. At the same time, MRV requirements should maintain strict accuracy standards and allow for effective and efficient government oversight and control. The success of the cap-and-trade program depends to a large extent on the accuracy and effectiveness of the MRV functions. Chapters 9 and 10 provide further discussion of MRV issues. Chapter 11 examines the need for effective enforcement mechanisms. For any enforcement mechanism to work, a system of sanctions must be introduced. This chapter reviews how sources are sanctioned through the existing environmental regulations and the roles individual government agencies play in the enforcement of such sanctions. It also recommends enforcement mechanisms for the effective implementation of the CO 2 cap-andtrade scheme and an administrative infrastructure that will be able to administer and enforce them. 1.C Appendixes We include several appendixes to present our analysis in full without sacrificing the clarity of the main report. Appendix 1 provides a detailed review of emissions projection methodology, both for the sources and sectors covered under the cap-and-trade program and for the uncapped sectors and sources. The calculations provide an estimate of what GHG emissions will be in the year The projections were used to estimate the necessary stringency level for both the total emissions cap and the PAMs for nonparticipating sources. Appendix 2 examines the economic issues associated with various allowance allocation options. Appendix 3 reviews special MRV consideration by sector and suggests how individual sources in various sectors should approach emissions calculations. It examines each sector that is included in the trading program and presents specific emissions calculation and monitoring issues that deserve particular attention. The appendix also provides detailed analysis of the reporting, verification, and validation mechanisms that the government needs to implement. Page 3

8 2. Existing Environmental Regulatory Framework in Slovakia 2.A Air Pollution Control Current legislation in Slovakia establishes concentration limits for air pollutants, fees for emitting pollutants, and fines for exceeding the limits of concentration. Individual air pollution sources are subject to both fees for emissions and penalties for exceeding air pollution concentration limits. In addition to solid particulates, SO 2, nitrogen oxides (NO x ), carbon monoxide (CO), and volatile organic compounds (VOCs), the government regulates more than 120 other pollutants and compounds. The existing MRV system to implement clean air requirements is based on national MRV standards determined by the Ministry of Environment and administered by the 79 districts. 2.A.1 Emissions Fees The emission fees are paid (annually) by all sources with thermal capacity of 5 MW or above, regardless of how much of the given pollutant they emit or whether they comply with pollutant concentration limits. The five main pollutants (solid particulates, SO 2, NO x, CO, and VOCs) and more than 120 other pollutants are subject to the emissions fee requirements. The emissions fee program is a usage fee, or resource depletion charge. Even the cleanest emitters, such as natural gas combustion sources, are required to pay for each ton of pollutant. The fees system was introduced in 1992, and rates were designed to have an incentive function: Rates increased each year, up to 100 percent in 1999, although the rates were diminished by inflation over the period. In 1999, the Slovak government adopted a new Clean Air Act, which included a new pollution fees system. According to the new legislation, polluters are divided into two groups, depending on technical parameters. Although emission limits are uniform throughout Slovakia, higher rates are applied to polluters who have obsolete or poorly operated technologies. The legislation may provide an incentive for polluters to adopt alternative (i.e., cleaner and more efficient) technologies. Also, the law establishes a new payment calendar and sets a deadline of meeting emission limits by The law raised the fees; however, an evaluation was not conducted to determine whether the levels reflect the real cost of pollution. In addition, the law introduced a new feature of inflation indexing was introduced. In the meantime, quotas on SO 2 emissions will be issued, and a cap-and-trade system will be established. The Ministry of Environment is now working on implementation of this new economic instrument. The system is expected to result in a more cost-effective abatement program. 2.A.2 Emission Fines Sources are subject to emission fines if they exceed a fixed air pollution concentration limit, defined in pollutant volume per mass of flue gases. The concentration limits are specified in the text of secondary regulations by the Ministry of Environment. In 1998, the Ministry of Environment conducted a study to assess how many polluters would not meet the new emission standards. The result showed that more than one-third of polluters (the majority in the public sector, such as heating stations and incineration plants) were in serious noncompliance and would need to be closed as required in the legislation. In only one Page 4

9 case was a company shut down, however. Most polluters were asked to improve their environmental performance while paying fines for exceeding standards. 2.B Existing MRV Infrastructure The Slovak Hydrometeorological Institute is responsible for defining the methodology of emissions data development and collection. The Ministry of Environment instructs district offices on this methodology. Thus, each district office collects and assesses data using standard methods. The database software is available to all district offices; however, only some of the district offices have access to the necessary hardware for data collection. The current plan calls for the installation of that hardware in several years in all district offices. Emission sources are categorized as follows: REZZO 1: Stationary sources with thermal capacity greater than 5 MW REZZO 2: Stationary sources with thermal capacity of 0.2 to 5 MW REZZO 3: Stationary sources with thermal capacity less than 0.2 MW REZZO 4: Mobile source, all capacities. Data are reported per individual smokestack. Sources report the total amount of pollutant emitted and the concentration limits of pollutants per mass unit of flue gases (i.e., cubic meters) annually, but some information is collected on a monthly basis. Because sources pay emission fees for each ton of pollutant, they have an incentive to underreport emissions. Total emissions are calculated by the source on the basis of measured concentration of pollutant in the flue gases and extrapolation of this measured amount over the calendar year. The methodology has its drawbacks. When the licensed measurement firms perform their measurements, sources may adjust their combustion process to reduce concentration of pollutants in the flue gases, or they may use low-sulfur fuel to reduce the amount of sulfur in the flue gases. Such practices have come to light during the implementation of Slovakia s SO 2 emission quota program this year. Although the government issued emission quotas for 2002 to 2004 that are greater than current emissions reported by each source, after the allocation of quotas to individual emission sources, some companies declared that their emission quota was lower than their actual emissions. The government responded that it issued emission quotas on the basis of reported emission levels by the sources themselves; therefore, any shortfall in the emission quotas is the fault of the source. Assessing emission fees and penalties and enforcing breaches of any provision of environmental permits are the responsibility of the environmental departments of the district offices. The district offices make decisions on fees, including payment schedules, which are based on the calculated and reported amount of emissions by each source. Emission concentrations, total emissions for the calendar year, and the applicable fees are measured, calculated, and declared by the emitters themselves. The district offices have a limited capacity for verification of those calculations and generally accept the reported amounts of emissions. Verification is performed by comparing the reported amount of emissions for the given calendar year with measurements that licensed firms perform at the source. Such measurements are performed only periodically, generally once a year, so that the government authority can only extrapolate the measured results for the calendar year. Page 5

10 Until 2000, REZZO 1 represented by far the most comprehensive inventory of pollution sources in Slovakia. A total of 979 sources are in this category. Each source reports detailed information, including chemical analysis, about fuels used for combustion. Specific requirements for reporting the carbon content of fuels or CO 2 emission factors do not exist. Coal mines typically offer different qualities of coal, according to the carbon content and heating value. Oil and gas importers also report the quality of fuels on the basis of heating value. Until 1996 all sources in REZZO 1 reported the amount, type, and quality of consumed fuels as well as detailed descriptions of combustion technologies. Since 1996, selected sources (i.e., the largest sources) have been required to undergo a detailed measuring procedure conducted by a firm licensed by the Slovak Hydrometeorological Institute. The district office and the State Environmental Inspectorate may review reported data and order additional measurements if doing so deemed necessary. In 2000, the government began implementing a new data system called NEIS (National Emission Information System). This inventory is based on the REZZO system but expands it by adding information on how emissions were calculated, details on fuel and technology type (e.g., types of processes and boilers), and information about production. The emissions information from this database is publicly available, but other information is classified and can be released only with permission of the company reporting the data. Only a few of the largest sources have continuous emissions monitoring capability. Most sources calculate the amount of emissions on the basis of two factors: (1) fuel records and (2) periodic measurement by licensed firms of flue-gas concentration in the smokestack. Such measurements, however, are conducted for a period of several hours or days in a calendar year and are used to determine compliance with concentration limits. Their use for calculating the annual emissions is limited. The district offices play a passive role in the verification of calculations supplied by the polluters. In most cases, the district offices do not have the personnel resources to verify reported emissions. As discussed above, sources have an incentive to underreport emissions in order to lower their fees. Knowing that the Air Act administration at the district level is poor, source owners have been underreporting emissions. The underreporting illustrates that the existing MRV system for conventional pollutants in Slovakia is inadequate, primarily because of the government s lack of verification capabilities at the district level. New verification procedures, clearer rules, and legal requirements on fuel data all mean that the existing REZZO database and the data collection methodology can be used for MRV under the proposed CO 2 cap-and-trade program. The REZZO database uses fuel-supply records, which indicate both fuel quality and quantity. As will be explained later in this report, those data, along with appropriate emissions factors, are necessary for an effective CO 2 MRV system. The main issue that the government will have to resolve is that of the poor quality of the reported data and the consistency of the methodology across sectors and years. We believe that a source-level CO 2 inventory can rely on the existing data collection effort and, with sufficient verification and validation methodology, could be used Page 6

11 to provide sufficient guarantees for the integrity of the proposed CO 2 cap-and-trade program. Our recommendations for source-level monitoring are described in Chapter 8. 2.C Existing Enforcement Mechanisms Penalties for exceeding emission concentrations are provided for in the legislation; the district offices assess and enforce the penalties. For example, discharging pollutants without required permits or breaching the terms of a permit by emitting greater volumes or higher concentrations than allowed draws penalties of various sizes, depending on the nature of the violation. Revenues from penalties go to the Slovak State Environmental Fund. Penalties also may be imposed by the Slovak Environmental Inspectorate. Municipalities have a limited role in environmental management; they may impose pollution charges on small air pollution sources, and the generated revenues go into the municipal budget. According to the Ministry of Environment, failing or bankrupt emitters and the general lack of good business behavior result in a collection rate of about 80 percent, meaning that 20 percent of sources do not pay. Companies that do not pay pollution fees often do not pay social security on their employee wages and other taxes. Whereas taxes and social security are paid to the Finance Office (i.e., tax collector), pollution fees are paid to the State Environmental Fund. The Finance Office has effective tools at its disposal, such as blocking bank accounts of nonpayers, to collect due amounts. The State Environmental Fund, however, can resort only to court proceedings to collect due amounts. Sanctions against nonpayers are those that can be used in general business relationships, such as interest rates charged on the owed amount. Fines are optionally applied to emitters that exceed air pollution concentration limits. The amount of fines collected in 1998 was less than 10 million Koruna (Sk), roughly US$200,000, compared with 400 million Sk (US$8 million) in assessed fees. Generally, fines are charged to emitters whose behavior has been particularly bad and when milder forms of enforcement have failed. The amount of fines is limited by law to 10,000 to 5,000,000 Sk for the first year, and they may be doubled in subsequent years if the offense continues. The maximum penalty amounts may exceed the cost of compliance for small and medium-size sources, but for large sources the cost of compliance is higher than the maximum amount of penalty. The largest source in Slovakia, however, complies with the law. Noncompliance is mostly seen at small and medium-size sources. The regional government office (Kraj), on the advice of the State Environmental Inspectorate or on the basis of its own findings, however, may resort to more extreme forms of pressure, such as forcing the shutdown of the emitter. 2.D Experience with Emissions Trading As discussed above, a 1999 amendment to the Air Law (No. 309/1991) established the possibility of setting emission quotas (i.e., caps) for regulated pollutants, including sulfur dioxide (SO 2 ) and carbon dioxide (CO 2 ). The Ministry of Environment issued emission quotas in April 2000 for SO 2 emissions, to be enforced in The Ministry of Environment sets emission quotas for each of the 79 districts in Slovakia. Individual districts allocate quotas to individual emitters. Only sources of greater than 50 MW thermal capacity (i.e., Page 7

12 large sources, according to the law s classification) are allocated quotas; these sources are responsible for more than 80 percent of total SO 2 emissions. Once the quotas are allocated among individual sources, emitters may trade allowances among themselves to meet their allocation. The only restriction on trading is on sources in areas in which the ambient air quality is noncompliant. Such sources may not buy allowances from outside those areas. When developing the SO 2 quotas, the Ministry of Environment based its allocation on historical emissions as well as on expected developments in individual sectors of the economy. The quotas for the first three years ( ) are higher than current total emissions; however, the planned annual quota will decline over time and will be lower than the 1998 emission levels starting in The planned quota for 2009 will be 45 percent below current emission levels. No banking of allowances is allowed, and annual quotas are to be met separately each year. The reason for not allowing banking is to meet international commitments that Slovakia has with respect to SO 2 emissions. Because this commitment is set as total emissions in a particular year (2005 and 2010), allowing banking could lead to the actual emissions in a particular year exceeding the commitment. Slovakia s experience with the SO 2 quota program has helped build the institutional capacity for the government to develop and implement a similar program for CO 2 emissions. Page 8

13 3. Composition of GHG Emissions in Slovakia 3.A Overview of GHG Emissions Data Slovakia uses Intergovernmental Panel on Climate Change (IPCC) guidelines to develop its national aggregated GHG inventory. It also collects bottom-up data on fuel use by all stationary sources of greater than 5 MW capacity. We used both data systems in this analysis. Our recommendations on the CO 2 trading system design (presented in the following chapters), however, are based on source-level, bottom-up information because it is more reliable than the IPCC-based data. Aggregating energy and emissions data into sectoral categories in Slovakia presents a variety of problems. Because so many industrial boilers serve both the industrial facility in which they are located and a district heating network, distinguishing between energy consumption and emissions associated with a facility and those associated with district heating is difficult, at best. The methodology for making this distinction was changed in 1997, so data before and after this time are inconsistent. Apparently, both methodologies for attributing emissions from industrial sources to district heating are fairly arbitrary and may not accurately reflect the real breakout. The misattribution of emissions at the source level is compounded in sector-level data. Aggregate sector data, therefore, are thoroughly unreliable. Nevertheless, the data are used in Slovakia s official reporting of its GHG emissions. We also used sectorlevel data in this overview of Slovakia s CO 2 emissions. Figures 3.1 and 3.2 illustrate the discrepancy between sector-based and source-based data by looking at three broad sectors: central and district heating, power plants, and industry. Even though the source data represent emissions from sources greater than 5 MW, not from all sources in the sector, the source-based emissions data are consistently higher than the sectorbased data, which supposedly include all sources in the sector. Figure 3.1 Figure 3.2 Total Emissions by Sector Aggregate Sector Data Central & District Heating Power Plants Industry CO2 (kt) 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5, CO2 (kt) Total Emissions by Sector Source Data (>5MW) Central & District Heating Power Plants Industry 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5, Page 9

14 The discrepancy in data becomes even more pronounced when looking at the industrial sector more closely. Figures 3.3 and 3.4 illustrate the significant differences between bottom-up, source-based data and top-down, aggregate sector data. Figure 3.1 Figure 3.2 CO2 (kt) Total Industrial Emissions Aggregate Sector Data 30,000 25,000 20,000 15,000 10,000 5,000 Other (remaining)* Refineries,coke chambers Machinery & Engineering Cement & Constr.Materials Non-ferrous metal Chemicals Iron and Steel CO2 (kt) Total Industrial Emissions Source Data (>5MW) 30,000 25,000 20,000 15,000 10,000 5,000 Other (remaining)* Refineries,coke chambers Machinery & Engineering Cement & Constr.Materials Non-ferrous metal Chemicals Iron and Steel Slovakia s aggregate economy-wide carbon emissions data appear to be accurate. The data problems illustrated above lie in the breakdown of emissions by sector. Inaccurate data on sector emissions may lead to MRV difficulties in the context of international emissions trading. Because data quality is a key factor in setting the trading system target and estimating growth for uncapped sources, it is crucial that the government operate with accurate and verified fuel and emissions data. Therefore, we recommend that the government launch a special effort to improve the quality of the existing data systems and reconcile source-level (i.e., bottom-up) and aggregate (i.e., top-down) inventories. Page 10

15 4. Scope of CO 2 Emissions Trading in Slovakia 4.A Possible Options of Trading System Design A key issue in designing a domestic CO 2 emissions trading system is identification of the level at which sources will be required to surrender allowances for CO 2 emissions. The leading options are to implement the CO 2 cap-and-trade system either at the level of primary fuel producers, such as coal mines and natural gas processing plants (i.e., upstream ), or at or near the point of emissions (i.e., downstream ). Under an upstream system, primary fuel producers the extractors, processors, and carriers of fossil fuel would be required to hold allowances for potential CO 2 emissions embodied in their fuels. Under a downstream emissions trading system, the sources with direct emissions would be required to surrender permits for actual CO 2 emissions from fuel combustion and production activities. 4.A.1 Upstream Trading System An upstream system has a major advantage over a downstream system in that an upstream system covers all fossil fuel use and carbon emissions in an economy, thereby covering small sources not included in a downstream system. This breadth of coverage improves the efficiency of the trading system and minimizes the total cost to the economy. In contrast, a downstream system would cover large emission sources, such as power plants or large industrial facilities above a certain size threshold (i.e., 5 MW). Moreover, excluding some sources from the cap-and-trade system may enable those sources to gain a competitive advantage over sources that were included, which can potentially shift economic activities and emissions leakage to sources or sectors not covered by the trading system. In addition, an upstream approach is more cost-effective and administratively feasible in regulating carbon emissions than a downstream system is. An upstream system would regulate fewer industries and entities than a comprehensive downstream system and would therefore lower MRV costs. As shown in Table 4.1 below, Slovakia has three coal mines, one refinery, one domestic oil producer, one natural gas producer, and one natural gas importer. An upstream emissions trading program aimed at those entities, as well as at refined products and importers, would cover virtually all CO 2 emissions in the country. The drawback to an upstream system with so few entities is that the market for allowances would not be robust. In fact, a few entities could easily engage in oligopolistic behavior and use their market power to drive up the price of allowances. Purchasers of allowances would pass along those inflated prices to consumers. Conversely, with full international trading, the domestic price of allowances would never exceed the world price of allowances, unless a tariff or quota on international allowances were implemented. Page 11

16 Table 4.1. Number of Regulated Entities in an Upstream Carbon Trading System Industry Production Activities Number of Entities Coal Coal mine 3 Preparation plant n/a Oil Refining 1 Production 1 Pipeline 1 Refined product importers n/a Natural gas Pipeline 1 Production 1 Processing plant n/a n/a = not available. 4.A.2 Downstream Trading System A downstream system presents two key advantages over an upstream system. First, a downstream program would include more participants than an upstream program, thereby fostering a more dynamic allowances market. 2 Second, a downstream program may also be the preferred choice both culturally and politically. The major disadvantage of the downstream approach is the lack of coverage of total emissions in the economy. It is not administratively feasible to construct a system that includes all sources. In addition, covering small sources under the downstream system could be costly and administratively cumbersome. Leaving some emissions activities outside the cap-and-trade system could invite economic distortions and drive up the total costs of compliance. 2 The number of tons of carbon dioxide covered and traded would be greater in an upstream system. Page 12

17 Table 4.2 Number of Regulated Entities Greater than 5MW Capacity All sources above 5MW capacity # of facilities 1999 GHG emissions % of total GHG Cement % CHP 14 2, % Construction materials % Electricity 5 5, % Fuel extraction/processing 18 4, % Iron & steel 14 10, % Machinery % Metallurgy % Pulp and paper 8 1, % Textiles % Woodworking % Chemicals 32 1, % Commercial % District heating 326 1, % Food products % Waste Incineration % Agriculture 1000s % Transportation 1000s 3, % Residential space heating 1000s 4, % Non-CO2 GHG 1000s 11, % Total 51, % 4.A.3 Upstream Downstream Hybrid Approach Upstream and downstream systems are not mutually exclusive. On the contrary, combining upstream and downstream systems can overcome the weaknesses of both approaches and maximize the economic efficiency and environmental effectiveness of a trading scheme. 3 In an upstream downstream hybrid system, small emission sources (e.g., small industrial sources, residential and commercial direct combustion, and the transportation sector) would be covered upstream at the fuel processing and bulk transportation stages. The major challenge in implementing a hybrid system would be to avoid double-counting. Every ton of carbon must be counted once, and only once. Consequently, for accounting purposes the fuel producers and distributors regulated upstream would have to distinguish fuels consumed by large, capped sources from fuels consumed by small, uncapped sources. Although the Slovak government finds the hybrid option interesting, it is not inclined to adopt it because of the possible complications with the accounting. In addition, this option will not be accepted politically because Slovakia has a long history of regulating polluters directly and almost no experience with imposing environmental regulations on fuel producers. 3 Tim Hargrave, An Upstream/Downstream Hybrid Approach to Greenhouse Gas Emissions Trading. Washington, DC: Center for Clean Air Policy, Page 13

18 4.B Selection of a Trading Scheme for Slovakia The following key elements were evaluated in designing Slovakia s scheme for the CO 2 capand-trade system: Compatibility. Because Slovakia has already established a cap-and-trade system for SO 2, the CO 2 cap-and-trade system should be compatible with the SO 2 program both in scope and in MRV requirements. Preferably, resources and infrastructure would be shared to reduce administrative costs and increase economic efficiency. Existing environmental requirements (i.e., policies and measures [PAMs]) for the sources participating in the new trading system also should be evaluated to ensure that sources included in the trading system do not face PAMs with the same regulatory intent and to ensure that the sources get credit for the expenses associated with the PAMs. Familiarity with a trading system. Although not essential, familiarity with a trading scheme may be preferable. In general, the regulator and the regulated community would feel more comfortable choosing a system with which they already have experience. Familiarity with a trading system would ease the political barrier for passage of the regulation. In addition, the institutional capacity acquired from existing programs can reduce the up-front investment in learning a new system. Political considerations. In Slovakia, an important precedent exists for a downstream system in that the existing regulatory framework focuses on emitting sources directly. Administrative burden. The system should be designed so that the government s cost of administering the program is manageable. The Slovak government estimates that a trading system (in its initial stage) involving fewer than 300 sources is administratively manageable. Government tasks include maintenance of a registry, verification of emissions reports, distribution of allowances, technical assistance, and enforcement of penalties for noncompliance. Of course, the monitoring and reporting burden placed on emissions sources also should be manageable. Compatibility with the EU CO 2 trading system. Because Slovakia will accede to the EU, Slovakia s trading system eventually must be compatible with the EU system. Market power. The trading system must be designed to prevent one or a few companies from being able to manipulate the market for allowances. Effects on competition. Ideally, the system will be designed so that competing firms and industries face the same marginal cost of carbon control; CO 2 emissions controls therefore will not distort competition. This goal may be achieved by designing the CO 2 control strategy so that firms and industries in competition with one another are either both included in or excluded from trading. (If they are excluded, they should be subject to the same non-trading PAMs.) o Relationship of the trading system to non-trading PAMs. PAMs can reduce the efficiency of meeting total carbon reduction targets by forcing reductions in particular sectors or sources, which may result in a higher cost per ton of CO 2 reduction than trading provides. The overlay of trading on existing PAMs, Page 14

19 however, could improve their economic efficiency. For instance, a trading program that exceeded efficiency standards could give regulated sectors an incentive to make reductions beyond those required by the PAMs. Moreover, some PAMs could improve the efficiency of a trading system by addressing market failures. Economic Efficiency. The system should include as many sources as possible to provide the greatest possibility for cost savings through trading. Capturing the greatest number of sources and the highest percentage of total emissions in the trading system will generally reduce the total cost of CO 2 control, especially when the marginal costs of mitigation differ widely among sources and industries. Equity. The system should be designed so that the burden of CO 2 reduction is distributed fairly. 4.C Recommendations Considering Slovakia s familiarity with a downstream trading system (i.e., its SO 2 program), the potential for market power in an upstream trading system, and the difficulty of distinguishing fuel sold to large and small downstream sources in a hybrid system, we recommend that Slovakia implement a downstream CO 2 emissions cap-and-trade system. Our proposed initial trading system would include just under 300 sources, an easily manageable number. As discussed later in this report, we recommend that the Slovak government expand the downstream system as MRV systems improve and as the government creates the necessary administrative skills to manage a large number of sources. Eventually, the Slovak government could adopt an upstream downstream hybrid system to cover small emitting units or sectors not included in the upstream cap-and-trade system. The government can also consider including other gases, starting with methane, at a later stage. Page 15

20 5. Who participates in the trading system? 5.A Defining System Coverage We propose a sector-based approach to including participants in the trading system. Sectors that contribute most significantly to total CO 2 emissions would be included in the trading system. o Significant contribution is based on both total emissions and size distribution of sources. o For sectors included in the system, all sources above the size threshold either 5 MW or 20 MW will participate in trading. We recommend a 20 MW size threshold for district heating and a 5 MW threshold for all other participating sectors. The district heating sector s 326 sources greater than 5 MW would make administration of the system difficult. A 20 MW threshold would reduce the number of district heating sources to 57. Emissions in district heating are declining, so including district heating sources smaller than 20 MW to encourage emission reductions may not be necessary. Furthermore, because small district heating sources are tied to a local heating network, they have little opportunity to capture market share from large district heating systems that are in the trading system; therefore, competitive distortion caused by a 20 MW threshold is expected to be at a minimum. The government could eventually expand the system by lowering the threshold to 5 MW. Sectors in which emissions are difficult to monitor and verify, such as the chemical sector and the waste incineration sector, 4 also would be excluded, at least until monitoring and verification is improved. 5.A.1 Sector Selection On the basis of the criteria described above, the following sectors are included in the trading system (see Table 4.2 for the reference): Cement Iron and steel Pulp and paper Combined heat and power District heating Textiles Construction materials Machinery Woodworking Fuels Metallurgy Although the chemical sector is a major contributor of GHG emissions in Slovakia, the difficulty in monitoring and verifying emissions in the chemical sector, which has many different processes and products, is too great to include it in the trading system. Slovakia can include non-process emissions from the chemical sector, however. The proposed European 4 Waste incinerators in Slovakia are required to operate sophisticated equipment that monitors all conventional pollutants. Installing CO 2 emissions monitors on such equipment would be inexpensive and would allow waste incinerators to be included in the CO 2 trading program. Page 16

21 Commission s (EC) trading system, for example, excludes process emissions, but it includes emissions from electricity and heat production within the chemical sector. Once MRV procedures have improved, the Slovak government can include process emissions as well. Similarly, the waste incineration and food products sectors generate substantial process emissions that are difficult to monitor and verify. We recommend excluding those sectors until the MRV system in Slovakia is sufficiently improved to handle their emissions. 5 5.A.2 Sector and Source CO 2 Emissions An assessment of source size thresholds was conducted using the sectors that are in the trading system. Two size thresholds were considered as possible criteria for source participation in the trading system: 5 MW and 20 MW for combustion boilers, and 50 TJ of energy consumed in industrial processes. The energy consumption of 50 TJ roughly corresponds to the 5 MW boiler size. See figures below. 5MW Threshold 20MW Threshold In trading system Would be in NOT in trading system Would NOT be in In Trading System Would be in NOT in Trading System Would NOT be in 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Cement CHP Construction materials Electricity Fuel Iron & Steel Machinery Metallurgy Pulp and Paper Textiles Woodworking Chemicals Commercial District Heating Food Products Waste Incineration 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Cement CHP Construction materials Electricity Fuel Iron & Steel Machinery Metallurgy Pulp and Paper Textiles Woodworking Chemicals Commercial District Heating Food Products Waste Incineration Table 5.1 summarizes the emissions data reported to the Ministry of Environment. 6 In the analysis, CO 2 emissions from fuel combustion were estimated on the basis of the emissions factors of the fuel, total fuel consumption, and assumptions about oxidation factors. CO 2 emissions from industrial processes (i.e., cement, glass, and lime) with fuel input of 50 TJ or above were included, although the methodology for those emissions is not consistent among the sources and is not considered reliable or accurate by Profing, the company that compiled the data. The table presents the total number of sources, total thermal capacity, emissions, and share of emissions from each sector according to 1999 emissions data. As shown in the table, a total of 358 combustion and process sources would be included in the trading system if the threshold of the total capacity for sources were 5 MW thermal and 5 The cement and construction materials sectors generate process emissions, but those sectors are included in trading because the products and processes in these sectors are uniform, making emissions easier to monitor. 6 All energy-consuming sources with a total thermal combustion capacity of 5 MW or above are required to report their fuel use and emissions data to the Ministry of Environment in Slovakia. Page 17