Linking Carbon Markets
Linking allows allowances from one carbon market to be used for compliance in another. This expands the market, reduces costs, and can increase ambition. But linking also requires careful design to maintain integrity and manage risks.
What Is Linking?
Linking connects two or more carbon pricing systems so that:
- Allowances from either system can be used for compliance in both
- Prices tend to converge across linked systems
- Emissions reductions occur wherever they are cheapest
Linking carbon markets is like connecting two pools with a pipe. Water (allowances) can flow between them, and the water levels (prices) equalize. Each pool is still distinct, but they are no longer isolated.
Types of Links
Full bilateral linking:
Complete mutual recognition of allowances. Allowances from either system can be used in either system. Prices converge. Example: California-Quebec link.
One-way linking:
Allowances from System A can be used in System B, but not vice versa. Creates an asymmetric relationship. Example: Some offset provisions.
Indirect linking:
Two systems both accept credits from a third source (like international offsets) without directly accepting each other's allowances. Creates some price convergence without direct connection.
Restricted linking:
Partial recognition with quantitative or qualitative limits on cross-system use.
| Link type | Price convergence | Complexity | Sovereignty retained |
|---|---|---|---|
| Full bilateral | Complete | High | Shared governance needed |
| One-way | Partial | Moderate | Asymmetric |
| Indirect | Partial | Lower | High |
| Restricted | Limited | Moderate | Moderate |
Benefits of Linking
Economic efficiency:
Larger markets allow reductions where they are cheapest. If reducing a ton costs $30 in System A and $60 in System B, linked markets enable the $30 reduction.
Market liquidity:
More participants mean more trading opportunities, better price discovery, and lower transaction costs.
Reduced price volatility:
Larger markets are typically more stable, with shocks absorbed across a broader base.
Political benefits:
Linking demonstrates international cooperation and can strengthen political commitment.
Ambition ratchet:
Linking can enable more ambitious targets because cost-effective reductions are available across systems.
Challenges of Linking
Design alignment:
Systems must be similar enough to link. Significant differences in stringency, allocation, or rules create problems.
Sovereignty concerns:
Linking means accepting another jurisdiction's design choices. Price levels in your system become partly determined by the linked partner.
Contagion risk:
Problems in one system affect the linked partner. A loose cap or fraud in System A can undermine System B.
Governance complexity:
Linked systems need coordination mechanisms for rule changes, enforcement, and disputes.
Asymmetric outcomes:
Capital may flow from high-price to low-price systems, affecting domestic investment.
The California-Quebec link is the most successful North American example:
How it works:
- Mutual recognition since 2014
- Joint auctions held quarterly
- Common reserve price
- Harmonized rules where necessary
Key design features:
- Both systems maintain separate registries
- Allowances are fungible across systems
- Compliance can use either jurisdiction's allowances
- Joint market oversight
Challenges addressed:
- Currency differences (CAD vs USD)
- Different political systems
- Varying energy mixes
- Different offset provisions
Results:
- Prices have converged
- No significant problems
- Market liquidity improved
- Political cooperation strengthened
Lesson: Linking works when systems are similar and there is political commitment to cooperation.
Prerequisites for Linking
Before linking, systems should consider:
Compatibility:
- Similar MRV standards
- Comparable stringency
- Compatible allocation approaches
- Aligned compliance periods
Governance:
- Agreement on decision-making for linked system
- Dispute resolution mechanisms
- Coordination on rule changes
Trust:
- Confidence in partner's enforcement
- Transparency about system performance
- Shared commitment to integrity
Legal framework:
- Authority to recognize foreign allowances
- Treaties or agreements as needed
- Clear legal status of allowances
The EU-Switzerland Link
The EU-Switzerland link (2020) demonstrates linking between different-sized systems:
Key features:
- Full mutual recognition
- Registries connected
- Swiss allowances equivalent to EU allowances
Challenges addressed:
- Size asymmetry (EU much larger)
- Different aviation treatment
- Swiss voting requirements
- Governance structures
Outcome:
- Swiss prices converged to EU levels
- Increased liquidity for Swiss market
- Political benefits for both parties
Looking Ahead on Linking
Several potential links are discussed:
Within regions:
- EU with other European systems
- North American expansion
- Asian regional discussions
Cross-regional:
- Conceptual but distant given design differences
- Article 6 may provide alternative pathway
Challenges:
- Design divergence limits near-term options
- Political barriers significant
- Requires sustained diplomatic effort
Linking offers significant benefits but requires compatible systems and mutual trust. The trend is toward more linking over time, but major cross-regional links remain aspirational. Article 6 of the Paris Agreement may provide an alternative framework for international cooperation.
Looking Ahead
Article 6 of the Paris Agreement creates new frameworks for international carbon market cooperation. The next lesson examines Article 6 mechanisms and their implications.