Types of Links and Design Considerations
Linking carbon markets requires careful attention to design details. Differences in how systems are designed can create problems when they connect. This lesson examines the key design considerations for successful linking.
Design Dimensions That Matter
When considering linking, several design dimensions must be aligned or reconciled:
Cap stringency Allocation methods Price stability mechanisms Offset provisions Compliance and enforcement MRV standards
Significant differences in any of these areas can undermine linked market integrity.
Cap Stringency
If one system has a loose cap and another has a tight cap, linking creates problems:
The dynamic:
- Allowances flow from the loose system to the tight system
- Prices converge toward the lower level
- The tight system achieves fewer domestic reductions
- Overall ambition may decline
Stringency mismatch example:
System A: Loose cap, $20/ton price System B: Tight cap, $60/ton price
After linking:
- Allowances flow from A to B
- Price converges around $35
- System B entities buy from A instead of reducing
- System A entities sell surplus
- Net result: System B's ambition is diluted
This is only acceptable if the combined cap represents appropriate total ambition.
Solutions:
- Only link with systems of comparable ambition
- Adjust caps before linking
- Use exchange rates (2 allowances from A = 1 from B)
Allocation Methods
Different allocation approaches create complications:
Free allocation differences: If one system gives generous free allocation and another auctions fully, linked markets may see:
- Different competitive positions for similar industries
- Political tensions about fairness
- Lobbying for harmonization
Benchmark differences: If benchmarks differ, same products face different allocation levels.
Output-based vs historical: Mixing approaches creates incentive mismatches.
Perfect harmonization is not required, but major differences in allocation philosophy can create tensions. The California-Quebec link works partly because both systems use similar allocation approaches.
Price Stability Mechanisms
Price floors and ceilings create specific linking challenges:
Price floors: If one system has a floor and another does not, allowances cannot flow to the floor-less system when prices are below the floor. This can break the link.
Price ceilings: If one system has a hard ceiling, unlimited supply becomes available at that price, affecting both systems.
Different trigger levels: Even if both have floors/ceilings, different levels create discontinuities.
The California-Quebec link required harmonization of price mechanisms:
Initial situation:
- California had auction reserve price
- Quebec had similar but not identical mechanisms
Harmonization:
- Joint auction reserve price established
- Price containment reserves aligned
- Shared mechanism for determining settlement
Ongoing coordination:
- Both jurisdictions must agree on changes
- Regular coordination meetings
- Joint regulatory processes
Lesson: Price mechanisms must be harmonized or at least compatible. This requires ongoing coordination, not just initial alignment.
Offset Provisions
Different offset rules create arbitrage opportunities:
Quality differences: If System A accepts lower-quality offsets than System B, participants will:
- Acquire cheap offsets in A
- Use allowances freed up in B
- Net environmental benefit is reduced
Quantitative limits: Different limits on offset use complicate compliance.
Eligible project types: Different eligible projects create uneven treatment.
Solutions:
- Harmonize offset rules before linking
- Accept the stricter standard
- Exclude offsets from linking
Compliance and Enforcement
Linked systems need comparable enforcement:
Penalty alignment: If one system has weak penalties, violations may concentrate there.
Verification standards: Different verification requirements may mean data quality varies.
Legal frameworks: Enforcement powers differ across jurisdictions.
Mutual recognition: Trust that partner system enforces effectively.
MRV Standards
If monitoring, reporting, and verification standards differ:
Higher uncertainty: Data from one system may be less reliable.
Arbitrage opportunities: Facilities may game differences in measurement approaches.
Solutions:
- Mutual recognition of equivalent standards
- Harmonize key protocols
- Joint verification oversight
Governance Considerations
Linked systems require ongoing governance:
Rule changes: How are changes to either system's rules handled? Do they require partner approval?
Dispute resolution: How are disagreements resolved?
Exit provisions: What happens if one party wants to unlink?
Information sharing: What data must be shared between regulators?
| Governance issue | Options |
|---|---|
| Rule changes | Unilateral with notice / Joint approval required |
| Disputes | Mediation / Arbitration / Joint committee |
| Exit | Immediate / Notice period / Wind-down provisions |
| Information | Full transparency / Limited sharing / Regular reports |
The Exchange Rate Option
One approach to managing differences is using exchange rates:
How it works: Instead of 1:1 recognition, systems trade at a ratio. For example, 2 allowances from System A equal 1 from System B.
When useful:
- Systems have different stringency
- Different carbon content definitions
- Different unit sizes
Challenges:
- Politically difficult
- Implies one system is "lesser"
- Creates complexity
Assessment Framework
Before linking, assess:
1. Compatibility: How similar are the systems on key design dimensions?
2. Trust: Do you have confidence in the partner's implementation?
3. Capacity: Can both systems manage linked market operations?
4. Political support: Is there domestic support for linking?
5. Legal authority: Does the legal framework allow linking?
Linking is like merging two companies. Success depends on cultural compatibility, aligned incentives, strong due diligence, clear governance, and ongoing coordination. Rushing into a bad link can harm both parties.
Looking Ahead
Beyond bilateral linking, Article 6 of the Paris Agreement creates new frameworks for international carbon market cooperation. The next lesson examines Article 6 and its implications for global carbon markets.