Banking and Borrowing
Should entities be able to save allowances from one year for use in future years? Should they be able to use future allowances to cover current emissions? These questions of banking and borrowing have significant implications for price stability, flexibility, and environmental integrity.
What Are Banking and Borrowing?
Banking
Saving allowances from the current period for use in future periods. If you have surplus allowances this year, you can keep them for later.
Borrowing
Using future allowances to cover current emissions. If you need more allowances this year, you can use next year's allocation early.
Banking and borrowing work like saving and borrowing money. If you earn more than you spend this month, you can save the extra (banking). If you need more than you earn, you might borrow against next month's paycheck (borrowing). Carbon allowances can work the same way.
The Case for Banking
Banking provides valuable flexibility:
1. Smooths price volatility
If prices are low today and expected to rise tomorrow, entities will bank allowances for future use. This increases current demand, raising today's prices and reducing future prices. Banking helps smooth price fluctuations.
2. Enables efficient timing
Some emissions reductions are cheaper to make in certain years. Banking allows entities to reduce more when it is cheap and use saved allowances when reductions are expensive.
3. Rewards early action
Companies that reduce emissions early can save their surplus for later, receiving a return on their early investment.
4. Reduces compliance risks
If unexpected circumstances increase emissions in one year, banked allowances provide a buffer.
Most ETS systems allow unlimited banking. It is generally seen as beneficial for market function, price stability, and giving entities flexibility to optimize their reduction strategies.
The Risks of Banking
While banking has benefits, it creates some risks:
Surplus accumulation
If allowances accumulate over time (because caps are too generous or economic downturns reduce demand), a large bank can form. This bank can satisfy future caps without additional reductions.
Price suppression
A large bank acts like extra supply, keeping prices lower than they otherwise would be.
Delayed reductions
If entities bank heavily and use banked allowances later, actual emissions reductions may be deferred.
The EU's banking problem:
By 2013, the EU ETS had accumulated a surplus of about 2 billion allowances due to:
- The 2008 financial crisis reducing industrial output
- Over-generous initial cap setting
- High use of international offsets
This bank kept prices depressed for years. Even as the economy recovered, the surplus satisfied demand and prices stayed low.
The Market Stability Reserve (MSR) was created specifically to drain this surplus and restore price signals.
Managing Banking
Systems can manage banking through various mechanisms:
Unlimited banking with stability mechanisms
Allow banking but use price floors or supply adjustments to prevent price collapse. (EU approach with MSR)
Discount rates
Banked allowances might lose some value over time (e.g., 1 2019 allowance = 0.95 2024 allowances). Discourages excessive banking.
Expiration
Allowances expire after a certain period. Prevents indefinite accumulation.
Volume limits
Caps on how many allowances can be banked per entity or in total.
| Approach | Pros | Cons |
|---|---|---|
| Unlimited | Maximum flexibility | Risk of surplus accumulation |
| Discount rates | Reduces incentive to bank excessively | Complex, may distort timing |
| Expiration | Prevents indefinite accumulation | Reduces flexibility, sharp edges |
| Volume limits | Controlled risk | Limits beneficial smoothing |
The Case Against Borrowing
While banking is widely accepted, borrowing is more controversial:
1. Environmental integrity concerns
Borrowing effectively increases the current cap. If a company uses future allowances today, more emissions occur now, even if they are "paid back" later.
2. Default risk
What if a company borrows against future allowances and then goes bankrupt? The emissions occurred but the debt is never repaid.
3. Cumulative emissions matter
For climate, cumulative emissions matter, not just annual flows. Borrowing front-loads emissions, which may be worse for the climate even if eventually balanced.
4. Political risk
Future caps might be loosened. If a company borrows expecting to repay with future allowances, and caps are later relaxed, the borrowed emissions may never be offset.
Climate change depends on cumulative emissions over time, not just annual rates. This matters for borrowing:
The problem: If a company emits 100 tons today using borrowed allowances, and "repays" by emitting 100 fewer tons in 2030, the net emissions are zero. But the 2024 emissions warm the planet for 6 years before being offset.
Why this matters:
- CO2 persists in the atmosphere for centuries
- Every year of warming increases climate impacts
- Front-loading emissions accelerates warming
The asymmetry:
- Banking (delaying emissions) is climate-positive
- Borrowing (accelerating emissions) is climate-negative
- This asymmetry justifies treating banking and borrowing differently
A nuance: If borrowing enables investment that reduces emissions faster long-term, it might be beneficial. But this depends on specific circumstances and is hard to guarantee.
Limited Borrowing
Some systems allow limited borrowing within safeguards:
Within compliance period
Entities might use next year's allocation for this year's compliance, but only within the same multi-year trading period. This is really more "flexible timing" than true borrowing.
Automatic allocation advance
Some systems issue multi-year allocations upfront, effectively providing built-in borrowing capacity.
No cross-period borrowing
Most systems prohibit borrowing across major compliance periods.
California's approach:
California does not allow traditional borrowing but provides flexibility through:
- Multi-year compliance periods (every 3 years)
- No annual surrender requirement within the period
- Entities can manage emissions across the 3-year window
This provides some borrowing-like flexibility without creating true cross-period debt.
Price Stability Effects
Banking and borrowing affect price stability in different ways:
Banking stabilizes prices:
When prices are low, entities bank (increasing demand, raising prices). When prices are high, entities sell banked allowances (increasing supply, lowering prices). This creates natural price smoothing.
Borrowing could destabilize:
If borrowing were allowed, a price spike might trigger massive borrowing, collapsing prices. This could create boom-bust cycles.
Banking acts like a dam on a river, smoothing water flow. When the river runs high (lots of allowances), the dam stores water. When it runs low (scarcity), the dam releases stored water. Unlimited borrowing would be like allowing the river to run backward, creating unpredictable flows.
Design Recommendations
Based on experience, most systems:
Allow unlimited banking
The benefits of flexibility and price smoothing outweigh the risks, especially with complementary mechanisms like price floors or stability reserves.
Restrict or prohibit borrowing
The environmental integrity and default risks make borrowing problematic. Limited within-period flexibility may be acceptable.
Use complementary mechanisms
Price stability mechanisms (covered in the next lesson) can address banking-related surplus issues without eliminating banking's benefits.
Looking Ahead
Banking and borrowing are part of a broader set of flexibility and stability mechanisms. The next lesson explores price stability mechanisms that directly address carbon price volatility, including price floors, ceilings, and reserves.