This  geographic displacement of emissions is a concept known as leakage. EU Emissions Trading Scheme Established a Carbon Market and Provides Lessons That Could Inform U.S. Decision Making on Climate Change Policy

According to available information and experts, the primary effect of the  first ETS phase was to establish a functioning carbon market for emissions  allowances, but its effects on emissions, the European economy, and  technology investment are less certain. Nonetheless, experts  suggest that phase I offers important lessons about program design and  implementation that may prove useful in informing congressional decision  making. By  limiting the total number of allowances under the program and enabling  covered entities to sell or buy allowances to cover their emissions, the  ETS used market forces to set a price on carbon emissions that fluctuated  based on changes in supply and demand. The Effect of ETS Phase I on Emissions Is Uncertain Because of Data Limitations

Although the first ETS phase was overallocated—the overall emissions  cap exceeded actual emissions by more than 3 percent in phase I—the  ETS’s cumulative effect on emissions across the EU member states is  uncertain largely because of data limitations. The  researchers stated that some covered entities likely reduced emissions by,  for example, switching to cleaner fuels to generate power or improving  energy efficiency, in response to the allowance price in the early stages of  phase I. Impacts of concern  under the ETS have included leakage—the shifting of covered entities’  economic activities to countries that have not adopted binding emission  limits—and the competitiveness of covered entities, compliance costs, and  price changes for consumer goods and services, such as electricity. Specifically, the duration of phase I was not compatible with investment  decision timelines. Baseline Data

First, available information indicated that accurate baseline data are  essential to setting an effective emissions cap and achieving the intended  environmental objectives. Experts identified design features that would provide  incentives to reduce emissions even if the cap initially exceeds emissions. Allocation method. The experts commenting on timelines stated  that a trading program should cover a long enough time period to  influence technology investment decisions. The CDM’s Environmental and Economic Effects Provide Important Lessons That Can Inform Congressional Deliberations on Climate Change Policy

According to available information and experts, the CDM has enabled  industrialized countries to make progress toward achieving their  emissions targets at less cost and has involved developing countries in  these efforts; however, the program’s effect on emissions is uncertain, and  its impact on sustainable development has been limited. Nonetheless, the international experience with the CDM has provided key  lessons that may help inform congressional decision making. The CDM Has Enabled Covered Entities to Pursue Lower-Cost Reductions and Involved Developing Countries in the Global Carbon Market

Beginning operation in 2002, the CDM can allow countries to make  progress toward their emissions targets under the Kyoto Protocol at less  cost through the use of carbon offset credits. Despite Rigorous Review Process, the Net Effect of the CDM on Emissions Is Unclear

The overall effect of the CDM on international emissions is uncertain,  largely because it is nearly impossible to determine the level of emissions  that would have occurred in the absence of each project. The Scale and Cost- Effectiveness of the CDM Is Limited by the Current Project-by-Project Approval Process, but Proposed Reforms Could Improve Its Effectiveness

The CDM’s project-by-project approval process may not be a cost-effective  model for achieving emission reductions. Specific lessons from the ETS that the Congress may wish to consider  include: (1) the importance of ensuring the availability and reliability of  historic emissions data, with an accuracy compatible with the program’s  point of regulation, from entities that will be affected by the regulatory  scheme prior to its establishment; (2) the importance of long-term  certainty in encouraging investments in low-carbon technologies; and (3)  the importance of understanding how the means of distributing  allowances to emit greenhouse gases—such as free allocation versus  auctioning—may create and redistribute substantial wealth. Specific lessons from the CDM that the Congress may wish to consider  include: (1) that it may be possible to achieve the CDM’s sustainable  development goals and emissions cuts in developing countries more  directly and cost-effectively through a means other than the existing  mechanism; (2) that the use of carbon offsets in a cap-and-trade system  can undermine the system’s integrity, given that it is not possible to ensure  that every credit represents a real, measurable, and long-term reduction in  emissions; and (3) that while proposed reforms may significantly improve  the CDM’s effectiveness, carbon offsets involve fundamental tradeoffs and  may not be a reliable long-term approach to climate change mitigation.
Why GAO Did This Study

International policies to address climate change have largely relied on market-based programs; for example, under the European Union's Emissions Trading Scheme (ETS) phase I (2005 to 2007) carbon dioxide emissions reductions were sought by setting a cap on each member state's allowable emissions and distributing tradable allowances to covered entities, such as power plants. Beginning operation in 2002, the Kyoto Protocol's Clean Development Mechanism (CDM) has relied on offsets, allowing certain industrialized nations to pay for emission reduction projects in developing countries--where the cost of abatement may be less expensive--in addition to reducing emissions within their borders. Legislative proposals to limit greenhouse gas emissions are under consideration in the United States. In this context, GAO was asked to examine the effects of and lessons learned from (1) the ETS phase I and (2) the CDM. GAO worked with the National Academy of Sciences to identify experts in market-based programs and gathered their opinions through a questionnaire, interviewed stakeholders, and reviewed available information.

What GAO Found

According to available information and experts, the ETS phase I established a functioning market for carbon dioxide allowances, but its effects on emissions, the European economy, and technology investment are less certain. Nonetheless, experts suggest that it offers lessons that may prove useful in informing congressional decision making. By limiting the total number of emission allowances provided to covered entities under the program and enabling these entities to sell or buy allowances, the ETS set a price on carbon emissions. However, in 2006, a release of emissions data revealed that the supply of allowances--the cap--exceeded the demand, and the allowance price collapsed. Overall, the cumulative effect of phase I on emissions is uncertain because of a lack of baseline emissions data. The long-term effects on the economy also are uncertain. One concern about design and implementation was that the economic activities associated with emissions from covered entities would shift from the European Union to countries that do not have binding emission limits--a concept known as leakage. However, leakage does not appear to have occurred, in part because covered entities did not purchase allowances but received them for free. The effect of the ETS on technology investment also is uncertain but was likely minimal, in part because phase I was not long enough to affect such investments. Phase I of the ETS offers three key lessons: (1) accurate emissions data are essential to setting an effective emissions cap; (2) a trading program should provide enough certainty to influence technology investment; and (3) the method for allocating allowances may have important economic effects, namely, free allocation may distribute wealth to covered entities whereas auctioning could generate revenue for governments. According to available information and experts, the CDM has provided flexibility to industrialized countries with emission targets and has involved developing countries in efforts to limit greenhouse gas emissions, but the program's effects on emissions are uncertain, and its effects on sustainable development have been limited. Nonetheless, the CDM's effects reveal key lessons that can help inform congressional decision making. Specifically, the CDM has provided a way for industrialized countries to meet their targets that may cost less than reducing emissions at home; however, available evidence suggests that some offset credits were awarded for projects that would have occurred even in the absence of the CDM, despite a rigorous screening process. Such projects do not represent net emission reductions and can compromise the integrity of programs--including the ETS--that allow the use of CDM credits for compliance. We also found that the cost-effectiveness and overall scale of emission reductions are limited by the current project approval process, although proposed changes may improve its effectiveness. Key lessons from the CDM include: (1) the resources necessary to obtain project approval may reduce the cost-effectiveness and quality of projects; (2) the need to ensure the credibility of emission reductions presents a significant regulatory challenge; and (3) due to the tradeoffs with offsets, the use of such programs may be, at best, a temporary solution.