Josephine V. Yam

Carbon Finance: To Trade or Tax?

There are a lot of features of a Carbon Tax that make it an effective economic-incentive approach to address climate change:

  1. Carbon taxes lend predictability to energy prices. This allows for strategic decision-making involving energy to be made will full awareness of the carbon–appropriate price signals, whether it is design of new electricity generating plants to the purchase of the family car.
  2. Carbon taxes will provide quicker results. The taxes themselves can be designed and adopted quickly and fairly.
  3. Carbon taxes are transparent and are easier to understand than Cap & Trade. The government simply imposes a tax per ton of carbon emitted, which is easily translated into a tax per kWh of electricity or gallon of gasoline.
  4. Carbon taxes address all sectors and activities producing carbon emissions. They target carbon emissions in all sectors such as energy, industry and transportation.

Indeed, the three-letter word called “tax” can spell political suicide for some governments, especially in the midst of this global financial crisis. Thus, some governments may not be bold enough to espouse it as a strategic policy tool to fight climate change.

Written: 2011 November

The Issue of Double Counting in the Monitoring and Reporting of Greenhouse Gas Emissions (MRG)

There is a complexity inherent in MRGs, especially in respect of consistency of reported information. One related issue relates to international offsets and double counting.

The issue revolves around the following questions:

How will offsets be accounted for in reporting and reviewing countries’ progress toward meeting their emission-reduction targets under the Cancun Agreement? Will both developed (buyer) and developing (seller) countries be able to count emission reductions from offset projects towards their respective pledges? Or will only the buyers get to count them, as is currently the case under the Kyoto Protocol and domestic emissions trading systems?

Currently, there is uncertainty in the existing agreements. Most countries have not taken an official position on what they would be doing.

A Stockholm Environment Institute paper and policy brief entitled “The Implications of International Greenhouse Gas Offsets on Global Climate Mitigation” addressed this issue when the paper was presented at a carbon markets and accountability seminar hosted by the OECD and the International Energy Agency in April 2011.

The paper concluded that the use of international offsets, if counted both by the supplying (developing) and buying (developed) country, could effectively reduce the ambition of current pledges by up to 1.6 billion tons CO2e in 2020. It suggested that the current pledges could significantly fall 10% lower than the total abatement required to stay on a path consistent with limiting warming to 2°C. The paper assumed that each ton of offset credit represents a ton of emissions benefit. To the extent that offsets do not represent real, additional reductions, then the effective dilution of pledges could be even greater.

It would be highly beneficial if this double counting issue of international offsets is settled uniformly across the EU and globally in order to preserve the environmental integrity of the EU ETS and the upcoming emission trading systems around the world.

Written: 2012 March
Reference: Stockholm Environment Institute, “The Implications of International Greenhouse Gas Offsets on Global Climate Mitigation (2011)

What are the advantages and disadvantages of catastrophe bonds?


  • Catastrophe bonds have less credit risk because the total amount of funds which can be called by the (re)insurer if a catastrophe occurs are placed in trust. In contrast, reinsurers do not hold funds equal to their maximum exposure, and thus reinsurers have insolvency risk.
  • Catastrophe bonds also reduce agency costs relative to equity capital, because the funds raised from the bond issue are placed in trust and cannot be used by managers unless a specified catastrophe occurs.
  • Catastrophe bonds involve lower tax costs than equity capital, just as debt financing in general has a tax advantage relative to equity financing.
  • The catastrophe bond structure reduces financial distress costs relative to traditional subordinated debt, because the contingent payments are based on readily observable variables (the occurrence of a catastrophe) and the payments are agreed upon ex ante. Additional debt financing generally involves greater financial distress costs.
  • Catastrophe bonds have a moderating effect on reinsurance prices and prevent reinsurance prices from increasing any faster than they did. By presenting an alternative to traditional reinsurance, the development of cat bonds has forced reinsurers to become more competitive with pricing.
  • Investing in catastrophe bonds could be recommended since they have presumably low or zero correlation with other currently traded assets and are therefore a promising instrument for portfolio enhancement. Also, cat bonds have attractive risk/return characteristics, especially for those large, sophisticated investors they are designed for, such as mutual funds/investment advisors, proprietary/hedge funds, and (re)insurers.
  • Returns on catastrophe bonds are proven to be less volatile than either stocks or bonds.


  • The use of catastrophe bonds is hindered by regulatory constraints that generally require that the bonds be issued by an offshore special purpose vehicle. As a result, catastrophe bonds can involve substantial transactions costs. Transaction costs indeed represent approximately 2 percent of the total coverage provided by a catastrophe bond (for example, $2 million for a security providing $100 million in coverage). These costs include: underwriting fees charged by investment banks, fees charged by modelling firms to develop models to predict the frequency and severity of the event that is covered by the security, fees charged by the rating agencies to assign a rating to the securities, and legal fees associated with preparing the provisions of the security and preparing disclosures for investors. The price of a reinsurance contract would not typically include such additional fees.
  • Others institutions avoid purchasing catastrophe bonds altogether because it would not be cost-effective for them to develop the technical capacity to analyze the risks of securities so different from the securities in which they currently invested.
  • Catastrophe bonds are available only to institutional investors.
  • The market in cat bonds generally suffers from lower levels of liquidity relative to mainstream bonds.
  • The dramatic recent growth in the catastrophe bond market has in turn spurred the launch of some new insurance related businesses which could potentially undermine the long term growth prospects of the cat bond market.

Written: 2011 October

Inclusion of Airline Emissions by European Union Emissions Trading System (EU ETS) triggers International Law Dispute

The brewing international controversy of airline emissions being included in the European Union Emissions Trading System (EU ETS) highlights one of the risks of the EU unilaterally imposing a carbon market on its member countries while China, US and other major economies do not have their own carbon markets.

The Law

The European initiative, effective January 1, 2012, involves folding aviation into the six-year-old emissions trading system, in which polluters can buy and sell a limited quantity of permits, each representing a ton of carbon dioxide. The law requires airlines to account for their emissions for the entirety of any flight that takes off from — or lands at — any airport in the EU bloc. While airlines landing or taking off in Europe are included in the EU ETS beginning January 1, 2012, they do not have to start paying anything until April 2013.

The goal of this European initiative is to speed up the adoption of greener technologies at a time when air traffic, which represents about 3 percent of global carbon dioxide emissions, is growing much faster than gains in efficiency.

Consequences of the Law

Airlines will have to buy 15 percent of their emissions certificates at auction. Carbon emissions from planes will initially be capped at 97 percent of the 2004-2006 levels. The emissions rules apply from the moment an aircraft begins to taxi from the gate, either en route to or from a European airport, and they cover emissions for the flight from start to finish — not just the portion that occurs in European airspace.

Why the EU went ahead with the Law

Governments and airlines have been in negotiations for more than a decade over the creation of a global cap-and-trade system under the auspices of the International Civil Aviation Organization, an arm of the United Nations. The organization’s 190 member states passed a resolution in 2010 committing the group to devising a market-based solution, though without a fixed timetable.
Impatient with the pace of those talks, the European Commission moved ahead with its own plan, which was passed two years ago with the support of national governments and the European Parliament.

Airline arguments

Some 26 countries, including China, Russia and the United States, formally showed their dissatisfaction with the European system — a move that heralds a possible commencement of a formal dispute procedure at the International Civil Aviation Organization (ICAO), a U.N. agency that handles global aviation matters. They have questioned whether this EU directive is invalid. Their arguments include the following:

  1. Why the requirements apply to emissions from the entire flight, not just the portion that occurs within EU airspace?
  2. In applying its environmental legislation to aviation activities in third countries' airspace and over the high seas, the E.U. has violated fundamental and well-established principles of customary international law.
  3. The EU's actions infringe on the notion that each nation has sovereignty over its territory, a universally recognized principle of international law.
  4. By acting unilaterally, the European Union also breached international obligations that require such matters to be resolved by consensus under the auspices of the International Civil Aviation Organization (ICAO), a U.N. agency that handles global aviation matters.

In fact, China recently announced that its carriers would be forbidden to pay any charges under the European emissions system without Beijing’s permission.

EU Response to China and the other countries

The EU posits that the ETS is not a charge or a tax but a cap-and-trade system. Its defense includes the following claims:

  1. The purpose of our legislation is to reduce emissions, not make money.
  2. Including aviation in the ETS is "fully consistent with international law" because the EU is not seeking to extend its authority outside of its airspace.
  3. However, given the complaints of China and other countries, the EU could suspend parts of a new law requiring airlines to account for their greenhouse gas emissions if countries were to make clear progress this year toward establishing a global emissions control system.

Written: 2012 February

Why was there an over-allocation of allowances in the European Union Emissions Trading System (EU ETS)?

One reason why there was an over-allocation of allowances in the European Union Emissions Trading System (EU ETS) was because of national self-preservation. The EU gave its member states the authority to determine their specific allocation of allowances. In the name of protecting national economic self-interest, the member states over-allocated allowances to themselves, especially France, Germany and Italy. With no ability to bank allowances into the second phase because of their expiration dates, the allowance price of a Phase I allowance dropped to zero in 2007.

Written: 2012 February
Source: PriceWaterhouseCoopers (PWC). (2009). Carbon Taxes vs. Carbon Trading: Pros, cons and the case for a hybrid approach

What are the two main conditions that make emissions trading systems feasible in the European Union Emissions Trading System (EU ETS)?

Condition 1 - the participants covered by the program must be sufficiently varied for there to be potential gains from trading allowances. If all firms were the same, then they would all face the same abatement costs and so they would all be either net buyers or net sellers. Hence no trade would occur. In the European Union Emissions Trading System (EU ETS), the coverage includes power plants and five major industrial sectors (including oil, iron and steel, cement, glass, and pulp and paper) that together produce nearly half the EU’s CO2 emissions.

Condition 2 - there should be a sufficient number of polluters included in the scheme in order to ensure a reasonably liquid market. This increases the amount of trades that occur, hence allowing a clear price signal to emerge. In turn, this reduces the uncertainty that participants face when making long-term investment decisions because the expected gains from investing to abate are much clearer. Furthermore, the risk of any one participant holding extensive market power, which would restrict trading, is reduced. In the European Union Emissions Trading System (EU ETS), approximately 12,000 facilities in the 25 EU member states are covered.

In successfully meeting these two conditions, the EU ETS’ massive scale and breadth has enabled it to build a very robust emissions trading market in a short period of time. For example, in 2007, over 100 million allowances per month were traded. Moreover, rates of compliance amongst participants were encouragingly high.

Written: 2012 February