Restricted linking of emissions trading systems: options, benefits, and challenges

With over 17 emissions trading systems (ETSs) now in place across four continents, interest in linking ETSs is growing. Linking ETSs offers economic, political, and administrative benefits. It also faces major challenges. Linking can affect overall ambition, financial flows, and the location and nature of investments, reduces regulatory autonomy, and requires harmonization of ETS design elements. This article examines three options that could help overcome challenges by restricting the flow of units among jurisdictions through quotas, exchange rates, or discount rates. We use a simple model and three criteria—abatement outcome, economic implications, and feasibility—to assess these ‘restricted linking’ options. Quotas can enhance cost-effectiveness relative to no linking and allow policy-makers to retain control on the extent of unit flows. Exchange rates can create abatement and economic benefits or unintended adverse implications for cost-effectiveness and total abatement, depending on how rates are set. Due to information asymmetries between the regulated entities and policy-makers setting the exchange rate, as well as uncertainties about future developments, setting exchange rates in a manner that avoids such unintended consequences could prove difficult. Discount rates, in contrast, can ensure that both cost-effectiveness and total abatement are enhanced. Overall, restricted linking options do not achieve the benefits of full linking, but also avoid some major pitfalls, as well as offering levers that can be adjusted, should linking concerns prove to be more significant than anticipated.